alternative markets update h2 2021 outlook

​The macroeconomic environment will largely drive the market in H2 2021, which itself is based on significant degree how Covid-19 will evolve in the near future. With regards to the pandemic, the key questions are how the number of vaccinations evolve going forward, in particular as developed economies no longer have shortages of vaccines, but rather a declining number of people that want to get vaccinated. A crucial point is whether herd immunity can be achieved, either by being vaccinated or having had the virus. Another important point is how long the vaccine will last, as the cases of vaccinated people contracting the virus rises. Luckily, the symptoms seem to be minor. Probably even more important is whether new strains of the virus emerge that completely bypass vaccinations and essentially setting the world back to March 2020. The latter scenario seems less likely but should be considered to some degree. In a non-negative scenario, US inflation is likely to drop towards the end of the year with expectations around 3%. For the next years, it is expected that US inflation will remain between 2% and 3%, following the change in the FED’s inflation target of being 2% in the long-term instead of capping inflation at 2%. Thus, it is unlikely that inflation will drop below 2% for quite some time. In the EU, the inflation outlook is lower compared to the US, as the ECB expects inflation to rise to around 2.6% in Q4 2021. In 2022 and 2023, inflation is expected to remain around 1.5%. Furthermore, the FED and ECB also hinted at possibly putting more emphasis on employment instead of inflation going forward. This suggests gold being well positioned in the current market. As of July 2021, gold is almost back at its average in 2021 of $1800 per ounce. Despite being at a relatively high level historically, gold seems attractive with surging inflation and short-term interest rates being very close to 0%. Yet gold’s record high of more than $2000 per ounce lies back almost a year, at a point in which inflation was at 1% and not a concern for many. Since May 2021, inflows in gold ETFs are positive again albeit a bit sluggish. This is remarkable as previously, there were mostly only net outflows. Currently, the global gold AuM is at $214bn. Equities, in particular in the US, have experienced a great 2021, as shown in Figure 1. The S&P 500 is trading very close to its record high of around 4,450. During 2021, expectations for the S&P 500 level were adjusted multiple times. At the end of 2020, when the S&P 500 was 3,700, moderate expectations were around 3,900, while optimistic scenarios targeted 4,300. Yet, all those expectations were already surpassed in the low-interest rate environment, monetary stimulus and increased corporate earnings due to the recovery of the economy. Goldman Sachs has updated its target for the S&P 500 to 4,700 at the end of 2021. Contrarily, Chinese tech companies have suffered in July with the worst month since the financial crisis in 2008. Investors feared the crackdown of Chinese regulators on tech companies. Figure 2 shows valuations of Chinese companies listed in Hong Kong and in the US. Not only, are Chinese tech companies strongly undervalued compared to US tech stocks. Furthermore, Chinese tech companies listed in the US are even stronger undervalued, as very few even reach a multiple of 5, as shown in Figure 2.

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RESEARCH PERSPECTIVE VOL. 161 August 2021 Alternative Markets Outlook H2 2021 The macroeconomic environment will largely drive the market in H2 2021, which itself is based on significant degree how Covid-19 will evolve in the near future. With regards to the pandemic, the key questions are how the number of vaccinations evolve going forward, in particular as developed economies no longer have shortages of vaccines, but rather a declining number of people that want to get vaccinated. A crucial point is whether herd immunity can be achieved, either by being vaccinated or having had the virus. Another important point is how long the vaccine will last, as the cases of vaccinated people contracting the virus rises. Luckily, the symptoms seem to be minor. Probably even more important is whether new strains of the virus emerge that completely bypass vaccinations and essentially setting the world back to March 2020. The latter scenario seems less likely but should be considered to some degree. In a non-negative scenario, US inflation is likely to drop towards the end of the year with expectations around 3%. For the next years, it is expected that US inflation will remain between 2% and 3%, following the change in the FED’s inflation target of being 2% in the long-term instead of capping inflation at 2%. Thus, it is unlikely that inflation will drop below 2% for quite some time. In the EU, the inflation outlook is lower compared to the US, as the ECB expects inflation to rise to around 2.6% in Q4 2021. In 2022 and 2023, inflation is expected to remain around 1.5%. Furthermore, the FED and ECB also hinted at possibly putting more emphasis on employment instead of inflation going forward. This suggests gold being well positioned in the current market. As of July 2021, gold is almost back at its average in 2021 of $1800 per ounce. Despite being at a relatively high level historically, gold seems attractive with surging inflation and short-term interest rates being very close to 0%. Yet gold’s record high of more than $2000 per ounce lies back almost