David: 2022 has been a tough year for most public asset classes, leaving many investors confused on how to position portfolios, protect against inflation and identify areas for potential excess returns going forward. While markets have been more challenging, the need for income, capital appreciation and capital preservation has not changed. That's where alternative investments may provide some solutions. However, the alternative space is very broad and it's difficult to generalize within the asset class.
Today, we're going to talk about the outlook for different areas of alternatives in this new higher rate, slow growth environment. And so I'm very glad to be joined by my colleague, David Lebovitz, global market strategist for J.P. Morgan Asset Management and the author and architect behind our Guide to Alternatives. So, David, welcome back to InsightsNow.
David Lebovitz: Thanks for having me
David: Before we kick off, a lot of the topics we're going to talk about today are also reflected in our Guide to Alternatives. Can you share a few comments on what that is and what goal it aims to achieve?
David Lebovitz: Sure. So the Guide to Alternatives was developed in an effort to provide more clarity around what is happening across a variety of very opaque, private asset classes. And so within the Guide to Alternatives, we break things down into real estate, other core real assets, private equity, private credit, and hedge funds, and really strive to do the exact same thing that we do in the Guide to the Markets, which is not predict the future, but rather see the present with clarity. And so we hope that the Guide to Alternatives will continue to evolve into a tool that investors can use when evaluating the opportunities as well as the risks across those less liquid private markets.
David: Thanks, David, for that clarification. So to start, we know that the rise in interest rates this year has been tough for public equities, but what impact of higher rates had on private markets? What's going on in the space this year?
David Lebovitz: Well, it's interesting, because in the first quarter of this year, as you saw big moves in interest rates really destabilize things on the public side of the spectrum, you didn't necessarily see that have a direct knock on effect to the private markets. As I think we're going to talk about here in just a little bit, private market investors are obviously not marketing things to market every single day. Rather it happens a handful of times each year. And we didn't really see any significant markdowns in valuation, at least not during the first three months of the year.
Now, what's gone on here during the second quarter so far is you have begun to see markdowns, not just across private equity markets, but across venture capital markets as well. And I do think that, that's going to be the primary transmission channel through which higher interest rates impact private markets. It's really going to be all about valuations. When the cost of capital is zero, you can discount those cash flows into the future and get a really nice number for what a company might be worth. When there actually is a cost of capital, that means there are differences between good businesses and bad businesses. And I think that you're going to continue to see that play out likely through the end of the year. My view is that what we've begun to see here in the second quarter is really just the beginning of a re-rating in valuations, across private equity markets in particular.
David: So, I guess, perhaps you answered my next question, but how confident are we in those valuations? Do you think that there's a fair amount of marketing to a lower market still to come here?
David Lebovitz: I do think that we will see further markdowns, but I also think that when it comes to private markets, it's important to keep in mind that when you control a single asset, you can actually do things to impact the performance of that asset. If you're a public equity holder, you're beholden to what the C-suite of that company does in terms of operations and the knock on effect of cash flow and earnings. If you think about a private market investment, there are actually levers you can pull as the investor to try to do things, like improve earnings, improve cash flow, maintain margins.
And so while there will be some continued dislocation from the move in rates, I actually think that in some cases, you'll see valuations hold up a bit better as companies work to rejigger these assets to better operate in the macro environment that we see playing out over the course of the next 12 to 18 months.
David: And, of course, these rising rates are really tied to higher inflation. And real estate has long been known as a good hedge against inflation, but how does inflation really impact returns as asset class? And do these benefits still hold when inflation may be peaking north of 8%?
David Lebovitz: Real estate is interesting. And I think the first thing that's important to recognize is that there is a big difference between public real estate being REITs. And private real estate being more the focus of your question historically, REITs, they mark to market every day, they tend to perform like real estate over the long run, but in the short run, they tend to act much more like equities. What we have seen is that over time and we can actually take this analysis back to the late 1970s, which is something you cannot do with a lot of the other private less liquid asset classes. You can actually look at real estate returns, private real estate returns by inflation environment. And what we've found is that whether inflation was above the median and rising above the median and falling, that was when we tended to see the best returns from that asset class.
