The trajectory of interest rates is beginning to level off as inflationary pressures ease. Nonetheless, there’s a growing sentiment that rate cuts may not materialize as swiftly as investors are predicting. In this third quarter outlook, our perspective remains that fluctuating expectations will mark the bulk of 2024. Artificial intelligence (AI), clean energy and cloud computing stand out to us as significant macroeconomic factors that are likely to provide momentum to worldwide economies.
Strategy highlights
- Equity market neutral: The spread between dispersion and volatility is at the widest levels of the past 10 years. Winners and losers are largely canceling themselves out at the index level but provide plenty for stock pickers to choose from.
- Discretionary global macro: Market reactions to incremental data releases and political developments have picked up, with manager conviction on directional themes appearing lower. This environment may favor tactical trading, especially heading into the US election.
- Commodities: Geopolitical tensions in tandem with an active wind season, warmer-than-average climate, and general supply and demand fundamentals allow for a vast array of interesting trades.
|
Strategy |
Outlook |
|---|---|
|
Long/short equity |
Upgrade to neutral given higher sustained levels of dispersion. Idiosyncratic risk is driving price action, and high gross exposures reflect managers’ confidence in their portfolios. AI represents a massive product cycle to create winners and losers. |
|
Relative value |
Underweight for fixed income and convertible arbitrage, neutral for volatility trading. Significant excess liquidity has compressed volatility and dispersion across many asset classes, limiting opportunities for relative-value trading but offering attractive entry points for a potential volatility increase. |
|
Event driven |
Neutral outlook for traditional event-driven strategies, with a continued 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 favorable sentiment and a busy campaign calendar. |
|
Credit |
Recent downgrade to an underweight given excess of available capital and tight spreads. There is potential for improved dispersion between issuers to benefit long/short credit managers, but volatility remains low. Structured credit is still marginally more attractive in our view than corporate, though that market also suffers from lower return expectations and higher illiquidity risk. |
|
Global macro |
Markets have been highly reactive to new data in anticipation of policy shifts and political elections. This environment may continue to favor tactical strategies over long-term thematic approaches with a greater frequency of trading opportunities as well as event risks. |
|
Commodities |
Opportunities across commodity markets, encapsulating energy, metals and agricultural, continue to persist due to weather, various macro factors and continued geopolitical tensions across the globe. The current environment allows participants to capitalize on fundamentals and technicals alike. |
|
Insurance-linked securities (ILS) |
After 13 months of spread tightening in the cat bond sector, a reversal occurred, leading to widening ahead of the upcoming wind season. This has led to deals pricing on the wide end, if not outside, of initial guidance, resulting in a couple deals being pulled from the market. We continue to favor the sector given its attractive yield potential in addition to cleaner structures and underlying terms and conditions. |
Macro themes we are discussing
For nearly a year, we've been suggesting that the Federal Reserve (Fed) is highly attentive to inflation. During the fourth quarter of 2023, the Fed intimated the potential for up to five or six rate reductions in 2024 as indicators of inflation began to show easing. Yet, despite the Fed's planned path, there's an abundance of Fed predictors. This seems a bit paradoxical since the Fed itself has expressed its approach of considering each data point and meeting sequentially and acknowledges the complexities of forecasting in this unparalleled historical period. We remain concerned that the actual neutral interest rate might exceed what both the Fed and the market are predicting, which could lead to a reassessment of risk levels.
Six months ago, we anticipated a number of issues would characterize the market characterize the market, including a pendulum of expectations about growth and monetary policy, swinging from prospects of subdued growth and reduced future interest rates to scenarios of strong growth with consistent rates and possibly even to vigorous growth with renewed inflationary pressures. This pendulum swing in expectations is expected to continue to create numerous alpha opportunities across different investment factors, regions, asset classes and trading strategies.
We still believe that the technology sector will likely dominate the market's overall performance. As this dominance begins to fade, we might observe a shift in trading focus toward the end of 2024. Indeed, the journey ahead is lined with the potential for obstacles and sudden changes. During this quarter, we anticipate that investors will closely monitor the earnings cycle, economic expansion and the statements of central bankers. Near the end of the summer, the US election cycle is expected to dominate the spotlight, with attendance being free, but the repercussions potentially expensive.
