The risks of a recession for the markets cannot be ruled out
As Kier BoleyUBP’s Alternative Investment Solutions investment manager explains to Verità&Affari how to behave in the event of
new difficulties on the markets.
BOLEY KIER
The markets were very nervous in the first three months of the year, alternating between up and down phases a lot
accentuated and often very short. What is your view on this context? Will it continue?
The quarter began with a strong rally in January, followed by a sharp correction in February and punctuated in March by the confidence crisis in US regional banks and the UBS takeover of Credit Suisse. Government guarantees on deposits and more cautious central banks managed to calm the markets, which ended March in positive territory.
Equity and fixed income markets were positive across the board, in both developed and emerging markets. Commodities fell, primarily driven by energy prices. Looking ahead, markets continue to be driven by macro factors, focusing on the Fed and economic data. Global inflation continued to decline thanks to low energy prices, but core inflation remained more stable, prompting the Fed to hike rates further in March despite banking system instability. A growing consensus points to an impending recession, which could cause markets to refocus on corporate fundamentals, resulting in a return of dispersion.
2022 has seen a return to the fore of hedge funds. How did they behave in these first months of 2023 instead? What strategies have done best in this context?
Long-short equity managers (those who aim to replicate the returns of the markets when they are growing, but to preserve capital when the investment climate deteriorates, ed.), represented by the Hfri Equity Hedge (Total) index, recorded a gain of +3.4% in the first quarter. The first quarter of 2023 started with a strong rally in the equity markets and was characterized by strong reversals of
trend, especially at the sector level, with lagging funds in 2022 becoming the strongest in Q1 2023 and best funds in 2022 becoming the weakest in Q1 2023.
Over the course of 2022, most funds significantly reduced their sector bias, but generally maintained a bias towards quality and growth factors, which performed strongly over the quarter. However, some funds have swung positively into financials, which tend to benefit from higher interest rates, but were somewhat caught off guard when yields fell spectacularly in March following the collapse of the Silicon Valley Bank and Signature Bank.
Can this good performance of long short equity funds extend into the rest of 2023?
Few investors expected 2023 to start with a strong rally in equity markets. However, the outlook for earnings and equity markets in 2023 remains challenging. We expect the huge macro jolts seen in 2022 to translate into a sharp increase in equity market dispersion in 2023, as the fundamentals of strong companies are much less impacted than those of weak companies.
Ultimately, stock prices are driven by fundamentals and a renewed focus on company-specific fundamentals creates a rich set of opportunities for long/short equity funds, especially low net exposure strategies. Alpha, which is the primary return driver of such strategies, is highly correlated with levels of equity market dispersion. During
Even if equity markets move sideways or modestly down for the year, we expect these low net exposure Long Short Equity strategies to deliver strong absolute returns with low correlation to equity markets. We also prefer more liquid strategies, as they allow portfolios to be quickly repositioned if the overall outlook for equities improves.
What other alternative hedge strategies look best positioned for the coming months?
The widely held view on the market remains that inflationary pressures remain too strong for central banks and that they will have to keep real rates positive longer than the market would like. The macro driven strategy (the one that profits from macroeconomic imbalances and geopolitical events, trying to predict changes in prices on the financial markets, ed) is one of the few able to take advantage of very different market regimes, including the recent market bias towards inflation, but also fears of a recession which could favor defensive exposures such as long-dated bonds, the yen and long value/short growth positions.
We maintain our high conviction on macro driven strategies as inflation trends remain the primary economic concern, but as the peak of rate hikes nears, we should expect more risky events to unfold. We are increasing our exposure to corporate credit managers, who are capable of generating alpha on both the long and short sides of portfolios. High inflation and rising rates will leave some companies over-leveraged and unable to meet the increased burdens since the start of the pandemic in 2020. We do not necessarily expect a material increase in default rates, but a real potential for dispersion , spread widening and volatility, which offers credit managers a fertile set of opportunities, enabling them to earn higher interest income. As the risk of a recession increases in 2023 and the capital markets essentially shut down, the opportunities for new stressed and distressed positions will also increase.