- Good afternoon, Bazarkhan. The rising inflation and its causes dominate headings of economic news over recent years. Could you please elaborate about it and the overall economic situation?

Good afternoon! The current economic situation is a consequence of processes, which have been observed in post-pandemic period, and importantly, the result of measures taken by developed markets to fight it. Moreover, worsening of geopolitical situation over recent years poses additional challenges for global economy.  

Unlike previous recessions, consumption of goods and services was different. In developed countries, consumption of services dropped rapidly due to quarantine restrictions, but then gradually started recovering as lockdowns started to be lifted. On the contrary, consumption of goods ramped up after small reduction at the beginning of COVID pandemic, partly as a result of governments’ fiscal support. For example, according to IMF data, the global volume of governmental assistance amounted to almost $17 trillion, including $1.9 trillion in the US. Meanwhile, goods manufacturers couldn’t cope with growing demand due to strict quarantine measures in China and disruptions in global supply chains, and this resulted in imbalance between demand and supply, which further increased inflation. The other cause of global inflation was the growth of prices for energy and food due to geopolitical situation.

Regarding monetary policy, during the pandemic key central banks increased their assets to record levels, dropping interest rates almost down to zero within the quantitative easing program to support economy through reducing cost of long-term borrowing. For example, the balance of the Fed has increased twice from the beginning of 2020 to the beginning of 2022up to almost $9 trillion.  

As a result of the aforementioned processes and events, in 2022 inflation in developed economies soared to values, that beat the record of the last fourty years. The peak of price growth in the US was in June 2022, and in Eurozone the inflation peak came with five month lag, i.e. in October 2022. At that time, inflation reached just above 9% in the US and almost 11% in Eurozone.

- What measures were taken by central banks to reduce inflation and what is the effect?

Key central banks started raising rates from the beginning of 2022 to fight inflation. From March 2022 to June 2023, the Fed’s interest rates have grown by 5% to 5.25%, that is the fastest increase of the rate over the last two decades. The ECB raised the rate following the Fed from zero to 4.0%. The latest review of the US and Europe’s economic data shows that efforts of central banks started bearing the fruits. This could be seen in slowdown of the GDP growth rate in the US and the Fed’s main indicator – PCE (Personal Consumption Expenditures). There is an improvement of demand and supply balance at the labor market due to reduction in number of open vacancies. With that, PCE, clear from influence of energy and food price dynamics, remains at the level of 4.6% for the fifth month. Technical recession was registered in Eurozone over the last two quarters.

It is worth noting that existing disbalance in the labor market keeps fueling inflation in services, which is more rigid than inflation of goods. That is why the issue of high inflation is still one of the main themes in global economy. It is expected that despite a pause with rate increase at the June meeting, the Fed will increase the rate by 25 b.p. at the July meeting. ECB will continue tightening policy further.

In this regard, it should be mentioned that today, key central banks face the dilemma, on the one side, contractionary monetary policy to fight the inflation, on the other side, the risk of financial instability and bankruptcies. The last aspect was frequently discussed since March, when three large regional banks – Silicon Valley Bank, Signature Bank and First Republic Bank went bankrupt. The bankruptcy of First Republic Bank and Silicon Valley Bank is the second and the third largest bankruptcy in the US banking history after Washington Mutual in 2008. Regional banks suffered more due to growth of interest rates as a result of reduced value of securities’ portfolio, which was dominated by mortgage loans and outflow of deposits into other instruments with higher rate. In other words, increase of rates led to growth of interests costs and reduction of interest margin. The state of regional banks’ deposit portfolio grew even worse when the news about Silicon Valley Bank and Signature Bank went wide. Banks’ seizure caused outflow of cash from regional banks to larger financial institutions or money market funds. Now the situation with deposits is stabilized.

In general, the Fed expects a recession in the second half of this year due to rise of interest rates and tightening of the credit conditions. All the above-mentioned factors are the main reasons for the market pessimism.

- How the current situation impacted financial markets and, in particular, alternative asset classes?

Raised interest rates and quantitative tightening led to a rare historical combination – decline of both capital and bond markets, leaving investors with few opportunities to preserve capital. In 2022, only the US Dollar and some primary commodities – oil, gas and nickel – had positive returns.

Regarding alternative asset classes, 2022 was also one of the tough years for many funds. Investors redeemed approximately $55 billion from hedge funds following downward in stocks and bonds. It was the largest capital outflow from the industry over the last 6 years. Nonetheless, market volatility opened opportunities for funds, focused on Macro, Multi-Strategy and certain Relative Value sub-strategies.

After successful 2021, activity in private equity fell due to high inflation in the US and Europe, tightening monetary policy of central banks and risk of recession. Number of IPOs, the main exit strategy in 2021, dropped significantly due to high volatility and the market corrections. Nonetheless, growing demand for companies, providing cyber security services was observed in private markets. In the last quarter of 2022, the market was optimistic due to the stock market recovery.

The factors that caused slowdown of activities in private equity, also negatively impacted real estate market. Market slowdown could be observed in the first half of 2022. In the first three quarters of 2022, there were significantly less investments in industry, than in previous six years. The largest capital was attracted in industrial and multi-apartment residential sectors. In addition, the growth of investments in healthcare real estate was notable. In office sector the growth was in premium segment. During the last quarter of 2022, both raised capital and volume of transactions showed activity decay. Interest rate increase, economic uncertainty and expectations of asset revaluation were the major headwinds.

- What strategies in alternative asset classes look attractive in current market conditions?

Stock market growth since beginning of 2023 gives some hope that global economy may escape recession. However, “bear” patterns dominate global markets after bankruptcy of regional banks in the US. Markets forecast that rising interest rates will negatively impact global economy, most likely leading to a recession in the second half of the year. It should be noted that US economy has slowed down to 1.1% at an annual rate in the quarter I, 2023, compared to 2.6% growth in the quarter IV, 2022. Analysts claim that the current market environment opens opportunities for secondaries in private equity, as many institutional investors need to rebalance their portfolios. Overall, funds focused on secondary transactions have raised more than 22% from the total raised capital. The same indicator was just above 13% for 2020.

According to results of quarter I, 2023, the largest number of hedge funds focused on equity strategies were launched, which indicates the demand from investors for this strategy, despite negative returns in 2022. Global Macro, one of the most popular strategies in 2022, possibly will retain its position in 2023 due to expected volatility of financial markets. Uncertainty of banking sector, tightening of credit conditions and growth of borrowing cost will increase demand for hedge funds, specialized in credit strategies. However, these factors and expected recession will probably negatively impact activities at private real estate. Data on quarter I, 2023 shows that the number of transactions and volume of raised capital for the asset class decreased; the same trend was observed in 2022. Still, as the outlook for real estate market is mixed, the investors will probably allocate more capital into the less risky strategies, in particular, debt strategy with more stable income. On the other hand, funds focused on the credit strategy will partially cover bank liquidity, which, most probably, will limit issuing loans for real estate. In general, credit strategy is attractive for all alternative asset classes in current environment.