alternative markets update - 2022 outlook

Alternative Markets Outlook 2022
2021 was firmly in the grasp of Covid-19 through the Delta and Omicron strain. Although Covid-19 was managed solidly, the imposed restrictions and the economic interventions have severely impacted the economy and society. Not only has inflation skyrocketed but it is also likely to persist for quite some time. In January 2021, the US CPI was at 1.4% and rose to 6.8% in November 2021. In Europe, the situation looks similar, although the initial surge started earlier in the US and currently Europe’s inflation is lower with 4.9% in November 2021. In 2022, inflation will prevail with even higher levels in early 2022 with a realistic chance to subside towards the latter part of 2022. This rather grim outlook is largely in line with the observation during 2021, when inflation targets were mostly too low and the estimated time period were too short. The US will probably experience slightly higher levels, due to the larger extent of money printing to fight Covid-19 originally. Central bank intervention will be reduced to normal levels in the latter part of 2022. It has been already announced that they will scale back their asset buying programs but not entirely. Depending on how Covid-19 is evolving, it seems reasonable that towards the end of 2022, these programs will be discontinued. Aside from these monetary interventions, there were also substantial fiscal interventions, as shown in Figure 1. Figure 1 depicts the US national debt and the increase of additional trillion of debt. Since Covid-19 emerged, six additional trillions were spent to fight the immediate impact. In particular, the speed at which the money was spent is remarkable. While it took between 30 and 300 days for an additional trillion during Covid-19, it took between 170 and 320 days during the global financial crisis in 2008. The measure undertaken to fight Covid-19 are massive but they have helped the economy to bounce back. Among others, the development of the employment is largely desirable. For example, in the US, the unemployment rate was reduced to 4.2% from its peak of more than 14% in 2020. Equity markets, which have contributed in a major fashion to the overall success of 2021, will be largely impacted by Covid-19 in 2022. This was once again observable in November 2021 when Omicron emerged. Assuming a positive development, it is likely that equity markets will keep rising, although at a normal pace below unlike 2020 and 2021. Figure 2 and 3 show the S&P 500 and the Euronext 100 indices over the past two years. Since January 2020, the S&P 500 gained 47.5%, while the Euronext 100 gained 18.9%. The gains since their bottom in March 2020 are 118.4% for the S&P 500 and 86.0% for the Euronext 100. One potential reason for the strong growth in 2020 and 2021 may be due to expected inflation ahead, which is compensated by higher nominal gains. This effect is likely to fade given the enormous growth numbers in 2021 which have given rise to doubts about the sustainability of these profits alongside fears of another financial bubble. This is in particular true for industries that have benefited from Covid-19, such as technology. One example of seemingly unhealthy gain is Tesla, which is up more than 1,000% since Covid-19 emerged. The companies benefiting from Covid-19 should be viewed with caution, while companies that were negatively affected by Covid-19 certainly involve less risk. A negative development with the handling of Covid-19 could turn the situation upside down again and trigger similar effects as in March 2020. This may occur, for example, if a new strain emerges with a substantially increased fatality rate, is spread relatively easily and vaccinations are of only mediocre effectiveness against the new strain. Yet, this scenario is rather unlikely given that with each wave, the number of infections remains at a relatively similar level, while hospitalizations and fatalities decline. Furthermore, virus strains that spread more easily, such as Omicron, frequently are less deadly. These two observations favour the good scenario going forward. In an environment of high volatility and many opportunities, alternative assets are well positioned. Figure 4 highlights the volatility in the market measured by the VIX. Since the occurrence of Covid-19, the volatility in markets has never reached levels prior to Covid-19, although there has been a massive improvement. From the peak in March 2020 and a level of more than 80, markets have stabilized between 15 and 25 in quiet times with occasional spikes. With regards to alternative assets, 2020 and 2021 were highly beneficial for several reasons. Firstly, in crises, actively managed vehicles are of increased interest as they try to mitigate the negative impact of the crisis. Secondly, due to the nature of being a healthcare crisis, this brings many opportunities with it. Thirdly, the substantial uncertainty in markets also favour alternative assets, as for example, private equity funds are less sensitive to significant short-term volatility. 2021 was especially profitable for the private equity and hedge fund industry, which make up the largest part of alternative assets. In the following sections, hedge funds, private equity, private debt and crypto assets are discussed in a more detailed fashion.