And the simple way to think about it is if you own an apartment building in New York City and it's costing you more to power the building and staff the building and so on and so forth, well, you're just going to pass that increase in cost onto the tenant who's renting a given apartment. And so it's that element of pass through. And this is the case in a couple of other parts of the real asset spectrum as well, but it's that ability to pass along costs to the end consumer that give these assets the resilience we've historically seen in a variety of different, but elevated inflation environments.
David: Can you give me an example of another real asset, which has the same property of hedging against inflation?
David Lebovitz: In general, we've found, and we show this across our Guide to Alternatives that real assets in general, whether it be real estate, infrastructure, Timberland, transportation, they all have that element of being able to pass along higher costs. But I think one of the best examples and one of the longest tenured examples are really things like regulated utilities, which we would put in the infrastructure space. If you look over time, back to the 1970s, again, there's been a very tight relationship between the year over year change in inflation and the allowed return on equity for regulated utilities in the United States put differently. If it's costing these utilities more to do business, they're able to go to the regulators, point out that it's costing more and then pass those costs on to the end consumer. And so real estate and infrastructure are really our two best ideas when it comes to protecting portfolios against elevated inflation.
David: So getting back to real estate, obviously the pandemic caused a lot of significant changes among real estate markets and within real estate markets, what do you think the Outlook's going forward? And do you think that some of these COVID trends or pandemic trends are going to revert back to where we were beforehand?
David Lebovitz: What I think is so interesting about real estate today is if you look at valuations in aggregate, they're effectively in line with their long run average, but if you were to look at vacancy rates by sector, you would see that dispersion is near its widest levels on record. And so the pandemic, as we all know, created winners and losers within the real estate market. I do think that some of these trends are here to stay. I do think that you'll see other trends begin to normalize a bit. In my view, the idea that everybody is always going to have everything shipped from a warehouse to their front doorstep, yes, there are things that we will have delivered, but it's not going to be every single thing like it was during the dark days of the pandemic. And I think that will take a little bit of pressure off of retail lead vacancy rates in the industrial space to rise and vacancy rates in retail to begin to come back in.
But one of the things we actually saw in retail prior to the pandemic was that it was all about tenant mix. And if you look at those successful retail properties, they were characterized by tenants who tended to provide more experiences and more services, less about the consumption of physical consumer goods. And so I do think you'll see retail begin to heal here, but it's very much going to look like it did prior to the pandemic in terms of what businesses are inhabiting those various retail establishments.
On the residential front, there are a lot of questions I think about the future of hybrid work. I think it's fair to say for the time being, we're going to continue to operate in a hybrid world. And furthermore, you've seen a lot of very large businesses move out of major metropolitan areas towards other parts of the United States, particularly places like Florida and Austin, and jobs drive residential real estate. And so if you have more businesses moving to places like that, there will be an opportunity on the residential side. And we think that we've begun to see that play out, but there is arguably more room for it to run.
And then finally on the office, obviously you can see I'm here in the office today, to me, the office is not going away, but the office is going to change. I think I might have said this the last time you had me on, David, but in a services economy like the United States, the most valuable asset that all of these businesses have is their human capital. And the best way to develop human capital is vis-a-vis in person interaction. And so to me, offices are going to evolve away from the cubicle farms that you and I were so familiar with into spaces for collaboration and interaction. It's going to be much more about getting groups of people together to engage with one another and much less about doing individual work at your desk for 10 or 12 hours a day.
David: Sticking with the whole theme of hedging against inflation, people have also talked about gold over the years as an inflation hedge, and also a hedge against tightened geopolitical uncertainty. But characteristics in that regard have become... I guess, performances have been a little mixed recently. Do you think the gold is still an attractive portfolio diversifier?
David Lebovitz: So I've always been more in the Buffett camp on gold where because there are no cash flows to discount, I can't really tell you what it's worth. To me, gold is worth what somebody will give you for it. But when I think about a framework for thinking through, including something like gold in a portfolio, to me, it really always comes back to what are your alternatives and what does the projected rate of return look like on those alternatives.
And historically, there has been a fairly significant negative correlation between real interest rates and the price of gold. Basically, when you're getting paid more in real terms, people are less willing to hold that shiny yellow metal because of the opportunity cost. And so if we're right here, that inflation does begin to come off the boil over the next couple of months, and the federal reserve does continue to raise interest rates. That, everything else considered, implies a higher real rate of interest, which I do think could weigh on the performance of gold, despite some of the inflation fears that we're seeing in the current environment.
