2022 was a year that tested the worldwide economy. The highest inflation in 40 years, unprecedented interest rate hikes, and the invasion of Russia into Ukraine were only some contributors to the hugely difficult year of 2022. In the US, inflation started soaring during 2021 and peaked in the summer of 2022 at 9.1%. Thanks to the central bank’s quick response, inflation has since continuously slowed down and is currently at 6.5%. Europe had significantly more issues handling the inflation crisis. The EU started the year at an inflation rate of slightly above 5.5% and it continued to soar until October 2022 when it reached its peak at 11.5%. The UK was similarly affected, despite the BoE being the fastest-acting central bank to raise interest rates. However, its inflation behaved like the EU’s and soared to its peak at 11.1% in October 2022. Both economies have not been able to reduce inflation below 10% so far. In contrast to the US, European countries were much more affected by the direct impact of the war between Russia and Ukraine. Soaring energy and food prices, for both of which Russia and Ukraine are crucial suppliers, were the main constituents causing the high inflation. Additionally, the ECB did not enjoy as much freedom as the Fed had when raising interest rates. This is in large part due to the high indebtedness of certain European countries that would have gone bankrupt if interest rates would have been raised as much as the US did. Other countries, such as Switzerland, Japan, and China stand out in this discussion, as those countries managed to keep their inflation relatively low. Switzerland managed to avoid such high inflation due to its strong currency, and a limited dependency on fossil fuels. Japan avoided high inflation through the continued quantitative easing by the BoJ. However, in contrast to the other countries, Japan’s inflation is still soaring and poses substantial issues to the country. China avoided high inflation through its rigorous Covid policies and its limited governmental support when Covid emerged. The source of this soaring inflation is a combination of the war but is largely based on unprecedented central bank intervention to save the economy during the early Covid days when large parts of the economy were completely unable to function. Figure 1 shows the inflation levels of the previously mentioned countries during 2022.
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.
Central banks continue to be in the spotlight. Over the past months, it is hard to find a central bank that has not raised interest rates at least once. Inflation remains at four-decade highs in most countries, despite the measures taken by central banks so far. The Fed raised interest rates by another 75bps this month and maintains its stance to aggressively combat inflation. This led the 2-year Treasuries to surge above 4%, for the first time since before the global financial crisis, and increases the likelihood of a recession as well as potentially sharply declining equities. The latest hike increased the federal fund rate to 3% - 3.25%. The ECB also raised its interest rate by 75bps in September, while the Bank of England increased its rate by 50bps. The ECB’s rate is now at 1.25% and the UK’s is at 2.25%. Switzerland also raised its rate by 75bps which brings it into positive territory as the last country in Europe. In the middle East, Saudi Arabia, the UAE, and Qatar follow the Fed with their 75bps hikes as well. Across the developed countries, Japan remains the last country with currently negative rates at -0.10%. September 2022 has also been highly relevant for the currency market. The dollar has strengthened substantially over the year. Compared to the Euro, it appreciated from around 0.9$/€ in 2020 to 1.03$/€. The British Pound declined strongly. The latest tax cut in the UK is threatening even higher inflation and will force the BoE to act more aggressively in tightening. After the announcement, the Pound dropped below 1.1$/£, and some speculate that the Pound could fall below parity to the USD. The Japanese Yen also experienced substantial movements, as the country is buying Yen again for the first time in nearly a quarter century. In spite of the negative developments of equities in 2022 and their even more grim prospect, equities are doing great on a historical scale. Figure 1 shows the growth of global equities with the impact of several crises
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.
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.
Inflation remains a major concern in 2022. It is also crucial to watch the central banks’ responses to deal with it. In particular, the inflation numbers in the coming months should be watched closely, as they likely determine the extent to which central banks intervene. As seen in May 2022, when the CPI was higher than expected, markets lost substantially. With current market expectation of US interest rates being close to 2% later this year, it is vital that the 50bps hike last month, as well as the upcoming hike (likely another 50bps) show effectiveness. If that should not hold, there will be a bumpy road ahead. Especially, as the Fed is starting to reduce its balance sheet, which puts further pressure on markets. A similar observation can be made for the UK. For the EU, this is likely occur a couple of months later, as they have not raised interest rates yet, but are expected to do very soon. This development, alongside the war and supply chain issues, has led to a more and more pessimistic view of GDP growth in most countries. The World Bank expects that most countries will in fact experience a recession. They further emphasize that stagflation is looming. The possibility of a stagflation environment is certainly not unlikely and many factors speak for it. For example, the very high inflation, frequently downward-adjusted GDP projections, and the pressure put on companies with significant supply chain problems among others. Although employment looks healthy in most countries, if this should worsen, the treat of stagflation becomes very urgent. A more detailed view on the macroeconomic situation is provided by Macro Eagle further below. Hedge funds are in a good position to mitigate much of this market volatility. Many hedge funds pursuing equity and fixed income strategies have experienced rough times but they have the capabilities to reduce risk in such a market environment, despite a rather unimpressive performance. Hedge funds that use different strategies than the previously mentioned ones, mostly had a great year. This is in particular true for global macro funds. A substantial number of funds managed to deliver a YTD in 2022 in excess of 100% already. Another strategy that stands out are funds of hedge funds that could truly show their risk mitigation potential. Although private equity and venture capital could not maintain their trend from 2021, the asset class still remains an attractive opportunity. Valuations are down since early 2022. However, the industry is still in a healthy state, despite the slump of public equities. Inflows in the industry are likely to be smaller than in 2021, but there is still significant investor interest as most investors report that their private equity investment substantially outperformed their public equity investments over the long-term. The industry also still sits on a large cash pile amassed over the past year that needs to be deployed. This pressure further mitigates the decline in valuations resulting from the bear market.