In their first-quarter (Q1) 2018 outlook, K2 Advisors’ Research and Portfolio Construction teams believe favorable dispersion has created reasons for optimism in three main hedge-fund strategies: Long/Short Equity – Europe, Relative Value and Discretionary Macro. We believe offering these insights will help investors better understand the rationale for owning retail mutual funds that invest in hedge strategies.

As the Liquidity Tide Recedes… Will Investors Need a Different Boat?

The post-2008 expansion of the Federal Reserve’s (Fed’s) balance sheet from around $900 billion to nearly $4.5 trillion today has been one of the most dominant market-shaping forces over the last decade; a massive tide of liquidity that lifted assets across the globe—in some instances indiscriminately—while influencing investor behavior. In addition to yields being driven toward record lows and stock markets to record highs, many investors migrated toward riskier assets while the cost of capital was kept artificially suppressed. We believe this dynamic is about to change.

The tide appears to be receding. While the Fed has already embarked on its journey toward rate normalization, other major central banks around the world also appear poised to begin unwinding in 2018, with many striking increasingly hawkish tones. In addition, global growth has reset inflation expectations to the upside, led by China’s resilient economy.

Investors who are not prepared for this shift from the recovery era of monetary accommodation to the expansionary post-QE era may be exposed to significant risks, in our view. Markets could see increased volatility and sharp corrections, recalling, for example, the magnitude and speed of adjustments in US Treasury (“UST”) yields that occurred during the fourth quarter of 2016.

One of the challenges for investors in 2018 will be that the traditional diversifying relationship between bonds and risk assets investors expect may not hold true in this new era, particularly if we experience the cycle of UST declines we anticipate. It’s quite possible to see risk assets also decline as the “risk-free” rate (yield on USTs) ratchets higher. Markets have become accustomed to exceptionally low discount rates; a shift higher would materially impact how those valuations are calculated.