Expert conversation with Matt Henry and Jackie Bowie

What are macroeconomic themes that could have an impact on our clients in 2023?

In order to think about what our clients should be focused on in 2023, we should just do a brief recap of 2022. The end of low inflation, the end of low interest rates, and, arguably, the end of globalization were key factors last year. As we've come into 2023, clients have been adjusting to new inflation and the new interest rate environment. They are adjusting to the fact that the world is maybe not quite as global as it was before. They've also had to adjust to thinking that what they were planning for may not be reality.

If we consider our own business at Chatham, we were thinking that 2022 was going to be focused on recovery from Covid and how do we get back to normal. Instead, we faced China who continued to pursue a zero-Covid policy, which has had significant implications for the global economy, and then on top of that, Russia started a war with Ukraine.

As we take last year into consideration and plan for the year ahead, we already see our clients wondering:

• How to operate in an inflationary environment when they’ve never had to do that before.
• How to think about the cost of their funding — both in terms of the underlying interest rate as well as credit spreads (i.e., the margins have also increased).
• How to think about valuations including the interest rates impact on valuations.
• The value of the assets that they own and opportunities for those assets that they might want to be looking to buy.

Can you discuss what's different about how the markets in continental Europe and the U.K. are reacting to economic conditions?

When we think about our client sectors, where we focus within real estate, private equity, and infrastructure, there are some different trends that are driving investment opportunities, the valuations and pricing of those investment opportunities, and the cost of debt. There's certainly more focus from the U.K. perspective on energy security. Our infrastructure team has been very busy working with clients, specifically in the U.K., on new renewable investment opportunities.

Across Europe, if we look at the interest rate market, I will say investors and borrowers were much more relaxed about interest rate risk than they were in the U.K. That may be a product of 10+ years of negative rates for the vast majority of that time. The focus is now on the cost of financing new projects as well as the interest rate risk exposure that they have, whereas I think that was much more of a behavioral risk management strategy for U.K. borrowers and investors.

Another difference between the U.K. and Europe is what will happen with the unwinding of the central banks’ balance sheets. The U.K. has progressed fairly far in terms of what they've indicated to the market as well as what they've done regarding quantitative tightening compared to the European markets. That has an impact on the money supply, the cost of money, and other influences on decision making. I don’t think most of us have seen a complete unwind of the balance sheet on that scale, and that's quite a concern. In the U.K., given what the Bank of England (BoE) has done so far, people are starting to think they might be successful in that unwind, where the European Central Bank (ECB) still must prove themselves in that regard.

What do you think the impact of the market's volatility will have on interest rates?

I heard an investment bank coin the phrase of 2023 being stabilized volatility. It does make some sense because in 2022, it was the sheer speed and extent of the rate moves that took people by surprise. The volatility in the U.K. market through the government’s mini-budget was awful. People couldn't get any execution trades done. The expectation is that there will be continued volatility in 2023, but it won't be quite as bad as in 2022.

Our clients are now looking for what happens beyond 2023. There's some expectation that the U.S. Federal Reserve might pivot first into a rate-cutting strategy this year. There really isn't any expectation of rate cuts from the ECB or the BoE until well into 2024. The reason for that is the U.K. is not expected to hit its inflation target again until the end of 2024. While inflation is still significantly above target, I don't expect we'll see central banks being particularly aggressive in cutting interest rates.

In this “stabilized volatility,” what are things that clients can start to execute on today in terms of interest rate and FX strategies that will help them years from now?

Many clients are starting to look ahead at refinancing points and finding where they have debt that’s coming to maturity and then trying to go into that decision-making early. That allows them to look ahead and potentially consider pre-hedging. We have an inverted curve in the U.K., and we have a mild inversion in Europe, not anywhere near the extent of the inversion in the U.S. There are some opportunities to get lower interest rates further out in time which can depend on credit capacity with their lenders and counter parties. Rates may never come all the way down to 10 basis points or negative again, but if during 2024 you could fix your cost of funding to 4%, does that work for your investment strategy? How could you go about doing that today? If you're using swaps, credit capacity is an issue, but there are also good opportunities to use more flexible hedging products to pre-hedge such as new acquisitions or refinancing points. I think this is the first time in a few years where we've seen clients look much further ahead than just the next 12 months.

Are there any ways to hedge against the lack of credit capacity we're seeing at financial institutions?

It depends on the status of the borrower, while we're not in a credit crunch by any extent, balance sheet lenders are certainly looking to scrutinize their credit exposure more than they were 12–18 months ago. To pick up on another theme, there has been growth in private credit across Europe and the U.K. Similar to the U.S. markets, the private credit balance sheet has been great for plugging gaps where bank lenders have reined in because of the regulatory capital changes. That means, however, that the borrower or the company using those private credit funds, doesn’t have an automatic line of credit for hedging or a derivative strategy. This requires them to look at different counterparties to be able to achieve that. If the trend of private credit continues to grow, borrowers will have to look at more option or option-based hedging products in order to hedge their risk compared to if they were borrowing from the balance sheet lender.

Is there anything changing in the FX markets as our clients plan for 2023 and beyond?

We haven't seen any major changes in how people are addressing their FX exposures. What we have seen is an increase in people concerned about their FX exposures coming off the volatility in the interest rate market in 2022, which has an impact on the FX market. Certainly, some of the more peripheral countries in Europe, where many of our clients are investing, are not part of the Eurozone. This means they don't play in the euro currency, and it’s been extremely difficult to hedge those currencies. There is an increased awareness and people are more switched on to the risk that comes with investing outside of the core Eurozone and the U.K. market.

If you’re a fiduciary for your client, what are two or three things that you need to be asking about your capital markets risk in 2023?

In 2022 the rate market moved very quickly and moved a lot, but oftentimes, investors or even corporates were too reactive and lacked a risk management strategy. The market was moving away from people, potentially going into the capital markets not at the right time, paying more because they didn't plan enough in advance. What we're seeing now is many of those investors, investing on behalf of their clients, are putting in place much clearer parameters or guardrails around what exposures they're willing to take and really digging much deeper into where the risks and their portfolios sit.

If a recession comes, and the U.K. and Europe are predicting a recession, it could be quite short-lived with what the current data is telling us. There will be opportunities for many of those investors, but I think their capital providers will be scrutinizing much more. Investors will be asked, “Do you really understand the fundamentals of this business and where the potential risk exposures lie?” They'll plan for it as opposed to react to it.

In a market like this one, where we have war, an energy crisis, and "stabilized volatility," what should I be thinking about and watching this year?

If the interest rate market does turn and central banks start to cut rates, companies, borrowers, and investors will be facing financing conditions and decisions that they haven't faced for 15 years. My concern is that they don't make decisions quickly enough to restructure, to restructure their capital, maybe even restructure their businesses in many circumstances, and restructure portfolios to adjust to the cost of debt. They need to be looking at what does their business and investment opportunities look like with these new inputs. If businesses use the last 10 years as the norm and delay their decision-making, we could stagnate. The U.K. has quite a productivity problem already, and businesses need to be investing in new capital, improving productivity, and if they don't reset to the new environment, then that could be delayed.