Market Outlook 2023: Navigating Economic Uncertainty

Market Outlook 2023: Navigating Uncertainty in Geopolitical and Macro-Economic Headwinds

As we enter 2023, the market outlook is facing a multitude of uncertainties as the geopolitical and macroeconomic headwinds that plagued us in 2022 still persist. The global economy did not see the strength that many had hoped for, as unprecedented inflation swept through economies not seen in almost two generations.

The Fed and other central banks tightened monetary policy, widening credit spreads, and causing sell-offs across equity markets. Political strife in several areas across the globe did not help the situation either, and to top it off, we saw the biggest war in Europe since World War II with the Russian invasion of Ukraine.

Where are the markets now, and what can we expect for the future? While we cannot predict the future, it is reasonable to anticipate that many of the challenges we faced last year will continue to affect the market outlook for the foreseeable future. The Ukraine War, in particular, will likely have a significant impact on investor confidence as it continues to unfold. The direction of domestic and global inflation is another area of uncertainty.

While U.S. inflation seems to be slowing down, history has shown that we could still be returning to an accelerating pace of rising prices. This makes it difficult to predict how inflation will affect economic growth in a monetary tightening environment. Therefore, we should expect continued turbulence across asset classes, strategies, and markets.

Despite the challenges, there were some managers and strategies that successfully navigated the 2022 environment and generated strong returns for investors. These include global macro, equity market neutral, multi-strategy on the hedge fund side, and private credit, LBO, and some venture on the private markets side. These managers and strategies may be well-positioned to capitalize on global uncertainty if these trends continue in 2023.

As we face more uncertainties from a political, social, and economic point of view, this may be the start of a golden age for alternative assets. Alternative assets may provide a way for investors to diversify their portfolios and potentially generate strong returns in the face of continued market volatility.

2022 Year in Review

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To better understand the market outlook for 2023, we must first reflect on what happened in 2022. While there was a lot of volatility in prices, the year started and ended with almost identical rates of inflation (7.04% on Dec 31, 2021; and 7.11% on Nov 30, 2022). Despite this consistency, inflation had a significant impact on the markets, with low growth and rising rates causing credit spreads to widen and equities to sell off.

Alternative Assets Outperformed in 2022 Amidst Volatility and Uncertainty

In the world of finance, the year 2022 was marked by an unprecedented degree of volatility and uncertainty. As the Federal Reserve started to tighten monetary policy, raising the Federal Funds rate by 75 bps at its July meeting, the immediate impact on growth was apparent, with two quarters of contraction in the middle of the year and a significant slowdown in employment.

Meanwhile, consumer confidence and spending, as well as the housing market, remained robust, while business confidence, as measured by the ISM Purchasing Managers Index, only recently turned negative in Nov of 2022.

In public asset markets, nearly all USD-denominated risk assets experienced a year-over-year selloff, including the S&P 500, Dow Jones Industrial Average, U.S. Treasuries, Barclays AGG, and cryptocurrencies, as well as some energy, agricultural, and industrial commodities prices. As a recent article in Vox put it, "the economy just doesn't make sense anymore."

However, despite this backdrop of turbulence, some alternative assets saw strong performance throughout 2022. Hedge funds, in particular, outperformed the S&P and AGG in 2022, with nearly every HFRI index delivering positive returns. Strategies that traditionally capitalize on high volatility and market uncertainty, such as Global Macro, saw particularly strong returns, with the HFRI Total Macro Index returning +9% over the last year, and the HFRI Equity Market Neutral Index seeing returns of nearly 2%.

On the private market side, while overall performance with private equity remained muted, private credit experienced enormous growth, driven by a handful of factors. As rates rose and risk appetite dropped, the primary market for syndicated and leveraged loans nearly evaporated, with a transition from banks being the primary source of funding to the direct lender ecosystem within private credit.

At the same time, investors' allocations to private credit have gone to a smaller pool of funds, as the private credit markets have started to mature, with investors finding themselves more selective when choosing a manager as the importance of diversification, track record, experience, and independent service providers rises to the forefront of investors' minds as recession fears loom.

Market Outlook for 2023: Insights for Investors

As the world enters 2023, uncertainty looms over the global economy. While it is challenging to predict the market outlook for this year, the events of 2022 offer insights into the factors that could affect the markets. In this article, we will look at some of the key issues that investors should consider before making investment decisions.

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Geopolitical Front: Tensions in Key Regions

Geopolitical factors such as war, civil unrest, and political tensions are likely to continue to affect markets in 2023. The ongoing war in Ukraine and tensions in the Taiwan Strait and the South China Sea may have a significant impact on the public’s perception of the global economy. Additionally, the sociopolitical unrest that Iran experienced in the last several months may escalate, further affecting the markets.

The Impact of COVID-19

COVID-19 remains a critical factor affecting the global economy, and it is likely to continue to do so in 2023. As China shifts from its zero-COVID approach to a more open economy, we can expect some degree of social strife as society adjusts.

The resurgence in purchasing power experienced by China after the initial lull from COVID-19 in late 2020 could lead to supply chain bottlenecks that could spill over to other parts of the world. At the same time, the recent rise in cases and deaths in China could result in a reactionary shutdown, affecting its economy and industrial capacity.

