Inflation was a core issue in 2022 and remains to be one in 2023. In the US, inflation started to decline in the summer of 2022 and remains currently at a level of 7.1%. Contrarily, in Europe and the UK, inflation remains a huge issue and has barely declined from its peak in 2022. It remains at 11.1% for the EU and at 10.7% for the UK. The difference between the inflation can largely be attributed to two factors. Firstly, the Fed hikes interest rates more aggressively than its European counterparts. This led to a quicker response to inflation. Secondly, Europe is more directly affected by the war between Russia and Ukraine and is largely dependent on Russian oil and gas, which soared in price following the war. Contrarily to other European countries, Switzerland managed to keep inflation relatively low with a peak in late summer 2022 at 3.5% and 3% currently. Switzerland managed to avoid high inflation due to its strong currency and relatively low demand for fossil fuels, as most of its electricity stems from hydropower and nuclear power. In Asia, both Japan and China also experience limited inflation issues. Japan achieved this through its central bank which continuously intervenes with large-scale monetary easing. Despite the low inflation, Japan is still suffering, as wages remain stagnant unlike in other major economies where it helps offset the higher inflation to some degree. China does not face an inflation problem, due to their different handling of the Covid crisis. Unlike most economies, they did not provide large stimuli to the economy. Additionally, their zero-Covid policy substantially reduced household demands. Figure 1 shows a summary of the inflation rates across the highlighted economies during 2022. Regarding 2023, it is widely expected that inflation, especially in high-inflation countries, will come down. For instance, in the US, it is expected that inflation will be around 4% on average, and close to the 2% Fed target by the end of the year. Inflation forecasts in the EU and the UK are more difficult to estimate, due to their dependency on the war and its outcome. Additionally, unlike in the US, inflation has not really started to decrease. Assuming further strong interventions by the European central banks, it is expected that inflation will drop substantially. The ECB expects the average inflation to be around 5%-6% during 2023 with inflation slightly below 4% by the end of 2023. In the short term, Europe will be under pressure and the measures take time to become effective, as shown in the example of the US. Despite a similar outlook to the US, albeit with a delay of around half a year, it is less promising. One important wildcard is energy prices, which are strongly linked to the war. While the EU managed to get its oil largely from other sources than Russia, it still needs Russia, and gas is not as easily substitutable. With the prospect of Russia’s supply cut and China reopening, prices of energy sources are likely to increase. Depending on the scale, if it occurs, the anticipated target may not be reached and inflation will remain higher than the target. In Switzerland, inflation is expected to remain around the 3% mark for 2023. Given the strong involvement of the BoJ, Japan’s inflation is expected to end the year 2023 below the 2% inflation mark. It is additionally expected that wages will rise for the first time in three decades. Inflation in China is expected to rise to around 2% in 2023. This is a combination of the reopening of the economy and the end of the zero-Covid policy. This will lead to an increase in economic activity and the necessity for further energy. Additionally, the price pressure across will also be felt in China, once demand picks up again. The interest rate hikes by most countries have been another crucial topic during 2022. So far, the hikes have shown limited effectiveness in dealing with soaring inflation. In high-inflation countries, it was effective for the US and had little impact on the European countries. However, this discrepancy is likely due to the steeper hikes in the US and less dependency on the war by the US. The US employed the strongest measures, as it hiked from 0% at the beginning of 2022 to 4.25% at the end of 2022. In contrast, the ECB just started hiking in June 2022 at -0.5%, which increased to 2% by the end of 2022. The BoE employed a mixture of the two. The UK started hiking at the end of 2021 but hiked in smaller steps than the US. Towards the end of 2022, it increased the step size and is currently at 3.5%. Switzerland started hiking earlier than the ECB, despite substantially lower inflation. Switzerland’s prime rate became positive for the first time in years in September 2022. Currently, the prime rate is sitting at 1%. Japan was one of the exceptions, as the BoJ did not hike at all. Its prime rate remains at -0.1%. However, the central bank still strongly intervened in the market as elaborated previously. The People’s Bank of China even lowered its prime lending rate over 2022, albeit to a minimal degree. Currently, the rate is at 3.65%. There is a strong consensus for the year 2023 in the US and Japanese markets. Most market participants expect the Fed to keep raising interest rates to around 5%-5.25%. The Fed is likely to do this in smaller steps than previously. Nonetheless, this level should be reached by the end of Q1 2023. Afterward, a majority of institutions do not expect further hikes or cuts in 2023. The remainder anticipates potential interest rate cuts in Q4 2023. The exact outcome of potentially further hikes or cuts largely depends on the state of the US economy in the latter part of 2023. While the measures seem to be effective and inflation is going down considerably, the risk of a recession is considerable. This largely stems from substantially higher financing costs for businesses, and lower demand from consumers as Covid reserves are exhausted and households feel the pressure from the inflation over the past year. Given that the BoJ has not intervened by raising interest rates, it is not expected that it will in 2023. It is more likely that it will continue its qualitative and quantitative easing philosophy employed so far. In particular, as Japan does not face an imminent inflation problem. With expected wages adjusted, the pressure of inflation should also be eased without a strong necessity to make policy adjustments. For the EU, it is expected that rates will be hiked further to combat the prevalent inflation. Market participants expect interest rates of around 3%, which should be reached during Q2 2023. For the UK, additional hikes of 1% are expected, resulting in interest rates of around 4.5% for 2023. For both economies, no rate cuts are expected in the latter half of 2023. In Switzerland, the SNB is anticipated to hike another 0.5% in 2023 with no rate cuts as well.
