Inflation remains a major concern and continues to exert pressure on markets. At least inflation is declining in most economies. In the US, inflation is declining since July 2022 due to the most aggressive measures taken by the Fed in comparison to other economies. Inflation fell from over 9% to now below 5%. The EU’s inflation kept rising until September 2022 when it surpassed the 11% mark. The more hesitant central bank interventions and higher exposure to the war led to a substantially slower decrease. As of April 2023, inflation still remains slightly above 8%. Toward the end of 2022, the UK behaved similarly to the EU, but could not maintain this trend. As of March, inflation in the UK remained above 10%. The continued struggle of the UK – in comparison to the EU – is largely attributable to a combination of its higher food price inflation, high reliability on gas, and worker shortages as well as wage rises. The latest data revealed that the UK could substantially reduce its inflation in April to below 9%. China and Switzerland were able to keep their inflation below 4% throughout this period and have achieved decreasing inflation similar to the previously discussed economies, albeit for different reasons. Japan followed this development but saw a spike in inflation in April 2023, which stems from a surge in food prices. Figure 1 summarizes the inflation rate development from the beginning of 2022. Figure 2 shows the corresponding interest rate measures the various central banks undertook. The Fed took the most aggressive measures with the current range being between 5% and 5.25%. Market participants widely expected rate hikes to stop earlier in 2023, and it seems now that during the June meeting, there will be a break. However, officials stated that the fight against inflation is not over, and further hikes are still reasonably likely. This dampened the optimism of market participants, especially considering views at the beginning of the year with fewer increases and possible cuts as early as autumn. Such a development seems highly unlikely at this stage. The BoE followed the Fed’s development most closely. Unfortunately, it did not achieve the same results, as the substantial discrepancy in inflation data shows. The ECB took almost half a year longer to implement such measures. As of May 2023, central bank rates in the EU are still 1.25% lower than compared to the US. It is also reasonable to assume that the ECB will continue hiking to offset its currently substantially higher inflation. This can be attributed to the later reaction of the ECB in comparison to the Fed. Switzerland, which had fewer problems with inflation, required less severe interventions. In total, the SNB increased its core interest rate by 2.25% since May 2022. In contrast to other Western economies, its core interest rate sits at a moderate 1.5%. Asian countries, such as China and Japan have struggled little with inflation and needed no or only minor central bank interventions. Nonetheless, the countries still did not go through the aftermath of Covid unscathed.
Recession fears and interest rates keep holding investors on high alert. The ECB and the Fed both raised interest rates in their last meeting in May 2023. While the Fed hinted at a decent likelihood that interest rate hikes will stop, it is not the case for the ECB which emphasized that there is still more work to be done to get inflation under control. In particular in the US, this is a positive development, as the premise of no further hikes might be realistic for the time since the recent hikes started. Despite this outlook, the situation is still highly uncertain. A large contributor is the banking crisis, which already includes the second-largest insolvency of a bank. The pressure on the industry is continuing with the collapse of First Republic and subsequent acquisition by JPMorgan. The uncertainty is further increased by the debate on the debt ceiling of the US. So far, there has been little progress but there needs to be a solution fast, as according to some sources, the US could go bankrupt as early as June 2023. This development also led to the largest aggregate short position of US Treasuries in history. In the EU, officials of the ECB highlight that further measures are necessary, as inflation is not low enough yet and it has been staying at such high levels for too long. On the opposite end, there are more and more concerns arising from high rates. Many expect the banking crisis to keep continuing and lower growth rates, which is evident by the GDP growth of the EU in Q1 2023 of only 0.1%. In this rather critical state, gold has seen a resurgence over the past months. Gold reclaimed the $2k mark in early April 2023 and has maintained there ever since. The increased uncertainty also manifested itself in substantial inflows in gold ETFs in recent weeks. Thus far, hedge funds have done well in this challenging ecosystem. The industry mostly managed the initial drawdowns well. It also led to a more promising perception of hedge funds themselves, as the number of launches is comparable to pre-Covid levels for the first time. The industry also reached a new milestone of $5tn AuM according to Barclay. Fundraising remains an issue for all alternative asset classes with the exception of very large hedge funds. The fundraising problem is especially dire in private equity and venture capital funds. The private equity industry is starting to feel the pain from its delay from public markets and their drawdown a few months ago. Not only have valuations dropped by almost a third, but private equity-backed IPOs are virtually inexistent. Investments also have become more scarce. In particular venture capital has been hit hard, as quarterly investments have dropped by 50% YoY.
In this challenging ecosystem, alternative assets showed resilience to the drawdowns in public markets. While some hedge funds have struggled in recent times, the industry is managing the current situation well. For the first time since the pandemic, hedge fund launches have reached pre-pandemic levels again. Regarding performance, in particular large hedge funds have managed the drawdowns well. Figure 2 shows a comparison of public equities and bond indices relative to equity and fixed income hedge funds. For equity strategies, hedge funds were able to mitigate the largest drawdowns of public equities, while also benefitting from the recovery periods (although not to the degree as public equities have). For fixed income strategies, the results are even better. Not only were the funds able to mitigate the drawdowns in fixed income significantly, but they also posted stronger gains in the recovery periods, at least in most instances. Private debt and private equity funds achieved similar results, although it is unknown as of yet how they did in the very short-term. Throughout 2022, private debt funds managed to return a positive performance in each quarter and enhance the stability of a portfolio substantially. Private equity strategies functioned similarly to equity hedge funds, as they mitigated most of the drawdowns of public equity, even for the riskiest sub-strategy in venture capital. Figure 3 shows a comparison of direct lending, private equity, and venture capital benchmark indices versus public equities. While these results are promising, the private equity industry has not been unfazed by the recent crisis. Fundraising became a substantial issue in Q1 2023 as well as more and more downrounds. This leads private equity funds to search for alternatives. One of which seems to be buying back its own debt, which has been more prominent in recent months. Especially in the fundraising department, private debt also saw a substantial shortage, such that pension funds and endowments make up almost 50% of the capital raised. While higher interest rates also lead to higher yields in the private debt markets, it comes at an increased risk with rising loan default rates.
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.
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