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.
Macroeconomic factors continue to dominate financial markets. Inflation in the US keeps rising, despite attempts of the Fed to slow it down. In June, inflation rose to 9.1%, higher than the anticipated 8.8%. Figure 1 summarizes the development of inflation over the past year in the US. The major drivers remain food and energy, but these are not the only issues. As the prior two are global issues, it is unlikely that those factors will slow down quickly. The Russia-Ukraine war has a substantial impact on those factors. Russia, a key supplier of energy, has led to the possibility of Europe not being able to use as much energy for heating in the winter as usual. Ukraine, which is a key supplier of food, e.g., wheat, puts further pressure on food prices. That Russia started burning down acres does not help the matter either. Although this has no direct impact on the US, the impact on the price of those goods is a significant contributor to the increased prices of those goods. This development has caused markets to anticipate an even larger hike in the upcoming July meeting. Markets analysts now see a hike of an entire percentage point as possible. This further emphasizes how dire the situation looks, as a few months ago, the discussions were between no hikes, a 25 bp, or at worst a 50bp hike. The US federal fund rate is now at 1.75% and likely to rise substantially. Despite these increases, inflation hit a record high (within the past four decades) in June 2022. With this in mind, voices of a looming recession are increasing. The fact that the yield curve inversion between 2y and 10y-Treasuries is at its highest since 2000, does not help mitigate this threat. Figure 2 shows the recent inversion of the two Treasury yields. This recession indicator should not be considered too much, as depending on which maturities are compared, the implications look very different. In Europe, the situation is even more serious. Not only is the continent directly affected by the war and its possibly horrendous outcomes, but it is also susceptible to possible bottlenecks for both energy (in particular gas) and food. Additionally, EU inflation hit a new record of 8.6% in June 2022 without any central bank interventions yet. The development of inflation in the EU is shown in Figure 3.
With the announcement of the CPI rising again in May 2022, the Fed was put under even more pressure as the previous hikes did not show the desired effect. This led to the announcement of the Fed increasing the federal fund rate by 75 basis points instead of 50 which was the prediction ahead of the bad CPI news. In addition, the Fed announced a hike of either 50 or 75 basis points in July to combat inflation. The expectation of the federal fund rate for the end of 2022 is now between 3% and 4% and even higher for the end of 2023. Historically, inflation and interest rates have rarely been so far apart as Figure 1 shows. For example, in the 1980s when the inflation reached 20% for a short time, the federal fund rate was between 10% and 15%. These announcements led to another decline in bond and equity markets. The Fed’s plan to decrease their balance sheet further pressures these markets. In particular, as the decrease just started in June 2022, and is expected to more than double by September 2022. In the European Union, inflation hits a record 8.6% and the central bank is preparing its first interest rate hike. Commodity markets are not doing great either. After their rally in early 2022, largely backed by inflation and war concerns, commodities declined during June 2022, albeit to a relatively low degree. Cryptocurrencies are feeling the pain the most, as Bitcoin dropped below the infamous $20k mark, while Ethereum fell below the $1k mark last week. These was a short-lived recovery which was stopped again by the discussions on regulation of cryptocurrency exchanges in the European Union. Alongside the collapse of TerraUSD (LUNA) last month, the collapse of DeFi platform Celsius and crypto hedge fund Three Arrows did not increase the confidence in the space. Given that the macroeconomic outlook is not favourable, it is unlikely that this decline will revert quickly. It is much more likely to continue for some time. While the decline in crypto asset seems dramatic, it is quite common for the asset class. This is further shown by Figure 2 which compares the drawdowns of asset classes in terms of standard deviations. It shows that the decline in Bitcoin is equivalent to the drop in equities, which are both far less than what bonds experience currently. In particular the 2-year yield has experienced a huge 5.68 standard deviation move. Although Bitcoin is considered the safest crypto investment, a few altcoins managed to outperform BTC during this recent drawdown. Figure 3 shows a comparison of the most important cryptocurrencies and their performance with BTC as a benchmark. In the hedge fund space, conventional bond and equity strategies continue to struggle. More defensive strategies, such as fund of funds, as well as niche strategies that focus on bear markets mitigate the current drawdowns or may even profit from it for the aforementioned niche strategies. The big profiteers of this ecosystem are global macro and commodity funds that have returned huge numbers so far in 2022. The best example for this is the Discretionary Global Macro strategy with a YTD of 158%.
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