K2 Advisors: Second Quarter Hedge Fund Strategy Outlook

The coronavirus pandemic has created a number of pricing dislocations within markets across the globe. In its second-quarter outlook, the K2 Advisors team takes a look at how hedge fund managers are navigating the current market environment and which strategies are finding opportunities from these dislocations.

In our view, pricing dislocations between companies, industries, regions and asset classes due to the impact of COVID-19 and corresponding price adjustments offer abundant opportunities for select hedged strategies. The length and depth of both the economic supply-and-demand curve adjustments are key to the richness and tenor of the opportunities.

Macro Themes We Are Discussing

Sector, Geographical and Cross-Asset Rotations in Full Swing

Even before COVID-19 affected global markets, we were expecting sector rotations, geographical movements and asset class rebalancing to occur, creating a rich environment for alpha1 generation. Today, the theme is even stronger, but due to the depth and length of the COVID-19 impact, the energy sector, as well as several industries including transportation, travel, restaurant and retail shopping now face challenges that were never part of the business plan. Technology, health care, online gaming and entertainment, and food delivery are experiencing tailwinds also not foreseen. Regional differences in social distancing, hence infection rates, will affect countries and regions in various ways. We expect interest rates and foreign exchange rates to provide a “relief valve” for pressures elsewhere, creating a viable opportunity set for managers deploying risk in those asset classes.

How Long and How Deep Will COVID-19 Impact the Economy, Consumer and Government Actions?

Clearly, both demand and supply curves are in the midst of repricing the impact of COVID-19, which we have labeled a health crisis impacting the financial and labor markets. The length and depth of COVID-19’s impact will affect the speed and degree of repricing going forward. If the global infection curves flatten and/or a vaccination becomes available, then mean reversion of risk-on repricing will quickly emerge. On the other hand, if the death count rises to unimaginable numbers, the virus mutates or the lockdown continues longer than a few months, then risk-off sentiment will likely return and be reflected in security pricing.

Has the Health Crisis Created a Deleveraging and Risk-Reducing Unwind?

In mid-February, no one wanted to hold cash as money market rates were paying very little in yield, if anything, and the opportunity cost of missing out on other investment opportunities was estimated to be large—even larger if one were to borrow at historically low rates and employ leverage to enhance return on investments. The leverage unwind and “dash for cash” put central banks in the position of having to lower interest rates and buy securities from the crowd looking to unwind and reduce risk. This has created dislocation in areas of sovereign fixed income, corporate credit and structured credit, with the largest dislocation occurring in structured credit.