Macro trends, the end of cheap credit and a global recession

As we go into 2023 and start to come-down from a prolonged period of cheap credit, and indulgent spending from institutions, businesses and consumers - it’s nearing time to pay the bill. Unfortunately, we can’t use Afterpay or Klarna to defer payment here.

The terms of the bill have been changing on a near monthly basis, as major central banks continually raise interest rates, in a bid to stop the ‘transitory’ inflation - because it turned out not to be so transitory after all.

You’re probably thinking – righto champ, so what does any of this mean for me? The answer really depends on an array of interconnected factors…and it’s the intent of this post to begin to explain the cascading macro-economic events that could occur across 2023. Noting that attention spans are limited – in alignment with my energy, all of these won’t be captured in this post but will unfold over several, in the coming weeks.

Major central banks lead us into a global recession

The CBA Chief Economist stated in the banks’ 2023 Australian outlook, major central banks (e.g. US Fed, BoE, PBoC, RBNZ) have been so preoccupied with battling ‘today’s problem’ which is rising inflation, that ‘tomorrow’s problem’ of a potential recession both in the US, Australia and globally, is waiting to unfold – as are many of the consequences. In a complex balancing act, the Fed, RBA and others, are trying to manage domestic price stability, supply-demand relationships and their correlation to employment rates. They do this through the use of monetary policy, to manipulate the supply of money and credit into both the real economy and the financial economy.

Today’s problem – Too much demand chasing too little supply

In an inflationary environment, there are two distinct factors:

1. The demand for goods and services outweighs supply e.g. oil

2. The price vs. value ratio of goods and services is misaligned e.g. >$10 for a lettuce

Simply, when supply is too constricted, the price of the goods and services in circulation rises – but not necessarily the value. Oil is a great example, whereby the raw material never changes, neither does its utility, but the supply (governed by OPEC) largely dictates the price…and the subsequent prices associated with the sectors which consume it e.g. transport, infrastructure, manufacturing. When these are becoming too extreme, major central banks step in with monetary policy amendments.

These policy amendments act as a tool, that can be used to loosen or tighten the rules on the accessibility of money and credit. It can be broken down across:

A. Interest rates e.g. the cost associated with borrowing/provision of credit

B. Duration at which rates are held e.g. the term/period which will be maintained

This is where things start to get interesting (and complicated) economically – buying power is reduced and so are capacities to repay debts.

Driven by more stringent accessibility to funding – followed by reduced consumer demand and revenues, businesses begin to halt their growth ambitions. Moreover, the average consumer begins to avoid taking out a mortgage, or sell their existing property to avoid financial difficulty when their fixed rate matures. This is where demand for goods and services starts to decrease, and stunts economic growth i.e. inducing a recessionary environment and is already in motion across the world.

The real spectre in the rear-view mirror, is the credit that had been taken out during a low-interest rate environment. As JPMC stated in their 2023 Macro Outlook, learnings from the GFC had ensured many mortgages in the (specifically in the US) had been locked in on fixed-rates, but for many - these are reaching a maturity period which eventually exposes owners to significant volatility, unless they proactively manage it. This could be classed as a tomorrow (2023/24) problem.

Tomorrow’s problem – Paying the bill for the cheap credit

Typically, businesses don’t fail overnight (unless you’re FTX) and consumers don’t default on loan repayments immediately after a rate change. Australian banks however, have already begun to address an anticipated increase in arrears and defaults, by readjusting their collections strategies. They are aware that a significant number of housing loans will be transitioning from fixed, to variable, with Westpac seeing ~36% of their fixed housing loans maturing mid-2023.

Goldman Sachs has estimated that the Fed will continue to raise rates throughout 2023, from a current 4.25% (as of 23/01/23) to an eventual 5.5%, with their staggered prediction detailed in the below visual. Alternatively, according to CBA Chief Economist, there is no real clarity as to the extent the RBA may enhance rates in Australia from current 3.10%, although there is a moderate probability of a further 25 bps hike early in the year.

