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European divorce

Brexit and other political risks could create opportunities for discretionary macro.

The duration of divorce negotiations rarely surprises the relevant counterparties with a swift outcome. It does not help matters either if you give your lawyers new marching orders, just before they sit down to hash the settlement with the other side. Unfortunately, that's exactly the situation the United Kingdom (UK) now finds itself in. Prime Minister Theresa May called a snap election to increase her parliamentary majority. Instead, British voters delivered a hung parliament. A wounded Ms. May now has to rely on the support of Northern Ireland's Democratic Unionist Party to stay in power and avoid yet another general election.

All this leaves the outcome of the Brexit negotiations more open than ever. There now appears a decent chance that an arrangement could be found to maintain many of the advantages the UK gets from being a member of the European Union (EU), the so-called "soft-Brexit" option. Even a reversal of the decision to leave the EU can no longer be ruled out completely. Conversely, the risk of a calamitous exit due to brinkmanship on both sides has also gone up.

For hedge funds, such uncertainty can create opportunities. Discretionary macro, for example, already benefited from the triggering of Article 50 during the first quarter. The expected uncertainties from the negotiations led to sustained investments in UK Gilts, which have been among the best-performing assets within fixed income for the quarter. This benefited some funds but not others. It was a similar story in continental Europe, where the main source of volatility stemmed from the election risks in France and the Netherlands.

More opportunities ahead

While political risks have since receded in Europe, they have grown across the Atlantic. At the time of writing, President Trump's health-care bill appears on life support, reflecting divisions in the ruling Republican Party. That does not augur too well for progress on other parts of the Trump agenda that require legislation, notably corporate-tax cuts. And if we have learned anything from the Trump presidency, it is to expect the unexpected.

With more political uncertainty on both sides of the Atlantic ahead, we reiterate our positive view on discretionary-macro strategies. Higher interest rates, swings in foreign-exchange markets and fairly volatile commodities markets also create opportunities for the strategy. Overall performance has been solid, driven by a broad mix of directional and relative-value strategies. However, it is worth noting that within discretionary macro, the dispersion of managers' performance can be quite high, as we saw during the first quarter. Manager selection remains key, not least because getting trades right is hard in the politically capricious times we live in.

As for other strategies, the environment has clearly improved for stock picking; in particular pair-wise correlation (such as the correlation of one company's stock with another's) has been falling and dispersion has been rising. That has led us to upgrade the outlook for equity-market-neutral investing strategies to positive. Long/short equity strategies were upgraded, too, but only to neutral, as we felt the need to temper our marginally negative outlook for market direction.

Event-driven strategies also benefit from the better stock-picking environment. However, merger arbitrage is getting harder, as merger spreads on announced takeovers have compressed to relatively tight levels. Deal counts and, to a lesser extent, deal volumes have also shrunk. Given the somewhat more limited opportunity set, we have had to adjust one of the drivers we are using to assess event-driven investing strategies. As a result, our outlook for these is neutral.

Commodity-trading-advisor (CTA) strategies should benefit from any bounce-back in volatility, as well as from the possibility of persistent trends across asset markets. Of course, the timing and immediate causes of a rise in volatility are anyone's guess. While troubles for Trump and Brexit-related setbacks may be plausible potential causes, continuing low volatility cannot be ruled out. We are neutral on credit strategies, with rising interest rates potentially dampening performance, and remain negative on distressed strategies, given that default rates remain very low.

Good news for stock pickers

Cross-stock correlations have fallen further in Europe and the U.S. This helps hedge funds specializing in analyzing individual stocks or sectors.

Source: Deutsche Asset Management Investment GmbH; as of 3/31/17

*Chart shows the rolling 1-year cross correlations of constituents that make up the S&P 500 and Euro Stoxx 50 using daily returns

But volatility remains low

Implied volatility remains very low. A rebound would benefit several hedge-fund strategies, notably equity-market-neutral and discretionary-macro.

Source: Bloomberg Finance L.P.; as of 6/27/17

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