The US Federal Reserve (Fed) has affirmed to the market that interest-rate cuts are in the cards for the near future. For now, it appears that inflationary pressures are in the rearview mirror of central banks, with economic growth and financial stability on the dashboard. However, we think there is the potential for increased dispersion and volatility during the months ahead, which we believe will, in turn, provide opportunities for active investment management, of which hedge funds are the ultimate expression.
Strategy highlights
- Discretionary global macro: Markets continue to focus on central bank policy, changes in political leadership, and geopolitical tensions, all of which can play in favor of discretionary macro managers.
- Insurance-linked securities (ILS): Despite recent tightening, the sector remains well-supported and poised for continued growth, in our view, particularly with the primary issuance slated through year end that is expected to help restart activity in the secondary market.
- Long/short credit: We see potential to benefit from an increase in dispersion across single issuers given still-elevated base rates, tight spreads, and prevalence of political, economic and technical risks impacting both public and private credit markets.
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Strategy |
Outlook |
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Long/short equity |
Neutral but improving given higher sustained levels of dispersion. Fundamentals are driving price action, and high gross exposures reflect managers’ confidence in their portfolios. Artificial intelligence (AI) represents a massive product cycle to create winners and losers. |
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Relative value |
An upgrade for the strategy from underweight to neutral, prompted by modest improvements in each of the sub-strategies due to potential for higher volatility across asset classes, increased dispersion in central bank policies, and a busier new-issue calendar. |
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Event-driven |
Maintain neutral outlook with minimal improvement at the sub-strategy level. Environment for activism and special situations investing remains favorable due to easing monetary policy. Merger arbitrage continues to face deal-specific regulatory risks, favoring active deal selection and trading due to high dispersion of outcomes. |
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Credit |
Modest improvement at the sub-strategy level, though the strategy remains an underweight given generally tight spreads and excess of capital across public and private credit markets. Long/short credit is one area of improvement this quarter given its potential to benefit from an increase in volatility or dispersion at the issuer level. |
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Global macro |
Macro strategies should continue to benefit from an environment dominated by central bank policy, changes in political leadership, and geopolitical tensions. The potential for regime shifts may favor shorter-term strategies, though longer-term trends and themes may develop in the coming months. |
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Commodities |
Commodity strategies may continue to face headwinds if macro factors like China’s growth and US politics continue to dominate market moves. Managers may focus on relative value and tactical trading opportunities while directional moves may be swayed by factors outside of typical supply and demand. |
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Insurance-linked securities (ILS) |
The sector remains well-supported and is positioned for continued growth. We continue to maintain our overweight outlook, anticipating that activity will return both in the primary and secondary markets in the coming months. |
This outlook is provided to you for informational purposes and is not intended for redistribution. It shall not constitute an offer to sell or a solicitation of an offer to buy an interest in any investment product or fund. This outlook discusses strategies that are available through a variety of structures such as separate accounts, mutual funds and private funds. Not all structures are available for all strategies shown. Interests or shares of an investment fund are offered only through the fund’s offering documents, such as a Prospectus or Confidential Private Offering Memorandum.
Macro themes we are discussing
The Fed affirmed to the market that interest-rate cuts are in the cards for the near future when it decided to cut rates by 50 basis points in September 2024. Some central banks had already moved in the direction of lowering interest rates, including the United Kingdom, eurozone and Canada, while others were waiting to draft off the US move. For now, it appears that inflationary pressures are in the rearview mirror of central banks, with economic growth and financial stability on the dashboard. Investors are now focused on the US presidential election, congressional seats and the expected resulting policy implications.
We would argue that geopolitical tensions have increased in recent months despite some market complacency about the risks. We continue to think that AI, the clean energy transition, and cloud computing are significant macroeconomic factors likely to provide momentum to worldwide economies. Potential downside catalysts include a flareup in geopolitical tensions, a variation of economic weakness/slower growth/reduced spending, as well as a cascading risk-reduction event. Increased dispersion and volatility are opportunities for active investment management, of which hedge funds are the ultimate expression.
Based on these factors, we continue to favor discretionary global macro as a strategy that is well- positioned to monetize cross-asset volatility in response to policy shifts and political changes. Given the binary nature of many outcomes and non-linear impact of such changes on various asset classes such as currencies, rates and commodities, we continue to believe that an actively traded strategy is better suited to capitalize on these types of events.
We also continue to favor insurance-linked securities as an uncorrelated source of attractive carry at a time when many other spread products are trading at or near all-time tights. In contrast, insurance-linked strategies offer a significant premium to traditional credit, while remaining disengaged from traditional corporate credit risk. Furthermore, the asset class is still relatively inefficient, offering attractive opportunities for active trading-oriented managers.
Finally, this quarter we upgraded our outlook for long/short credit strategies. Despite what appears to be benign credit market conditions, there is a significant amount of dispersion at the individual issuer level. In fact, high-yield issuer-level dispersion in recent months has been consistent with levels typically seen during meaningful credit dislocations such as the 2015 energy crisis or the 2020 COVID-19 crash. We expect dispersion in credit to remain elevated in the coming quarters due to a preponderance of economic, political and technical market risks, presenting a favorable environment for long/short credit managers who can capitalize on such relative value opportunities.
