ALTERNATIVE MARKETS UPDATE - H2 2022 OUTLOOK

​Alternative Markets Outlook H2 2022
Inflation will likely dominate the news in the latter half of 2022. It is likely to stay high although decreasing. Exact predictions are always difficult, especially in such a market environment. This is also observable in the research from economists who struggle to predict accurately, as employment is high, GDP is shrinking, and the current inflation issues. Whether inflation will in fact slow down is largely dependent on the ongoing war between Russia and the Ukraine, as energy and food are the main drivers behind the current inflation levels. Regardless of how the war ends, even if soon, there is a low chance that the energy supply of Russia to Europe will ramp up significantly. There may be some help from the OPEC+ countries in alleviating the problem but high energy prices are obviously beneficial for them. Food inflation on the other hand is likely to go down to some degree, as the Ukraine is a key supplier assuming that it remains independent. The energy situation will get very tense during the winter, as Europe is expecting energy shortages. It is likely that energy inflation will spike there. Afterward, in early and mid-2023, the situation likely will improve. At that point, energy prices have a chance to enter a deflationary state, as inflation is measured on a year-on-year basis, in particular when considering that energy inflation is higher than 40% in the US for example. The remaining subcategories in inflation measures are more affected by actual central bank measures. In particular, the US and the UK have taken substantial measures to combat current inflation. At least in the US, the measures have relieved some of the pressure as the monthly inflation fell for the time in a couple of months. However, this does not ease the pressure, as such events must be persistent. It is likely that this will continue, especially if the Fed keeps rising its interest rates, which some of the board members intend to do. It is expected that inflation will keep going down during 2022 and 2023. Frequently expected intervals estimate inflation to be between 2% and 4% towards the end of this period. Figure 1 shows expectations for the core CPI in the year 2023 alongside a lagged M2 growth measure. In Europe, the situation in terms of food and energy is more dire, due to its direct reliance on Russia. However, energy inflation surprisingly is lower than in the US but is rapidly growing, especially with the current concerns about the winter ahead. In terms of central bank measures, it becomes a bit more tricky, as the ECB has to manage many countries and consider their economic situation. This is where its major problem occurs, as large countries, such as Italy, are in a dangerous position. Its debt level is extremely high and it is potentially at risk of defaulting if interest rates should rise. On the other hand, the ECB has to combat the ever-soaring inflation by rising the interest rates. This dilemma will likely reduce the ECB's capabilities to combat inflation by rising interest rates as the UK or the US did. Most likely, this will cause inflation to be mitigated slower and to a lower degree. It is therefore expected that inflation in Europe will still rise in the latter half of 2022 and decline slower than in the US or the UK. This assumption is based on a status quo-like ongoing war. Nonetheless, sudden events can massively alter this outcome. Contrary to the outlook of Europe, the US’s development in July 2022 is largely positive. Firstly, it managed to reduce inflation slightly for the first time in multiple months. Secondly, US employment is back at pre-Covid levels and at the highest since 1969. While the economy lost 22 million jobs in the first two months of the Covid outbreak, in July 2022, it regained all of them. The impressive recovery is shown in Figure 2.

