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Hedge Funds vs. Private Equity—What’s the Better Option?
No matter what sort of future analysts are predicting for 2023 — in particular, interest rates — professionals and investors alike are hoping for 2022’s inflation and interest rates to cool. However, the Federal Reserve’s plans may differ.
To fully understand future predictions for interest rates, it’s important to understand the reasons for rate movements.
- Interest rate levels play an important part in the global credit and lending markets; in particular, the supply and demand of credit.
- An increase in the demand for funding, cash, or credit can contribute to rising interest rates.
- A decrease in the demand for loans, cash, or credit can decrease these rates.
While runaway inflation didn’t appear until early 2022, it’s vital to look back to 2020, as this is when the COVID-19 pandemic sowed the seeds of the current and future interest rate climate.
While the pandemic’s effects were thought to have largely subsided by 2022, new economic situations — added to the lasting effects of the global supply chain crisis — created a “perfect storm” of inflation that affected not only the United States but the entire world.
The first months of the COVID-19 pandemic resulted in a global economic recession, although the unexpected recovery of the residential real estate market helped limit its effects on Americans, transforming it into a “mini-recession.”
From mid-2020 to late 2021, the retail residential housing market went on an unexpected tear that eventually put homeownership out of reach. Unemployment numbers sank as well, and consumer spending rose.
Some considered these optimistic signs for a growing economy…but was it really?
Factors That Led to 2022’s Meteoric Rise in Interest Rates
By the beginning of 2022, several economic factors were contributing to building painfully high levels of inflation.
Two of these, low unemployment and high wealth levels, weren’t the good news they appeared to be. Consumers viewed increased spending and short unemployment lines as supporting businesses and the economy instead of increasing retail prices across the board.
Working backward from early 2022, the following events helped push inflation numbers to the highest in 40 years.
The Ukraine Invasion
Most recently, Russia’s February invasion of Ukraine and the ensuing response caused fuel and gas prices to rise 18.3% in March. Together with the United States, other countries imposed sanctions on Russia for what was viewed as a hostile invasion.
This was the final wave in the perfect storm of runaway inflation, pushing inflation to a 40-year high in March 2020.
Here are more factors that contributed to rising rates.
COVID-19 Pandemic
As some, but not all, effects of the unexpected global pandemic in March 2020 dissipate, it’s easy to underestimate the pandemic’s lasting effect on today’s inflation numbers.
In the beginning, quarantines and lockdowns were enacted to help decrease COVID infections. The global supply chains that maintained inventories of retail goods also ground to a halt.
Today, COVID still disrupts economies and contributes to inflation for the following reasons.
Supply and demand problems still persist because of new COVID outbreaks in China and resulting quarantines. A recent example: In October 2022, around 200,000 workers were quarantined at a plant in central China that is a major manufacturer of the Apple iPhone.
Many US households’ financial positions improved between 2020 and 2022. As infection rates began to trend downward, many consumers — especially those who had not lost their jobs due to COVID — saw their bank accounts grow.
This was largely because millions of quarantined consumers weren’t able to travel, shop, visit restaurants or attend music, sports, and other events.
It is estimated that households accumulated $2.5 trillion in excess savings (inflation-adjusted to 2020 dollars) between March 2020 and January 2022, much of which appears to have been deposited in checking and savings accounts.
This resulted in a spending spree that concentrated first on durable goods, then on travel as consumers freed from quarantine restrictions took long-overdue vacations.
Residential real estate, after a brief hiccup in spring 2020, also began a record-breaking run. Homeowners who transitioned to home offices, many seeking 24/7 social distancing, left urban areas en masse for suburban and rural areas.
As a result, house prices rose at least 18.2% year-over-year from January 2021 to January 2022. Rising mortgage interest rates only recently put the brakes on the residential property market.
Another factor: unemployment numbers sank to the lowest in decades. Workers found themselves in such demand that employers kept increasing wage offers, leaving smaller business owners losing the “bidding war” for staff.
This, in turn, forced the small business owners to increase wages, which pressured them to increase their prices to retain the same levels of profitability.
Stimulus payments to individuals and businesses issued in 2020 and 2021 were suspected to contribute to inflation, even though some economists claim that the economy might have slid into a recession without these payments.
Now that we’ve reviewed the economic and global events that are considered to have contributed to the inflation spiral that began in 2021, we can take a close look at how alternative investments often protected investors from its effects.
How Rising Interest Rates Affected Alternative Investments in 2022
One reason investors build portfolios around alternative investments is that their performance generally doesn’t correlate to stock market performance. This has helped to protect many alternative investors against possible stock losses caused by runaway inflation and subsequent market crashes, including those with one or more of the following in their portfolios.
- Real Estate: While rising mortgage rates eventually brought the residential housing market to a near-standstill, with first-time buyers priced out of the market and others walking away before finalizing a purchase, more consumers chose to rent their homes. This was particularly rewarding for alternative investors who had opted for real estate with an income objective. Possible drawbacks to investing in rental properties include a slowdown or reduction of passive income if rising vacancy rates create competition.
- Private Equity: During 2022, private equity was a creative solution to the rising costs of conventional financing, rewarding investors accordingly for their acceptance of higher risk. Privately-held companies wishing to expand their manufacturing capacity, introduce new products, or restructure provided opportunities to alternative investors. Private equity can be a high-risk investment, so it is only recommended to experienced investors who are acquainted with the business being funded, and the reasons for providing the funds.
