Second quarter (Q2) 2026 outlook: summary
As we move through 2026, the investment backdrop remains defined by elevated valuations, uneven macro signals, and a growing divergence between surface‑level calm and underlying market fragility. While past monetary policy easing has created favorable liquidity conditions, it has not resolved structural risks tied to concentration, leverage and geopolitical uncertainty.
In this environment, hedge funds have continued to offer differentiated value through diversification, active risk management and alpha generation. Elevated dispersion across regions, sectors and capital structures is creating opportunities for managers able to operate with flexible mandates and disciplined risk budgets. We believe the investment opportunity set increasingly favors strategies that emphasize alpha over beta, exploit episodic volatility and remain adaptable as macro narratives evolve.
- Credit: The strategy has been facing increased investor attention due to greater economic uncertainty, along with concerns about valuations and illiquidity. Despite these challenges, spreads remain tight by historical standards, and there is significant dispersion at the issuer level which active and highly selective managers can capitalize on.
- Long/short equity: We believe the combination of increasing intra‑market dispersion, broadening equity leadership beyond a narrow cohort of artificial intelligence (AI) beneficiaries, along with an acceleration in idiosyncratic, reform‑ or event‑driven catalysts across regions, support an attractive environment for stock selection.
- Global macro: In our view, the environment remains broadly supportive, with elevated market volatility expanding the opportunity set. Meanwhile, geopolitical risks are adding complexity and uncertainty around inflation, growth and policy paths.
| Strategy | Outlook |
| Long/short equity | Neutral but more constructive outlook as macro and valuation concerns persist, but increased stock dispersion and international markets provide opportunities for active management. As such, we continue to favor lower-net strategies with the optionality for international exposure. |
| Relative value
|
Neutral but improving outlook, particularly for convertible and fixed income arbitrage, both benefiting from ability to capitalize on elevated market volatility, tempered by heightened risk of liquidity stress or sharp spread dislocations. |
| Event driven
|
Neutral and modestly declining outlook, as elevated market volatility can temper confidence, leading to less deal activity. Additionally, certain event-driven strategies may exhibit higher downside beta in periods of market stress. |
| Credit
|
We maintain an underweight stance given historically tight spreads and an oversupply of capital, with a preference for nimble, idiosyncratic and long/short credit opportunities as a way to capitalize on volatility and dispersion. |
| Global macro | The environment remains supportive, driven by policy divergence, elevated sovereign issuance and renewed volatility in foreign exchange (FX) and commodities. The Iran conflict has added a further source of cross-asset volatility, increasing the opportunity set but also increasing tail risks and likely widening dispersion across managers. |
| Commodities | The opportunity set looks vast but challenging, as renewed volatility increases tail risks for directional and relative value strategies. Geopolitical tensions, evolving trade policy, and structural shifts linked to electrification and industrial policy are likely to remain key drivers of commodity prices and cross-commodity relationships. |
| Insurance-linked securities (ILS) | Catastrophe (cat) bond issuance has remained strong, with momentum carrying through the end of last year into the first quarter and likely extending into the next quarter. Existing sponsors are expected to return to refinance maturing bonds, while new sponsors continue to enter the market. Although yields and spreads have compressed compared to this time last year, the market remains healthy, with no evidence of weakening fundamentals. |
Macro themes we are discussing
As we move through 2026, we think the market environment remains constructive on the surface but increasingly fragile underneath. Liquidity has improved, volatility remains contained and risk assets continue to find support. At the same time, valuations are elevated, positioning is crowded, and sensitivity to incremental macro and geopolitical developments is rising. In our view, this combination reinforces the importance of flexibility, selectivity and active risk management.
1. Financial conditions are supporting markets, not resetting them.
Global financial conditions have transitioned into a more neutral—and in some areas tightening—phase, as of March 2026. While markets benefited earlier in the year from the residual effects of 2025’s central bank easing, recent inflation surprises and geopolitical developments have reduced the margin of policy flexibility. As a result, the longer these pressures persist, the greater the risk of valuation and risk‑premium adjustment. Markets have become increasingly reactive to marginal changes in data, geopolitical developments and policy expectations. We see this as an environment where returns remain available, but the margin for error is thin.
2. Moderate volatility coexists with rising dispersion.
Despite ongoing geopolitical tensions, headline volatility measures have remained relatively muted; however, divergence among regions, sectors and individual securities is increasingly pronounced. This reflects uneven growth trajectories, differentiated balance‑sheet quality, and concentrated positioning in a narrow set of themes. In our view, this is a favorable backdrop for active managers, but one that also carries the risk of sharp, short‑lived drawdowns when crowded trades unwind.
3. Geopolitical risk is now embedded in market structure.
Trade policy uncertainty, shifting alliances and a more transactional global order are no longer episodic shocks—they are ongoing inputs into market pricing. These forces are influencing corporate decision‑making, supply chains and capital allocation, and they increase the likelihood of discrete volatility events. We expect geopolitics to remain a source of periodic dislocation rather than sustained trends, reinforcing the value of tactical, flexible strategies.
4. Balance‑sheet quality and leverage are becoming more important.
Years of low interest rates encouraged higher leverage across both public and private markets. While easing policy provides some near‑term relief, refinancing risk, funding costs and capital‑structure discipline are becoming more visible differentiators. Markets are increasingly distinguishing between issuers supported primarily by liquidity and those supported by underlying fundamentals, contributing to wider dispersion within both credit and equity markets.