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RESEARCH PERSPECTIVE VOL. 185 August 2022 Alternative Markets Outlook H2 2022 Inflation will likely dominate the news in the latter half of 2022. It is likely to stay high although decreasing. Exact predictions are always difficult, especially in such a market environment. This is also observable in the research from economists who struggle to predict accurately, as employment is high, GDP is shrinking, and the current inflation issues. Whether inflation will in fact slow down is largely dependent on the ongoing war between Russia and the Ukraine, as energy and food are the main drivers behind the current inflation levels. Regardless of how the war ends, even if soon, there is a low chance that the energy supply of Russia to Europe will ramp up significantly. There may be some help from the OPEC+ countries in alleviating the problem but high energy prices are obviously beneficial for them. Food inflation on the other hand is likely to go down to some degree, as the Ukraine is a key supplier assuming that it remains independent. The energy situation will get very tense during the winter, as Europe is expecting energy shortages. It is likely that energy inflation will spike there. Afterward, in early and mid-2023, the situation likely will improve. At that point, energy prices have a chance to enter a deflationary state, as inflation is measured on a year-on-year basis, in particular when considering that energy inflation is higher than 40% in the US for example. The remaining subcategories in inflation measures are more affected by actual central bank measures. In particular, the US and the UK have taken substantial measures to combat current inflation. At least in the US, the measures have relieved some of the pressure as the monthly inflation fell for the time in a couple of months. However, this does not ease the pressure, as such events must be persistent. It is likely that this will continue, especially if the Fed keeps rising its interest rates, which some of the board members intend to do. It is expected that inflation will keep going down during 2022 and 2023. Frequently expected intervals estimate inflation to be between 2% and 4% towards the end of this period. Figure 1 shows expectations for the core CPI in the year 2023 alongside a lagged M2 growth measure. In Europe, the situation in terms of food and energy is more dire, due to its direct reliance on Russia. However, energy inflation surprisingly is lower than in the US but is rapidly growing, especially with the current concerns about the winter ahead. In terms of central bank measures, it becomes a bit more tricky, as the ECB has to manage many countries and consider their economic situation. This is where its major problem occurs, as large countries, such as Italy, are in a dangerous position. Its debt level is extremely high and it is potentially at risk of defaulting if interest rates should rise. On the other hand, the ECB has to combat the ever-soaring inflation by rising the interest rates. This dilemma will likely reduce the ECB's capabilities to combat inflation by rising interest rates as the UK or the US did. Most likely, this will cause inflation to be mitigated slower and to a lower degree. It is therefore expected that inflation in Europe will still rise in the latter half of 2022 and decline slower than in the US or the UK. This assumption is based on a status quo-like ongoing war. Nonetheless, sudden events can massively alter this outcome. Contrary to the outlook of Europe, the US’s development in July 2022 is largely positive. Firstly, it managed to reduce inflation slightly for the first time in multiple months. Secondly, US employment is back at pre-Covid levels and at the highest since 1969. While the economy lost 22 million jobs in the first two months of the Covid outbreak, in July 2022, it regained all of them. The impressive recovery is shown in Figure 2. Figure 1: Comparison of the Core CPI Inflation and the M2 Growth Lagged by 13-Months from 2017 to 2023, Source: Bureau of Labor Statistics, Federal Reserve & Egan Jones, August 2022 Figure 2: US Total Nonfarm Payrolls in the US from January 2020 to July 2022, Source: Charlie Bilello & YCharts, August 2022 Aside from the geopolitical tensions and inflation concerns around the world, a potential recession is another issue. While equities, especially in the US declined substantially this year, this is largely in line with a correction from the past two years. When comparing the current levels to their historical average, equity levels are where they should be. Over the past months, the risk of recession is increasing. Alongside the severe correction from the bull market in 2020 and 2021, the steep central bank interventions put pressure on markets. This stems from two sources. Firstly, higher interest rates mean higher discounting, which puts valuations at lower levels. Secondly, the money injected into the economy by quantitative easing will be rolled back which takes money out of the market. While the Fear & Greed Index is currently neutral, it has remained largely in the fear and extreme fear area throughout the year with the exception of a couple of weeks. Figure 3 shows the levels of the index over the past year. Other commonly used recession indicators, such as yield curve inversions, are at alarming levels. While there have been many minor inversions since Covid-19 