Rising inflation, hawkish central banks, and geopolitical tensions are among the omnipresent topics that influenced all markets substantially. David mentioned that the last time such a level of inflation was witnessed the dollar was going down while oil prices, interest rates, and inflation were all going up. The Vietnam War was coming to an end and there was a lot of bearishness around, which has some similarities with the situation today. However, there was one big difference: today a greater selection of private market investments is available, with much greater access to private equity, private credit, and private real estate. There was a lot of fear back then, and that opened up great investment opportunities for people who were able to maintain flexibility, balance, and perspective, David Darst highlighted.

Trends to Watch For

On the topic of the three most important trends to watch for, especially in 2023, David placed at the top of the list earnings and the strength of China’s recovery. Will the economy fall into a mild recession or a deeper recession; a hard landing or a soft landing? That's number one. Number two is monetary policy: will the Fed stop raising interest rates when it declares victory over inflation? The last factor to watch very closely this year is geopolitics and politics, especially in the United States with the upcoming ceiling debt discussion. David believes that investors need to be prepared for surprises.

From his side, Naji highlighted that one of the factors he will be keeping an eye on   is the health of the U.S. consumer. Despite market volatility in 2022, U.S. consumers have been very healthy and continued to spend record-breaking amounts on online shopping on Black Friday and Cyber Monday. All the parachute money given during COVID-19 increased their savings and recent data show that these savings have largely declined. So Naji is watching closely whether the U.S. consumers are going to feel the pain of high inflation this year, and possibly reduce their spending, which accounts for 70% of GDP.

The second factor relates to change in rates of inflation and the direction of inflation. The third factor is volatility that according to Naji, volatility will still be present in 2023, and investors should be nimble and agile to take advantage of it.

Main Risks Outlook

 In terms of key risks, especially regarding different asset classes, namely fixed income, equity, and also private markets, David believes that this decade should face a much more challenging environment following an enormous monetary and fiscal stimulus in response to the global pandemic . Secondly, debt levels are also at a record high: the global GDP is approximately $100 trillion while its debt is $300 trillion. Thus, he believes we may be entering some years of deglobalization and decoupling.

David mentioned that risks could come from the shadow banking system, as well as risks to the currency, in addition to the risks to the global infrastructure of pipeline, undersea cables and even satellites.

David encouraged investors to always carefully evaluate price versus value; take time to deliberate; consider having adequate liquidity; and be prepared to use it opportunistically in liquid markets.

Outlook for the recession

Naji divided recession into three categories based on a study by Goldman Sachs: structural recession, cyclical recession, and event-driven recession.  Structural recession results from financial bubbles. A cyclical recession results from  rising interest rates. An event-driven recession follows shocking and unexpected events, such as 9/11. While each has certain implications for markets, the worst recessions in terms of market performance have been  structural recessions. He believes that if we follow the historical path, a cyclical recession, a little milder than previous ones, might be underway due to the strength of the consumer and the economy.

Naji believes that the major risk today is the transition from very stimulating, accommodative policies and a very low interest rate environment to a phase of a higher interest rate environment. He added that we are at the inflection point, the most critical phase of portfolio construction. Investors need to be very careful when selecting assets, how they want to maintain liquidity, and how to construct defensive portfolios.

Opportunities in public markets

David highlighted that we may entering a period of higher interest rates than usual; so, investors need to find companies, industries and managers who can thrive and take advantage, and can generate high return on equity, not through leverage, but through profitability and revenue growth.

Going forward, investors want to be looking for companies that can generate returns through dividends, through stock repurchases or a combination.  Preference is given to defensive sectors, including healthcare and consumer staples. Investors need to search for companies that can outperform in circumstances like this, gain market share, and maintain profitability whether the recession is mild or deep.

Outlook for private markets and the classic 60/40 portfolio

Naji highlighted that the classic 60/40 portfolio has dropped by 17% last year and the outlook for inflation indicates that a traditional 60/40 portfolio is not going to offer as much defense as it has historically. That's why he thinks adding private markets to a portfolio is attractive, as private markets provide diversification against volatility and rising correlation between equities and fixed income.

Both David and Naji agreed on the importance of selecting a good top-tier manager capable of creating value in its underlying portfolio companies.  On this topic, the speakers highlighted that internally at Petiole there is a greater emphasis on value drivers to generate margin expansion and/or revenue expansion, especially now that a more defensive approach is being adopted.

Investment solutions

Naji highlighted that the company has been very busy last year evaluating opportunities.  He added that the firm is looking more and more into private equity transactions, but not at any price and not any business model. Priority is given to having a defensive balance sheet, with key value drivers revolving around earnings and less around multiple expansion or even revenue growth.

Naji believes that the secondary market is also going to come back. Investors who have had an overexposure to a certain asset class over the last few years might want to rebalance their portfolios.  Petiole is looking at providing first lien or second lien private debt, financing real estate development in prime cities as well as structured credit.

Guidance to Investors

As a general comment, Naji noted that investors’ nimbleness and agility are important in their investment strategy. In addition, Naji marked that investment opportunities will probably arise this year, therefore investors could commit capital to them.  He finally highlighted the importance of diversification within the private markets.

Disclaimer

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