At the beginning of 2022, there was an expectation that the cycle was turning and the economic growth of the previous year would slow following the large post-COVID-19 bounceback. The language heard from central banks of ‘transitory’ inflation shifted to runaway inflation. Soft landings morphed into recession predictions. Central banks indicated that there would be higher interest rates. But the outcome of what occurred in the markets was significantly more than the initial forecasts at the beginning of the year.
In general, the expectations all turned out to be correct. The surprise has been the sharpness of the market’s move and the speed with which things have changed, most acutely in interest rates. The Federal Reserve raised interest rates seven times in 2022. After two modest rate increases in March and April, it implemented four consecutive 75 basis point (bps) rate hikes in the second half of the year, followed by a final 50bps in December. This took the Fed Fund rate from zero at the start of 2022 to nearly 4.5%.
While the Bank of England has not moved UK rates to quite the same extent, it is still a material shift from the 0.25bps in December 2021 to 3.50% at December 2022. At one point in 2022, after the Truss mini-budget, the market was pricing in that UK interest rates would reach 6.25% in 2023.
One of the odd features of this cycle is the labour market. In the UK, it is estimated that more than 500,000 people have left the employment market; in the US it is close to four times that number. Unemployment is very low and the number of vacancies is higher than those actively seeking work. This is having an impact on wages and productivity, making it harder to keep inflation under control and challenging the ability to generate growth.
Economic outlook
Global growth, having gone from 6% in 2021 to 3.2% in 2022, is forecast to slow to 2.7% in 2023. However, this masks the contractions expected in individual EU countries and in the UK. Inflation looks to have peaked (in the US in particular), but we are still far off the price stability targets of central banks, with the UK not forecast to get below the Bank of England’s 2% target until 2024. Average annual inflation is expected to outpace annual average wage increases and so real incomes will continue to decline, which in turn is negative for consumer confidence.
Beyond the macroeconomics, there is further bad news for businesses. A 1% decline in US GDP tracks through to an approximate 15% drop in US corporate profits. Rising interest rates mean future cash flows are discounted at a higher rate, and so negatively impact asset valuations. The valuation re-set has not yet played out, particularly in the private capital sectors. This will be the theme in the first half of this year.
Beyond the half year, there are reasons to be more positive. The Fed looks likely to pivot first and signal rate cuts in 2023. While inflation will still be above target, it will not be increasing and asset valuation falls will bring a new dawn of opportunities for those with capital to invest. It does not need to be an environment of strong growth and abundant positive news to encourage deal activity – just a marginal change in sentiment is enough. Investors and dealmakers will anticipate an improvement and take advantage.
Deal opportunities
While M&A deal volumes in 2022 were down on 2021, a bounceback is not predicted for 2023. Transactions reliant on leverage will need to bake in much higher assumptions for the cost of that debt. Private equity investors are likely to put more weight on the quality of the management teams in their diligence. Longer hold periods will be a feature of 2023, as will off-market transactions, as vendors target specific buyers rather than run a full competitive process.
Use of the public equity market was unavailable for many in 2022: global IPO volumes were down 45% and proceeds down more than 60%. The pipeline is therefore quite full and companies will await the right time to revive IPO plans. In the meantime, ensuring the fundamentals are in good shape will be critical. Investors will be scrutinising revenues, profitability and cash flows to identify strong, sustainable businesses.
It is said that it is always darkest before the dawn – and it certainly feels like this first quarter of 2023 will be dark. Using that time to shine light on good opportunities will stand investors in good stead, when sentiment turns in the second half of the year.