By HENRY H. MCVEY May 19, 2020
Phase II: The Next Chapter
Following a fairly rapid ‘recovery’ in the capital markets after the advent of the coronavirus, we are now entering the second chapter, which we are calling Phase II, of what we believe will be a multi-quarter de-leveraging cycle driven largely—in contrast to the downturn of 2008—by the corporate sector. As we expect to see consumer demand below trend until a vaccine is not only developed but also made widely available, investors should consider approaches that look for: 1) secular winners that the market may be underestimating, given the structural economic changes we are forecasting; and 2) opportunities to provide solutions to good companies that were caught with poor capital structures at the onset of the pandemic. Overall, our base view is that the next 12-18 months will likely be remembered for ongoing dislocations, as industries restructure and/or reposition their business models in the new environment we envision. Against this backdrop, as we move into Phase II of the current crisis, we are viewing COVID-19 as a likely catalyst to create an investing regime change — one that will require a new lens through which to view the world economies and their associated capital markets.
26th president of the United States
A few weeks back we penned a piece titled Keep Calm and Carry On. It represented our best attempt at the time to reflect our views on both the human tragedy of the coronavirus pandemic as well as its impact on the global investment climate. It was also an important reminder of the somewhat humbling and daunting task that this pandemic represents to us as investing professionals: that we are essentially tasked with shaping favorable outcomes and solutions for all of the underlying constituents we serve, including teachers, first responders, and retirees. A very real consequence of this virus is that many of our society’s best are now more reliant on their savings to provide a way forward.
Overall, we remain committed to our core belief that COVID-19 remains – above all else – a human tragedy. The virus knows no borders, and reminds each of us of our existential vulnerability. Sadly, this pandemic also highlights society’s inequalities, as rates of infection and death are often worse for lower income victims, people of color, and older individuals.
For me personally, the impact of COVID-19 has taken a winding road. Indeed, after initially experiencing the pandemic in the confines of my New York City apartment with my wife and two kids, I have spent the past few weeks in Richmond, Virginia, my hometown, and where I grew up as the youngest of three boys. My Richmond experience has provided an important foil to what was occurring in New York City, the metropolitan area I have called home for more than 25 years. Specifically, as the data shows in Exhibit 2, different locations in the United States have had vastly different experiences. Indeed, the top 10 cities in the United States have consistently accounted for 65-70% of all cases, with New York generally north of 40% of the total. On the other hand, Virginia – until recently – has not seen the same type of impact, and as one might guess, behavior patterns surrounding the disease have been quite different. A similar story is playing out on the global stage, as China is recovering much more quickly than, for example India, whose 733 districts have been categorized into red, orange and green zones, which allows for differing levels of activity by zone.
Interestingly, while the global case count – to date – has been more concentrated in areas with greater population density, the economic devastation has been far more dispersed. In fact, globally, it has affected almost every industry across almost every region. Given this destruction, our base view is that the coronavirus has initiated a multi-quarter de-leveraging cycle – a de-leveraging cycle driven mostly by the corporate sector. As such, we want to underscore that today’s macro backdrop looks quite different from the 2008 downturn, which is remembered as largely a consumer driven financial de-leveraging cycle centered primarily around the banking system. That said, given the reality that lending institutions are the counterparties to the corporate sector, the banking system too will likely suffer some collateral damage as well (Exhibit 33).
In terms of where we have been and – more importantly – where we are headed, we see the current cycle as having three distinct waves. Phase I, which we think has actually just ended, will be remembered as a time when there was no clear line of sight to fiscal or monetary stimulus relief. During this period, investors had the ability to buy the highest quality equities and credits at really attractive prices. However, given the size and the speed of the response, this ‘market recovery’ period was shorter than many had expected. We link the shortness to the reality that central banks around the world already had the ‘technology’ in place from the last crisis to move more quickly this downturn.
Each Country and State Will Rebound at A Different Pace, With Many Seeing Slower Recoveries…
…The Same Is True in the U.S. at the City Level
In Addition to Peak Corporate Margins, High Yield Leverage Is Projected to Rise Above GFC Levels
The Amount of Global Stimulus Has Been Breathtaking, But We Actually Believe There Is Likely More to Come
Today, we think that we are entering Phase II, which will likely be remembered as a period of rolling dislocations, dislocations that will go on for quite some time. In Phase II, because we expect overall consumer demand to run below trend until the medical community finds a widely available vaccine, investors should consider the following two approaches to investing:
- Buying secular winners where – given all the changes we are forecasting – the market is underestimating the sustainability of their growth rates in the out years; and
- Providing solutions for good companies that got caught with bad capital structures at the onset of the pandemic.
