By HENRY H. MCVEY Dec 19, 2022
Despite all the uncertainty across today’s global capital markets, we are poised to enter 2023 with a more constructive tilt, especially on many parts of Credit.
Our basic premise is that it will be easier to navigate inflation’s negative impact on corporate earnings and consumer balance sheets in 2023 than it was to invest with inflation continually surprising central banks and investors in 2022. However, what we are proposing will require both patience and courage – and a game plan that leverages the type of long-term frameworks we employ at KKR across asset classes and regions. At its core, our message is to ‘Keep it Simple’ in 2023. The massive increase we have seen in short-term interest rates in many instances has created attractive total return opportunities across several parts of the global capital markets without having to stretch on leverage, volatility, and/or risk. Implicit in our outlook is our strong view that now is a good time to be a lender. As such, we continue to lean towards collateral-based cash flows such as Infrastructure, Private Credit, Real Estate Credit and many parts of Asset-Based Finance. We also like some of the convexity that liquid Credit provides after the recent sell-off. Within Equities, our advice is to shift away from larger- capitalization Technology stocks in favor of smaller capitalization names with better valuation profiles. History suggests that 2023 will be a good vintage year for Private Equity. We also see the U.S. dollar’s strength reversing, which means that many international assets need to be re- considered. Finally, while we see the positive relationship between stocks and bonds easing in 2023, our longer-term view remains that we have entered a regime change that requires a different approach to overall global macro and asset allocation.
"Truth is ever to be found in the simplicity, and not in the multiplicity and confusion of things."
Isaac Newton, English mathematician and physicist
With a higher resting heart rate for inflation amidst record stimulus, we have been cautioning for some time that we see a ’different kind of recovery‘, and that investors should ‘walk, not run’ when it comes to deployment, especially as the correlation between stocks and bonds turned positive. No doubt, we still think the macro environment remains challenging, but we now feel more emboldened as we think about deployment entering 2023.
Key to our thinking are the following considerations:
- Global central banks are much further along in their tightening campaign, As Chairman Powell said recently, rates are ‘getting close’ to sufficiently restrictive levels. Our work shows that the share of the top 25 central banks boosting rates will fall to 12% in 2023, compared to fully 84% in 2022. This decline is an important one to consider, we believe. We also think the chance of the U.S. dollar bull market continuing well into 2023 is now much more limited. This macro consideration is a big deal, in our view.
- United States inflation has peaked, though it remains quite high. In fact, with this publication, we just tweaked our inflation forecast lower for the first time in almost two years. See below for more detail, but a ‘tug of war’ between falling housing prices and rising labor costs now better reflects the Fed’s intentions to cool the economy.
- Capital markets new supply (i.e., new issuance), which we track closely as a proxy for calling bottoms, has dwindled essentially to nothing. In the United States, for example, we measure that it is now approaching the lows we saw in 2009, especially when one adjusts for the growth in GDP since then (Exhibit 1).
- A more visible hand: We think government spending will quietly surprise on the upside in 2023. Our travels to major political hubs such as Washington DC, Paris, and Tokyo of late lead us to believe that key initiatives like the Inflation Reduction Act (IRA, which we think could be closer to $700 billion versus the ‘headline’ of $370 billion) and EU Recovery Budget (€1.8 trillion over 2020-2026) will result in more spending than many folks think. Meanwhile, spending on military budgets is increasing around the world, as geopolitics is no longer a discretionary line item in most government budgets these days. Finally, in China, our local research leads us to believe that further stimulus is gaining momentum to offset the headwinds created by recent property developer defaults.
- The technical picture is actually quite compelling. Many allocators have de-risked their portfolios, especially allocators who likely over-emphasized the stability provided by bonds as we transitioned from QE to QT. We also take comfort that the S&P 500 has already corrected 25%, an important ‘lean in’ signal based on history, as well as that most High Yield bonds now trade at 85 cents on the dollar, another signal that one should add back some risk to a diversified portfolio. Importantly, our view is that the massive adjustment in the risk-free rate, not necessarily a record widening of credit spreads, will be what is remembered about the opportunity set created during this tightening cycle.
