Hedge funds have an exceptional record of outperformance when it comes to high-interest and high-inflation markets. So, with the recent Federal Reserve mega-cuts threatening to change the US financial landscape, is Wall Street’s institutional winning streak set to take a turn?
The Fed’s recent 50 basis point rate cut signals a pullback from its highest interest rates in the United States for 23 years and signals a period of uncertainty for the S&P 500 which has experienced higher levels of volatility owing to weaker-than-expected labor market data and widespread geopolitical unpredictability.
Despite the cuts signifying a more optimistic outlook for Wall Street, with strategists raising their targets for the S&P 500 in anticipation of stronger consumer spending, hedge funds have remained cautious in their market movements.
Decreasing their long-short gross leverage, metrics indicate that hedge funds spent June 2024 lowering their market exposure at a rate that hasn’t been seen since the weeks that followed Russia’s invasion of Ukraine in March 2022.
Life After a Winning Streak
The uncertainty of hedge funds can be supplemented by the fact that they’re collectively on an impressive four-month winning streak, with overall YTD returns pushing near to double-digit territory.
Impressively, this outperformance saw institutions overcome the Vix Cboe Volatility Index reaching a six-year high in early August as labor market data sparked fears of a recession in the US.
In August, despite the volatility that impacted the early stages of the month, hedge funds administered by Citco obtained an overall weighted average return of 1.1% over the month, growing from the 0.6% recorded in June and accelerating collective YTD returns to 9.5%.
The leading institutions were equities funds, which recorded a 1.7% weighted average return, while global macro and fixed-income arbitrage grew an average of 1.4% and 0.9% respectively.
However, the more cautious reversion in recent weeks ahead of the Federal Reserve rate cuts points to collective shifting strategies for hedge funds. This dovish reversion could see added forces at play throughout Wall Street, and funds are adapting their approaches accordingly.
The Impact of Rate Cuts
Lisa Shalett, CIO at Morgan Stanley, has adopted a bullish stance towards the prospect of hedge funds in the wake of the Fed’s ongoing rate cuts.
Based on expectations that the Fed will continue to cut rates no lower than 3%, and that nominal growth is set to remain below 4%, Shalett expects markets to reward companies that demonstrate sustainable management structures, realistic earnings forecasts, and grounded valuation multiples.
This will see an opportunity for investors to look to large-capitalization cyclical stocks throughout sectors like financials, energy, industrials, aerospace, defense, and grid infrastructure, as well as REITs.
Crucially, Shalett recommends greater exposure to hedge funds for investors seeking to profit from this new market environment and has identified funds as a core component of a holistic portfolio for investors.
Hedge Funds Turn to Tech
The market jitters experienced in August saw hedge funds gobble up the dips experienced throughout the tech sector following the S&P 500’s worst rout for nearly two years.
However, this increased volatility played into the hands of institutions, and following the initial sell-offs, net purchasing of US single stocks climbed to its highest levels in around five months.
Hedge funds were laser-focused on tech stocks, with institutions adding technology-focused stocks in their largest volumes since June, illustrating the cautiously optimistic tone that institutions are adopting for the lower-interest environment ahead.
Following a 3% pullback for the S&P 500 during its rout, hedge fund buying power helped the index to recover 1% within 24 hours.
Despite the buying opportunity, the exposure of hedge funds to information technology shares is still at its most underweight in more than a decade, suggesting that there could be more dip-buying ahead for institutions seeking to take advantage during the return of low rates.
In those 10 years, we’ve seen globally-focused prime brokerage services accelerate to accommodate more global markets, making the prospect of a worldwide recovery from a high-interest, high-inflation environment uncover more opportunities than ever before for hedge funds honing their strategies.
Asymmetric Risks Linger
Despite clear opportunities for growth among hedge funds, Brad Boyd, founder of Confido Capital, has warned that the anticipation of lower rates has generated brighter equity and credit price levels that create asymmetrical market risks for institutions.
Boyd suggests that he would short risky assets like stocks, low-quality balance sheet company bonds, real estate, and emerging markets in favor of buying credit default swaps.
The reasoning behind this cautious approach stems from Boyd’s anticipation that markets have become overpriced for the Federal Reserve’s rate cuts and could suffer fresh pullbacks if the lower-interest climate fails to deliver the economic results that Wall Street expects.
Investors have been dealt plenty of warnings over the US economy failing to play ball with market expectations time and again in 2024. Firstly with hotter-than-expected inflation rates throughout the first half of the year, and then August’s weaker-than-expected labor market statistics causing significant volatility.
Cautious Optimism Reigns
The arrival of a low-interest environment will be supplemented by the rapid adoption of artificial intelligence tools among hedge funds to gain a competitive advantage. The timing of Citigroup’s plan to hire 2,500 technology professionals, including coders, engineers, and data analysts is telling, while McKinsey data suggests that the emergence of generative AI could add between $200 billion and $340 billion in value to banking, wholesale, and retail sectors moving forward.
Market volatility characterized by the recent six-year peak reached by the Vix index is likely to make the reliance on AI among hedge funds more intricate in discovering fresh opportunities, and the return of consumer confidence will push these tools into the limelight in Q4 2024 and 2025.
As a whole, the Federal Reserve’s 50 basis point rate cuts have created a new battleground for hedge funds to strategize, and August’s gobbling up of underpriced tech stocks shows that Wall Street’s most ambitious institutions are ready for action.
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