Hedge funds: The Red Thread – Alternatives

2Q26 outlook

The conflict in the Middle East and subsequent closure of the Strait of Hormuz are shifting the global economy from a ‘goldilocks’ state (steady growth and falling inflation) towards stagflation (lower growth and rising inflation). The recent rebound in risk assets, albeit welcome, may prove short-lived; supply chain disruptions are underway as energy prices and shipping costs rise and global inventories are depleted. Higher food prices are expected later in 2026, as current fertilizer shortages impact crops. While a prompt reopening of the Strait of Hormuz may shorten a potential inflation surge, this episode once again has showcased the weaponization of physical resources, which could intensify hoarding behavior and price volatility in the future.

That said, supply inflation could be alleviated by a commensurate decline in demand. Artificial intelligence (AI) could also be a deflationary factor, as it materially lowers prices for ‘information goods’ (e.g., software) and replaces labor. The extent to which governments are willing to support basic consumption will likely define the final outcome. Given the complexity of the economic factors at play, the outlook for global growth remains uncertain, thus driving risk premia and correlation instability across asset classes higher.

Strategy views

In trading, we maintain conviction in developed markets (DM) discretionary macro strategies. The oil supply shock may lead to greater divergence in central bank decisions and fiscal policies, potentially creating opportunities in cross-market rates and foreign exchange (FX) trading. Equity thematics should remain relevant, particularly in areas such as defense, infrastructure and other cyclical sectors impacted by the recent market sell-off.

We acknowledge that heightened geopolitical uncertainty and managers’ lower risk levels following their March 2026 drawdowns could challenge directional risk-taking in rates over the near term, but more sustained directional trends could emerge across asset classes as we obtain more clarity. For emerging markets (EM) macro, assuming no material escalation in the Middle East, the near-term opportunity set remains relatively attractive, supported by high carry, a benign USD backdrop and some unwinding of consensus positioning that we believe has created more attractive entry points.

Our exposure to equity hedged has been at the higher end of the historical range, given the broadening alpha opportunities we are seeing across regions and sectors. We believe the opportunity set for equity hedged remains robust, incrementally shaped by AI winners/losers and geoeconomics. However, as observed among broader asset classes, the correlation between trading and equity hedged could potentially be less reliable than in recent history, and as a result, we are marginally reducing equity hedged exposure in favor of more defensive relative value sub-strategies, which often exhibit lower correlation.

In relative value (RV), we plan to maintain our exposure to fixed income relative value (FIRV). Our probability-weighted expected return for FIRV strategies has increased, and while we have not yet observed notable distortions in funding markets or cash/futures basis, any deterioration in macro risk sentiment would likely push rates volatility higher, which should be supportive for micro RV strategies as well as tactical macro themes. In addition, many crowded macro RV trades have become dislocated and offer more attractive entry levels. We also remain constructive on quantitative equity.

Recent performance has been consistent with liquidity provision dynamics in a choppy trading environment, and the strategy’s resilience through a volatile Q1 has highlighted its positive diversification properties. For merger arbitrage, we see sustained momentum in global M&A as corporates and sponsors act within a strategic window defined by national priorities such as energy independence, the accelerating race for AI leadership and critical minerals necessary for defense and manufacturing. Agency mortgage derivatives are another source of attractive carry in portfolios, and we plan to maintain our exposure as valuations improved in 2025.

Within credit/income, we believe the strategy remains well positioned for the current environment as dispersion is likely to stay elevated. While the strategy can lag in strong risk-on markets, we believe the overall return profile remains favorable. The asset-backed securities (ABS)/other income strategy continues to target high-yielding, fundamentally stable assets, with no meaningful change in expected returns for the strategy since the beginning of 2026 given relatively consistent base rates and spreads in the space.