The Supply/Demand Dynamics Across the Capital Markets Have Become Quite Favorable for Lenders Who Have Capital
So, after what we believe will be a dismal earnings season in January, we think investors should accelerate to at least a jog from a walk in terms of deployment budgeting for 2023 as well as lean more aggressively into the periodic bouts of dislocation we continue to forecast during the next 12-18 months. Simply stated, the recession fears we face in 2023 are likely less ominous and more in the price than the inflation fears that surprised markets in 2022.
To be clear, though, we are not advocating a full ‘risk-on’ approach like we did after COVID roiled the markets. So, our call to arms is not to ‘buy the market’ with abandon. Rather, it is to be selective within and across asset classes. Key to our thinking is that:
- Earnings estimates are still too high, and falling unit volume in recent months will become more apparent as inflation cools. European earnings, in particular, look to be at risk in the first half of 2023.
- Some parts of the market still need to correct. Large cap ‘old economy’ Technology stocks, for example, are still over-owned by both institutions and individuals. This reality is also occurring at a time of increased competition and regulatory oversight. Looking ahead, we see Technology being less than 20% of the S&P 500 weighting within the next few years, compared to what we think was a peak of 29.1% in 4Q21. See below for details on our analysis.
- There are still some spicy capital structures, debt in particular, in challenged sectors of the economy that will be tested in the slower growth and higher rate environment we envision. Negative operating leverage, ‘layering’ of old debt with new debt (a product of weak documentation during the go-go years), and refinancing risks will all be important issues to sidestep in 2023, we believe.
- We still don’t fully understand QT. The European and the U.S. central banks both want to shrink the size of their massive balance sheets, which now total 65% and 33%, respectively, of their GDPs. Translating this reduction into rate hike equivalents feels much more like art than science, and as such, our expectation is that this process takes longer and acts as more of an overhang on liquidity and financial conditions than in prior cycles. We also forecast that short rates do not come down as fast as the consen- sus expects, given that we see inflation being above the Fed’s target for at least five years in a row (2021-2025e).
- We expect to see some unexpected provisioning around Office Real Estate and non-secured consumer lending in 2023, which could surprise some banks and investors in the coming quarters.
So, against this backdrop, our most important message is to keep it simple and buy simplicity. Indeed, as Isaac Newton once said, “Truth is ever to be found in the simplicity, and not in the multiplicity and confusion of things.” We think it is also the time to diversify across multiple asset classes ― not concentrate one’s portfolio the same way one would have during the 2010-2020 period.
If we are right, then Credit makes more sense to own than Equities right now across most asset classes. Indeed, given that many traditional banks are reining in their lending, now is a good time in many instances to be a provider of capital, especially to businesses that align with our key themes. Just consider that our S&P 500 target is up only marginally versus current levels, while senior Direct Lending offers returns well north of 10%. Within Credit, keep it simple. Specifically, we favor shorter duration, bigger companies, and attractive call protection features. Further, we also still favor collateral linked to higher nominal GDP growth.
Rate of Change Matters. While we still see a higher resting heart rate for inflation this cycle, we think that headline inflation peaked in the latter half of 2022. We expect a peak tightening of financial conditions to occur in 2023.
We recently lowered our 2023 U.S. inflation forecast for the first time in almost two years to 3.9% from 4.8%. As part of this transition, we expect nominal GDP growth to slow by fully 50% to about four percent in 2023 from 10% in 2022. As such, we expect the dollar to be less of a headwind to financial conditions in 2023. We also expect less duration risk for bonds, a notable change in our thinking about asset allocation.
Earnings. We have higher conviction in our long-held view that earnings will decline in 2023, and we see a lower than normal rebound in EPS in 2024. This backdrop means creaky capital structures will be under pressure, especially those with challenged margin expectations.
It is too early to just buy all risk assets across the board. Rather, an allocator should focus on long-term attractive valuations in key areas such as Small-Cap Equities, unlevered Private Credit, Real Estate Debt, and select parts of High Yield and Investment Grade Debt. Defendable margins will be key across all asset classes.
