Success for most alternative strategies depends largely on producing returns from alpha—sources beyond broad market movements. It’s been harder to do that in recent years, but that could change in 2017.

A number of factors worked against alternative returns last year, including a stricter regulatory environment and low interest rates. And after the US election, volatility faded and equity markets rose steadily, making exposure to broad market moves—or beta—a winning strategy.

We don’t think this state of affairs will last indefinitely, though. Here are some of the bigger trends we see taking shape that could drive results this year and beyond for alternative investments.

Short-Selling Potential on the Rise

We saw increased dispersion last year among individual stocks, forcing investors to differentiate again between weak and strong investments. This should improve short-selling opportunities for equity hedge strategies.

In recent years, a flood of monetary stimulus from major central banks has ended up lifting all boats—even the least seaworthy ones. That has made uncovering long/short potential in global stock markets a challenge.

Today, central bank policies are diverging. The Federal Reserve has already started to raise interest rates, with more hikes likely in 2017. This environment could make things difficult for some companies, industries and asset classes. And while central banks in Japan and Europe are still easing aggressively, the effect of their policies on financial markets has been fading somewhat.

Periods of higher interest rates also mean managers can earn a higher yield on the cash balances that result from successful short sales, providing another potential return boost. Rising-rate periods have historically been profitable for equity long/short strategies and active managers in general.

Deal Activity Heats Up

Corporate merger activity was vigorous last year, making it a good year for event-driven strategies; we expect more of the same in 2017. Deal spreads aren’t quite as wide as they were a year ago when the collapse or delay of several high-profile mergers drove spreads higher. But they’re still attractive, so this could be a good time to invest.

For starters, companies still have plenty of cash on their balance sheets. Activist investors have been pushing them to return cash to investors. But with interest rates still low, we think many companies can put it to better use by growing revenue and earnings through mergers and acquisitions.

Another potential positive: deregulation. Increased regulatory scrutiny of deals has slowed activity in recent years and affected the outcome of many event-driven strategies. The Republican sweep in the US presidential and congressional elections last year, however, could put deregulation back on the table. And talk in the Trump administration of a possible repatriation tax holiday for corporations with money parked overseas would bring more corporate cash into the US. There should be a lot of opportunities for event-driven and special-situation investing.

In Credit, Relative Value Is Harder to Find

Credit strategies bounced back strongly in 2016 as the high-yield market rallied. Strategies involving distressed debt, especially in energy and mining, did particularly well. But the outlook for 2017 is less certain. Oil prices have rebounded, and there’s still plenty of demand for yield. But yield spreads are tight, making it harder for strategies that focus on credit and distressed debt to uncover relative value.

That makes for a less-than-compelling opportunity set for investors. Unsurprisingly, many credit/relative-value managers are reducing risk by lowering their net long exposure, increasing cash balances and focusing on securities higher up in the capital structure.

Of course, there are always pockets of value to be found if investors look hard enough. They may want to keep an eye on Europe, where political uncertainty and macroeconomic issues may yield attractive opportunities.

It’s also important to remember that dealer bond inventories are low and market liquidity is still limited. That means credit- and event-driven managers who keep some of their powder dry may be able to seize opportunities from sudden market dislocations, like the oil-market rout in 2015 and subsequent rebound the following year.

Credit/relative-value strategies have generally had low or negative correlations to broad bond market indices, and should perform well in periods of rising rates, higher volatility and increasing defaults.

Will Macro Strategies Feast on Unpredictable Politics?

Central banks aren’t the only ones becoming less predictable. Political uncertainty around the world is rising too. That should lead to dispersion among currencies, stocks and interest rates—and result in a broad range of economic paths in countries around the world. We think this will create opportunities for global macro strategies across asset classes.

Discretionary macro-driven strategies that focus on the most liquid assets—currencies, equity indices and rates—are most attractive in the current environment. They’re best suited to choppy trading conditions, and we think the potential for political or policy changes that cause sharp market reversals will remain high in 2017. Systematic strategies powered by algorithms tend to be more momentum-driven and can get caught leaning the wrong way when trends reverse unexpectedly.

In particular, we think emerging markets, where we’ve seen dispersion in growth rates as well as monetary and fiscal policies, should provide plenty of relative-value opportunities.

In sum, we expect markets to become more volatile, monetary policy less uniform and politics around the world—especially in developed countries—less predictable. US interest rates are likely to rise. But at the same time, US growth is picking up and economic fundamentals are improving in many emerging markets. We expect trading to be choppy, but we also expect more opportunity for alternative strategies to generate alpha across asset classes.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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