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%.
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.
Although financial markets are struggling in general, cryptocurrencies are suffering most. After the collapse of the Terra stablecoin in mid-May 2022, cryptocurrencies barely recovered their losses. Even before this crash, the market was down substantially. This development may indicate another ‘crypto winter’ as it was the case in late 2017 and early 2018. After this crash, Bitcoin needed until 2020 and other cryptocurrencies until 2021 to recover. Although the current ecosystem is certainly not favourable, the situation is not equivalent to 2017. There are numerous reasons for this. Firstly, the investor base has changed massively with many more institutional investors in the market. This is likely to reduce the volatility of the asset slightly, as the majority of capital in the market is still retail-based. Secondly, the principle of blockchain and the applications are a lot better understood than back in 2017 when most people held coins for the profit only. Nowadays, assets are also held out of conviction which should further limit the downside potential. Thirdly, cryptocurrencies tend to crash the hardest at the beginning of a crisis but also tend to recover ahead of other asset classes. One of the best examples of this occurred at the beginning of Covid-19 when Bitcoin recovered quickly and soon rose to a new record high. Currently, Bitcoin is trading relatively stable at the $30k mark. The development of Bitcoin during 2022 is shown in Figure 1. Ethereum is trading consistently trading below the $2k mark since the crash.
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