2023 Predictions — Brace for Volatility & Uncertainty

At every gathering over the holidays, perhaps after discussing the prospects for the Raptors and the Maple Leafs, there would ultimately…

At every gathering over the holidays, perhaps after discussing the prospects for the Raptors and the Maple Leafs, there would ultimately be a discussion about the economy and the markets. You could sense an aura of uneasiness and gloom, and for good reason; 2022 was a year of turbulence. We’ve experienced slowdowns before, but the speed at which we pivoted from strong economic growth to challenging economic headwinds has been hard to digest. For entrepreneurs, it’s especially difficult to make sound business decisions when the field of play keeps changing.

So, what’s in store for 2023? To put it simply, we need to brace for further volatility and uncertainty. Here are my 2023 predictions:

Inflation

Prediction: Canada’s inflation rate will moderate over the course of 2023 but will remain at elevated levels throughout the year and into 2024. Inflation will end the year in the 3.5% to 4% range.

COVID-19 presented unique challenges for central banks around the world. When lockdowns went into effect, inflation fell dramatically and there were serious concerns about economic depression. Central banks quickly provided extraordinary monetary support, while governments injected significant levels of fiscal stimulus in an effort to sidestep an economic disaster. But when it came time to reopen economies, a different set of challenges emerged. The demand for goods began running ahead of the economy’s ability to supply the goods, which was largely impacted by supply chain disruptions for all types of goods from furniture to cars. In addition, businesses could not operate at capacity given labour shortages. And then, President Putin authorized Russia’s invasion of Ukraine, which further impacted world trade and resulted in soaring energy and grain prices.

The steep increases in grocery bills, energy costs, and travel expenses have hit Canadian households hard over the past year. In Canada, inflation peaked in June 2022 at 8.1% and has eased to 6.3% as of December 2022. I believe that inflation will continue to moderate over the course of 2023 as energy and commodity prices decline and demand wanes from higher interest rates. With that said, a tight labour market, coupled with increasing geopolitical tensions (and a prolonged war in Ukraine) and continued supply chain disruptions, will keep inflation well above the Bank of Canada’s 2% target. My prediction is that inflation will ease to the 4% to 5% range in the second half of the year and end the year in the 3.5% to 4% range, which will still be well above the Bank of Canada’s 2% target.

For entrepreneurs, elevated levels of inflation can wreak havoc on business, especially when selling discretionary goods or services. Everything costs more, which will erode margins if one cannot commensurately raise prices. However, if prices increase too much, it weighs on consumer demand. As a result, leaders should reduce expenses, reassess pricing strategies, and strengthen their balance sheets to protect themselves against high inflation.

Interest Rates

Prediction: Bank of Canada will increase its overnight rate from 4.25% to 4.75% by the end of Q3 and then hold it steady heading into 2024.

From the beginning to the end of 2022, the Bank of Canada increased its overnight rate 7 times from 0.25% to 4.25%. This rapid pace of change in interest rates is taking a toll on the Canadian economy. A large part of the Canadian population has not experienced a significant rate hiking cycle before.

The Bank of Canada is pulling the interest rate lever in an attempt to combat inflation. When interest rates increase, borrowing costs for consumers and companies rise. This results in people and businesses spending less and lowering overall demand, which slows down the economy. With lower demand, inflation should also moderate.

Although the Bank of Canada has signaled that it may be close to the end of its rate hikes, I predict that there will be two more 25bps hikes over the next six months and then rates will remain flat through the end of the year (and well into 2024). I believe the Bank of Canada is underestimating the effects of the tight labour market, the impact of the prolonged Russia-Ukraine war on energy and commodity prices, and my belief that there will be continued supply chain disruptions in parts of our economy. My view contradicts the consensus view that once interest rates peak, the Bank of Canada will start cutting rates shortly thereafter. I believe the Bank of Canada is more concerned with curbing inflation than trying to finesse a soft landing for the economy, which means it may overshoot on interest rate hikes (or keep rates higher for longer) to ensure high inflation does not re-emerge.

For entrepreneurs, it is crucial to understand one’s exposure to higher interest rates. Since higher interest rates will eat into one’s cash position, leaders should reduce expenses and potentially defer growth capital expenditures. Leaders should also take a proactive approach with lenders to communicate how they are managing the business and surface any potential issues or concerns. Lenders do not like to be surprised.

Recession

Prediction: We will experience a mild recession in 2023.

