Central banks give markets a respite

Fed fund futures markets now give a 58% probability for a rate hike at the mid-December FOMC meeting. The market is now prepared for the next interest rate move, provided that US data releases do not deteriorate.

Hedge funds recovered from recent losses, up 0.4% overall last week. CTAs were up 2.4%, however they remain in negative territory month-to-date. Additionally, L/S Equity managers outperformed as they were up 0.8% last week. European L/S equity funds outperformed as defensive styles such as momentum, quality and low beta outperformed aggressive styles such as value and size in Europe. After several years of underperformance of value stocks, many L/S managers have favored defensive biases and do well when quality and momentum stocks perform well.

The recent rise in risk aversion, which was a short term movement, did not lead to a significant deleveraging by hedge funds. We estimate, on the back of a bottom-up calculation, that the equity beta has fallen by five percentage points, to 25% as of midSeptember. This is a moderate move that has occurred on multiple occasions this year. At the hedge fund strategies level, L/S Equity managers were the most aggressive in cutting their equity beta, followed by CTAs. Overall, the beta remains at high levels at present compared to the year to date average (18%).

Going forward, we maintain our preference for hedge fund strategies which provide protection considering the rich valuation of traditional markets. Upside risks appear rather limited, though the US earnings season, which will start in two weeks, can bring positive surprises.

As a result we maintain the overweight stance on merger arbitrage, fixed income arbitrage and market neutral L/S. We also maintain long term CTAs at neutral as their long equity/long fixed income stance implies that CTAs are less protective than they used to be.