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RESEARCH PERSPECTIVE VOL. 170 December 2021 Alternative Markets Outlook 2022 2021 was firmly in the grasp of Covid-19 through the Delta and Omicron strain. Although Covid-19 was managed solidly, the imposed restrictions and the economic interventions have severely impacted the economy and society. Not only has inflation skyrocketed but it is also likely to persist for quite some time. In January 2021, the US CPI was at 1.4% and rose to 6.8% in November 2021. In Europe, the situation looks similar, although the initial surge started earlier in the US and currently Europe’s inflation is lower with 4.9% in November 2021. In 2022, inflation will prevail with even higher levels in early 2022 with a realistic chance to subside towards the latter part of 2022. This rather grim outlook is largely in line with the observation during 2021, when inflation targets were mostly too low and the estimated time period were too short. The US will probably experience slightly higher levels, due to the larger extent of money printing to fight Covid-19 originally. Central bank intervention will be reduced to normal levels in the latter part of 2022. It has been already announced that they will scale back their asset buying programs but not entirely. Depending on how Covid-19 is evolving, it seems reasonable that towards the end of 2022, these programs will be discontinued. Aside from these monetary interventions, there were also substantial fiscal interventions, as shown in Figure 1. Figure 1 depicts the US national debt and the increase of additional trillion of debt. Since Covid-19 emerged, six additional trillions were spent to fight the immediate impact. In particular, the speed at which the money was spent is remarkable. While it took between 30 and 300 days for an additional trillion during Covid-19, it took between 170 and 320 days during the global financial crisis in 2008. The measure undertaken to fight Covid-19 are massive but they have helped the economy to bounce back. Among others, the development of the employment is largely desirable. For example, in the US, the unemployment rate was reduced to 4.2% from its peak of more than 14% in 2020. Equity markets, which have contributed in a major fashion to the overall success of 2021, will be largely impacted by Covid-19 in 2022. This was once again observable in November 2021 when Omicron emerged. Assuming a positive development, it is likely that equity markets will keep rising, although at a normal pace below unlike 2020 and 2021. Figure 2 and 3 show the S&P 500 and the Euronext 100 indices over the past two years. Since January 2020, the S&P 500 gained 47.5%, while the Euronext 100 gained 18.9%. The gains since their bottom in March 2020 are 118.4% for the S&P 500 and 86.0% for the Euronext 100. One potential reason for the strong growth in 2020 and 2021 may be due to expected inflation ahead, which is compensated by higher nominal gains. This effect is likely to fade given the enormous growth numbers in 2021 which have given rise to doubts about the sustainability of these profits alongside fears of another financial bubble. This is in particular true for industries that have benefited from Covid-19, such as technology. One example of seemingly unhealthy gain is Tesla, which is up more than 1,000% since Covid-19 emerged. The companies benefiting from Covid-19 should be viewed with caution, while companies that were negatively affected by Covid-19 certainly involve less risk. A negative development with the handling of Covid-19 could turn the situation upside down again and trigger similar effects as in March 2020. This may occur, for example, if a new strain emerges with a substantially increased fatality rate, is spread relatively easily and vaccinations are of only mediocre effectiveness against the new strain. Yet, this scenario is rather unlikely given that with each wave, the number of infections remains at a relatively similar level, while hospitalizations and fatalities decline. Furthermore, virus strains that spread more easily, such as Omicron, frequently are less deadly. These two observations favour the good scenario going forward. In an environment of high volatility and many opportunities, alternative assets are well positioned. Figure 4 highlights the volatility in the market measured by the VIX. Since the occurrence of Covid-19, the volatility in markets has never reached levels prior to Covid-19, although there has been a massive improvement. From the peak in March 2020 and a level of more than 80, markets have stabilized between 15 and 25 in quiet times with occasional spikes. With regards to alternative assets, 2020 and 2021 were highly beneficial for several reasons. Firstly, in crises, actively managed vehicles are of increased interest as they try to mitigate the negative impact of the crisis. Secondly, due to the nature of being a healthcare crisis, this brings many opportunities with it. Thirdly, the substantial uncertainty in markets also favour alternative assets, as for example, private equity funds are less sensitive to significant short-term volatility. 