between some specific maturities, none of them lasted as long as the current one and to that degree. Currently, between the 10-year and 2-year Treasury the spread is -0.27% and was almost at -0.5% once in the last month. Figure 4 summarizes the spread between those two maturities over the past year. In a persistent status quo situation of the current geopolitical landscape, it is reasonable that a recession can be prevented. However, if either the war between the Ukraine and Russia, or the tensions around Taiwan should escalate, the recession risk rises significantly. It also depends on how severe central banks will enforce their measures to combat inflation. For example, if the Fed is keen on combating inflation as they did this year, interest rates will rise substantially, which will likely cause a recession. Similarly, it also depends on the extent of the roll-back of their prior quantitative easing. Figure 3: Fear & Greed Index over the Past Year, Source: CNN, August 2022 Figure 4: 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity, Source: Federal Reserve Bank of St. Louis, August 2022 Hedge Funds Performance-wise, the outlook for hedge funds is not great given the rather negative outlook for the economy as a whole. This is further emphasized by the slow reaction of hedge funds in H1 2022, when they did not manage to mitigate the drawdowns. This is in stark contrast to their reaction when Covid-19 hit when they mitigated the drawdown very well. In particular equity-based strategies will be under pressure going forward as the outlook for equities is rather grim as highlighted previously. Fixed income strategies have the chance to reclaim their losses with the rising interest rates, especially if those should go higher than anticipated. The ecosystem for global macro strategies will not be as beneficial as it has been in H1 2022, but there is still a lot of room for opportunities with the huge uncertainty in the market. The AuM of the industry is also likely to decrease in the following quarters. Outflows have increased and will continue, as investors are not satisfied with their downside mitigation in 2022. The wave of redemptions will continue, due to redemption periods and rigid processes for institutional investors. As performance will likely not be great in the latter half, the AuM is likely to decrease. However, with the large success of global macro funds, this sector is likely to see further inflows but will not cover the dissatisfaction and the resulting outflows from other strategies. Cryptocurrencies / Blockchain Cryptocurrencies had a horrendous 2022 so far, as almost all coins lost at least 60% at some point in 2022. Nevertheless, the industry is still a lot better off than before Covid-19. Bitcoin (BTC) lost almost 60% in value during 2022 and is currently trading at $21k. Similarly, Ethereum also lost a majority of its value from 2021 and currently trades at $1.5k. Figures 5 and 6 show the development of BTC and ETH in 2022. Most other currencies are even lower relative to their 2021 highs. Since August, cryptocurrencies seem to have recovered some of their losses, but they lost most of their gains again last week. The drawdown of the entire cryptocurrency market can be observed in Figure 7, which shows the total market capitalization of the industry since the beginning of the year. Currently, the industry in total has $1tn in assets. As very risky investments, it is likely that cryptocurrencies will suffer most if the crisis should become more serious, especially if the economy enters a genuine recession. One point of relief for the industry is that the high correlation with the equity market observed at the beginning of the year has largely subsided, which is commonly seen as a healthy indicator for the industry. Additionally, there is great news ahead related to the Ethereum network. In mid-September 2022, the “merge” will take place, which will merge the currently two outstanding Ethereum coins, which differ in the way that they are mined. The older version is based on the Proof-of-Work algorithm that is widely criticized for its high electricity usage. The newer version is based on Proof-of-Stake, in which computational power is shared to mine the coins instead of a winner-takes-all approach. It is likely that this event will put cryptocurrencies in the media again, similar to the Bitcoin halvings all four years, after which the industry usually rises substantially. Whether this will be persistent is another question, however. If the current crisis should subside rather quickly, this is likely very beneficial for the crypto space, as it usually responds the fastest. One great example is after the governmental interventions following the Covid-19 outbreak. If the economy should enter a recession, it is unlikely that the industry will lose much more, as the industry’s drawdowns are getting smaller and smaller with its continued maturity. Additionally, the substantial commitment from institutional investors also holds more capital bound and is no longer fully retail-based. Moreover, the industry also benefits from its continuous updates. This includes decentralized finance (DeFi) in 2020, NFTs in 2021, and the metaverse at the end of 2021. These aspects are likely to become more important going forward. Figure 5: Value of Bitcoin from January to August 2022, Source: CoinMarketCap, August 2022 Figure 6: Value of Ethereum from January to