5. Implications for hedge fund strategies.
This is not a market that rewards static positioning or broad beta exposure. Instead, it favors managers who can adjust risk dynamically, avoid crowded trades, and exploit short‑duration inefficiencies as they arise. Elevated dispersion and episodic volatility create a steady flow of opportunities, but outcomes are likely to vary widely across managers and strategies.
We continue to view Q2 2026 as an environment that should reward agility over conviction and alpha over beta. Traditional asset classes may continue to grind higher, but downside risks are asymmetric. Hedge fund strategies—particularly those with flexible mandates and disciplined risk management—remain well positioned to navigate this phase of the cycle and deliver differentiated returns.
Q2 2026 outlook: Strategy highlights
Highlighting areas where evolving market dynamics are shaping the opportunity set across hedge fund strategies
Credit
Credit is facing significant cross-currents, exemplified by greater geopolitical and economic uncertainty, along with investor concerns about valuation levels, liquidity and a potential rise in defaults. Despite these concerns, credit spreads remain quite tight by historical standards due to significant supply of capital deployed to the asset class in recent years. Should the trend reverse, we believe credit markets have potential for significant downside from current levels. Elevated dispersion at the issuer and sector level—for example in areas such as software or commodity-sensitive sectors—provides the opportunity for active managers to capitalize on this dispersion through relative value and directional trading in both long and short positions.
Exhibit 1: High-Yield Bond Spreads Remain Tight Relative to History
March 21, 2016 - March 20, 2026
Source: Ice Data Indices; ICE BofA US High Yield Index Option-Adjusted Spread retrieved from FRED. Important data provider notices and terms available at www.franklintempletondatasources.com.
Long/short equity
The intersection of a weaker yen, AI‑driven capex, shifting supply chains and governance reforms are reshaping the opportunity set in Japan. Japanese equities have benefited from a breakdown in the longstanding deflationary regime which has supported nominal growth and higher inflation and asset prices. Additionally, “value‑up” and broader corporate governance reforms are pushing management teams toward higher return on equity, cleaner balance sheets, and more shareholder‑friendly capital allocation, creating a cohort of structural winners on the long side and clear laggards that resist reform or misallocate capital on the short side. Increased corporate activity (reaching multi-year highs), creates further opportunities for catalyst and activist managers to unlock potential value.
Exhibit 2: Japanese Corporate Deal Activity Reaches 10-Year High January 1, 2015 - December 31, 2025
January 1, 2015 - December 31, 2025
Source: Bloomberg. Important data provider notices and terms available at www.franklintempletondatasources.com.
Global macro
The surge in oil prices amid the Iran conflict has direct implications for headline inflation and acts as a tax on consumers’ real incomes. This dynamic complicates what had appeared to be a relatively clear macro backdrop. At the time of writing, markets are pricing two divergent outcomes. In one scenario, an off-ramp is found and the conflict is resolved in the near term; this could allow markets to re-engage with key drivers from earlier in the year, like central bank policy easing and resilient economic growth. In the alternative scenario, the conflict persists and keeps energy prices elevated, contributing directly to headline inflation, weighing on gross domestic product growth, and potentially influencing US mid-term elections in the months ahead. The path that emerges will be a key determinant of the policy mix going forward, with direct transmission to asset prices. Against this backdrop, nimble discretionary managers may benefit from greater potential payoffs by dynamically positioning around geopolitical and policy developments, but they also face higher risk of sharp reversals with elevated market volatility. Systematic strategies, by contrast, may benefit if elevated volatility gives rise to more persistent trends and cross-asset dispersion.
Exhibit 3: US Gasoline Prices Rising Amid Iran Conflict
January 6, 2020 - March 16, 2026
Source: US Energy Information Administration via FRED. Important data provider notices and terms available at www.franklintempletondatasources.com.
GLOSSARY
Alpha
A mathematical value indicating an investment's excess return relative to a benchmark. Measures a manager's value added relative to a passive strategy, independent of the market movement.
Beta: Beta measures the sensitivity of an investment to the movement of its benchmark. A beta higher than 1.0 indicates the investment has been more volatile than the benchmark and a beta of less than 1.0 indicates that the investment has been less volatile than the benchmark.
Correlation
The degree of interaction between an investment’s return and that of the comparison Index. The correlation coefficient, expressed as a value between +1 and –1, indicates the strength and direction of the linear relationship between the investment’s returns and the returns of the index.
Credit Spread: A credit spread is the difference in yield between two different types of fixed income securities with similar maturities.
Duration: Duration is a measure of the price sensitivity of a fixed-income security to an interest rate change. It is calculated as the weighted average of the present values for all cash flows, and is measured in years.
Lower-net strategies: Lower-net (or low-net) market strategies involve balancing long and short equity positions to maintain a small net exposure—typically 10-20% long—reducing overall portfolio volatility and market risk.
Z-score
A Z-score is a numerical measurement used in statistics of a value's relationship to the mean (average) of a group of values, measured in terms of standard deviations from the mean. If a Z-score is 0, it indicates that the data point's score is identical to the mean score.
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.
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