Importantly, we are not looking for a huge, sustained sell-off in markets across all asset classes that pierces the lows hit in March. That dire outcome is the exact opposite of what global central bankers want, and we continue to respect the old adage of “Don’t fight the Fed.” That said, liquidity does not guarantee solvency. Moreover, even if we are lucky enough to find a near-term vaccine, there are still likely to be ongoing dislocations, as industries restructure and/or reposition their business models in the new environment we are envisioning.
Against this backdrop, we are treating COVID-19 as the likely catalyst to create a regime change, one that will require a new investment lens through which to view the world economies and associated capital markets. History can provide guidance, and while it never exactly repeats itself, we do view current events as most akin to a combination of a 1987-style crash and a 9/11-type external shock. There could be similarities to the Great Depression, but we take comfort that the ‘Authorities’ have been much more thoughtful, speedy, and forceful in their approach. No comparison is perfect, but the combination of these three events can serve as somewhat of a roadmap for what investors should expect over the next few quarters – and potentially years.
If we are right in our worldview, then those that prosper in the investment community are likely to have the ability to provide holistic capital structure solutions. Distinct industry expertise as well as a global perspective—including understanding of public policy, geopolitical, and societal questions—will be required as this recovery will be uneven and often linked to policy incentives and actions which, in turn, will be impacted by populist sentiment in many nations, in our view. Yet, as we have already seen in the United States with the size and speed of the bank loan markets ratings downgrades this cycle relative to 2008/2009, existing capital structures dependent on adjusted EBITDA forecasts are likely to come under significant pressure in short order. That is both the risk and the opportunity that we see ahead for the global capital markets.
Right Now, the S&P 500 Is Disconnected from Leading Indicators
The Rating Agencies Have Moved Much More Quickly This Cycle. This Accelerated Pacing Has Important Implications for the CLO Market
In terms of our macro analysis at KKR, we continue to refine our scenario analysis to better pinpoint how things will unfold. Our ‘severe’ case remains our base case, but as we describe below, it is now even more severe. To be sure, visibility has improved, but it generally remains low relative to past downturns, given the uncertainty of the disease and the huge surge in unemployment where we are likely more cautious at the rehiring schedule than the consensus (note: the U.S. jobs data indicated that nearly 80% of those interviewed characterized their unemployment as purely temporary). For those of us doing economic forecasting at KKR, we look for a gradual reopening of the global economy, albeit one whose growth is periodically dented by regional, government-mandated or citizen-driven “clamp downs” to contain the disease. In our base case, we also expect geopolitical tensions to escalate further, as nationalist and populist tensions intensify. The banking sector too could come under pressure, as financial institutions are forced to reserve more capital for losses than is now expected. Undoubtedly, the backdrop we are describing will create continued uncertainty in the near-term, which has implications for capex, hiring, and ultimately growth.
The good news is that we have some important levers to pull that help guide the direction of the Global Macro & Asset Allocation, Balance Sheet, and Risk Analytics team (GBR) at KKR. For starters, over the last two decades, we have built a top-down investing framework that relies upon a steady and consistent approach. It has served us well not to jump around from data point to data point. Rather, we have continued to rely on models and approaches that date back as far as the early 2000s to inform our perspective. Second, given the Firm’s global breadth and access to more than 175 portfolio companies, we remain comfortable that we have something unique to add to the current debate about the direction of the global economy and related capital markets activity. We benefit from colleagues around the world with their fingers on the pulse of public policy and public sentiment. Finally, because of the Firm’s culture, we continue to benefit from the intellectual “sharing economy” that has defined KKR during its 44-year history. To this end, we wanted to update our clients and prospective clients on the most recent questions that we have been fielding of late, as we navigate as an investment firm through this difficult period. They are as follows:
- How have your macro outlook and themes changed since your last publication?
- Can you give some color on the huge dispersion we are seeing across asset classes, and what it all means?
- Is this current market rally sustainable and how does it compare to past cycles?
- Are you still positive on Credit and what does the current low rate environment mean for asset allocation?