August 2022, Source: CoinMarketCap, August 2022 Figure 7: Total Market Capitalization from January to August 2022, Source: CoinMarketCap, August 2022 Private Equity / Venture Capital Private equity will face a tumultuous time ahead but is still well positioned in these markets. There are short-term issues related to performance, which are not incorporated yet, as their valuations lag behind public markets. How severe this impact will be is unknown at this stage and also depends on how the economy will recover, or if there indeed will be a larger recession. In any case, this will have a smaller impact on private markets than public markets, at least based on historical performance. Furthermore, the industry has benefited in large terms from the times after the crisis subsided, as private equity had its best years after the global financial crisis following the year 2008. Such crises are also less relevant in the lifetime of those funds, as they are around 10 years, and it is likely that the last two years will mitigate most of the issues ahead. Aside from the obvious economic implications (such as increased default risks due to higher financing costs), fundraising could be difficult in the short term. Given the historically strong performance of the asset class, it is important for investors to find the right tipping point, which mitigates most of the crisis, but also should catch most of the bull run afterward. The lack of new capital is likely not a significant issue for the industry, as dry powder levels are still close to their record high. Funds can use those to mitigate a low amount of new capital in the short run. Within private equity, venture capital did the best over the past years. Especially in the last two years, the sector returned record performances. This attracted a lot of new investors, and although fundraising declined, it did so by a small percentage compared to many other sectors. Despite the increased number of funds deploying capital and the decreased fundraising, the sector is still sitting on a record amount of dry powder. VC sits on more than half a trillion in capital, making up more than half of the dry powder of the private equity industry. Figure 8 shows the total dry powder of VC from 2000 to July 2022. Even if VC should face some losses, it is unlikely that investor interest will decline given its strong growth in the last couple of years. Figure 8: Global Venture Capital Dry Powder from January 2000 to July 2022, Source: Preqin, August 2022 Private Debt Private debt is in a good stage at the moment, especially if inflation keeps going down. The rising interest rates mean that the returns of the industry will improve as well. Additionally, companies may find it difficult to get bank loans, which opens up further opportunities for the industry. Nonetheless, the industry needs to weather the current storm of high inflation that consumes most of its gains. This is still a good state, as it is currently very difficult to achieve inflation-adjusted positive returns. Unlike many other industries that struggle to raise capital, fundraising in 2022 has been very consistent and is the best year so far with the exception of 2021. While the outlook for the industry is very favorable as a whole, it is dependent on the evolution of inflation. Another crucial point is that the industry managed to surpass the $1tn AuM mark recently. Given this outlook and the rather bad outlook for most other types of investment, the industry will continue its strong growth. Preqin supports this view as it is expected that the industry will reach $2tn within the next five years and manifest itself as a key investment strategy in the alternative space. Real Estate The real estate industry is in a difficult place. The industry suffered massively since Covid-19 emerged. Housing prices kept soaring and many people can no longer afford their own houses. House prices soared to record levels in many places across the world but have declined since then. Nonetheless, they are still at very high levels and voices about a real estate bubble are increasing. This is in particular threatening with the high inflation that increases living costs for individuals substantially and with the now rising interest rates. The latter means that mortgages are getting more expensive and pose the issue that people can no longer afford their houses. It is not unlikely that this could happen on a large scale which would bring house prices crashing down. From an investment point of view, this development does not make real estate appealing. Furthermore, the currently high inflation is likely to consume the passive gains from the initial investments. Additionally, the higher interest rates also make the financing costs more painful. Other sectors, such as offices, are also no longer persistent investments, as Covid-19 led to a shift in how people work, at least to a degree. These concerns have shown to be considerable, as fundraising in the last two quarters is on par with the worst quarters within the last five years. One potentially saving grace is the steady income stream similar to private debt, which is attractive in this environment, especially if inflation should decrease substantially. However, it is questionable how favorable this will be as it will likely be achieved by higher interest rates that hurt the industry on the other hand. 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