Welcome to part two of our two-part blog series, 2023 Economic Outlook, a comprehensive view of the markets, macroeconomics and the valuation landscape put together by our Chief Valuation Officer, Scott Gabehart, and Valuation Analyst, Ryan Thompson. If you missed part one, which focused on a general summary of 2022 economic activity, negative GDP growth and yield curve inversion, you can catch up here. 

Inflation

With increased interest rates and a slowing economy, it is anticipated that the inflation rate will fall closer to 5% by the end of 2023. While this is still above the Federal Reserve’s target rate of 2-2.5%, declining inflation is promising for growth in the second half of the year. 

Interest Rates

The US Federal Reserve (the “Fed”) uses interest rates as a mechanism to combat rising inflation. Throughout 2022, the Fed incrementally increased the federal funds rate from zero to nearly 4.5%. The increase in this rate raises the cost of borrowing money which is meant to curb the demand for goods and services and assist in lowering inflation.

At the end of January 2023, the Federal Reserve increased the funds target rate by another 0.25%; this marks the second straight meeting where the Fed has dialed back the size of the increase. How interest rates move for the rest of 2023 is largely dependent on the movement of inflation.

If inflation continues with its current downward trend, it is likely the Fed could increase interest rates to around 5.0% before pausing. Realistically this additional increase over current rates would come incrementally and could conceivably be accomplished before Summer 2023. At that time, the US could see the rate stabilized and potentially begin to be lowered in the short-term. If inflation continues to be persistent, then the Fed may need to continue increasing interest rates until the inflation trends toward typical averages. 

Public Markets

The three most widely followed indexes in the U.S. are the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite; each of these indices saw their largest annual years since 2008. With continued concern around the Russia-Ukraine conflict, interest rates, inflation and supply chain disruptions, investors can anticipate a tumultuous year for markets. 

Even with lingering uncertainty, the general consensus is that 2023 will end with the S&P 500 hovering around 4,100. For context, the index closed 2022 at 3,839. In many ways, this may also represent a return to normalization after several years of unsustainable valuations.

Business Transaction Activity

The accommodative monetary and fiscal policy in the US, along with the lifting of pandemic-related restrictions, led to a steep increase in business activity in 2021. Much of this momentum carried into the beginning of 2022 before cooling in the later parts of 2022 as rising interest rates impacted the cost to borrow, accommodative policies became contractionary, and overall market sentiment declined. Market activity for 2023 is expected to be in line with the latter part of 2022 but will be largely impacted by how the Fed continues to approach interest rates. The declining transaction activity more likely represents a return to the norm after the abnormal highs of 2021. Businesses with strong financial performance will likely see their valuations and opportunities remain resilient, despite the slowing activity.

It is likely business transaction multiples will fall during 2023 as compared to their 2021 and 2022 levels. Due to a relationship between earnings and transaction multiples known as the “size effect,” whereas when earnings grow so do transaction multiples and vice versa, it is reasonable that depressed company earnings and growth could further soften transaction multiples. Rising interest rates will increase the cost of borrowing, pushing out potential buyers while high inflation weighs in on company profits. The elevated sale prices of the last few years could also be in jeopardy as investors push for lower purchase prices to compensate for increased deal financing costs. With a looming recession and the cost to borrow ever increasing, it is probable that many companies will see stagnant or limited growth, a key variable that will impact business valuations. Simply stated, the increased borrowing costs, reduced profitability, declining market sentiment and slow growth would all aid in less activity and lower multiples.

On the other hand, many investors, including private equity and venture capital, may be waiting for more opportunities in 2023. A large swath of would-be investors waited on the sidelines in the second half of 2022 while the markets absorbed the impacts of inflation, a potential recession, rising interest rates, and geopolitical unrest; each of which came with large uncertainty. While these issues are expected to continue into and throughout 2023, the path forward for these concerns becomes clearer. It is likely that buyers will adapt to the current economic landscape and find a way to get deals done. In some cases, potential buyers are changing the way they will purchase a business, such as purchasing a minority stake so that they do not have to restructure debt at higher rates. Regardless of how the deal activity goes, selling owners can expect deal timelines to take longer as buyers take more time to perform their due diligence.

Looking Ahead

The 2022 year closed with a generally bleak sentiment for the new year; however, there just may be some light at the end of the tunnel. 

Despite some anticipated volatility during the first half of 2023, there are expectations of a more favorable second half. It is likely the United States will continue to battle inflation and rising interest rates throughout a large part of 2023, with each expected to begin subsiding toward the latter part of the year. The general consensus is that GDP growth and markets can expect some turbulence but should end the year on a flat, if not more positive, note.