See below for full details, but some of our key conclusions are as follows:
The S&P 500 is not reflective of global markets or the global economy. Although the speed of the rebound in stocks and bonds has been unprecedented, a closer look reveals that the recovery is much more uneven than meets the eye. Just consider that 21% of the total market cap of the SPX is dominated by five stocks. These five stocks, which are obvious ‘winners’ in the new world order that we envision, now have the same market capitalization as the bottom 350 stocks in the S&P 500. All told, three heavily technology influenced sectors of the S&P 500 (Communications Services, Technology, and Consumer Discretionary― i.e., Amazon) account for almost 50% of the S&P 500’s total market capitalization. By comparison, the Russell 2000, which we view as a more reasonable proxy for real economic activity, is down almost 25%, and its bounce has been much more meager in recent weeks. The same is true for the XLF (Financials Select SPDR Fund), which we like as a stand-in for the health of the banking system, and that has tumbled around 30%. As is detailed below, a similar bifurcation story is playing out in Credit.
Right now, we are seeing what is probably the maximum disconnect between Leading Economic Indicators (LEIs) and liquidity. Markets are discounting mechanisms, and at present, the market is responding to improved financial conditions. It is also responding to some of the green shoots we are seeing in China as well as the potential re-openings of many global economies. Over time, though, LEIs and markets should typically move much more in tandem. For our nickel, we believe that a ‘reconnection’ between LEIs and markets will occur once 1) the second derivative of money supply growth slows (remember money supply growth is about to peak); and 2) we transition from green shoots towards run-rate, sustainable growth in the coming weeks and months (which is where we expect to witness some disappointment).
Almost all major market sell-offs are followed by big bounces, and we expect this one to be no different. The question is about near-term sustainability of the recent move. See below for details, but this most recent rally now qualifies as the strongest on record following a major decline of 25% or more. This performance makes sense to us because of the size and speed of the central banks’ commitment to stabilizing financial conditions. In the U.S., for example, we estimate that the Federal Reserve has done 80-90% more bond buying in March/April than it did in total following the Lehman bankruptcy in 2008. Also, money supply growth is surging, a trend we have come to respect when we think about fading rallies (Exhibit 14). That said, our analysis shows that this rally likely warrants some backfilling, as we think we have now approached fair value (Exhibit 36).
However, our work also shows that we are not at unrealistic levels for investors who are willing to look towards 2022/2023 and beyond. The key for deployment is getting the macro/sector themes right, which we think is the most important lesson from from our historical analysis at KKR. As we describe below in more detail, S&P 500 earnings per share could rebound to $175 in 2022, which was – to give some perspective – our start of the year forecast for 2020. No doubt, there is a big pot hole in the middle of the highway (and we expect EPS of just $101 this year), but the 3,300 on the SPX in 2022 (19x $175) is not out of the question. So, for companies that represent secular winners coming out of COVID-19 that fit our key themes, we would stay aggressive.
We still remain more positive on Credit than Equities. See below for more details, but even with the recent tightening of credit spreads, the outlook remains favorable in the low rate environment that we envision. Specifically, the spreads on Credit relative to the risk free rate are still more compelling to us than the earnings yield on stocks. For Equity investors, we also see opportunities for those individuals who can find value where the public market has been overly punitive. On the private side, we expect more portfolio company acquisitions, corporate carve-outs, and rescue financings.
Traditional asset allocation is poised to change because the ‘math’ no longer works. As we describe below, there are two key underpinnings to our thesis. First, because of such low yields, sovereign bonds can no longer act as the return generator and diversifier that they have in the past (Exhibit 7). Second, as we describe below in more detail (Exhibit 40), the reality is that lower returns for many traditional asset classes may be in order. Japan post-1989 may not be the perfect corollary, but it could definitely serve as an important guidepost for several countries, in our view.
Bonds Have Been an Incredible Source of Investment Returns and Diversification the Last Five Years. Unfortunately, This Tailwind Can No Longer Exist, Which Has Huge Implications for All Investors, We Believe
Looking at the big picture, we think that the coronavirus represents a defining moment for the global economy. Beyond the huge human element that is likely to persist for years, the business community itself is likely to be reshaped. From our vantage point, we now believe that almost all things cloud-based will prosper, as will vast segments of the online security industry. Digital business-to-business applications, including healthcare, too are likely to thrive, and on the consumer side, the shift online in key industries such as healthcare, retail, education/learning and business services has likely been accelerated by five to seven years. Interestingly, though, many of these trends were already in place, and many had more economic momentum than the consensus fully appreciated. Indeed, as Exhibit 8 shows, technology-related company earnings have essentially represented 100% of profits for the last decade. This trend is only likely to accelerate.