With the final interest rate decisions of most central banks this year, it concludes a year of strong intervention to combat soaring inflation caused by the aftermath of Covid-19, and the ongoing war as well as general political instability. The Fed, the BoE, the ECB, and the SNB all increase their respective target rates by 50 basis points. The US interest rate is now at 4.25% - 4.5% with the British interest rate slightly lower at 3.5%. The European Union’s interest rate ends the year at a 2% target with the Swiss interest rate even lower at 1%. Figure 1 summarizes the interest rate hikes of these central banks during 2022. The UK and the US moved relatively quickly in increasing interest rates compared to the ECB and the Swiss National Bank. The impact of these measures is mixed at best. While inflation has been rampant throughout the year, only the Fed’s measures seem to have calmed inflation to a degree. The US inflation peaked in June at 9.1% and fell to 7.1% as of November 2022. Although they managed to control it, the degree to which inflation is reduced is far lower than the interest rate impact. Despite a similarly strong stance by the BoE, inflation is going up and down with a tendency to go up. The UK inflation remains at 10.7%. Compared to the US, the UK is dealing with several other issues not prominent in the US. Not only is the UK still somewhat in a transition phase with the EU, but it is also more directly impacted by the ongoing war and experienced a few chaotic months with the election, the resignation of ex-PM Truss, and her historical tax cut when the economy was already strongly under pressure. Inflation in the European Union is also unlikely to slow down fast given the close involvement in the war and the slow reaction to the rising inflation. As of October 2022, the EU’s inflation is the highest of the four economies at 11.5%. Lastly, Switzerland reacted slightly faster than the EU but hikes less aggressively. However, compared to the other economies, Switzerland does not face such an imminent problem with inflation, as the current inflation rate is only 3% with its previous peak being in August 2022 at only 3.5%. Figure 2 summarizes the development of inflation across the four discussed economies during 2022. Despite the general tone of central banks that they plan to decrease their balance sheet and keep raising interest rates well into 2023, market participants see fewer interest rate hikes ahead with a potential reversal earlier than expected. Going forward, interest rates will rise further with likely declining inflation, as the measures should work in the longer term. When inflation is showing signs of a continued slowdown and comes back to reasonable levels, interest rates are likely to decline gradually. This transition period will be especially intriguing to fixed income hedge funds and instruments, as high interest rates and low inflation offers stable and low-risk returns. This is especially true, as this economic ecosystem has not been present in the past decade. Equities did well in the latter half of 2022, despite the unfavorable ecosystem with rising interest rates and a harsh economy. If the situation should normalize sooner than expected, equities are well positioned to regain some of their incurred losses in the first half of 2022. Macro strategies have had an exceptional year in 2022 with plenty of opportunities. Most macro hedge funds could use these opportunities to generate strong returns.