With the Bank of Canada and the Federal Reserve rapidly raising interest rates to slow the economy, there’s a very good chance that we enter a recession. It’s almost inevitable when interest rates rise this quickly. I think we will experience a mild recession in 2023. Why mild? Although we will see an increase in the unemployment rate, it will not be as severe as previous recessions given demographical forces and an already short supply of labour in key sectors. I also think we will see tepid growth in 2024 and 2025 instead of a sharp recovery. Let’s hope for a soft landing.

For entrepreneurs, it is important to conduct scenario planning and develop operational game plans. It is prudent to prepare for the worst-case scenario and understand what levers can be pulled to survive. Develop an understanding of the key risks in your business and ensure you have strategies to mitigate those risks.

Stock Market

Prediction: The stock market will experience volatility but will ultimately end the year higher than last year.

With interest rates continuing to rise and the potential onset of a recession, there will be significant impact on corporate earnings and growth prospects. When you incorporate a prolonged Russia-Ukraine war and increasing US-China tensions, the stock market is bound to experience some turbulence over the short to medium term. I expect the markets to be choppy for the first 9 months of the year before optimism sets in for Q4 (and beyond) given that the stock market is 6–9 months forward-looking and will be pricing in the end of the recession and interest rate cuts.

Private company leaders are not necessarily impacted by what happens in the stock market, except for benchmarking one’s own company valuation. With that said, entrepreneurs should focus on what they can control — driving value creation at their companies — and not worry about the public markets.

Venture Capital (VC) / Private Equity (PE) Activity & Fundraising Environment

Prediction: VC and PE deal activity will accelerate in 2023. The highest-quality companies will get funded, while the rest will still find it difficult to raise capital. Investors will continue to support companies that can demonstrate sustainable growth. VC and PE firms will face greater scrutiny from limited partners (LPs).

Given the vast amount of dry powder on the sidelines, coupled with pent-up demand from a muted investment environment in 2022 and entrepreneurs coming to terms with more reasonable valuations, I believe that deal activity will accelerate in 2023, but there will be a dichotomy between the ‘haves’ and the ‘have-nots’.

There will continue to be a flight-to-quality. Companies with positive unit economics, significant top-line growth, clear path to profitability, and strong management teams will successfully raise capital, while the others will struggle. I predict we will also see more down rounds and flat rounds in 2023 as new investors price financings at more reasonable valuations. Numerous founders and their existing shareholders ‘kicked-the-can-down-the-road’ by raising small internal rounds in 2022 (keeping their valuations intact) hoping for a better financing environment in 2023. These companies will be forced to raise external capital as existing investors reach investment thresholds and concentration limits. The back half of the year will see increased capital raising activity.

On the investor side, the VC/PE firms that deployed significant capital at sky-high valuations over the past 2 years will remain internally focused on their portfolios and valuation marks, and will spend less time on new platform investments. Firms that demonstrated discipline and have dry powder available will have great opportunities to invest capital in high-quality companies.

In 2023, we will continue to see investors reorienting their investment philosophies from “growth at all costs” to “sustainable growth”. Profitability, unit economics, and product market fit will be thoroughly evaluated. This will generate competition amongst investment firms for the highest quality deals, while leaving a wide swath of companies struggling to raise capital who will likely be forced to accept term sheets from investors seeking significant downside protection and structure.

I think VC and PE firms will face greater scrutiny from their LPs in 2023. On the back of the FTX and Celsius fiascos, investment firms will revisit their diligence practices and tighten processes to ensure their diligence checks all the boxes. Deals will take longer to consummate in 2023. I also think that LPs will re-evaluate their existing fund relationships, narrow down their list of preferred partners, and exit other relationships. As a result, VC/PE fundraisings will become more challenging in 2023.

Finally, I predict that the hottest sectors for investment will be artificial intelligence (AI), embedded finance, cybersecurity, and healthtech.

Advice to Entrepreneurs

How should entrepreneurs navigate this uncertain environment? As Winston Churchill once said, “Never let a good crisis go to waste.” Focus your companies on positive unit economics and profitable growth. Reassess your cost structure to ensure it is lean. Re-evaluate your pricing strategy. Develop a long-term strategic plan with scenario analyses. If you need to raise capital in 2023, start building relationships with value-added investors early on. Ensure you have the relevant information ready for a long, detailed diligence process. Reset your valuation expectations — taking a lower valuation with no structure is better than taking a higher valuation with significant structure — and solve for finding a value-added partner, not the highest valuation.

The views and opinions expressed in this article are those of the author and do not reflect the views and opinions of Maverix Private Equity Ltd.