- Private Loans: These are for individuals who need a short-term loan delivered quickly. This product’s main advantages include minimal eligibility requirements and fewer SEC rules. However, increased investor risk is the main reason why these loans’ rates are generally higher than conventional or government-insured loans. Like other alternative investments, private loans continue to thrive in today’s volatile environment.
- Energy: A prime advantage of this choice is that energy is expected to be largely unaffected by current interest rates, because of scientific and political pressure to address global warming. However, a global transition from fossil fuels to clean energy will require considerable, long-term investments in renewable energy infrastructure and may not offer short-term dividends.
- Commodities: often traded as exchange-traded funds (ETFs), oil and gas commodities were top performers, driven by global sanctions against Russian oil. Because commodities prices typically rise with inflation, they provide protection from its effects, including rising rates. However, investors in commodities must be ready to accept the risks of volatility due to commodities’ possibly being affected by sudden economic or geopolitical crises.
Alternative investments such as these are generally seen as potentially effective stores of value and “hedges” against volatile market performance.
Interest Rates in 2023: Forecasts & Predictions
The October Consumer Price Index (CPI) figures, released November 10th, finally brought positive news to the US economy. Some figures came in lower than predicted, which contributed to the belief that inflation was slowing and may have peaked.
However, consumer spending seemed largely unaffected by rising interest rates, rising by 2% in inflation-adjusted terms during the second quarter of 2022.
Mortgage interest rates began to rise in early 2022, going from under 3.5% in January to over 7% in November before nosediving to 6.61% in mid-November. But this drop likely won’t be sustained, and some experts believe mortgage rates could continue increasing in 2023. Predictions varied from 5.0% and 9.31% for a 30-year, fixed-rate mortgage.
When Will Interest Rates Peak in 2023?
Even after inflation’s October slowdown, economists from banks around the world continue to voice concerns that the Federal Reserve will continue to raise interest rates in 2023.
According to a survey of 65 economists, future rate estimates averaged 5% by March 2023. Most surveyed also insisted that rates would stay near or above the 5% average for the rest of the year, even if inflation continued to wane.
Will Inflation Worsen in 2023?
While inflation numbers may continue to slow in the months ahead, corporate America hasn’t stopped passing their increased manufacturing costs on to consumers. In addition to increased prices, some manufacturers have taken a more subtle path by reducing product weights and/or sizes. This has been nick-named “shrinkflation.”
While most consumers are aware of these corporate tactics, their spending habits haven’t shrunk accordingly. An all-time spending high of 14,149.03 USD billion was recorded during 3Q 2022, putting an inflationary spin on the supply/demand ratio even as prices continued to rise.
How Will Mortgage Rates React to 2023’s Interest Rate Adjustments?
While continued hikes to the Federal Reserve’s fed funds rate are expected in 2023, other trends are expected to affect mortgage interest rates, preventing a return to the bargain-basement rates of the previous years (mortgage rates sank to 2.68% in December 2020).
Most of these negative trends are carry-overs from the current year, including the continued volatility in the US and global stock markets, fears of a recession, and continued supply chain disruptions.
This is expected to keep rates near the current 6.91% rate for 30-year, fixed-rate mortgages as of late November 2022, although some mortgage bankers predict slightly lower rates ahead as the housing market continues to cool.
How Will Productivity Growth and Employment React to 2023 Interest Rates?
As the Federal Reserve’s continued interest rate hikes go into effect, this is expected to slow inflation. In turn, this is expected to have an eventually negative effect on employment figures, with some predicting a rise from 5% to 5.5%.
The residential housing market is also expected to proceed with more caution during 2023, even if prices fall in some areas. This is due to several factors, including predictions of higher mortgage interest rates and consumers nervous about the possibility of a recession.
Another factor: rising economic inequality, which tends to result in increased savings for higher-income households.
The share of income claimed by the top 10% of American households has risen steadily for decades before inflation’s higher prices slowed the pace of the “rich becoming richer.”
Here are statistics brought up during a conference hosted by the Kansas City division of the Federal Reserve:
- When consumers born between 1925 and 1934 reached the ages of 45 to 54, the top 10% of the group received 33% of the total income.
- 40 years later, when consumers born between 1965 and 1974 reached the ages of 45 to 54, the top 10% earned 47% of the total income.
The Federal Reserve neutral rate (when the Fed is neither stimulating nor slowing the national economy) tends to go down when savings are rising.
How Will the Overall Economy Fare in 2023?
Most economists are predicting a mild recession next year.
Factors that may contribute to this, in addition to higher interest rates across the board, include a slowdown in productivity and spending due to higher prices.
Consumer demand may also be affected by the recent increases in consumers’ revolving credit balances as inflation continues to take its toll on wages. As day-to-day expenses continue to rise, Americans are taking on more debt in the form of increased credit card use.
Card balances rose by 15% during the third quarter of 2022, which is the largest year-over-year increase in over 20 years.
The Road Ahead
While the elusive investors’ crystal ball is still AWOL, investment advisors generally agree that 2023 will be a year when the world economy is recovering from inflation.
Here in the United States, investors and consumers alike will continue to cope with the Federal Reserve’s continuing rate increases, which have been described as “bad-tasting, yet effective medicine.”
San Francisco Federal Reserve president Mary Daly remarked that although the recent CPI numbers offered some relief, “we have a lot of work to do at the Fed to bring us back to price stability.”
If you’re considering adding alternative investments to your portfolio, either to reduce your exposure to the markets or as a longer-term diversification, let’s talk about it.