2021 was especially profitable for the private equity and hedge fund industry, which make up the largest part of alternative assets. In the following sections, hedge funds, private equity, private debt and crypto assets are discussed in a more detailed fashion. Figure 1: US National Debt History in Number of Days Between Trillion USD, Source: Compound Advisors, December 2021 Figure 2: S&P 500 from December 2019 to December 2021, Source: The Wall Street Journal, December 2021 Figure 3: Euronext 100 from January 2020 to December 2021, Source: Euronext, December 2021 Figure 4: VIX Level from January 2020 to December 2021, Source: CBOE, December 2021  Hedge Funds The hedge fund industry was among the largest winners in 2020 and 2021. The industry could turn around its largely negative perception stemming from the aftermath of the financial crisis in 2008. After the initial dip to below $3tn in AuM in early 2020, it bounced back strongly and reached a new record AuM in 2021 of above $4tn. In 2021, the number of launches exceeded the number of closures for the second year in a row, which did not happen several years prior to Covid-19. In 2022, the industry is expected to maintain the current level of growth, at least in terms of inflows but not necessarily the performance numbers that significantly contributed to the growth in AuM this year. In terms of performance, our SMC Cross-Asset indices are up 62% and 57% as of November 2021. The most successful strategies were cryptocurrency-based, which were up between 100% and 400%. Our SMC Tactical Trading Strategy Index which is based on global macro strategies gained 37.6%. Equity strategies have faced more difficulties in 2021, as our SMC Equity Strategy Index is up only 10%. Fixed income strategies had considerably more volatility, as some strategies have gained almost 20%, while others were around 0% during most of the year. Lastly, fund of hedge funds (FoHF) strategies were up between 3% to almost 10%. Hedge funds will continue to see inflows in 2022, due to favourable economic ecosystem involving high uncertainty. High uncertainty requires nimble adjustments, such that active management is of high interest. Another crucial development is the relatively unattractive situation to commit capital in the public market at the moment. It is neither attractive to buy overvalued stocks nor is it attractive to buy low interest bonds. For this reason, hedge funds with a partial exposure to the private sector are of additional interest. Within private markets, investors seek venture capital and private credit as the preferred alternative investments. Private Equity & Private Debt The private equity industry had the best year among any type of alternative asset. After an initial slump in early 2020, due to difficulties in the deployment of capital, the industry started to rebound strongly in the second half of 2020. In 2021, this development further strengthened and was bolstered by the public equity market. This is clearly observable by a record year of IPOs and SPACs. The private equity industry had performed very well and substantially better than public equity markets. According to Cambridge Associates, the US Private Equity Index gained more than 20% as of Q3 2021, while their venture capital index is up almost 50% as of Q3 2021. The industry sat on a record level of dry powder ahead of Q2 2020, which continuously increased and has not changed by now despite a huge number of deals at record valuations. These valuations are caused by the high valuation in public market and the pressure of funds to commit capital, especially after the initial break when Covid-19 emerged. According to Pitchbook and BIS, the private equity industry is sitting on a cash pile of $1.2tn with another $700bn in venture capital. In each quarter in 2021, the industry saw new records of cash inflows and it is widely assumed that this trend will continue with the lack of viable investment opportunities in the public markets and the attractive performance of the private industry in the past two years. Within the private equity industry, venture capital is clearly the most sought-after strategy and also saw the highest relative inflows in the recent time. Figure 5 shows the preferred sector allocations based on the type of investment. For all, private equity, venture capital and private credit, information technologies and services are most prominent but to vastly different extents. Especially for venture capital, of which information technologies account for 40% of capital committed. With regards to 2022, it is strongly assumed that the trends of 2021 will continue with minor changes. AuM, dry powder and fundraising will maintain the growth from 2021. Whether the performance of the industry will follow the results from 2021 is questionable and will likely result in slightly smaller numbers. Nonetheless, this is also dependent on the public equity market and how the development of IPO continues. It is also likely that the capital commitments to information technologies will decline slightly for industries that have been hit hard initially by Covid-19 and have not recovered to a similar degree than the economy as a whole. The private debt industry did well in 2021, although not to the degree of hedge funds or private equity. However, the outlook for the industry looks brighter than for the aforementioned alternatives, at least compared to the relative level the industries are now. Most of the factors mentioned why private markets are attractive in that ecosystem also favour private credit. The main argument is obviously the extremely low interest rates from bonds worldwide, which automatically makes yields from private investments more attractive. The structural shift imposed by Covid-19 also benefits the industry. Firstly, certain strategies, in particular