a year, at a point in which inflation was at 1% and not a concern for many. Since May 2021, inflows in gold ETFs are positive again albeit a bit sluggish. This is remarkable as previously, there were mostly only net outflows. Currently, the global gold AuM is at $214bn. Equities, in particular in the US, have experienced a great 2021, as shown in Figure 1. The S&P 500 is trading very close to its record high of around 4,450. During 2021, expectations for the S&P 500 level were adjusted multiple times. At the end of 2020, when the S&P 500 was 3,700, moderate expectations were around 3,900, while optimistic scenarios targeted 4,300. Yet, all those expectations were already surpassed in the low-interest rate environment, monetary stimulus and increased corporate earnings due to the recovery of the economy. Goldman Sachs has updated its target for the S&P 500 to 4,700 at the end of 2021. Contrarily, Chinese tech companies have suffered in July with the worst month since the financial crisis in 2008. Investors feared the crackdown of Chinese regulators on tech companies. Figure 2 shows valuations of Chinese companies listed in Hong Kong and in the US. Not only, are Chinese tech companies strongly undervalued compared to US tech stocks. Furthermore, Chinese tech companies listed in the US are even stronger undervalued, as very few even reach a multiple of 5, as shown in Figure 2. Figure 1: Value of the S&P 500 from January 2021 to August 2021, Source: The Wall Street Journal, August 2021 Figure 2: Valuation of Chinese Internet Companies in Hong Kong and the US as of 30th July 2021, Source: The Multipolarity Report, August 2021 Hedge Funds During 2021, the AuM of hedge funds has surged to a record high of $3.96tn according to HFR. The performance of the industry in H1 2021 was great but varies depending on the source. Most estimates report performances between 10% and 13% in H1 2021, which makes it the best H1 in the last two decades. These numbers have led to substantial increases in capital in the industry alongside how Covid-19 was managed. Hedge funds have struggled to keep up with the performance of equity indices, which led to long times of consistent net outflows. The strong performance of hedge funds has slightly declined in June and July, during which the industry experienced some net outflows again. Yet, the industry is well positioned going forward. Equities are expected to continue to perform well in 2021, albeit not to the same degree as so far in 2021. The current economy has a wide range of opportunities, such as equity and commodity price volatility and inflation. The wide array of opportunities has also led to a surge in launches of niche strategies, as Figure 3 shows. Niche strategies in Q2 2021 accounted for more than 20% of fund launches, compared to around 5% in Q3 2020. Other profiteers were equity and event driven strategies. All those increases were largely on the cost of credit strategies. In the current environment, it is very likely that the industry will continue to grow supported by both, inflows and growth through performance. This is further backed by the Hedge Fund Conference Index which showed that the industry is as confident as it has not been in many years. Yet, one should remain cautious to some degree, not only if the environment changes, but also with regards to the performance of hedge funds. Figure 4 shows a comparison of hedge fund returns compared to the S&P 500. While hedge funds achieved better results in Q4 2020 and Q1 2021, the industry was significantly under the return of the S&P 500 in Q2 2021. If that should continue, the hedge fund industry is in danger to be perceived similarly as before Covid-19, when the industry was largely seen as an inferior product to passive index funds. Figure 3: Hedge Fund Launches by Strategy from Q3 2020 to Q2 2021, Source: Preqin, August 2021 Figure 4: Performance of Hedge Funds Compared to the S&P 500 Over the Last 5 Years, Source: Preqin, August 2021 Cryptocurrencies / Blockchain Cryptocurrencies have experienced considerable volatility in 2021. They strongly surged until April 2021. When Bitcoin (BTC) hit its all-time in April 2021, it fell slightly and remained relatively constant around $50k to $60k. In mid May 2021, altcoins reached their peak, after which the cryptocurrency market crashed. At its height, its market cap was around $2.5tn and it dropped $1.25tn in only two weeks. At the time of writing, the total market cap just surpassed the $2tn mark again, after a strong performance of the industry since August 2021. BTC rose to $46,400, while Ethereum (ETH) is already back at $3,250. An outlook of where cryptocurrencies are going is obviously difficult to obtain, as there are barely any valuation models. The most widely used model for BTC is the stock-to-flow model shown in Figure 5. It expresses the price of BTC through the number of BTC’s earned from mining. Therefore, the halvening that takes place all four years is crucial, as the model assumes that the price of BTC increases by 10x every time the mining reward is cut in half. At the current stage, when 6.25 BTC are mined, the projected price of BTC should be $100k. From past data, it is observable that it usually takes 1.5 years after the halvening to reach this projected price. Towards Q3 2021, the price should be close to $100k per BTC. Historically, when BTC was above its projected price, it usually crashed severely. In particular, in the early 2010s, it frequently crashed by more than 90%. The more recent crashes, 2017/18 and 2021, the price was only slightly above the target, yet the crashes were substantial in particular from the view of classic finance, not necessarily from the view of a crypto veteran. Given those observations, it seems likely that BTC will continue to rise, well past its previous record of almost $65k but it is doubtful whether the $100k is reasonable, and if the mark is reached, it is very susceptible to crashes. 