Our greatest concerns hinge on the possibility that economic growth, inflation and interest rates may remain elevated longer than what the market currently anticipates. We are actively questioning how these risks might come to fruition. Could AI have a more significant and rapid impact than expected? Is the growth in immigration in the United States contributing to the nation's economic engine? Geopolitical tensions continue to rise, but for the most part, the global markets have looked through such events with local and direct markets taking the brunt of the selling. Could there be an incident that triggers a lasting move away from risk? Should interest rates not decrease rapidly, what implications might this have for real estate, private credit, banks and less-regulated financial entities?
Equity market neutral and commodities are notable additions to our preferred strategies. We believe there is untapped value in today's market related to the narrowing breadth of the equity rally. Given that most commodities are beaten up, the chance of inflation persisting longer than expected, supply disruptions/hot weather and consistent demand all paint a very attractive mosaic for commodity appreciation in the next 12 months. We continue to endorse our strategic focus on discretionary global macro for all the reasons we've discussed over the past 9-12 months. We think investors should consider diversifying strategies and top-down-driven global macro to complement their long-only portfolios, which are increasingly becoming interrelated. It seems wise to anticipate future returns and risk distributions to be broader, with more pronounced extremes on both the upside and downside. Active asset managers, particularly hedge funds known for their agility and dynamism, may need to play a more significant role in asset owners' portfolios.
Third quarter 2024 outlook: Strategy highlights
Equity market neutral
There’s an interesting dynamic playing out in equity markets, with low volatility at the index level but high levels of dispersion among stocks. Exhibit 1 demonstrates this, as the spread between dispersion and volatility is at the widest levels of the past 10 years. What’s driving this? The path forward for inflation and rates has narrowed dramatically over the past few months. There just isn’t a major difference for stocks between one rate cut later this year or two. On the other hand, plenty is happening at the company level. Higher-for-longer rates are starting to impact individual names differently, which is something managers have been looking forward to for a long time. At the same time, the AI theme is dominant and is producing many winners and losers. These winners and losers are largely canceling themselves out at the index level but provide plenty of potential opportunities for stock pickers. The high levels of idiosyncratic risk in portfolios and a strong first half of the year from an alpha perspective demonstrate this.
Exhibit 1: Spread Between Dispersion and Volatility
June 2014—June 2024
Sources: CBOE, Wall Street Journal. As of June 2024. Important data provider notices and terms available at www.franklintempletondatasources.com.
Discretionary global macro
The market reactions to recent elections have been meaningful but reasonably isolated. The Mexican peso, for example, experienced a relatively violent selloff in a matter of days following the country’s presidential election, unwinding a profitable carry trade popular among many managers. As citizens in India and France went to the polls (and in the case of France, a snap election,) their respective stock and bond markets also reacted. But despite the political turbulence, the global market impact overall has been relatively limited in scope, at least so far. As we head into the second half of the year, markets are beginning to focus on the US presidential election. Campaigning, policy promises and polling have the potential to have a material impact on domestic and international markets, which could be risks to popular themes, like the unwind of the peso carry trade, or opportunities for politically-savvy managers. Macro managers focusing on these risks, including those with a tendency to be long volatility, may face a compelling opportunity set over the coming months.
Exhibit 2: Mexican Peso Sells Off Sharply Following Presidential Election
December 30, 2022—June 14, 2024
Source: Bloomberg. Important data provider notices and terms available at www.franklintempletondatasources.com.
Commodities
Natural gas across the United Kingdom and Europe may be challenged in the near future given the upcoming maintenance season in addition to supply outages, which have occurred throughout the globe. This challenge is further exacerbated by an increase in bid competition stemming from Asia, which has led US cargoes to Asia rather than the European region. This can be referenced in Exhibit 3, as Title Transfer Facility-Japan Korea Marker (TTF-JKM) spreads have widened this year with APAC’s return to the market.
Geopolitical tensions remain front and center, most notably as Germany’s Uniper announced it will terminate long-term contracts with Gazprom following a €13 billion award relating to damages due to Uniper for gas the company has not received since 2022. This further signals the West’s departure from Russian sources. Around the time of the announcement, gas flows from Norway to Britain were disrupted for nearly two weeks due to a crack the size of a golf ball in the pipeline that runs from Nyhamna to Easington. Both examples sent prices soaring on the news as well as renewed fears of energy security across the region given the necessity of the resource, though spared over the past couple of years due to mild weather/winters.
Exhibit 3: Eurozone Energy Crisis Looms—European Union TTF, and JKM Spread Widening
May 31, 2023—May 31, 2024
Source: Bloomberg. As of May 31 ,2024. Important data provider notices and terms available at www.franklintempletondatasources.com.
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.