A whirlwind first six months of 2022
As we wrote in our 2022 Outlook, it has indeed been the year of higher hurdle rates and lower potential returns — but to a much greater extent than we (and almost everybody else) anticipated. With stocks and bonds falling in concert, a classic 60/40 portfolio, which we expected in the best-case scenario to return just over 5% for 2022, returned -16% in the first half of the year.1
We also flagged that U.S. Federal Reserve (Fed) tightening would serve as a headwind to multiples. However, we again underestimated just how much, as the Fed adopted a much more aggressive tightening stance than anticipated in the face of unrelenting inflation. At the end of January, the market was projecting that the Fed funds rate would reach 2.6% by the February 2023 Federal Open Market Committee meeting, versus a projection of 3.5% by the end of June.2
The next six months
Overall, we think the second half of 2022 could mark a long-awaited return to more rational activity, on many fronts. As pandemic-induced imbalances in goods, services, housing and market prices, fiscal spending, and monetary policy, among others, continue to unwind, we expect a shift back toward prudence among consumers, corporates, the Fed, and market participants. This return to rationality is not a bad thing, but it does have implications for the economy and markets, discussed below.
Slower growth, but likely avoiding recession
Our base case is that the United States will experience a further slowdown but avert a full-blown recession in the second half of 2022 (avoiding two consecutive quarterly GDP contractions). Both U.S. and Eurozone growth are likely to slow to 1.5% year-over-year by the fourth quarter of 2022, while China growth could rebound to 5.0%.3 There are signs of U.S. demand slowing, including a weakening in the residential housing and commercial real estate (CRE) markets due to rate increases.4 But for growth to collapse into recessionary territory, we believe we would need to see something “break”—like higher rates creating unsustainable debt burdens or an asset price collapse that triggers a wave of deleveraging. Right now, we do not see these signs at any significant scale. The strength of consumer, corporate, and bank balance sheets, plus prudent financials and a lack of systemic overleverage, should help avert a crisis.
Risks include monetary policy tightening and rate hikes
Still, there is a chance that in the next six months central bank policy tightening and rate hikes could precipitate a “break” of some kind, although we do not envision the consequences to be systemic, at least not yet and not in the United States. However, there are areas of particular concern — these include cryptoassets and pockets of venture capital and unprofitable technology. Collateralized loan obligations, which comprise floating-rate leveraged loans taken on by lower-quality buyers, may see higher rates of default, although it is likely that borrowers have the financial resilience to absorb rate increases.
The S&P 500 could test another low
After a big multiple reset, earnings revisions are expected to trend down, with earnings-per-share (EPS) numbers dropping a median 13% during previous recessionary periods.5 The blended next-12-month EPS estimate for the S&P 500 is $239.6 If we assume a slowdown rather than a full-blown recession, estimated earnings projections may be cut by roughly half of that median (6.5%), which would bring us to $224. Further assuming that the multiple holds at around 16x, this would generate a fair value of around 3,575 for the S&P 500, 6% below the closing price on June 30.7
A further dip could create attractive opportunities
We have seen a major reset across many segments. There has been a material upward repricing in rates across the curve, offering more attractive risk-free yields, while S&P 500 equity valuations at 15.9x forward price-to-earnings are now below the five- and 10-year averages of 18.6x and 17.1x, respectively. At the same time, the S&P 500 and credit spreads, when looked at together, price in a 77% recession probability, compared to a 36% — 43% likelihood implied by economic data.11
Revisiting Our 2022 Picks
Venture Capital
WE SAID:
VC will continue to provide significant opportunities for value creation, but careful selection is critically important. A repeat of 2021’s performance is unlikely, but we believe returns can continue to outpace those of private equity and public markets. Record cash on balance sheets should drive strong M&A interest, with valuations moving in tandem with value creation.
Crypto Assets
WE SAID:
The crypto ecosystem could provide potential opportunities for hypergrowth, driven by decentralized exchanges, automated market makers, smart contracts, and Web 3.0 and the resulting decentralized social media and gaming. Given that we are still in the early stages of the adoption of DeFi and its protocols, we see massive potential for growth and disruption ahead.
Private Credit
WE SAID:
Private credit continues to cement itself as a fast-growing asset class, well positioned for both current and anticipated market environments. Amid a 2022 backdrop of rising short-term rates, we see private credit – specifically middle-market direct lending strategies – offering a significant buffer to publicly traded high-yield or leveraged loans. Structural drivers should continue to propel private credit issuance.
Real Assets
WE SAID:
Real assets should offer an attractive return profile in 2022 given their strong income streams and hedging abilities amid an inflationary and rising-rate backdrop. In periods of inflation exceeding 3%, real assets have outperformed not just equities and bonds, but also private equity.19 In particular, commercial real estate offers attractive inflation-hedging characteristics and strengthening fundamentals. CRE has gained 7.4% so far this year.20
Hedge Fund Arbitrage
WE SAID:
Hedge fund arbitrage strategies will likely provide strong risk-adjusted performance in 2022, given that asset classes globally are seeing increased volume, in terms of issuance, and greater velocity, given increased volatility.
Selling Put Options
WE SAID:
Selling options can help enhance the traditional forms of yield in a portfolio, particularly amid elevated volatility. Despite a reset to lower volatility throughout 2021, volatility remains high relative to pre-pandemic levels.21 Put volatility is systematically higher than call volatility and that spread today is especially elevated.
1. eVestment, HFRI, as of June 13, 2022.
2. Bloomberg, as of June 30, 2022.
3. Ibid.
4. Ibid.
5. Goldman Sachs Research, as of May 18, 2022.
6. iCapital Investment Strategy, Bloomberg, as of June 30, 2022.
7. Bloomberg, as of June 30, 2022.
8. Ibid.
9. iCapital Investment Strategy, Bloomberg, as of June 30, 2022.
10. Bloomberg, iCapital Investment Strategy, as of June 30, 2022.
11. JPMorgan, as of June 17, 2022.
12. TradingView, CoinMarketCap, as of June 30, 2022.
13. Bloomberg, as of June 30, 2022.
14. Pitchbook, as of June 30, 2022.
15. Bloomberg, iCapital Investment Strategy, as of June 30, 2022.
16. Bloomberg, as of June 30, 2022.
17. Pitchbook, as of June 14, 2022.
18. Bloomberg, as of June 30, 2022.
19. iCapital, AltsEdge, as of September 30, 2021.
20. eVestment, S&P Global, iCapital, as of March 31, 2022.
21. Bloomberg, as of June 30, 2022.
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