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Potential Macro Influences and Hedge Funds: 1Q17

Hedge Fund Landscape

The first few months of Donald Trump’s presidency have produced some controversy, to say the least. And while the U.S. equity markets have largely responded positively thus far since the change in leadership, there is uncertainty about what some of the changes being proposed by the Trump administration will mean for both the U.S. economy and markets worldwide on a long-term basis. Given such uncertainty, the role that hedge funds play in portfolio diversification is more important than ever1 and is evidenced by the fact that total hedge fund industry capital increased to a third consecutive quarterly record in the first quarter (1Q17), according to the latest HFR Global Hedge Fund Industry Report. There are a number of factors that the hedge fund industry will be watching closely as 2017 progresses – from increasing protectionism in countries such as the UK and France to changing demographics in China and even changing investor sentiment regarding investment in hedge funds2.

Domestic Policy Influences

One change to come about with the new administration is Republican control of both Congress and the Senate –a shift that could potentially result in an easing of Wall Street regulations. President Trump has vocally promised to disassemble the Dodd-Frank Wall Street Reform and Consumer Protection Act of 20103. Given some of the appointments he has already made to his cabinet, and the dismissal of high profile regulators such as Preet Bharara – the U.S. attorney for the Southern District of New York who aggressively prosecuted several high-profile hedge fund firms4 – a number of experts predict that the Volcker Rule, which prohibits banks from proprietary trading, could well be eliminated5. Similarly, the Trump administration is campaigning for a more business-friendly environment to spur job creation with tax breaks that favor businesses, according to the Tax Policy Center in Washington, D.C. One exception that may be worth noting, however, is President Trump’s criticism of carried interest and his promise to end the controversial tax treatment6. Presently, carried interest enables the long-term gains of investment managers to be taxed at the capital gains rate, which is lower than what they would otherwise be required to pay. While more of an issue for private equity funds, where long-term investments are standard practice, carried interest is still utilized by many managers within the hedge fund industry6.

While any policy changes put in place by the Trump administration are anticipated to be favorable for specific sectors such as financial, construction and infrastructure-oriented businesses, they have the potential to be equally harmful to others7. Take, for instance, the aerospace and defense industry. Prior to taking office, President Trump announced that he would nix a government contract with Boeing to replace the current Air Force One planes –news that substantially impacted the stock prices of Boeing and companies involved throughout the supply chain8. Though the Trump administration has since changed its position with Boeing, their criticism of the North Atlantic Treaty Organization defense fund has left investors wary of President Trump’s promises of protectionism9.

With President Trump, having taken an extremely anti-trade position during campaigning, including promises to eliminate the North American Free Trade Agreement among other policies favorable to trade between the U.S. and other major economies9, there are fears about what it would mean for markets if the Trump administration follows through with some of these threats. The ‘Buy American, Hire American’ executive order signed by President Trump in late April suggests that protectionist inclinations are indeed more than just campaign rhetoric. The side effects of protectionist policies can be unintended, such as potentially being harmful to U.S. businesses or industries heavily reliant on trade, not to mention the impact on global markets as well. Though emerging market equities seem to finally be on an upswing that is expected to help the performance of hedge funds focused on the strategy, a recent report from Mercer, “Economic and Market Outlook 2017 and Beyond,” notes that any efforts by the Trump administration to impose tariffs on countries such as Mexico and China could not only hurt those countries but the global economy as well. Of course, protectionism is by no means limited to the U.S. – a reality that both emerging market and global macro fund managers should be well aware of.

Global Macro Influences

British Prime Minister Theresa May has triggered Article 50 of the European Union’s Treaty on Lisbon, which is the process that member states must use to withdraw from the EU and which has set in motion a two-year countdown during which time the UK must negotiate the specifics of how Brexit will occur. “2017 Investment Themes and Opportunities,” another recent report from Mercer, predicts weak UK economic growth in 2017, given uncertainty about how Brexit will play out. Meanwhile, 2017 elections in both France and Germany, both of which have candidates who have indicated desires to either leave the EU or review their countries commitments to the single currency10, could lead to currency volatility – creating opportunities for global macro managers or strategies involving active currency hedging.

Another country that fund managers will continue to actively watch in 2017 is China. In January, following seven straight months of declines, China’s reserves of U.S. dollars fell to just above the $3 trillion mark, the lowest point for its foreign reserves since February, 201111. While President Trump has backed away from his initial claim that China has been a currency manipulator12, fears of trade restrictions still loom. As the world’s second largest economy and the United States’ largest trading partner, trade restrictions could undermine global equity returns1.