Tech Earnings Have Outstripped Those of the Global Market. We Now See Technology Earnings Shifting into More Sectors, as the Pace of Digitalization Intensifies
U.S. Initial Unemployment Claims Suggest A Jump in the Unemployment Rate to 35% (Which May Overstate the Actual Number)
Importantly, these changes will occur both in the private and in the public sectors. Against this backdrop, substantial retraining will be required, which has implications for how governments, companies and educational institutions train people, as well as for unemployment and government deficits. Indeed, many of the concerns we highlighted surrounding excessive government deficits as far back as our 2018 Midyear Outlook note (see New Playbook Required) will only be accelerated by the pandemic as the rate of technological change and automation intensifies. In that report we highlighted findings from The Work Ahead, detailing the need for changes in worker skill sets, including more technological prowess, to maintain economic security and sustainability. Some key findings, which were published even before the coronavirus (i.e., these numbers will be even more profound once they are updated post-pandemic), included the following:
- Nearly two-thirds of the 13 million new jobs created in the U.S. since 2010 required medium or advanced levels of digital skills.
- As many as one-third of American workers may need to change occupations and acquire new skills by 2030 if automation adoption is rapid. The average worker will know over a dozen separate jobs during his or her lifetime while education will become a lifelong affair, not something completed prior to entering the workforce, with continuous retraining becoming the new normal.
- The United States spends roughly one-fifth of what the average European country spends on active labor market programs, which are designed to provide individuals who lose their jobs with the training, skills, and job counseling they need to return to the job market.
- At many levels (government, corporate, educational), these training programs will need to be online and driven by predictive data about rising industries and skills needed for success in them.
Public Expenditures On Assistance and Retraining For Unemployed Workers in the U.S. Remain Quite Low
Many Stalwarts of Job Growth Have Been Decimated Post COVID-19
So, while we are filled with some optimism about the future and belief in the resiliency of the human spirit, we are quite realistic about the significant challenges that many economies – and their citizens – will likely face in Phase II. Given this view, we think that an expanded set of skills will be required to navigate the Phase II environment that we envision. We also must all remain focused on adaptability. No one has all the answers, but the current environment is an excellent one to leverage our top-down framework to begin to lean in where appropriate on behalf of the constituents we serve. Indeed, while KKR is primarily in the investment management business, the Firm is also highly connected to multiple local business communities because of our role as a fiduciary to retirees, first responders, and teachers across thousands of local communities. To this end, we look forward to moving ahead in a positive fashion to fulfill our responsibilities as thoughtful stewards and guardians of capital amidst a crisis that is likely to define the current generation.
Question #1: How have your macro outlook and themes changed?
As we mentioned earlier, we believe forecasting an exact outcome for the coronavirus is a fool’s game. There is just too much uncertainty. What we can do is create scenario analyses and adjust accordingly as data comes in that either confirms or denies the base case. To this end, this piece provides an update on how the data is tilting relative to what we laid out in Keep Calm and Carry On. We note the following:
GDP: Trending Worse Because of Our Increased Concerns Around Demand In our last note we suggested that U.S. and European GDP growth could fall to mid-to-high single digits in 2020. Today we think that growth will likely disappoint these original forecasts. While we were correct to forecast a significant spike in unemployment in the United States, our initial view that 70% of jobs lost would return within six months likely will prove too optimistic. We now think that percentage could be closer to 30%. Meanwhile, though we are encouraged by China’s containment of the virus, it has not led to a substantial rebound in GDP. Said differently, the notable improvement we are seeing in our big data sources around mobility is not translating directly to a sustained acceleration in personal consumption. There are, we believe, two forces at work. First, on the demand side, China too is suffering from higher unemployment and increased bankruptcies. My colleague Frances Lim estimates that 26-50 million jobs have been lost, coupled with less demand for Chinese exports. In fact, Frances estimates that exports in China could plunge by 20-40% year-over-year in coming months as China’s exports are heavily linked to U.S. and European demand, which our work shows is poised to crater in 2Q20. Finally, in Europe, Aidan Corcoran estimates real GDP growth for 2020 will be in the region of -10.7%. His more conservative forecast is due to the two-way risk given the increasing size of the economic hole that is associated with a full stop in the economy. Notably, he is seeing eight standard-deviation moves in many macro variables, and traditional macro relationships are untested at those levels.
While There Are Some Positive Green Shoots, the U.S. Economy Largely Remains Idle
Overall, we have adjusted our forecasts in our base case scenarios to assume more flare ups of the virus until a vaccine is found versus forecasting a massive re-spiking of cases in the fall. Already, in Singapore and Hong Kong, we have seen additional clamp downs, and recent efforts to accelerate “back to work” programs in Europe and the United States could lead to the resumption of intermittent stay-at-home orders. As we look ahead, this type of back-and-forth growth rate in most of the major countries seems the most likely outcome, and it is more consistent with our Phase II framework.
