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Q4 2021 Hedge Fund Outlook

Premier paragraphe

A gradual transition toward a more 'normal' mid-cycle… We think global growth has peaked but will remain above average, boosted by broadening consumption and surging capex. A return to more 'normal' has already started but will likely take more time than anticipated, complicated by covid variant(s), supply chains disruptions, firming inflation and more hawkish central banks, and multiple political wildcards. The cycle remains modestly supportive for risk assets. In perspective, over the last 30 years, transitions to a mid-cycle usually resulted in few months of less comfortable phase of wait-and-see, before more bullish market trends could resume.

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… has substantial implications for the alpha backdrop. First, markets sensitivity to covid trends would gradually decline, except for segments most hit by restrictions. Second, markets would be more driven by traditional macro fundamentals. Growth, inflation, productivity, leverage would be stronger market movers and asset prices would better respond to their fundamentals. Third, we expect central banks to be cautious, which would limit bond market volatility, but their uneven pace would fuel greater regional and asset discrimination. These divergences would provide a pool of relative opportunities. Fourth, as global liquidity moderate, we expect fewer trading and valuation anomalies and better capital allocations, another positive for alpha. However, the biggest wildcard would come from politics, as government seek to withdraw stimulus, reduce inequalities, and protect strategic segments. Speculative in nature, political choices regarding fiscal spending, tax and labor regimes, regulations, allocation of public investments, would be the main challenges for alpha generation.

L/S Equity: healthier alpha with potholes and less juice (gOW Diversified, kN Neutral). As we return to more 'normal', stock returns would be more driven by their corporate fundamentals than by changes in valuation multiples. Less erratic quant factor rotations would set a more stable ground for alpha generation. More themes would emerge beyond covid, with corporate activity providing many price movers. Higher rates would also mean more DCF and business model differentiation. Alpha from short books would improve, less vulnerable to short-squeezes and favored by more generous valuations, primarily supporting neutral styles. However, politics would spur volatility in sectors most exposed to tax, labor, public spending changes. Richer valuations and more limited stock dispersion would also reduce the arbitrage potential.

Event Driven: Merger Arb. and Special Situations both appealing (gOW). The menu of merger opportunities would be plentiful both in the US and EU, with a rising share of hostile deals (riskier but juicier) and heavy private equity funding. Some deal breakups hurt merger spreads early 2021, but they remain small in proportion. Greater regulatory scrutiny is the key risk as authorities tighten their oversight of antitrust and strategic companies. Yet, at 6% on average, deal spreads dwarf IG or dividend yields and factor higher regulatory risk, evidenced by conservative implied deal-probabilities.
Special Situations would benefit from companies' restructuring and soaring asset sales. Multiple extraordinary shareholders meetings, where corporate changes are decided, suggest the trend is not over. Managers' exposures are modest and well balanced across sectors, mitigating their market beta exposure. Activists, often lead indicators for this segment, focus on smaller caps and are starting discussion or taking small stakes in a variety of companies, suggesting they are no short of ideas. However, softening growth and liquidity will require more patience for special situations’ opportunities to come to fruition.

FI Arbitrage: EM Credit and FI Relative Value (kOW) favored over L/S Credit (mUW). Low dispersion in credit is leading managers to move to riskier issues, as well as loans and securitized credit (that are less sensitive to spreads but more sensitive to low default rate and liquidity). We see credit spreads modestly widening as we move into a mid-cycle, which would restore some alpha potential. Until then, we favor EM Credit that would benefit from diverging macro and central banks exit strategies, as well as more affordable valuations. FI relative value are also set to benefit from diverging rates and are expert in trading monetary policies.

Global Macro: Gradual reweighting (kOW). While top-down strategies usually suffer at each turn of the economic cycle, they tend to thrive afterward. As we return to more 'normal', traditional economic fundamentals would be stronger drivers, with fewer trading and valuation anomalies from excess liquidity. Declining fiscal and monetary support would accentuate regional disparities, creating relative opportunities. Diverging inflation trends and central banks’, especially in EM, will be key market movers. Managers have reduced their exposures since the summer and have dry powder to benefit from these opportunities.

CTAs: Contrasted outlook (mN). We see no indication of major asset trends' pending reversals (which hurt CTAs the most). The market structure is sound, and many asset trends have recently been reset, are not overly stretched, and do not display unsustainable correlation anomalies. However, the phase of the cycle would be less supportive, with softer market directionality. A higher share of assets trading in a range could result in small but more frequent market reversals, capping CTAs' performance.