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What a difference a month makes

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Over the recent weeks, market conditions switched swiftly from panic mode to exuberance mode. 

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What a difference a month makes

Over the recent weeks, market conditions switched swiftly from panic mode to exuberance mode. Active investors are left behind scratching their heads about what markets are discounting now on the risk of U.S. recession and monetary policy normalization. In our view, the January rally is an opportunity to gradually reduce risk in portfolios, especially in Europe where the probability of a hard Brexit rose last week. The U.S. equity market rebound was led by value stocks, which looks unsustainable. Yet, an aggressive de-risking seems premature with U.S. recession risk in check this year.

In the meantime, hedge fund strategies experienced a symmetric move. Those who suffered in December rebounded last month (L/S Equity, Special Situations) while those who were resilient at the end of 2018 lagged behind. Looking at the performance over the past two months, Event-Driven stands out as the outperforming strategy and Macro/ CTAs as the underperforming one according to broad benchmarks. CTAs suffered from the trend reversal in equities at the turn of the year, down 3.3% in January after a dismal year in 2018. Their long positioning on bonds is now at risk if improved economic expectations eventually translate into higher bond yields, as we expect. 

Where does it take us in terms of strategic allocation? First, we keep preferring strategies that managed to be resilient in recent downturns without suffering during the rebound. That includes Merger Arbitrage and Fixed Income Arbitrage and to a lesser extent L/S Equity Market Neutral and Global Macro. Second, we stay cautious on L/S Equity strategies with an elevated net market exposure and prefer flexible L/S Equity strategies that can adjust their beta according to market conditions. Third, the outlook on EM assets has improved with the Fed turning less hawkish. EM-focused Global Macro strategies could benefit from it. We thus have a bias in favour of Global Macro versus CTAs. The latter tends to face difficulties when markets experience such gyrations. But CTAs will protect portfolios if things go wrong and a persistent downward trend in risk assets takes shape eventually. 

Overall, we continue to believe that alternative strategies are attractive relative to traditional assets at this stage of the business cycle. But caution is required on strategies with a long equity market bias and selectivity is key from both a top down and bottom up perspective.