Macro-economic Front: Inflation and GDP

Forecasting how inflation and GDP will perform is challenging. However, investors and analysts anticipate a slowdown, possibly even a mild recession in the US, as the Fed Reserve continues to restrict monetary policy. If inflation were to plummet faster than expected, rate hikes might decelerate, pause, or even reverse in 2023, as the effects of 2022’s rate hikes permeate throughout the economy.

Where Can Investors Turn This Year?

Given the high level of uncertainty in the global economy and political sphere, investors may be well placed to consider alternative investments. Global macro, a strategy where hedge fund managers nimbly play across marketplaces, countries, and asset classes, to capitalize on market dislocations, may be worth considering.

In a slow growth environment, equity market neutral may be effective at avoiding overall equity market beta. Private credit may also see outperformance, given the continued issues with regulatory treatment of private debt for banks removing the available supply of credit, credit spreads remaining elevated, and rates continuing to rise, as most private debt are floating rate assets.

LBO/take-private strategies may benefit from the weakness in public equity markets. Weaker overall economic growth can present opportunities for successful managers to strive to turn underperforming public companies around and effectively identify synergies and rectify inefficiencies within target companies.

Conclusion

While many of the challenges experienced in 2022 will continue to affect the economy and markets in 2023, this year may bring a host of new concerns, issues, and conflicts. Rather than worrying about the dynamics of individual assets and markets, investors may find it more effective to consider alternative assets that can capitalize on global uncertainty.

As such, many of the same strategies that performed well in 2022 may continue outperforming the public markets. Investors should identify managers with a long track record through multiple market cycles, diversified portfolios, skin in the game, and independent service providers. While many managers will reap great gains in 2023, investors should exercise caution and diversify their portfolios to strive to mitigate risks.

How To Do a 1031 Exchange When Breaking Up a Partnership

Purchasing real estate with other investors can open new opportunities – it can allow investors to access larger assets and higher return potential. However, investing with other people can present some challenges. One of the most common issues facing partners is deciding what to do when they want to sell the asset. More specifically, what should investors do when they have different opinions on how to distribute the proceeds from the sale of the property?

Generally, when investors sell a real estate asset, they are required to pay capital gains – taxes on the profit from the sale of the property. However, the Internal Revenue Service (IRS) offers investors a unique tool to sell their real estate assets and defer capital gains. To do so, however, the entity holding the property must be the same entity purchasing the next property.

How can partners accomplish this when they disagree on what to do? They can restructure their ownership by leveraging a “drop and swap.” 

What is a 1031 exchange?

Before diving into the details of a drop and swap, let’s first look at the basis for a 1031 exchange. A 1031 exchange, also known as a “like-kind exchange,” is outlined in Internal Revenue Code (IRC) Section 1031 and states that property owners can exchange real property used for business or held as an investment solely for another business or investment property that is the same type or “like-kind.”

Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts, and any other taxpaying entity may qualify for a 1031 exchange. 

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The Drop and Swap

The IRS does not allow partners to sell or dispose of their partnership interests while deferring taxes if they acquire like-kind replacement property. However, a workaround solution exists in the form of the “drop and swap.” This practice allows a subset, or portion, of a partnership or LLC to engage in a 1031 exchange without the need for all parties to participate in it.

Investors can “drop” their current ownership structure and “swap” for a tenancy in common (TIC) interest. This allows investors to redistribute the proceeds from the sale of the property independently of each other.

Let’s look at an example. Alex, Kelly, and Jeff are partners in an LLC that owns real property, and they decide it is time to sell based on current market conditions. However, Alex and Jeff want to reinvest the proceeds from the sale via a 1031 exchange while Kelly is ready to cash out.

If the property is sold while held in the LLC, the only way Kelly can cash out is by the entire LLC cashing out; this results in Jeff and Alex paying capital gains before they can reinvest the proceeds. 

A drop and swap, by contrast, allows the partners to drop the entity, which means the real estate is now owned through a TIC, and each investor can use their portion of the funds following the sale of the property according to their individual investment plans. Jeff and Alex can reinvest via a 1031 exchange, deferring capital gains, and Kelly can cash out and pay capital gains. 

Advantages of the Drop and Swap

There are two key advantages to using a drop and swap. First, it provides investors with some additional flexibility to maneuver around their competing priorities. Second, it allows them to defer paying taxes until a later date. In addition, the 1031 Exchange process can be completed over and over, indefinitely, until the investors determine that they want to pay the taxes. 

Rules of the Drop and Swap

Because a drop and swap is not officially approved by the IRS, it can be extremely risky to undertake one, and the IRS could disallow the exchange if the entity swap was done incorrectly. To help ensure that a 1031 exchange is permissible, investors would generally follow these guidelines and always consult their lawyer prior to doing anything:

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Completing the Exchange

It is important to note that anyone completing a 1031 exchange needs to follow the rules of the exchange as outlined in IRC Section 1031.

Proceed with Caution and Prepare in Advance 

Parting ways is sometimes necessary among partners. Goals and objectives change, and new investment strategies emerge. While a drop and swap appears to be the solution to ownership problems in a 1031 exchange, all parties involved – especially those who want to complete a 1031 exchange and defer capital gains – should proceed with caution.

Any time investors change from one form of ownership to another, it is important to get professional help. Since there is no guarantee that the IRS will approve the exchange, it is highly recommended that everyone involved speak with a tax specialist or 1031 expert prior to selling the real estate.