Central Bank Interventions of the Fed, ECB, BoE, SNB Inflation in the US, the EU, the UK, and Switzerland
Voices of a recession in the coming year are getting louder. With the currently high inflation across the world, increasing interest rates, and drained reserves from the Covid-19 pandemic, companies are facing a bumpy road ahead. While inflation is declining to some degree, the crisis is far from over. In the US, inflation declined to 7.7%. This is likely a consequence of the continued and steep interest rate hikes from the Fed throughout the year that start paying off. With the most recent inflation data, the Fed hinted at lower hikes in the short term. In Europe, inflation is still higher, with 10% for the European Union and 9.6% for the UK. Nonetheless, it decreased in both instances compared to the previous month. Another interesting development is the price cap by the EU on Russian oil. It should mitigate Russia’s capabilities to finance the war with oil sales. Russia already stated that it will not oblige to the price cap. Over the past six months, oil substantially lost value. While it was trading well above $120 per barrel during the year, over the past six months it dropped. WTI crude oil is currently trading at $73 per barrel and has lost almost $10 per barrel since the official launch of the price cap on Russian oil. Figure 1 shows this development over the past six months. It will be interesting to monitor this development in terms of oil prices in general and whether the cap has the desired impact to stop Russian war financing. Since the end of Q3 2022, equities managed to rebound quite strongly and offset a proportion of the losses of the first three quarters this year. In contrast to the poor Q1-Q3 2022, the private equity industry was relatively stable over this time period, albeit with some losses and less activity. Nonetheless, the industry’s number of deals and deal value is still exceeding pre-pandemic levels, which is remarkable. Figure 2 provides further insights into global buyout deals, which make up most of the capital in the industry. Cryptocurrencies have not recovered from the shocking collapse of FTX. Since the collapse, Bitcoin is steadily moving between the $16k and $18k mark. Ethereum similarly moves between a range of $1.1k and $1.3k. Market participants are divided on their current opinions on the cryptocurrency market. With a looming recession ahead, cryptocurrencies are likely to face further drawdowns as highly risk-on assets. However, most people and institutions likely sold their over-allocation during the drawdown of 2022, and it remains to be seen how much more will be sold. Given the continued drawdown, most current holders are less likely to sell their positions due to being convicted of the underlying advances the technology will bring. Additionally, cryptocurrencies have done well in crises. Institutional investors also view the space with significantly different opinions. For example, Goldman Sachs plans to buy crypto on a large scale, while BlackRock is hesitant and expects many more collapses ahead.
Although there is a recession looming, markets started well in the fourth quarter. In particular, equities were able to recover some of their losses during the year. This development largely stems from the better-than-expected inflation report in the US. The inflation dropped to 7.75% compared to more than 8% for the past couple of months. The strong stance on interest rate hikes by the Fed seems to show an impact finally. However, this development needs to continue until inflation is back under control. While this development is a good indicator, the threat of a recession is far from over. For example, the yield curve does not look healthy at all, which has been the case for a while now. Figure 1 shows the current yield curve inversion in percentage relative to the inflationary bust in 1973/74. It suggests a strong possibility of a recession, as there always was a recession if the current threshold was surpassed. Nonetheless, with the inflation “cooling”, there might be a chance to avoid such a recession. The largest shock occurred in the cryptocurrency market. With the bankruptcy of FTX, one of the largest centralized exchanges, the industry took a huge hit. Just a few months ago, the company was in talks of raising another $1bn at a valuation of $32bn. The company collapsed after a liquidity shock. Documents in the bankruptcy filing reveal that the company had less than $1bn in assets compared to more than $9bn in liabilities. Initially, it seemed as if Binance, the largest centralized cryptocurrency exchange, might buy FTX. However, Binance decided against this endeavor. Following these events, the cryptocurrency market took a substantial hit. Bitcoin dropped to below $16k, and Ethereum fell lower than $1.2k. Since then, the market has remained relatively stable close to its lows. Figure 2 shows the price development of Bitcoin over the past three months. Nonetheless, the crypto market remains of interest. There is substantial interest from institutional investors, and the new lows offer good entry points for VCs, especially as they are under pressure to deploy capital. In the recent past, VCs have committed substantial amounts to crypto startups and emerging companies. Among these emerging technologies, the metaverse has the potential to become a significant industry. McKinsey estimated that the metaverse could be valued at up to $5tn by 2030, as shown in Figure 3. They see high potential in e-commerce, banking, telecom, and retail, among other industries.
