The interest-rate path appears to be stabilizing as inflation trends decline from the high levels seen in the summer of 2022. However, there are concerns that rate cuts will not happen as quickly as the market expects. We continue to think that most of 2024 will be an oscillation of expectations, shifting between cuts to no change in rates. Artificial intelligence (AI), clean energy and cloud computing are a few key macro elements providing a tailwind to global economies and equity market outlooks.
Strategy highlights
- Activism: It was a record-breaking year for activist campaigns in 2023. Higher interest rates and other headwinds have led to slowing growth for certain companies, thereby creating opportunities for activist investors.
- Discretionary global macro: Forward-looking and nimble managers should find ample trading opportunities in the months ahead as markets focus on the upcoming US election and potential monetary policy changes across regions.
- Insurance-linked securities (ILS): Despite continued catastrophe-bond market spread tightening, the forward-looking opportunity set remains attractive. Early indications are that 2024 could be another year of record primary market issuance
|
Strategy |
Outlook |
|---|---|
| Long/Short Equity | Maintain an underweight outlook as sentiment continues to be driven by AI, and volatility remains extremely low. However, dispersion is improving as the market focuses more on company-specific factors and less on rates. High gross exposures reflect managers’ confidence in their portfolios. |
| Relative Value | Underweight for convertible and fixed income arbitrage, and neutral for volatility arbitrage. Regulatory uncertainty and excess capital negatively impact our outlook for fixed income and convertible arbitrage, respectively. Volatility arbitrage is suffering from low realized and implied volatility levels but presents an attractive entry point to be long protection in case of unexpected market moves. |
| Event Driven | Neutral outlook for traditional event-driven strategies, with a notable overweight for activism. Merger arbitrage and special situations investing are benefiting from a pickup in activity, offset by higher regulatory and political risks. Activism represents a bright spot given fresh portfolios and ample targets for new campaigns. |
| Credit | Modest downgrade to a neutral outlook, given tight absolute credit spreads and excess capital allocated to the space. We continue to favor trading-oriented and relative value strategies such as long/short credit due to expectations that dispersion across issuers will likely stay high. Cautious outlook for structured credit given directionality and liquidity risks. |
| Global Macro | The environment remains constructive for macro managers, especially those that can trade tactically around major political and policy events. Campaigning ahead of the US election may contribute to market volatility and create trading opportunities. Monetary policy adjustments and regional differences are also likely to remain a key factor for both directional and relative value trades. |
| Commodities | Volatility across commodity markets, most notably energy and agriculture, remains high due to a variety of geopolitical and macro factors. This elevated volatility should continue to provide plenty of relative-value trading opportunities. |
| Insurance-Linked Securities (ILS) | Following a more orderly January renewal period relative to January 2023, the ILS market remains attractive. Despite recent tightening, the rate-on-line for private ILS strategies and the catastrophe bond market spread remain elevated and provide appealing total yield potential. |
Macro themes we are discussing
As we have been alluding to for almost a year, the Federal Reserve (Fed) remains laser-focused on inflation. Not too long ago, the Fed suggested that there may very well be five or six rate cuts in 2024 since inflation inputs appeared to be showing signs of relief. Apart from the Fed’s actual course of action, the world is full of Fed forecasters, which we find ironic since even the Fed itself has indicated that it is taking each data point and meeting one at a time and that it finds forecasting to be a challenging task in this unique historical environment. Our ongoing concern is that the neutral interest rate may very well be higher than the Fed and market expect, potentially causing a re-pricing of risk.
We expect that 2024 will be an oscillation of expectations, with outlooks shifting from a state of weak growth and lower future interest rates to a state of solid growth and steady rates, and even possibly to a state of very strong growth and resurfacing inflationary pressures. This “oscillation of expectations” will likely provide many alpha opportunities across numerous investment factors, regions, asset classes and trading strategies.
We continue to think that the technology sector is likely to be the leader of overall market strength. As that strength wanes, we may see more of a rotation trade toward the end of 2024. Of course, there are many potential potholes and sharp curves in the road ahead. Over the course of this quarter, we expect investors to take strong note of the earnings cycle, economic growth and central bank rhetoric. Over the summer, the US election cycle should be front and center stage, where tickets are free but the after party has the potential to be costly.
Items of most concern include the possibility that economic growth/inflation/interest rates will stay higher for longer than the market is currently discounting. We are asking ourselves lots of questions about ways that these risks could materialize. Will AI have a more powerful and/or quicker impact than many think? Is immigration growth in the United States strengthening, thereby fueling the country’s growth engine? Geopolitical pressures continue to rise. While today’s market environment has had the tendency to look through these events relatively quickly, will there be a situation that causes a sustainable risk-off liquidation? If interest rates do not fall quickly, what will the consequences be for real estate, private credit and banks, as well as for less-regulated financial institutions? What does recent strength in the metals complex mean?
