Looking ahead with regard to equity markets, we believe that whilst the overall direction for markets will be mixed, stock-picking opportunities will reassert themselves for equity long/short managers as soon as the impact on the US economy in Q1 becomes clearer. Despite concentricity of the problems in the US from a directional basis, we favour US markets over others in the current environment of heightened equity risk premiums. During the second half of the year, we also expect to see asset price inflation in Asian and emerging markets.
Credit markets are currently experiencing significant deleveraging and are arguably oversold on fundamentals. As a result, current spreads do not reflect either current or nearside corporate delinquency rates. However, we do expect to see a second trough towards the end of 2008early 2009.
In this economic context, we anticipate the most compelling hedge fund story of 20082009 to be that of the distressed strategy. This will be due to a number of factors including current indirect lending to mid caps; distressed mortgage-backed securities and asset-backed securities (predicted for Q3 2008); leveraged loans; and long USD denominated/short local currency emerging market debt. Assuming the continued absence of the structured credit financing bid for the remainder of 2008 and a US recession, 2009 may witness a rise in default rates that would precipitate traditional distressed opportunities.
It is our view that the next distressed cycle will be characteristically different to the previous one. This is due to the following:
The next distressed opportunity is likely to be precipitated by excessive leverage levels, declining real estate values and reduced consumer spending.
The outlook for mergers and acquisitions is unclear at this stage. Deals following the re-leveraging of balance sheets will not occur for the near future. As targets cheapen, those companies with significant sustainable cash balances could engage in transactions in the commodity sector. Further consolidation in the banking sector is anticipated as well as significant new financial regulation, which will throw up anomalies/opportunities for hedge fund managers.
We expect the environment for macro managers and CTA’s to remain fertile during 2008. As the two major monetary authorities in the West continue to exhibit divergent economic policies, we expect to see further opportunities in both interest rate and currency markets during the second half of 2008 and 2009 as these economies slowdown or move into recession.
Longer term, we believe that deleveraging as a theme during 20082009 will generate opportunities for hedge fund managers. We have seen the damage that US subprime and deleveraging in structured credit alone has done to the balance sheets of financials, although the traditional source of damage to banks balance sheets-that of bad debts due to an economic slowdown/recession-has not yet occurred. We expect to witness this in 2009. This will necessitate further deleveraging of balance sheets over the next 1 to 2 years. For investment banks, the situation is even more acute. This will have significant consequences for the re-pricing of instruments.
In conclusion, our assessment is that hedge fund managers can profit in Q2 2008, and onwards, by taking advantage of changing economic conditions precipitated by the credit crunch, reduced consumer spending, and deleveraging.
HAIL’s investment team continues to focus on those managers who are in a position to benefit from these longer-term dynamics.
Tim Gascoigne is the Head of Portfolio Management at HSBC Alternative Investments Limited