Macro news still continues to drive markets. Europe is at the center in early September. At the end of August, Europe’s inflation soared to another record this year at 9.1%. This increase is largely due to ever-soaring energy and food prices. A week after the release of inflation data, the ECB raised interest rates by 75bps which raises its base interest rate to 1.25%, still far off from other countries, such as the US or the UK. A recession in Europe is getting more and more likely with such announcements. This threat is especially high for the UK, as Goldman Sachs expects the recession to start in the UK in the fourth quarter. The UK faces the same issues as Europe does, but at an elevated pace. UK’s inflation is higher than 10% while the BoE has raised interest rates significantly more this year already. While the current base rate is only marginally higher at 1.75%, another decision in early September was delayed following the passing of the Queen last week. The weak currencies are another issue. Both, the Euro and the British Pound, are exceptionally weak compared to the US Dollar historically. In the US, the situation seems a bit more stable. Last month, the US managed to re-employ all people fired during Covid-19, and the country continues to employ more people, leading to a record low unemployment rate. However, markets are still heavily pressured by the hawkish Fed. The board emphasized that they are strongly committed to bringing inflation down soon rather than later. Markets widely expect at least another 50bps if not a 75bps hike in the next meeting. Another major development takes place in the cryptocurrency market. “The merge” of Ethereum (ETH) will be executed around the 15th September 2022. Essentially, the merge refers to the combination of the ETH main-chain and its side-chain, known as Beacon chain (launched in December 2020). The main-chain is based on the PoW (Proof-of-Work) consensus algorithm, whereas the Beacon chain uses PoS (Proof-of-Stake). The difference between the two validation algorithms is the resulting energy cost. PoW uses computational power to validate the network. In this approach, all computers try to validate a transaction, in which the fastest is rewarded. Unsurprisingly, this leads to a lot of unnecessary energy consumption. PoS also uses computational power to validate transactions but it bundles the computers together and everyone gets a fraction of the reward. This prevents energy consumption for nothing and leads to an energy consumption decrease of more than 99.9%. Figure 3 summarizes the timeline of the merge. While it is unlikely that there will be a large move in ETH immediately after it takes place (assuming it works well), such events have historically been followed by strong performances of the underlying chains. One example is the introduction of the Beacon chain in December 2020, after which ETH rose from $400 to almost $4,000 in less than six months. Cryptocurrencies were relatively stable and gained slightly over the past weeks. Bitcoin is currently trading at $22k and ETH is valued at $1,750.
Alternative Markets Summary H1 2022
Ever since Covid-19 has subsided from the daily news, inflation has taken over. Inflation is still a major concern in the current economy. This is further exacerbated by central bank interventions that have not been fruitful yet. An additional major contributor is the ongoing war between Russia and Ukraine. As of June 2022, inflation in the US is at 9.1%, the highest it has been in the past 40 years. In the Eurozone, inflation is slightly lower at 8.6%. The UK’s inflation is even higher at 9.4%. Asian countries, such as Japan and China, managed to keep their inflation relatively low at 2.4% and 2.5%. The development of inflation over the past year is summarized in Figure 1. For Western countries, inflation has more or less continuously risen. The US started the year with inflation close to over 5%, while European countries were close to 2%. Nonetheless, Europe has caught up to the US since April, when the UK’s inflation even got higher than the US’s. A potential reason for the higher inflation in the US at the beginning of the year and back until the latter half of 2021 is the rapid and steep unconventional measures taken by the Fed. This faster intervention led to more money being in the economy earlier, which theoretically should lead to higher inflation earlier. Figure 2 shows the growth in the balance sheet indexed to January 2019. Once Covid-19 hit the economy, the US reacted a lot faster and in higher magnitudes than Europe did. Within the first months, the Fed’s balance sheet grew by almost 70%, while the ECB’s only grew by 25% in the same time frame. Since then, the two central banks acted equivalently in terms of balance sheet growth. Very recently, the central banks started to shrink their balance sheets. These measures were announced during Q2 2022 and are slowly implemented. Going forward, this balance sheet shrinking will be strengthened, which is confirmed by an announcement from the ECB recently. Nonetheless, as the graph shows, these measures barely affect the original measures taken to combat the economic consequences of Covid-19. The low inflation in China largely stems from the consequences of their zero-Covid policy. In recent months, many places have been shut down to control the spread of Covid. This led to low production levels and low demand which is reflected in the low inflation levels of the country. In the case of Japan, inflation of above 2% is significant, as the average inflation during the past three decades was only 0.3%. Its inflation largely stems from the consequences of the war and the impact it has on food and energy.