Alternatives: all change so far in 2023

At the halfway point of 2023, it feels like many years’ worth of macroeconomic events have unfolded. Bank failures, the US debt ceiling drama and the leap forward in generative artificial intelligence (AI) technology were probably the most noteworthy. However, starkly contradictory economic data has also added to market volatility. While business surveys predominantly pointed to a markedly weaker macro backdrop, actual activity datapoints have remained surprisingly robust. Meanwhile, inflation softened as predicted but remained worryingly sticky, in particular because of higher wages

Exhibit 1: All change for alternatives sector returns (%)

Source: Morningstar Direct, Bloomberg. Total returns year to date to 30 June 2023. Indices used: LPX Composite Index TR EUR, Morningstar LSTA US Leveraged Loan Index TR USD, FTSE EPRA Nareit Global Real Estate Index TR USD, FTSE Developed Core Infrastructure Index TR USD, Morningstar Global Utilities – Renewable Index GR USD, S&P GSCI Gold Index Spot, Bloomberg Commodity Index TR USD, SwissRe Global Cat Bond Index TR USD, HFRI-I Liquid Alternative UCITS Index USD, MSCI World Index GR USD, Bloomberg Global Aggregate TR Index Hedged GBP. Past performance does not predict future returns.

Against this tumultuous backdrop, the performance of alternative assets was mixed. The equity market rally, predicated on a hoped-for soft landing and a surge in AI-linked tech stocks, boosted returns in listed private equity. This sector was also supported by the release of results showing generally strong underlying company performance and robust valuations. Gold shone, boosted partly by lower real yields and, later, by riskaversion during the US government debt ceiling stand-off, while commodities broadly weakened on China’s underwhelming growth trajectory.

Duration-sensitive assets such as infrastructure struggled as rates moved higher. Real estate investment trusts (REITs) experienced a high degree of volatility, initially rallying sharply from apparently oversold levels and then giving it all back as investors fretted about ‘higher rates for longer’ causing more potential pain in terms of debt-servicing costs and earnings. Problems at US regional banks – big lenders in the commercial real estate sector – also hit sentiment globally.

Reinsurance had a very strong start to the year as reinsurance rates had ratcheted up following Hurricane Ian in late 2022. The lack of capital available to fund reinsurance and catastrophe bond (funding for insurers in the event of a natural disaster) issuance meant that expected returns in the space have doubled since last year. Of course, we are now entering hurricane season, which means there is more risk to returns in the second half of 2023. Loans and other areas of specialist credit had a solid start to the year with high starting yields and spreads that traded within expected ranges despite a pick-up in defaults.

Outlook

Most traditional assets appear to be pricing in an expectation of near-flawless central bank policy decision making, anticipating that central banks can deftly tame inflation without prompting a subsequent meaningful recession. Listed alternatives, on the other hand, appear to be pricing in a far more pessimistic outlook.

Listed private equity and property trusts, which give exposure to unlisted ‘private’ assets, moved to historic discounts to net asset value (NAV) in 2022 and appear to remain attractively priced on this metric. Clearly, the market believes that NAVs are overstated and that reality will catch up with them. Our in-depth analysis on these two areas suggests that asset valuations, in private equity especially, are not overstated. Many market commentators scoff that price-to-earnings (PE) valuations always manage to defy gravity when listed equities have a correction, but, in reality, valuations do not tend to keep up in sharp public equity bull markets either. Meanwhile, private equity funds continue to make exits at valuations that are significantly (20-40%) above their carrying value. This implies an ongoing conservatism in valuations rather than the opposite.

Property in general looks more vulnerable to interest rates staying high for longer and the impact that this would have on interest costs and earnings. Conversely, occupational (rent and lease) markets look strong in our favoured sectors (logistics, the private rented sector and student housing), while the correction in warehouse prices, for example, looks over for now.

The key conundrum lies in the infrastructure and renewables space, where entrenched premiums evaporated to become record discounts in the second quarter of 2023. Rising interest rates imply lower NAVs for these long-duration assets, but this is in no small part offset by higher inflation-linked revenues and the greater returns on large cash balances, given the rise in interest rates. We feel that this de-rating has in no small part been driven by flows out of infrastructure/renewables into more straightforward fixed income assets, where yields are once again competitive. Nevertheless, we believe these non-cyclical assets remain very attractive on a standalone or relative basis and their defensive characteristics should stand out if central bank tightening precipitates a recession. We believe that a normalisation in ratings, combined with expected NAV returns of 7-8%, represent positive factors for infrastructure/renewables, with relatively low fundamental risk.

Broadly speaking, credit markets do not look to be pricing in anything other than an immaterial pickup in defaults, which means the asset class has limited appeal at present. Reinsurance on the other hand is offering very attractive yields compared to history, as premiums have doubled. These higher returns are on offer despite there being no greater risk of natural catastrophes occurring this year than any other year.

Finally, commodity prices look set to be driven by concerns over China’s spluttering economic recovery and recession risk in the western world. Gold remains a useful diversifier and macro-risk hedge. Rising real yields – a headwind in recent years – are likely close to a peak, suggesting there is less of an argument to avoid holding the precious metal.