Macro & Market Views
A gradual normalization is under way. Global growth has peaked but will remain above average, boosted by softer but broadening consumption and by surging capex. However, the return to normality will likely take more time than anticipated, hindered by supply issues. Pressures from supply-chains bottlenecks and energy prices on production and labor markets would get worse before they get better.
The uncertain inflation path would keep central banks on a less easy footing, moderating global liquidity. Finally, policies would add risks to growth prospects as governments start withdrawing stimulus, while rethinking ways to mitigate inequalities, often deepened by the pandemic.
Country divergences would accentuate, reflecting uneven recovery stages out of the pandemic, as well as heterogenous inflationary pressures, central banks' exit strategies and policy choices. China, which led the recovery, faces a continued economic deceleration, amplified by the reorientation of its economic model and by its real-estate imbalances. Pent-up demand would fuel activity in the U.S. Growth would stay firm despite several hurdles, including the pending fiscal cliff, debt-ceiling stalemate, and looming tax reforms.
Europe remains on its reflation path. Shallower inflationary fundamentals would also allow policy mix normalization to be more gradual. A fourth wave of Covid-19 infections delayed Japan's recovery, which would resume in Q4. Vaccination is unevenly gaining traction in EM countries, where the recovery has further to go. Yet, China's economic slowdown, soaring commodities inflation and tighter liquidity in developed markets would be stones in their shoes.
The backdrop remains modestly supportive for risk assets, but the uncertain inflation path, recalibration of growth expectations, and a higher wall of worries, will likely translate into bumpier market trends. We trim our O/W on global equities, downgrading US equities to neutral, favoring sectors likely to benefit from a steeper yield-curve and from fiscal policy changes. We remain O/W on EMU (focusing on cyclical sectors) and Japan. We stick to U/W 10y Govies and to Neutral HY on both side of the Atlantic. Inflation risks are better hedged through cyclical commodities in our view than with breakeven that may have run much of their course (Neutral breakeven in the US & EMU) or gold (Neutral). Within EM BRICS, we favor Brazil and Russia over China (still Neutral).
A gradual transition toward a more 'normal' mid-cycle will likely have substantial implications for hedge funds' alpha. More fundamental pricing and greater focus on micro developments will be supportive, while widening regional divergences would open more relative opportunities. Policy choices regarding fiscal spending, tax and labor regimes, regulations, allocation of public investments would be the biggest wildcard and hurdle for alpha.
This new phase would be net supportive for L/S Equity, benefitting from a healthier stock-picking environment, though rich valuations and low dispersion could constrain the potential for arbitrage. Opportunities for both Merger Arbitrage and Special Situations will likely remain plentiful. However, the former is expected to navigate serious regulatory risks, while Special Situations' holdings would take more time to come to fruition. Until credit spreads and dispersion improve for L/S Credit, we favor EM Debt and FI Relative managers, who would benefit from diverging inflation and central banks ‘exit strategies.
While Global Macro tend to suffer when the cycle turns, they usually thrive afterward. We would reweight the strategy at the expense of CTAs (downgraded to Neutral). Signs of major trend reversals are limited, but the phase of the cycle would be less favorable, with softer and bumpier market directionality.