2021 and 2022 will be crucial years for the valuation of BTC through the stock-to-flow going forward, as it will give a lot of insights on the model’s accuracy. One should be in cautious, as it is very questionable if BTC would have reached a valuation even close to what it is now, if Covid-19 and the measures by governments and central banks would not have happened. Inflation and being a gold alternative have certainly boosted cryptocurrencies massively. Moreover, the industry has experienced huge inflows from institutional investors with hedge fund launches in the crypto space almost on a weekly basis. Figure 5: Stock-to-Flow Model for Bitcoin’s Valuation from 2010 to 2021, Source: Buy Bitcoin Worldwide, August 2021 Private Equity / Venture Capital The private equity industry will remain in a great position for H2 2021. The returns from 2020 and 2021 were very high, even compared to other good years. This is in particular surprising in 2020, as how business is conducted nearly had to be rebuilt. The major drivers of the performance in H1 2021 will not go away in H2 2021. The economy is still recovering and likely to get closer back to normal than ever since the pandemic. Interest rates are very likely to remain low for quite some time; thus, financing will remain cheap. Despite the strong fundraising since Q4 2020, the available dry powder is still close to its record high. In addition, public markets remaining strong but to a lesser degree, makes private investments even more attractive. The IPO market is still huge, as 2021 has already broken all previous records. Going forward, the number of IPOs is likely to decline slightly but should remain resilient. Figure 6 shows the number of public offerings from 2000 to 2021. The fierce competition for the deployment of capital also will benefit the industry in the short-term, as it boosts valuations. It is likely that similar patterns as in earlier crises will occur again, meaning that the returns during the crisis will be extremely strong but will decline afterwards. One can expect that private equity returns will remain quite high going forward but with a declining trend. A similar scenario is likely for venture capital. Fundraising is likely to continue as strong as it is currently, certainly further elevated by the stellar performance of the industry since Covid-19 emerged. Figure 6: Number of Public Offerings (IPO, Direct Listings, Reverse Mergers, Dutch Auctions & SPACs), Source: Pitchbook, August 2021 Private Debt The industry managed to reach a record AuM of $1.05tn in H1 2021. However, the industry is still facing issues in particular in the deployment of capital, as despite its relatively low numbers in fundraising, the industry’s amassed dry powder has continuously increased and is at a record level of $380bn. Although there are issues, the industry is well positioned going forward, as interest rates are low, and other alternatives such as equities are getting expensive, and their returns are expected to shrink as well as there being a non-negligible crash risk. In this setting, private debt presents itself as a good alternative. In order to take full advantage of the current situation and to deploy a sufficient amount of capital, the discontinuation of governmental support is awaited in the industry. In the currently highly volatile market, senior-secured loans and generally relatively defensive investments are of high interest. One important factor to consider are the default rates, which so far have remained very low for investment grade corporations due to the governmental support. On the contrary, speculative-grade corporate default rates have surged since Covid-19, as shown in Figure 7. The default rates in the US are substantially higher than globally, with Europe being significantly lower than the global average. Given the current preference for defensive investments, this may be one reason why Europe’s fundraising accounted for almost 60% of global fundraising in Q2 2021. Figure 7: Default Rates for Speculative-Grade Corporations from 2018 to 2021, Source: Russell Investments & Moody’s Investor Service, August 2021 Real Estate Among the covered alternative assets, real estate certainly had the most issues, as 2021 will likely be the worst year in terms of fundraising in the last decade. Fundraising has collapsed in Q2 2021 as it was well below any other quarter in the last few years. For real estate overall, it is crucial that the world is going back to normal as soon as possible. Yet, this seems unlikely in the short future, as some companies still work from home and plan to introduce this form of work partially for the future, which puts offices under pressure. The beneficiary of this development is residential real estate. However, the overall picture for real estate does not look that grim, as real assets are in high demand under inflation, in particular if it continues to rise. Additionally, in Europe, the real estate market is on track for a robust recovery. 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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