One change in our list of favorite strategies is the inclusion of activism. We think that there is value in the market today that can best be realized by activist investors. We maintain our other two strategy highlights (discretionary global macro and insurance-linked securities) for all the reasons we have stated over the past 9-12 months. Investors should consider diversifying strategies and top-down-driven global macro as a complement to their long-only portfolios, which are only becoming more and more correlated to one another. We think it is prudent to think of future returns and risk distributions as being wider and having fatter tails to both the upside and downside. Active asset managers, of which hedge funds are the most agile and dynamic, may need to be a larger component of asset owners’ portfolios for the foreseeable future.
Q2 2024 outlook: Strategy highlights
Activism
It was a record-breaking year for activist campaigns in 2023, following what was also a very busy year in 2022. The increasing prevalence of campaigns indicates positive momentum among activists in pushing for change at target companies. Higher interest rates and other headwinds have led to slowing growth at certain companies, thereby creating opportunities for activist investors to push for things like margin expansion, new management or modified capital allocation plans. It’s worth noting that the record year in 2023 happened despite limited M&A activity. If dealmaking were to pick up, it could encourage additional campaigns. From a performance perspective, the high number of campaigns indicates a freshness for the underlying portfolios. Fresh portfolios mean that the expected return lies ahead in contrast to legacy situations that are rolling off. It’s important to note that beta plays a significant role in the activist space, as most managers are long-biased or even long-only. Furthermore, the strategy tends to focus on small- and mid-cap companies (greater potential for mismanagement vs. large caps), so there is potential to benefit from a reversion given the significant outperformance of large caps recently.
Exhibit 1: Activist Campaigns
2019–2023
Source: S&P Capital IQ. Important data provider notices and terms available at www.franklintempletondatasources.com.
Discretionary global macro
Central-bank policy is nearly always an important driver of market moves, and this has been especially true since the resurgence of inflation led many central banks to aggressively raise rates beginning in 2022. As inflation has cooled, policy rates have mostly stabilized at higher levels. Just as some investors began to price in a potential turning point for the Fed and European Central Bank (ECB), the Bank of Japan (BoJ) ended its years-long negative interest rate policy (“NIRP”) by hiking to a target rate range of 0.00%-0.10%. While this move appears incremental in the context of more aggressive changes in other jurisdictions, it also marks the end (at least for now) of the NIRP era.
Many macro managers have been focusing on this shift, both for its direct impact on Japanese markets as well as its potential indirect impact on international markets where Japanese investors have played an important role in recent years. As the policy environment continues to evolve, especially with differences in direction between regions, the environment may continue to provide ample opportunities for macro-focused investors.
Exhibit 2: Policy Rates Set by the Fed, ECB and BoJ
January 1, 2000–March 22, 2024
Source: Bloomberg. Important data provider notices and terms available at www.franklintempletondatasources.com.
Insurance-linked securities (ILS)
Despite recent rate and spread tightening, we believe the forward-looking total yield potential in ILS markets remains attractive. As for catastrophe bonds, the spread tightening that occurred throughout 2023 continued into the first few months of 2024, particularly as a large volume of bonds matured in January and further exacerbated the ongoing supply/demand imbalance in the market. Given the projections for an extremely active year of primary market issuance, coupled with the fact that we’ve already seen over US$5 billion of such offerings during the first quarter, we expect spreads will likely stabilize as we approach hurricane season. The combination of increasing investor demand for more senior ILS risk and higher total insured values (likely due to economic inflation) has led the catastrophe bond market to reach its largest size on record. The current spread environment, coupled with meaningful collateral return, continues to provide, in our view, an attractive entry point for investors into the catastrophe bond market.
Exhibit 3: Catastrophe Bond Market Spread
January 2014–February 2024
Sources: Swiss Re, Aon Benfield.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The allocation of assets among different strategies, asset classes and investments may not prove beneficial or produce the desired results. Some subadvisors may have little or no experience managing the assets of a registered investment company. International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Derivative instruments can be illiquid, may disproportionately increase losses, and have a potentially large impact on performance.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default. Currency management strategies could result in losses to the fund if currencies do not perform as expected.
Commodity-related investments are subject to additional risks such as commodity index volatility, investor speculation, interest rates, weather, tax and regulatory developments. Short selling is a speculative strategy. Unlike the possible loss on a security that is purchased, there is no limit on the amount of loss on an appreciating security that is sold short. Investments in companies engaged in mergers, reorganizations or liquidations also involve special risks as pending deals may not be completed on time or on favorable terms. Liquidity risk exists when securities or other investments become more difficult to sell, or are unable to be sold, at the price at which they have been valued.
Active management does not ensure gains or protect against market declines.