David: So, gold, not exactly the perfect diversifier in this environment. But frankly finding diversification is a little difficult right now. What are some of the ways that investors can think about diversification when the key stock bond correlation seems to be positive?
David Lebovitz: I think what's front and center for me is the idea that the reason stock bond correlations turned positive to start this year was because interest rates were the question, inflation was the question, monetary policy was the question and the common variable between pricing a stock and pricing a bond is interest rates. And so if you can't figure out what interest rates are supposed to be, well, then how are you going to figure out what the stocker bond is supposed to be, how it's supposed to be priced?
And what's been interesting is as we've seen the market shift and become more concerned about a downturn in the economy and more sluggish growth, you've arguably seen that negative correlation between stock and stocks and bonds come back into play. But I do think it's a bit premature to sound the all clear. And so some of the things that we've been advocating for in client conversations are strategies, funds, assets that are not as sensitive to the discount rate that are not as sensitive to interest rates.
And global macro funds are a great example. Global macro funds have been leading the charge from a performance perspective. So far this year, they performed very well in March and April 2020, they performed very well as Delta was spreading in the summer of 2021. And so hedge funds in general, which tend to benefit from elevated volatility and in those macro funds, which tend to focus more on things like currencies and commodities, so on and so forth, we think that those are great places to look for diversification in the current environment. We also think that certain types of hedge fund strategies, which are not taking a directional view on the market, those could be relative value credit strategies, long short equity strategies, those are the places where we think investors should be hanging their hats if they want to generate that diversification in addition to some of the real assets that we talked about at the very beginning of the call.
David: Well, you mentioned hedge funds. And hedge funds are supposed to do well in a high volatility environments, like the one that we're in right now, but what does the long term track record look like at this point on hedge fund returns?
David Lebovitz: It's interesting. It's almost a tale of two hedge funds, if you will, where in the 1990s, you had less efficient equity markets, you had higher interest rates, you had active management that tended to perform pretty well, and hedge fund returns where you look at some of the numbers in the time series, and they're almost eye watering. That hedge fund out-performance very much continued up until the global financial crisis. And then as we saw in the aftermath of 2008, hedge funds very much found themselves under pressure.
Now, part of that was the very elevated correlations we were seeing within places like the equity market, but part of it also had to do with the fact that interest rates were very low. And so hedge funds, they're posting collateral, they're getting paid on that collateral, usually getting paid the yield on short term fixed income. When that number is zero, well, the starting point for hedge fund returns is zero. If that number is two, now the starting point for hedge fund returns is two. And so I do think there's reason to expect given the interest rate dynamic today and given how we think it's going to evolve going forward. We do think that hedge funds could perform a bit better in the years to come, certainly than they did in the aftermath of the financial crisis.
David: Moving to a slightly different part of the asset class, and I want to ask you briefly about private credit markets. Are they going to see some distress now in a higher rate, potentially slow growth environment?
David Lebovitz: I think they well could. Fundraising activity in private credit markets broadly has been very robust over the past couple of years. And so far year to date, as we've seen some softening in fundraising on the private equity side for some of the reasons that we discussed earlier in our conversation, you've continued to see a lot of money raised on the private credit side of the equation. And so I think that all of this money flowing into the asset class has created a set of risks.
We were actually talking the other day on a call. And one of the points that somebody from our fixed income group was making was that private credit markets have absorbed a lot of the credit risk that nobody wanted to take on within the public side of things. And so I do think that there's a bit of risk beneath the surface. I think at the same time, because these are private deals, there are a lot of levers that can be pulled to avoid a default. But my personal view here is that there were a lot of cracks forming in late '19 and early 2020 before the pandemic showed up and the Fed got away with the policy error because of COVID. I'm not sure that, that we're going to be able to escape those cracks reemerging going forward. And that's going to create opportunity within private credit, specifically when it comes to distressed investing in special situations, rather than in direct lending, where a lot of the focus has been, particularly over the past couple of years.
