Is the downtrend in inflation enough for the Fed?
17 January 2023
Markets Price the Pivot on Interest Rates
3 February 2023RISK INSIGHT • 26 JANUARY 2023
The fate of the dollar, rates and inflation: Validus Risk Management outlines macro key risks for 2023
Macro-outlook: FX and rates
The last year has been defined by a stronger dollar, higher rates, and flatter curves. As we head into 2023, inflation seems to be turning a corner globally and messaging from central banks is as nuanced and complicated as ever. In this piece we will lay out macro scenarios to watch in the year ahead. Some are more likely than others, but each would have far-reaching impacts on investors and macro risk hedgers.
At Validus, we always try to avoid ‘sitting on the fence’ without having a clear directional bias. Frustratingly however, that is exactly the scenario we currently find ourselves in. Overall, our base case expectation for a weaker dollar remains unchanged from recent months. However, given the magnitude of the move over the past quarter, our conviction over further dollar weakness is lower than it was three months ago.
- The Dollar Loses its Sheen – (Prob: 65%): Our base case scenario is that the USD starts to weaken against major peers. We saw the beginning of this move in the last quarter of 2022, but we believe there is room for further weakness. Despite a confident Fed and strong payroll numbers, the story beneath the surface is much less rosy – leading indicators are pointing toward a marked downturn in US employment. A historically accurate leading indicator for the US labour market is the NAHB housing index, a tracker for housing market sentiment. Over 2022 we have watched this indicator collapse and it is now close to mid-Covid lows – if history repeats itself, this fall will be followed by a marked increase in the unemployment rate in the months to come. This would go against recent market sentiment that the US economy is going to fair better than its peers in the coming downturn - opinion of UK and EU growth for the next year is already low.
In the UK, the BoE has prepped markets for the longest recession since the 1920s with 8 quarters of declining growth expected. In the Eurozone we have politicians lamenting the ECB for hiking too quickly, and the ECB remaining resolute that further hikes are on the table. Should we see a merging of expectations – worse than expected in the US, better in the EU and UK – we believe there is a more room for the USD to weaken against the euro and the pound. Add to this that the USD remains markedly overvalued against both currencies, looking at PPP measures we see it some 13-16% overvalued, historically these valuations haven’t persisted for extended periods – another reason to be cautious on continued USD strength.
- Dollar remains robust on Fed and Inflation – (Prob: 25%): Current pricing in the rates market is interesting mainly because it is directly at odds with the rhetoric coming out of the Fed. The most recent dot plot showed that the average Fed member sees rates rising to 5.1% by the end of 2023 with some seeing it reaching as high as 5.5%. Powell was at pains to point out that market pricing was too low, and indeed rates may need to stay restrictive for longer than is currently expected. The market currently sees the peak below 5%, and it has rates falling faster than the Fed believes. Fed members see rates above 4% by end of 2024, but the market sees us closer to 3.5% by this time. Fed officials remain concerned about an inflation overshoot, and not without reason – their preferred measure (PCE) remains stubbornly high at 4.7%, more than double their target. And where CPI has been steadily falling for the last 6 months, there has been no such trend in PCE. If the market is wrong and the Fed delivers on what it is telling us it will do, we could easily see a continuation of the USD strength we have seen over the last 12 months. Though not the only driver of currency movements, USD correlation with rates remains more robust than the equivalent in GBP or EUR. Higher than expected rates could push investors back into the USD, especially if other central banks remain relatively dovish. Sterling seems most at risk in this scenario following Bailey’s resolute commitment to a peak of rates lower than 5%, at the same time as Powell was urging market pricing higher, Bailey was doing the opposite. Market pricing has heeded Bailey and should Powell deliver on his promises. Should the UK/US rate differential grow, it could spell trouble for GBP/USD. The euro will be far from immune, if stickier core inflation is a global issue (we are currently seeing it remain high amid falling CPI in Europe and the UK) and the ECB is forced to hike more aggressively, the peripheral bond issue will be front and centre again. Italian legislators are already voicing their discontent with rate hikes and a continuation will strain Italian finances and EU unity, with clear negative knock-on effects for the single currency.
- Dollar wins again on risk-off re-emergence – (Prob: 10%): Shocks to the global economy usually work to the benefit of the dollar, as we saw with Covid and the outbreak of war in the Ukraine. Though market attention has pivoted away from these issues, the issues themselves are not far from the surface. The conflict in the Ukraine continues, and it wouldn’t take much of an escalation to have it become front and centre for the global economy once again. The Chinese reaction to covid has softened, but they are nothing if not unpredictable on this front. Even though the sudden reopening has had a negative effect on Chinese growth, expectations are for this to be short lived and for cases to start dropping soon. But should cases continue to climb, the government could be pushed toward a new round of lockdowns turning investors toward the relative safety of the USD.