The duration interest rates are held will influence a variety of products, held across institutions, businesses and consumers. 2023 is going to be a test for those who do not have their balance sheets in order, across the following:

Secured

· Mortgages,

· Auto-finance,

· Lines of Credit (LOC),

· Working capital

Unsecured

· Personal loans/general unsecured loans

· Overdrafts

· Credit Cards

· Student loans

The longer rates remain ‘high’ and given the background context that many entities utilised lending facilities when rates were at near-zero a few years ago, there’s a high probability of cascading financial turmoil for those who haven’t managed their business and personal balance sheets effectively. Moreover, the narrative of a ‘recession’ becomes self-fulfilling.

Investors, businesses and consumers act in-kind and fuel the perpetual loop of demand reduction. Consequences will likely induce slower growth, cost cutting, hiring freezes, headcount reduction, wage growth stagnation, investment reduction in non-innovative areas e.g. marketing, infrequent travel and event expenditure and finally, lower woke-related activities.

To make the cascading economic reality a bit more impactful, it’s helpful to break down some real-world examples where impacts have either been felt or are anticipated to be felt, as a result of on-going monetary policy changes.

Real-world cascading events

Focus Area 1: Blackstone Real Estate Investment Trust

Context:

As a firm that actively pursues and acquires commercial real-estate at scale, amalgamates their portfolio within an investment trust and publicly offers it to their customers as an uncorrelated, yield-generating product – their success (partly) is tied to that of the real-estate market and ensuring customer funds are tied within the trust. Key determinants of REIT success consist of loan serviceability, occupancy and overall fund liquidity.

Situation:

In a response to the higher interest rate environment, reduction in occupancy rates and overall market volatility, Blackstone fund managers saw redemption requests from clients increase significantly – outpacing the rate at which they could return cash to investors. They had been quoted as saying redemptions can take between ‘four and eight quarters’ – so if you cashed out in January ‘23, you’d be waiting until Dec ’24 to receive your funds. Even as someone not invested in the “B-REIT”, I’d feel inclined to join the redemption queue…which causes issues for Blackstone.

Outcome:

Other REIT funds have capped redemptions, including KKR and Starwood Capital Group, to prevent clients fuelling a market collapse due to the speed at which these requests are incoming. As a marker, redemptions in Dec 2021 totalled $1.5bn whereas those in Dec 2022 neared >$12bn – thus highlighting the state of volatility in the Real Estate market already.

Focus Area 2: Buy-Now-Pay-Later (BNPL) Industry

Context:

Firstly, if you also missed the Afterpay trade back in 2020, join the loser club over here…and if you tried to overcompensate by backing Zip, welcome to the VIP lounge – I’m honestly not bitter.

To try and take the personal out of it, BNPL offers unsecured credit facilities at-pace, facilitated by its digital integration with most retail platforms; it targets the impulsiveness of the consumer and renders affordability an after-thought. Where this becomes a problem is when the consumer can’t afford the repayment and incurs late fees.

Situation:

The equity market began to get wind of the impending blow-up of the BNPL sector, when Klarna valuation dropped 85% in 12 months from ~$46bn to ~$6.7bn. Once regulators, such as the UK’s FCA, began to look under the hood of these firms, they realised that their credit checks were loose at best and their provisions for customers facing hardship were severely lacking – not great for a recession.

Unfortunately, core to the business model of BNPL is betting that consumers will pay late. LayBuy, stated that half of their annual revenue comes from late fees and it could be argued that the best customers for them, are the ones least likely to pay.

Outcome:

Financial regulation is on the way for the BNPL sector, but the extent to which, is still being mulled over. A study conducted by ASIC, determined that 20% of the BNPL users had missed payments, and had at some point experienced an inability to pay utility bills, rent and food expenses.

If hypothetically, the majority of BNPL users have a propensity towards financial hardship and inability to pay, this could incur considerable loan losses for the likes of Afterpay and Zip and also their financial backers.

Summary

The wheels are in motion for a global recession – or to narrowly miss it, if you’re aligned to Goldman Sachs beliefs.

Nonetheless, banks are gearing up to deal with masses of potential defaults, inspired by the wave of maturing housing loans in 2023. Businesses are proactively reducing headcount in response to the lower demand, which is synonymous with a recession and will be felt by the everyday consumer.

As jobs reduce, salaries stagnate, loan repayments increase and economic growth halts – ‘tomorrow’s problem’ is on our doorstep in 2023.