Labor. We are growing more convinced that the worker shortage in the United States is structural in nature, given the intersection of demographic trends and pandemic- related behavioral changes. All told in the U.S., for example, we think the labor force is missing about four million workers, with only about half likely to return at some point. So, we concur with Chairman Powell’s view that the labor market is “out of balance.”
This realization is part of our thesis that structurally higher inflation is the new normal and will be ‘stickier’ for longer. We favor automation, digitalization, and family care services, all of which help to address the current labor shortage. We also think it is more important than ever for management teams to be aligned with their workforces.
House Prices Under Pressure. Housing is one of the most direct ways that central banks have been able to slow growth. In the U.S., for example, we now forecast home price depreciation of minus five percent in both 2023 and 2024, respectively. Previously, we had assumed modest home price appreciation in our annual forecasts.
Household net worth is falling faster this cycle than in any other cycle on record (Exhibit 27). As such, being right that unemployment does not spike is a key underpinning to our overall macro thesis. Remember that we have unemployment in the U.S. increasing trough to peak by 1.4%, compared to an average of 3.7% during recessions.
Goods Deflation, Services Inflation. We have higher conviction in our goods deflation thesis; at the same time, we believe that inflation has shifted to the services arena and will stay higher for longer.
Our long exposures remain much more tilted towards Services than Goods. We continue to forecast a recession in the Goods sector in 2023, partially offset by an increase in global Services spending.
Asynchronous Recovery. It is too simplistic in our view to simply talk about one synchronized global economy. Asia’s inflation and monetary policy profiles are now wildly different than the West’s. Meanwhile, the U.S. is food and energy independent at a time when Europe and Emerging Markets are experiencing an unprecedented ‘war shock.’
Despite our view that the dollar is peaking, our models still do not show Emerging Markets as a high conviction ‘Buy’. As such, we continue to favor selectivity across regions. For example, we like corporate carve-outs in Korea and Japan, and we favor higher growth markets such as India and Vietnam.
Real Rates. Despite near record tightening, we see real rates staying below three percent this cycle. By comparison, the Fed brought real rates above three percent at least one time each decade from the 1960s through the early 2000s.
Our base case has fed funds reaching 5.125% in mid-2023 before settling in at 4.875% by year end. The market is much more bullish on the Fed accelerating rate cuts in late 2023/2024. Meanwhile, in Europe, we forecast the ECB to boost short rates to 3.5% in 2023 through the end of 2024. We expect a longer- term neutral rate closer to 2.25% in Europe.
We also want to mention that 2023 will feel a lot different than 2022. We note the following:
- The pace of central bank tightening is likely peaking. The percentage of the top 25 global central banks that will be tightening by the end of 2023 will likely be closer to 12%, compared to around 84% in the fourth quarter of 2022.
- After surging to double-digit levels post pandemic, we see nominal GDP growth cooling in 2023. We expect U.S. nominal GDP to fall to 4.2% in 2023 from 9.9% in 2022. This is a big drop and likely means that duration becomes less of a cycle risk over the next 12 months.
- We forecast that U.S. real wage growth will likely turn positive in 2023. If we are right and unemployment lags versus other cycles, we do not envision a 2008-type downturn in the United States.
- We no longer see the USD as a safe haven. We expect the recent dollar downtrend to continue in 2023, and as such, we are looking for hedges that will perform if the U.S. dollar actually weakens further than expected.
- The negative impact of inflation will shift from resetting upward the risk-free rate in 2022 to putting pressure on corporate profits and consumer balance sheets in 2023. If we are right, then longer-term rates may peak temporarily as earnings disappoint.
- China’s re-opening in 2023 helps Asia get out of its growth funk. We have growth above consensus in both 2023 and 2024. We think China’s shift in its zero COVID-policy leads to a run of better growth in Asia by the middle of next year.
Our bottom line
As we enter 2023, it is important to note that we still live in a world where both investors and corporations are struggling to accurately price the cost of capital across different parts of the economy as well as different parts of the capital structure. Therein lies the opportunity, we believe.