More upside in 2013 for hedge funds, says Lyxor research

Markets have digested the higher move in bond yields and any further rise in yields will occur because of firmer economic data.

Central banks globally are almost unanimously dovish which should translate into asset reflation and easy financial conditions. The Bank of England and European Central Bank were the latest banks to use “lower for longer” language to drive down interest rates. Chairman Bernanke has also indicated that the Fed will hold rates at the current 0% level for the foreseeable future.

At the same time, economic data is improving. High velocity indicators in Europe such as PMI are increasing from a dip in 1Q and broad data in the US such as jobs, spending and production are also suggesting the economy is improving.

The volatility spike and risk aversion in June presents an attractive entry point and opportunity going forward. Risk premium increased because of higher rates and concerns about emerging markets. Both of these issues have stabilized. Bond yields in the US have repriced sharply since May but the pace of the increase will likely slow going forward. China concerns have also dissipated as the authorities introduced more liquidity into the market. We expect risk premium normalization to continue which translates into higher asset prices.

Equities are our favorite asset class and a key beneficiary of asset reflation. Based on our metrics, equities are significantly more attractively valued than other assets at this stage in the cycle. Within equities, Japan is our most overweight region because it offers the best upside given the size of central bank stimulus and attractive valuation.

In our Alternative Strategies ranking, we have an overweight bias to directional strategies in the equity space. L/S Equity discretionary and systematic neutral strategies should benefit from a high dispersion, low volatility environment. We upgraded Long term CTAs to slight overweight after a challenging 2Q because we believe the factors responsible for the soft performance, such as a spike in rates, will be more benign going forward. On the credit side, the market appears richly valued and we downgraded L/S credit to neutral. We advocate focusing on relative value funds in the credit space with limited interest rate risk.