Monetary Stimulus

In the meantime, following several years of quantitative easing, the Fed and the European Central Bank have both indicated their belief that it is time to start dialing back their purchasing of government securities as a way of trying to boost their respective economies13. As such, rising interest rates are expected to significantly influence the U.S. market in 20171. In mid-December 2016, the Fed raised its key interest rate by 0.25%, followed by another 0.25% rate hike in mid-March. And with signs pointing to a strengthening economy, the Fed has indicated that it expects to raise rates another two times this year12. With quantitative easing finally coming to an end, bond yields are likely to increase and the markets are expected to become more volatile1. Meanwhile, though the Bank of Japan has said it is not yet ready to scale back that country’s quantitative easing efforts, there is no longer unanimous agreement among the members of its policy board that it should continue with the practice and economists believe Japan will soon be forced to follow the lead of the Fed and the ECB12. With the promise of inflation and rising interest rates in 2017, multi-strategy and macro managers could expect to have opportunities in asset-backed securities, corporate debt, and even high-yield debt1.

Potential Opportunites For Growth

Whether or not specific hedge fund strategies perform as predicted in 2017, one thing that has become clear is that hedge fund firms need to become more investor friendly. In 2016, hedge fund investors redeemed a total of $102 billion, according to data from Preqin. High management fees, lack of transparency, and better alignment of interests were the key reasons cited for the redemptions14. And with a December 2016 Preqin survey revealing that 38% of investors plan to decrease their hedge fund allocations in 2017, many managers have already begun to address the key issues by lowering fees and implementing transparency and alignment strategies. In addition, 75% of managers surveyed say they would be willing to reduce fees in the coming year15.

Given many of the changes taking place in the U.S. and abroad, 2017 continues to have the potential to provide opportunities for many hedge fund strategies. According to the latest HFR Global Hedge Fund Industry Report, total hedge fund industry assets increased $47.2 billion or 1.6% in the first quarter this year as investors increased allocations to event-driven and quantitative, trend-following systematic macro strategies. Investor outflows in the first quarter were at their lowest levels since 4Q152. Mercer Investment Management still finds a compelling foundation for alternative investments due to their low correlation to traditional asset classes and expects hedge funds to generate net-of-fee returns well in excess of cash1. Given this momentum, independent wealth managers should carefully monitor and consider how hedge funds might help their client portfolios navigate these uncertain times.

1 Mercer, Economic and Market Outlook 2017 and Beyond. January 2017

2 HFR, “Global Hedge Fund Industry Report”. April 2017

3 Lane, Sylvan, “Mnuchin: Trump orders take aim at Dodd-Frank, tax regs”. The Hill, April 2017

4 Toobin, Jeffrey, “The Showman: How US Attorney Preet Bharara Struck Fear into Wall Street and Albany”. The New Yorker. May 2016

5 Cao, Michael, “The Uncertain Future of the Volcker Rule”. Pitt Business Review. January 2017

6 Green, Robert A., “What’s So Awful About the Carried Interest Tax Law?” Forbes. September 2015

7 Heath, Thomas, “How a Trump Presidency Will Affect 15 Industries”. The Washington Post, November 2016

8 Johnson, Kirk, “Trump Talk Rattles Aerospace Industry Up and Down Supply Chain”. New York Times. February 2017

9 Reuters, “Trump Warns He Could End NATO guarantee, Scrap NAFTA”, July 2016

10 Lyons, Kate; Darroch, Gordon, “Frexit, Nexit or Oexit? Who will Be Next to Leave the EU?” The Guardian, June 2016

11 CNBC, “China Dec Forex Reserves Fall Lass Than Expected to $3.011T”. January 2017

12 Mercer, Market Summary, March 2017

13 Forbes, “The Federal Reserve Is Already Reversing QE In A Strange Sort Of Way”. February 2017

14 Cox, Jeff, “Why the Fed’s Almost-Certain Rate Hike is an Even Bigger Deal Than Normal”. CNBC, March 2017

15 Preqin, Investor Outlook: Hedge Funds H1 2017, January 2017

16 Preqin, “Hedge Fund Manager Outlook 2017”. Hedge Fund Spotlight, March 2017

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