Is the global economy tipping into recession? Most investors may be asking themselves this very question as their nation's economies are in or inching closer to recession, thanks to slowing growth, financial contagion, war in Ukraine, increasing geopolitical instability, a lingering pandemic, high inflation, and rising interest rates. However, one potential bright spot? Recessions historically haven't lasted very long – just over three fiscal quarters on average. These risks all arose fairly quickly following a sustained period of rather tranquil markets over the past decade. Interest rates were low, inflation was low, geopolitical tensions across the globe were (for the most part) calm, and capital markets were wide open.
Given this pivot, investors are grappling with the question of where to turn to for returns. We view alternative strategies, hedge funds specifically, as uniquely and particularly well-suited options from both a return and diversification perspective. That said, not all hedge fund strategies are created equally and not all hedge funds deliver the same underlying risk and return characteristics. In our latest outlook, we summarize the key drivers supporting our favorable outlook for the asset class while further elaborating on the opportunity within sub-strategies.
Market outlook – Our base case
Expecting a relatively benign soft economic landing where growth slows down but a significant recession requiring an aggressive loosening of monetary and fiscal policy is avoided. This is broadly consistent with the market consensus where analysts project almost double-digit earnings growth for the S&P 500 through 2024 and 2025 with interest rate markets pricing the Fed Funds Rate (FFR) to be modestly below the current level next year. In this scenario, the labor force participation rate improves, and vacancies fall sharply, which should allow wage growth pressures to ease back to levels consistent with the Federal Reserve's inflation target without necessitating a material rise in the unemployment rate. Inflation expectations remain well-anchored, consumer price data starts to come in below forecasts and the Fed is able to transition from a tightening bias to a neutral bias, bringing the FFR to a level that is neither stimulative nor accommodative.
abrdn strategy ratings
Table 1. Equity strategy ratings
Equity market valuations are generally expensive relative to history and there is evidence of crowding in certain areas as the market rally has been increasingly driven by just a small subset of stocks such as artificial intelligence and semiconductors. Whilst a soft landing should be supportive of risk assets, there are clear risks of reversals and rotations. However, dispersion has improved, and pair-wise correlations are falling, resulting in a much better environment for fundamental stock pickers. In addition, the market is expected to become increasingly micro-driven as macro variables, such as rates, inflation, and growth expectations, begin to stabilize. Expecting quality long/short, considered through a disciplined valuation lens, will be a solid performer in this environment. We are actively looking to add equity hedge managers with specific sector expertise (e.g., financials, healthcare, and energy) whilst also focusing on ex-US opportunities in Europe and Asia as diversification by region, sector, style, etc. is more critical than ever.
Table 2. Event-driven strategy ratings
All five sub-strategies within Event-driven are now rated neutral following the downgrade of Merger arbitrage. While forward-looking returns are supported by higher interest rates and wider spreads, the increasingly complex regulatory landscape is proving challenging to navigate for arbitrageurs and acquirers. Deal volumes are down amid higher financing costs, low business confidence, and higher regulatory risk though dry powder remains plentiful.
Based on our market expectations, risk assets should deliver marginally positive, though unspectacular returns. This is supportive for several Event-driven strategies, given their inherent beta exposure, but not the tailwind that it has been. In addition, expensive valuations make it harder for managers to uncover undervalued companies and can result in crowded trades. We expect Activists to continue their efforts to restructure/refocus against a more challenging economic backdrop as we prefer managers with hedging in place. Special situations managers, which tend to target opportunities with softer catalysts have been focusing more on corporate separations and divestitures in 2023 while equity-focused investing remains a source of frustration for some. Meanwhile, most of the Distressed opportunity in the market is in the lowest-quality companies and an abundance of covenant-lite debt has resulted in record low recoveries in 1st lien senior secured bank loans of 46 cents (vs. 64 cents long-term average). In 6–12 months we may see broader distress among higher-quality companies that could pose an opportunity to move more positive in our outlook for the strategy. Yield compression continues to be the driver of SPAC returns though there are opportunities in extension trades. Finally, Multi-strategy funds are more diversified and have a higher focus on capital preservation, but their neutral rating reflects our outlook for the underlying components.
Table 3. Macro strategy ratings
Maintaining a positive rating for Discretionary thematic, as managers can perform well in these late-cycle periods, helped by a broad opportunity set driven by elevated inflation and tight monetary policy. Discretionary managers should still be able to take advantage of global central banks and economies beginning to move in different directions. However, dispersion across the peer group is expected to remain elevated so manager selection is important. Systematic diversified is rated neutral as trends across asset classes, which rewarded managers last year, are expected to be weaker and more sporadic this year. With that said, we believe the longer-term performance of this strategy should start to improve once the hiking cycle is ultimately over.
Table 4. Relative value strategy ratings
Our outlook for the Fixed income: Sovereign strategy also remains positive. Higher levels of interest rates, increased volatility and dispersion across fixed income assets, reduced liquidity, and dealers' ability to warehouse risk, as well as on-going geopolitical tensions all translate into wide dislocations and attractive trading opportunities. Even if interest rate volatility starts to subside, managers should be able to capture a normalization of micro spreads. Higher front-end interest rates in G7 countries are also a notable tailwind for these managers given the high levels of unencumbered cash they typically run.
While most of our credit drivers are neutral relative to history, it is important to note that when credit spreads and dispersion moves into a top-decile category, it is often ephemeral as markets do not stay highly dislocated for long periods of time (i.e., 6+ months). Coupled with base rates rapidly moving from 0% to 5%, we are comfortable issuing positive outlooks for both Fixed income: Corporate and Fixed income: Asset-backed strategies. These strategies tend to have a long bias, and the underlying credits now carry a much higher yield-to-maturity from either lower fixed rate price movement or higher floating rate interest income. Investment grade credit spreads have retraced relative to the prior six months but remain in the median range while credit duration is likely to become more appealing in certain regions as we approach peak interest rates. Within the structured credit universe, we are particularly constructive on residential mortgage-backed securities and asset-backed securities, but less positive on commercial real estate and advise patience as we expect the correction in values to take time to play out.
The Volatility strategy is also positive though slightly tempered compared to 2022. 2023 has seen some strong downward trends in both implied and realized volatility levels, compressing spreads. However elevated levels of volatility across assets (notably interest rates and equity markets where the Fed’s hiking cycle has created not only winning and losing sectors but also intra-sector winners and losers) means this is still a good environment for relative value vol strategies. Finally, we remain neutral on Fixed income: Convertible arbitrage. Converts are a crowded asset class, but we are beginning to see capital move out of the space which could eventually set up the next cycle.
Discussion of individual securities above is for informational purposes only and not meant as a buy or sell recommendation nor as an indication of any holdings in our products. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of any mentioned securities.
Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
Past performance is not an indication of future results.
Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Hedge funds use sophisticated investment strategies that may increase investment risk in your portfolio. Among the risks presented by hedge fund investments are: the use of unregistered investments, which may make it difficult to assess the performance of the holding; risky investment strategies, which may result in significant losses; illiquid investments that may be subject to restrictions on transferability and resale; and adverse tax consequences.
Investments in asset backed and mortgage backed securities include additional risks that investors should be aware which include those associated with fixed income securities, as well as increased susceptibility to adverse economic developments.