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Chatham's Q4 2022 outlook: Inflation, market volatility, and LIBOR transition

Date:
September 16, 2022
  • amol dhargalkar headshot

    Authors

    Amol Dhargalkar

    Managing Partner, Chairman
    Global Head of Corporates

    Kennett Square, PA

Summary

Watch Chatham's Managing Partner and Chair, Amol Dhargalkar, discuss key trends for the upcoming quarter like inflation, market volatility, and LIBOR transition.

Macro trends

What are the biggest impacts?

It's incredibly difficult to predict what will happen from a geopolitical standpoint. But if we think back three years ago, no one saw COVID coming. If we look back even a year ago, there was a lot of chatter about Russia invading Ukraine, but there wasn't nearly the degree of analysis that's happened after the fact. We don't know what the next event will be, but we do know that there are some monumental events happening around the globe.

Russia-Ukraine war

The first is, of course, the Russia-Ukraine war. The price of gas is going up. EU citizens will, as we enter winter months, have a significant challenge with being able to pay their heating bills. The war also has an impact on things like crop production. Russia and Ukraine are very large wheat producers, and a lot of that wheat goes to developing countries. While production and distribution have stood up surprisingly well so far, it's not clear that will continue to happen.

China’s COVID policy

The second big area is China. In this case, it's specific to China’s Zero COVID policy. Anytime there's a COVID flare-up, Chinese authorities shut down that part of the country. That's having an impact on supply chains. Companies are starting to rethink their reliance on China as a manufacturing partner and reconsidering some of their relationships with suppliers in China.

Geopolitical events

Finally, large scale political events and elections are always on investors’ minds. Throughout Latin America, we see significant events and a lot of polarization in places like Brazil. Of course, there are midterms coming up in the U.S., and there’s a new prime minister in the U.K.

Commodities

Energy and climate change

The commodities markets are always volatile. There's always a link between the financial and the physical that’s unique to commodities markets. These past few years, we have seen the impact of that link between financial and physical.

Increased energy demand putting pressure on company budgets

Energy markets have been experiencing shocks like we haven't seen before, starting with Russia and Ukraine. Even now, we've seen unprecedented temperatures in Europe and California and the impact they have had on the grid, the prices paid for electricity. When we see all these countries having to rapidly rethink their energy infrastructure, their budgets have gotten blown out of proportion from their expectations. We're seeing more discussion of how we manage this risk going forward, but those are longer-term investments. In the short term, this rapid rise in energy prices has an impact on the cost of goods sold. Central banks have to take this into account even though they have zero control over it. And the current scenario that we're facing, with respect to energy prices and input costs, is rooted in a variety of challenges. Including the fact that there has been massive under investment. When these companies have drilled for oil and tried to increase supply in years past, we've seen a drop in prices which has led to negative returns for investors. And so now there's a lot of incentive to say, “we're generating some good returns. Let's send that back to our investors rather than reinvesting that into more supply, which is what the world needs right now.

Rates, FX, and inflation

Risk and hedging trends

We have seen the most aggressive Fed action, ECB action. Some of the most aggressive action that we've seen in central banks around the world as they deal with the current inflationary environment into what seems to be a much more certain recession. The dollar continues to strengthen in the face of that, having broken parity recently against the euro. As a result, we're seeing our clients really changing some of their approaches.

Assessing cross-border risk is now a focus for all types of investors

We are seeing companies, for the first time in some cases, really having to assess that cross-border risk. We've seen large investors in the private equity space and real estate space get pressured by LPs to evaluate and put in place a plan to mitigate that FX risk. We've seen companies that have never hedged before come out of the woodwork and say, “our earnings can't withstand this level of volatility and this level of strengthening of the dollar. What can we do?” We've seen investors as they're looking to do a cross-border acquisition, even if that's going to close in two months, three months, six months, nine months, say, I don't know what's going to happen between now and then. I really need to put in place some protection for this transaction. Whereas, that same company, just a few years ago, would have never considered doing that and would have considered self-insuring.

