What can we expect from 2023?

As an optimist, I like to cheer up my clients and the public by saying that even though 2023 is going to be tougher than 2022, it would be a way better year than 2024.

Let’s put the jokes aside and try to estimate the economic and financial risks for 2023, even though life proves so often that when humans build their plans and forecasts, gods laugh.

The biggest threat to the business in the short run, in my opinion, is not that much disrupted supply and distributions chains, high inflation or a China-US semiconductor dispute but political uncertainty, which may result in fiscal and taxation changes, and insufficient liquidity provided by creditors and investors. Next to that, a big risk factor is a drop in a consumer appetite, which leads to a drop of sales.

Three major threats are looming over modern business community.

We, modern people, are used to live in the inflation environment. What used to be a small Fiat 50, is now a real SUV car with 4 doors. Cars get bigger, houses get bigger, same we expect from our sales, salaries and dividends.  Yet do we know how to prosper in a world where things do not inflate?

Now we face unusually high inflation. There are two reasons, in my opinion therefor. The very first one has been spree of “helicopter money” that was disbursed by governments in G20 during created by the very same governments lockdown world paradigm.  A second one is the surge in energy prices due to disrupted supply chain of energy from Russia. As we all know, any hike in the energy/logistic cost has a ripple effect with a high multiplicator.

For the next years, the expert community, and I join this motion, is certain that the interest rates will inflate. Sure, that does help to bring the overall inflation down, yet it is a symptomatic treatment, which deals with the symptoms, not the reasons thereof. Furthermore, it has some dangerous side effects. High interest rates kill business from two sides: less funding in the working capital and in the capital expenditure (which is a foundation of future growth) and less sales as the clients use less debt to buy. Not to forget that any government «shoots itself in the foot» having to pay much more for the federal and municipal debt. This leads to less capital expenditure by a state, which harms the future growth.

Hence, I do believe that the very high interest rate period would not last longer than 2-3 years. After we should see risk-free rates around 2-4% p.a. However, all such predictions are subject to many carve outs, «ifs and whens». The war in Ukraine is a factor that plays in crucial role in our future, and it is hard to make forecasts with such a tragedy going on.

A next major factor in the macroeconomic analysis is the economy growth, usually measured by the GDP. It would be depressed as well, yet it is important to differentiate among countries, some (mainly Emerging Markets) will have a reasonable good prospects of growth, some (USA and quite a number of developed economies) not.

As a result, we will see deterioration of credit risks across the globe. For the borrowers it is important to address the risk of refinancing and strengthened dollar (as usual in times of increased geopolitical risks we observe a “flight to safe heaven” effect).

Due to increased rates set by regulators which are topped up by a wide margin spread imposed by a higher risk perception and inflation, the overall cost of new borrowing will be now two three times more expensive than in 2021. Having said this, let us not forget, some borrowers might not receive refinancing at all.

As most of the international debt is denominated in USD, many borrowers will have to pay much more of its base currency to purchase dollars in order to meet their debt obligations.

Sum up those two factors (refinancing and strong dollar) and one will see that borrowers face a tough time. I reckon we could see a push in the default rates way above historical average, perhaps, by two times.

It is time for the borrowers to think once again how important to have a good CFO on board. A good CFO would greatly reduce risk of refinancing by balancing float and fixed rate obligations in general. Additionally, a good CFO senses troubles way in advance. It was pretty obvious back in 2021 that the inflation would shoot up and so would the central bank rates. Hence a wise CFO would have swapped the float into fixed rates having analysed basic macroeconomics (“helicopter money” would push inflation up) well in advance of the actual rate hike. There are plenty of instruments to swap the float into fixed and vice versa.

Furthermore, it is always wise to have at least a portion of long term debt refinanced with a new debt at least a year in advance. It implies you starting to negotiate with banks about refinancing 18 months before the due date.

For the fixed income investors or creditors it is time to look into the borrowers liquidity positions and maturity timelines. For an investor that holds a fixed income portfolio I would advise to rebalance its portfolio by replacing paper that matures within the next two three years with a longer tenor one. The spreads are such that they would still cover even the increased default rates, hence a good diversification can do the trick of getting out of trouble in black, rather than in red.  The expectation of default rates for speculative grade issuers in USA and EU may reach annually 5%-6%, while yields for such issuers in USA are shooting to 8%, and in EU around 6,5%. Therefore, it makes sense to rebalance fixed income portfolio in favour of USA issuers. With regard to top quality issuers no preferences geographically, yet I would prefer EUR debt for a EU based issuer.  Surely, one has to think carefully about taking risk on industrial energy dependant issuers.

For bankers my best advice would be to beef up its teams with turn-around and restructuring experts. It would greatly improve a bank’s position in restructuring a debt with a client and a possibility to take over the business, if that needs be. Debt for equity swap is becoming customary.

I do recommend to deep dive into the “The Global Credit Outlook 2023” forecast made by a remarkable company “S&P rating agency”. As a financial analyst, who have gone through tons of material, I would pick up S&P along with very few other think tanks that can give a thorough and clear guidance to negotiating a path to the most realistic scenarios. The report covers mainly credit risk side of the global picture and therefore, could be most useful for the fixed income management and corporate banking.

Here you can download the report The Global Credit Outlook 2023.

Furthermore, apart from the fixed income world, there are equities. It may sound a bit strange, however, why not rebalance a portfolio in favour of equities. It would be wise to reduce fixed income holdings in favour of cash for now and be in a ready-to-go position to shift the funds into equities first half of 2024, subject to geopolitical situation not getting worse. I will elaborate on this thesis in another article later.