David: Let's turn to another area of a very broad description of alternatives, which we haven't talked about yet. And that's commodities. Commodities have been the top performing asset class on a year to date basis by a long run, but is it now too late to get in? And how should long term investors think about allocation to commodities?
David Lebovitz: I do recognize that commodities have run fairly far very fairly fast. And you pointed out in your notes on the week ahead that commodity prices have begun to roll over here. Is there another leg higher? I'd say, I'd be on the other side of that trade. I do believe that when the dust settles commodity prices will be at higher levels than what was observed prior to the pandemic.
But when it comes to commodities, it's really all about supply and demand. And I think that there are some clear takeaways, particularly from what's happened so far this year, where things like agricultural products are very much going to be in high demand going forward. If you believe in the energy transition, we actually show this in our Guide to Alternatives, copper is an essential input into nearly every renewable or sustainable source of energy and power.
And so there are ways to play the commodity market. I think it's going to become more nuanced going forward than it's been so far year to date. But we do believe that over time, commodities are also an effective hedge against inflation. And as we show in our Guide to the Markets, the historic relationship has been about 10 to one put differently for every 1% move in inflation. We've seen a 10% move in a diversified basket of commodities. And so I think, again, tying a commodity allocation into some of these longer term structural themes and recognizing the inflation protection, the inflation benefits that this asset class can provide, that's really the framework that I would encourage long term investors to use when thinking about an allocation to commodities.
David: If we take an even broader lens in looking at alternatives, I suppose we have to talk a little bit about crypto assets and NFTs. They have certainly had a tough year so far, but do you regard these kinds of assets as part of the broader alternatives landscape in the long run?
David Lebovitz: I do. And obviously it's been a tumultuous couple of weeks, as you noted, for all things digital and all things crypto. Now, you're hearing rumblings that we are entering a crypto winter, which very well could be the case for the foreseeable future. My thought here is that there are interesting parts of this asset class. To me, it's not really about trading the individual tokens. You've seen a lot of hedge funds get into a lot of trouble, simply trying to trade the underlying volatility. What's really most interesting to me is the potential application of things like blockchain technology, what benefits can these services and these blockchains provide to different types of businesses.
And I also think that you will see this show up, not just in financial services, but more broadly across the board. One of my favorite examples is there is a large retailer that uses a blockchain for quality control in its produce business. And if you have better control over your supply chain, and this is front and center for all of us, particularly given the past year and a half, if you have better control over your supply chain, well, now you're in a pretty good spot. And maybe that better control begins to manifest itself in earnings. Right now, we're talking about tying blockchain technology to an actual cash flow in the real economy. And that makes the thesis, the investment thesis, all that much more robust.
And so I do think things have been put on ice, but I don't believe that this asset class is going away. I think it's very much going to be part of the conversation for the foreseeable future.
David: Okay. Listen, to wrap up, I wanted to mention another exciting thing that you're working on, which is our new principles of alternative investing. Can you talk a little bit about what's going on there?
David Lebovitz: Absolutely. So, as I mentioned at the outset today, the Guide to Alternatives was really meant to provide more clarity on what are very opaque and difficult to navigate asset classes. Principles for investing in alternatives is really meant to provide a framework for thinking about building these allocations into your portfolio. One of the things that we've always come back to is this idea that investing in alternatives requires an outcome oriented approach. Step one is figuring out the problem you're trying to solve. And step two is determining the asset which provides that intended solution. And so the principles piece is really meant to help people better understand what these different assets and asset classes can do for their portfolio, so they can make more informed decisions when it comes to adding them to what is a traditional stock bond portfolio.
David: All right. Well, listen, thank you, David, for joining us today.
David Lebovitz: Thanks for having me.
David: And thank you all for listening. And I should also mention that we've also linked the Guide to Alternatives in the show notes for this episode.
Please tune into our next episode where I'll be joined by my colleague, Jack Manley, global market strategist at J.P. Morgan Asset Management for conversation on our midyear outlook and key investing principles investors should keep in mind when positioning for the remainder of the year and beyond. And then I invite you to read or listen to my Notes on the Week Ahead Podcast, where every Monday I share commentary on the latest in the markets and economy to help me stay informed for the week ahead. For even more timely insights, you can follow and subscribe to my content on LinkedIn.
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