Several other strategies saw modest upgrades or improvement in our outlook this quarter, including equity market neutral, convertible arbitrage, systematic macro and long/short credit (as described above). A common theme among these strategies is the fact that they are all focused on relative valuations or active trading, consistent with our expectation for continued elevated volatility or increasing dispersion across and within asset classes. In contrast, strategy downgrades include certain commodity sectors, structured credit, and merger arbitrage—typically strategies that are more likely to be less dynamic or more directional.
The above reflects the opinions of the K2 Investment Management (IM) group as of September 30, 2024, and may not reflect the views of other groups within K2 or Franklin Templeton. The information provided is not a complete analysis of every material fact regarding any country, market, industry, security or fund. Because market and economic conditions are subject to change, comments, opinions and analyses are rendered as of the date of this material and may change without notice. A portfolio manager’s assessment of a particular security, investment or strategy is not intended as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy; it is intended only to provide insight into the fund’s portfolio selection process.
Q4 2024 outlook: Strategy highlights
Discretionary global macro
The 2s10s yield curve in the United States finally disinverted in early September as investors priced in easier policy amid cooling inflation and signs of economic slowing. Many discretionary macro managers have flagged other reasons for a steeper curve going forward, especially the potential for increased bond issuance amid higher fiscal deficits. Regardless of the outcome of the presidential election, many pundits expect deficits to remain high through increased spending, reduced taxes, or some combination of both. Curve steepening and related themes have been popular among macro managers and could be a source of return as we approach and get through the US election. As always, popular trades like this can also come with higher risk of disorderly unwinds if the facts change. In either case, risks and opportunities abound around the evolving shape of the US yield curve.
Exhibit 1: The US Yield Curve Disinverted in Early September
January 1990–September 2024
Source: Federal Reserve Bank of St. Louis. Important data provider notices and terms available at www.franklintempletondatasources.com.
Insurance-linked securities (ILS)
Following a final transaction that was placed in July, the market experienced a spree of record-setting trading activity before tapering off through the North Atlantic wind season. This trading activity led to a successive tightening of yields, with most transactions continuing to price higher week-over-week across broker sheets. Despite this successive tightening over the last few months, catastrophic (cat) bond yields remain particularly healthy relative to history. We continue to maintain our overweight outlook in the sector, anticipating that activity will return both in the primary and secondary markets as we head into the end of 2024.
Exhibit 2: Cat Bond (Property Market) Yields
December 2009–August 2024
Source: Swiss Re. Important data provider notices and terms available at www.franklintempletondatasources.com.
Long/short credit
Despite what appears to be benign credit-market conditions, (as indicated by historically tight investment-grade and high-yield credit spreads), there is a significant amount of dispersion at the individual issuer level. In fact, high-yield issuer-level dispersion in recent months has been consistent with levels typically seen during meaningful credit dislocations such as the 2015 energy crisis or the 2020 COVID-19 crash. We expect dispersion to remain elevated in the coming quarters due to a preponderance of economic, political and technical market risks, presenting a favorable environment for long/short credit managers who can capitalize on such relative value opportunities.
Exhibit 3: US Dollar Spread Dispersion
January 2010–September 2024
Sources: iBoxx, Goldman Sachs Global Investment Research. Important data provider notices and terms available at www.franklintempletondatasources.com.
DISCLOSURE
The K2 Investment Management (IM) Outlook Scores are the opinions of the K2 IM group as of the date indicated and may not reflect the views of other groups within K2 or Franklin Templeton. Scores are determined relative to other hedge fund strategies and do not represent an opinion regarding absolute expected future performance or risk of any strategy or sub-strategy. Scores are determined by the K2 IM group based on a variety of factors deemed relevant to the analyst(s) covering the strategy or sub-strategy and may change from time to time in K2's sole discretion.
These scores are only one of several factors that K2 uses in making investment recommendations, which may vary based on a client's specific investment objectives, risk tolerance and other considerations. Therefore, a positive or negative score may not indicate that a particular strategy or sub-strategy should be overweighted or underweighted, respectively, in any given portfolio.
This information contains a general discussion of certain strategies pursued by underlying hedge strategies, which may be allocated across several K2 strategies. This document is intended to be of general interest only and does not constitute legal or tax advice nor is it an offer for shares or invitation to apply for shares of any of the funds employing K2 strategies. Nothing in this document should be construed as investment advice. Specific performance information relating to K2 strategies is available from K2. This presentation should not be reproduced without the written consent of K2.
Past performance is not an indicator or guarantee of future results.
Certain information contained in this document represents or is based upon forward-looking statements or information, including descriptions of anticipated market changes and expectations of future activity. K2 believes that such statements and information are based upon reasonable estimates and assumptions. However, forward-looking statements and information are inherently uncertain and actual events or results may differ from those projected. Therefore, too much reliance should not be placed on such forward-looking statements and information.
Professional care and diligence have been exercised in the collection of information in this document. However, data from third party sources may have been used in its preparation and Franklin Templeton/K2 has not independently verified, validated or audited such data.
Any research and analysis contained in this document has been procured by Franklin Templeton/K2 Investments for its own purposes and is provided to you only incidentally. Franklin Templeton/K2 shall not be liable to any user of this document or to any other person or entity for the inaccuracy of information or any errors or omissions in its contents, regardless of the cause of such inaccuracy, error
or omission.
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.