Volatility means cross-border risk remains for 2023

As we think about the future, this trend that we've seen over the course of the last several months, we see very much continuing into the latter part of this year and probably throughout 2023. Until we get to a bit more of a coordinated approach globally, that leads to a little more consistency in how different economies are performing. But until that happens, or until there's some other big shift, that changes the market tone. The focus on cross-border risk is very real and very significant for all types of investors.

Monetary policy changes lead to market volatility

One challenge for companies, as we look at the impact of this unprecedented action from central banks across the globe, is the level of market volatility that's associated with it. This is a level of volatility we just haven't seen in a long period of time. Multinational companies that have been using cross-currency swaps have been restructuring these at a clip that we haven't seen before, often restructuring them to reset rates and pull cash out. We've seen companies pull out anywhere from tens of millions of hundreds of millions of dollars over the course of the last year. As the dollar has continued to strengthen going forward, companies should keep looking at this type of structure.

A challenge that companies face is that it's a very different market environment than what they might have been used to during a period of relative calm over the last few years. The static programs that the companies maybe had in place before, and that may have been "we don't hedge, or this is what we do robotically," may not work going forward. It requires much more active assessments of what the risks are, and how much a firm is willing to pay to take away some of that risk and what the benefit of doing so is.

This is a level of volatility we just haven't seen in a long period of time.
Amol Dhargalkar

Digital trends

Companies invest in technology

With the rapid pace of changes that are happening amongst all our clients across multiple industries, we are seeing continued investments in digital transformation.

Data and BI tools enable you to make key decisions more quickly

The combination of using data and business intelligence tools that are embedded within our ChathamDirect software enables decision makers to make key decisions much more quickly. We see more and more of our clients walking into meetings with executives with dashboards that allow them to answer key “what if” questions: what if x happened, what if y happened? What's happening in the market that's impacting our portfolio, and how could it impact us in the future? The ability to do all of that quickly, on the fly has really sped up decision making for our clients.

LIBOR transition

Navigating the change

As our clients are going through this transition from LIBOR to SOFR, SONIA, and other alternative indices. They've been increasingly reliant on our technology, our software, and our models to help determine what the impact will be across all their debt and derivatives portfolio.

Investing in systems and tools can help you prepare for the transition

They're using this to analyze the cost, the different alternatives that they may have and ultimately able to track the outcomes of their decisions by leveraging our platforms as they go forward in a post-LIBOR world all stripes across all industries are facing our systems challenges. Systems are not well set up for moving from one index to another. We have clients that are telling us how manual of a process this is. We have clients that have been investing for years that are still not in a place to execute easily on this transition because of these systems challenges. And as a result, this is leading to a bit of a delayed transition, and we know the clock is ticking, and everyone knows the clock is ticking. The consequence of all of this is as we look forward is that we feel there could be a bit of a traffic jam as we get into the second quarter of 2023.

As companies continue to invest in systems and the tools, they need to be able to make this transition. We could find ourselves in a place where we have a lot of transition happening in a very small period, creating some incremental volatility in markets. So, for those that have large portfolios, it can make a lot of sense to start stepping into the transition — rather than transitioning everything all at once away from LIBOR — to take small steps into the transition away from LIBOR to a successor rate, some version of SOFR.

What's next for Chatham and our clients?

As we prepare our clients for the coming year, some principles will remain the same. Our deep capital markets expertise, along with our client relationships, will continue to be fueled by our knowledge, data, and tools. Our ability to harness and to see a large part of the capital markets, coupled with our willingness to use technology to solve problems, put us in a position to serve our clients well and enable them to make the best possible decisions in the capital markets.

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Content contributors

  • Jon Skeem

    Managing Director
    Global Head of Private Equity and Infrastructure

    Private Equity | Kennett Square, PA

  • Kevin Jones

    Director
    Treasury Advisory

    Corporates | Kennett Square, PA

  • Rob Mangrelli

    Managing Director
    Hedging and Capital Markets

    Real Estate | Kennett Square, PA

  • Todd Cuppia

    Managing Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA


Disclaimers

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.

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