distressed debt which is highly attractive given the support from governments for companies that likely would have ended in bankruptcy without the support. Secondly, the number of non-bank lenders has substantially increased which shows that the industry is maturing. Figure 5: Sector Allocation in 2021 by Private Equity, Venture and Growth Capital and Private Credit, Source: BIS & Pitchbook, December 2021 Blockchain / Cryptocurrencies 2020 and 2021 were the years of cryptocurrencies. In both years, these assets achieved astronomical returns. Bitcoin’s (BTC) returns were 430% and 134% in 2020 and 2021, which is of the lower numbers especially in 2021. In 2021, altcoins substantially outperformed BTC and brought an immense improvement of the blockchain technology on the markets. Going forward, it is unlikely that companies will not employ the blockchain technology internally. In 2021, the total market capitalization of all cryptocurrencies combined rose from around $800bn to around $2.2tn at the time of writing, although it almost reached the $3tn mark in November 2021. This is shown in more details in Figure 6. BTC’s market capitalization is $900bn, followed by Ethereum’s (ETH) with $446bn. ETH was extremely profitable, both in 2020 and 2021, with returns of 463% and 410% despite being significantly below its record high of 2021. The major changes in 2021 came in the improvement of the infrastructure of the blockchain technology, in particular with Solana (SOL) in the latter half of 2021. Consequentially, SOL’s YTD in 2021 is 10,851%. Infrastructure in blockchain refers to validation algorithm of the blockchain itself, among others. While it was clear that proof-of-work (PoW), as used in BTC and ETH 1.0, is not sustainable and has raised major doubts over the industry, proof-of-stake (PoS) was the first major improvement, e.g., used in ETH 2.0 by bundling computation power instead of competing with computation power. Nonetheless, the PoS algorithm is still way too slow for the everyday application of cryptocurrencies. Thus, layer two solutions were invented to validate transaction on off-chains to increase the transaction validation speed. Yet, the new approach piloted by SOL, proof-of-history (PoH) operates at such a high velocity that layer two solutions are no longer necessary. Application based on cryptocurrencies started towards the latter part of 2020 and continued in 2021. The attempt is to gradually rebuild traditional financial services on cryptocurrencies to cut costs and improve efficiency. The most prevalent services are lending and decentralized exchanges (DEX). These services are summarized under DeFi (decentralized finance) and further categories include automatic market makers or asset management solutions. Those services require a back-up, which is known as value locked in DeFi and it is frequently used as proxy for the market size of DeFi. During 2021, DeFi grew from around $15-$20bn to above $100bn. The rise of total value locked in DeFi and the decomposition based on the referring category is shown in Figure 7. In early 2021, NFTs (non-fungible tokens) rose to prominence and strong interest mostly coincided with surges in altcoins. NFTs grant ownership rights to (mostly) digital assets. Most of them are related to art and collectibles but increasingly more interest goes towards gaming, as shown in Figure 8. The last major “invention” in 2021 came from Facebook’s rebranding to Meta. The metaverse, essentially a digital reality, became hugely interesting overnight. Tokens that already focused on the metaverse surged multiple 100% over a very short time and the crypto industry is developing very quickly. For example, there were already sales of digital land for multiple $10m. With regards to expectations in 2022, it is likely that cryptocurrencies will remain in high demand due to the inflation concerns, which will not fade away very soon. In 2021, the industry has seen massive inflows in mostly BTC from large asset managers. The more comfortable these intuitions get, the more will be allocated to this new asset class and not only to the most conservative assets in the space. Hence, the industry is likely to see further inflows, although it is always important to consider the riskiness of the asset class and if a major loss should occur, this would cost most of the trust gained by the industry over the past two years. Nonetheless, such a scenario seems rather unlikely at the current stage. The industry is also likely to see inflows into early-stage projects in the form of venture capital and larger private equity funds. Lastly, a substantial increase in capital will flow towards metaverse products and applications as well as gaming, as it has been the case with DeFi and NFTs this and last year. Figure 6: Total Cryptocurrency Market Capitalization in 2021, Source: CoinMarketCap, December 2021 Figure 7: Total Value Locked in DeFi by Category in 2021, Source: DeBank & The Block, December 2021 Figure 8: Weekly Trading Volume of NFTs by Category in 2021, Source: Cryptoslam & The Block, December 2021 STONE MOUNTAIN CAPITAL Stone Mountain Capital is an advisory boutique established in 2012 and headquartered in London with offices Pfaeffikon in Switzerland, Dubai and Umm Al Quwain in United Arab Emirates. We are advising 30+ best in class single hedge fund and multi-strategy managers across equity, credit, and tactical trading (global macro, CTAs and volatility). 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