Macro-outlook: public markets
After a challenging 2022, investors have been left bruised by turbulent markets. However, looking ahead to 2023, there could be several factors that could drive a more stable outlook – though geopolitical and digital risks should not be underestimated:
- The global economy driving ahead: Our main forecast scenario - a neutral to slightly bearish US dollar – could be driven by a pick-up in world economic activity as it catches up with post-pandemic US growth and a soft landing in the US. As a result, risk assets could find a stronger footing in 2023.
- The Fed and markets meet on rare expectations: Paradoxically, if the US dollar weakens due to a change in tone by the Fed (i.e. less hawkish/more dovish) due to economic slowdown or a falling inflation. Not only could risk assets rally but we could also witness a rally in fixed income along equities, a mirror image of what we witnessed in 2022 representing a positive correlation of equity and bonds to the upside.
- A return to normality for stocks and bonds: If the weakness in the US dollar is a result of a hard landing with deteriorating corporate earnings and potential secondary effects of rate hikes, such as individual credit defaults or strains on corporate debt financing, then we would likely see a scenario where equities and bonds resume their behaviour of the past few decades. This would result in a negative correlation with equities under pressure and bonds rallying.
- Geopolitical risks will persist: While the energy crunch in Europe did not materialize, thanks to an unusually warm fall and start of winter, there is no end in sight to the war in Ukraine. The war has already strained relations between some EU members as they disagree on the line to follow, and the consensus is eroding. The Middle East also remains a lingering risk for risk assets as the perspective of a nuclear deal evaporates.
- Beware of digital risk: In an interconnect world, the risk of disruption to the economy both locally and globally due to digital risk – of which targeted hacking is one – continues to increase as technology becomes more sophisticated and our technological dependence increases. Similar to how the pandemic was a known risk even before Covid-19, and yet was underestimated by many, the far-reaching effect of digital risk (if it materializes) is vastly under-appreciated.
Macro-outlook: private markets
As we enter a new world of tight money and inflationary pressures, many are predicting a ‘private capital winter’, where fundraising is challenging, deal flow is tepid, and valuations come under sustained pressure. While it is undeniable that the dramatic shift in macro conditions will create challenges for the private capital sector, our view is that all is not as bleak as conventional wisdom suggests – indeed, there are some areas which may well benefit from this new world of higher rates. Volatility, after all, creates opportunities as well as threats.
- Investment performance: It is almost certain that the repricing of leverage will flow through to valuations and multiples in 2023, despite last year’s resilience. This will create a drag on investment performance across the private markets space, especially in private equity and real estate. One bright spot could be the private credit market. In terms of absolute performance, returns will be boosted by the 400-500 basis point rise in base rates and will likely also benefit from an increase in spreads (100-300 basis points) and deal fees.
- Deal Flow: While it is hard to imagine a return to the loose money and benign rate environment of 2021, we do not expect a prolonged slowdown. In fact, deal activity should start to pick up in 2023 as private equity investors, backed by in excess of $1 trillion in dry powder, adjust to the ‘new normal’. Anecdotally, deal pipelines remained strong last year despite depressed activity, and pitch counts, a key leading indicator of deal flow, remain healthy. In our view, the key macro factor holding back deal activity is not the level of interest rates (which will be addressed as valuations adjust) but the uncertainty over their future path. Once investor uncertainty in this regard is reduced, we could see a substantial pick-up in activity as backlogged pipelines start to clear. We expect to see this primarily in the mid-market, as larger deals (>$2 billion) may still struggle to get financed.
- Private Credit: Private credit will also be a beneficiary here. Just as the global financial crisis in 2008 proved to be a catalyst for the private credit business by filling the gap left as traditional lenders retrenched, the current environment will also create opportunities as banks remain in defensive mode. Private credit managers will need to adapt, managing credit risk by mandating tighter lending conditions, such as enhanced interest rate risk management from borrowers for instance, but the new ‘tight money’ environment will provide further opportunity for private credit to thrive.
- Fundraising: The fundraising climate will likely remain constrained by two factors: the ‘denominator effect’, where the relative decline in the value of public market holdings means that many investors are over-allocated to private capital; and the recent decline in distributions from many managers. However, the long-term picture remains bullish – in particular, the shortcomings of the traditional 60/40 portfolio highlighted last year, with both equities and bonds declining in tandem, will push many investors to increase exposure to other assets, with private capital poised to benefit from this shift in sentiment.
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