As we kick off 2023, it is time to look ahead to the new year to make economic predictions.
Making predictions can always be a dicey proposition, but my motivation is to share my mindset for managing what we expect to be choppy waters rather than achieving complete accuracy in our predictions. During times of market volatility, my focus is on managing downside risk and positioning to pounce on opportunities, rather than being overly optimistic and potentially disappointed if we experience prolonged market dislocation.
Make no mistake, I believe there will be plenty of opportunities in 2023, but the year will be characterized by a tale of two halves, where the macroeconomic environment in the first half of 2023 will be very difficult, and the second half will start to see some “green shoots.” Inflation will likely remain stubborn, and fighting it will be job No. 1 for the Federal Reserve in 2023, as it was in 2022. Various predictive models, including Citymark’s, show that inflation will likely remain above 4 percent throughout 2023, despite the Fed’s best efforts — leading to continued increasing interest rates.
The forward yield curve predicts future interest rates for the 10-year Treasury bond and the Secured Overnight Financing Rate (SOFR) index, upon which floating rate debt is priced, will peak in summer 2023. We expect these increasing rates in the first half of the year to slow the economy, and that will likely lead to increasing unemployment.
The higher interest rate environment will put pressure on borrowers with floating rate debt and lead to a higher probability of borrower defaults. The expected default risk caused banks to pull back in the second half of 2022, exacerbating a liquidity crunch that is likely to remain in the first half of 2023.
For those companies that utilize floating rate debt, higher debt service costs could lead to higher loan defaults and opportunities for well-capitalized investors to provide “rescue finance” (i.e., mezzanine debt, preferred equity) to help corporate borrowers and real estate investors restructure their balance sheets. The rescue finance option could be very effective in helping owners preserve their equity values until the economy begins to grow again in a post-inflation future.
As real estate investors, the cost of debt capital is an important driver of property values. While underlying rental housing fundamentals remain strong, higher borrowing rates typically cause downward pressure on real estate values and overall investment returns. This same dynamic is true in the private equity markets as the cost of debt capital increases. We think that the first part of 2023 will present some compelling distressed investing opportunities for well-positioned investors to provide capital to borrowers who need to restructure unhedged floating rate debt.
It is important to note that, unlike 2008, banks are well capitalized, which means a “liquidity crunch” is likely to be short lived, and after a rocky start to 2023, we expect the second half of the year to see early signs of recovery with a cautiously strengthening economy. Looking at the forward yield curve again, the 10-year Treasury and SOFR are reflecting a moderating of interest rates. Assuming the forward curve accurately reflects the future market, one would expect borrowing costs to begin to decrease in the second half of 2023, which could lead to increased transaction volume characterized by a strengthening stock market, private company acquisitions and new real estate investments.
The new year always brings new ideas, hope and optimism. We believe that while 2023 will have its challenges like every year does, there will be opportunities for those who are well prepared and positioned to pounce. Happy New Year! ●
Daniel Walsh is Founder & CEO of Citymark Capital
