Second Quarter Hedge-Fund Strategy Outlook

In their second-quarter (Q2) 2017 outlook, K2 Advisors’ Research and Portfolio Construction teams share the key market events they have an eye on.

K2 Advisors seeks to add value through active portfolio management, tactical allocation and diversification across four main hedge strategies: long-short equity, relative value, global macro and event driven. In their second-quarter (Q2) 2017 outlook, K2 Advisors’ Research and Portfolio Construction teams share the key market events they have an eye on. We believe offering these insights will help investors better understand the rationale for owning retail mutual funds that invest in hedge strategies.

Q2 Outlook: After the Trump Bump

The gap between political expectation and political reality has narrowed a bit in recent weeks, at least as it pertains to the 45th president of the United States. The failure to pass the health care bill delivered a sobering jab to the post-election giddiness intoxicating Wall Street. And while that outcome has produced no shortage of schadenfreude from some corners, a more sanguine view would be that the separation of powers as designed by the Founding Fathers is alive and well in Washington, DC.

The repeal-and-replace effort on health care as well as the rejection of the travel ban have signaled that implementing the agenda laid out by the executive branch will not be simply rubber-stamped by the legislative and judicial branches. For now, however, belief remains that the administration will be successful in implementing the so-called “Big Three”—tax reform, deregulation, and infrastructure spending—and that these initiatives will succeed in galvanizing the US economy and supporting current market valuations.

Stocks enjoyed a three-month rally following Trump’s election win. Time will tell whether hope and speculation are rewarded by the reality of governing.

Regardless of what the future holds in terms of political results, from a market standpoint, we anticipate more volatility going forward—and this could be a good thing for hedged strategies. Remember, alpha is a byproduct of an inefficient market, and in our view higher volatility is an indication of greater market inefficiency—hence greater opportunity for active investments like hedged strategies to succeed. Clearly Trump’s victory did represent a seismic shift, and while markets are discovering where this shift will ultimately lead, we anticipate sharp moves along the way—and in both directions. We also expect measurable dispersion on a sector and security basis. In these circumstances, investment managers with more latitude in trading may be better able to capitalize on price dislocations and trends.

A Brighter Climate in Europe: Long-Short Equity

In Europe, a brighter climate is emerging that bodes well for European markets—and for long-short equity strategies.

First and foremost, the specter of populism may be dissipating. This is a positive development, as the movement threatened to unwind decades of political and economic cooperation in the region. The recent defeat in Holland of populist “Freedom Party” candidate Geert Wilders may prove to be a barometer for Europe as a whole, indicating that perhaps sentiment in the region is shifting. In addition, the majority of polls in France show populist candidate Marine Le Pen lagging. In Germany, Chancellor Angela Merkel’s party and its affiliates continue to outpoll right-wing challengers. These shifts in political currents in the region should help provide support to growth in the region.

Beyond the encouraging political environment, positive economic and technical factors may be a tailwind for Europe as well. Bear in mind, European equities in general have underperformed US equities over the past ten years,1 and we expect this trend could reverse. We think European equity markets could benefit from favorable valuations, improving earnings growth and global reflation. After years of subpar growth relating to the sovereign debt and banking crises, economic growth and inflation in the region have started to improve.

Furthermore, weakness of the euro and the British pound against the US dollar, combined with market volatility caused by ongoing geopolitical uncertainty, presents managers with additional stock-picking opportunities in the region. Additionally, European companies with a euro or sterling cost base that generate income from stronger currencies (such as the US dollar) should be well- positioned. Lastly, many managers see opportunity in the financial sector, as banks in Europe have worked very hard in recent years to clean up their balance sheets and get stronger. We believe many of these institutions warrant a higher valuation than they currently have.