Central Bank Activity: Better There is a lot of handwringing these days around the recent surge in sovereign debt loads, which is increasing 20% or more as a percentage of GDP across many of the developed economies that we track. However, we see two offsets to these substantial increases. First, we believe that central banks will not get itchy to sell down the sizeable increases that they have accumulated in recent years. This viewpoint is significant because it should ensure against higher rates and/or crippling austerity programs (similar to what we saw in Europe after the 2011 sovereign crisis). Second, while debt loads are surging, they are not hitting the levels my colleague Dave McNellis deems to be tipping points. According to Dave’s work, developed market public debt loads become more problematic around 150% of GDP. One can see this in Exhibit 15.
Across the Globe, A Sizable Fiscal Response Is Being Fast Tracked. Unfortunately, It Comes at a Significant Cost to Government Budget Fiscal Deficits
We Expect Central Banks to Absorb the Lion’s Share of the Sovereign Debt Increase to Avoid an Austerity Backlash. Longer-term, Rationalization of This Debt Surge Could Be Problematic
As For Most Developed Market Sovereigns, Historical Odds of Defaulting Have Not Risen Materially Until Debt-to-GDP Exceeded 150%
However, Government Debt in Many Countries Is Now Trending in That Direction
Inflation: Higher Conviction Around Disinflation in the Near-Term But, despite the surge in money supply, we think disinflation/deflation is now an even greater risk. Lower wages, lower oil prices, and intensifying digitalization/technological change all conspire to keep a lid on inflation. Remember that even prior to the pandemic, technology was putting 50 basis points of downward pressure each year on inflation in the U.S. Also, near-term, de-leveraging is by definition disinflationary.
So, in this type of environment and with the prevalence across the globe of negative rates, the value of upfront yield increases meaningfully and supports leaning into private credit, infrastructure, and yielding real assets, etc.
Bigger picture, investors must appreciate that we are suffering the ‘double whammy’ of a global supply and a demand shock. Without question, in our view, this backdrop is near-term disinflationary. However, if the government creates enough demand via its sizeable stimulus and/or we get a surprise with a vaccine or other therapeutics, there would not be enough low cost supply to meet this demand. Remember that money supply in the U.S. is growing much faster than it did during the Great Depression or the Japanese bubble pricking post-1989. That scenario would be inflationary, particularly if global supply chains are being reconfigured. A separate issue on which to focus could be that the U.S. dollar falls out of bed and creates inflation. A Federal Reserve itchy to unwind its balance sheet, a policy mistake, and/or international players such as China or Japan selling U.S. bonds to free up capital for domestic initiatives are all issues to consider. To be sure, these events are not part of our base case planning, but they are topics we are watching closely.
Investing Themes: More Conviction, Particularly Around Digitalization, Preparedness, Resiliency Without question, we feel more strongly about the themes we laid out in Keep Calm and Carry On. In particular, ongoing discussions with executives across a variety of industries have led us to believe that the shift towards online, digitalization in particular, will accelerate. It will likely grow more quickly than the consensus thinks across business to business, not just business to consumer. All industries are likely to be impacted, including healthcare, consumer, logistics, and financial services.
Online Traffic Is Accelerating For Companies That Satisfy Individuals Desire to ‘Nest’
Meanwhile, we have even greater conviction about our ‘nesting’ concept. Cooking, home improvement, domestic travel, and sectors associated with equipping home offices should all prosper. We also expect more emphasis on ‘value consumption’, and while we still expect individuals to seek out experiences, we think that they will do so in a more environmentally and health-conscious way than in the past. Finally, we expect savings to become a theme. All told, Dave McNellis expects the savings rate to rise from 7.5% in December 2019 to close to or above 20% in 2Q20. Dave’s framework also suggests that disposable income may be close to flat or even positive after accounting for the unemployment and stimulus checks but that consumption spending may fall roughly in line with GDP, with those dollars diverted to savings.
Also, consumers and citizens around the world are likely to look at other rising risks that require preparation and protection. For example, food, pharma and business supply chains will be examined for disruption, and food safety will be more important. Home exercise equipment and platforms will be likely winners. As noted earlier, companies that offer tele-learning, training, and workforce development will be key. Policymakers may also embrace this trend. For example, resilient urban development will be emphasized, particularly in areas prone to flooding, and energy grid resiliency could be prioritized. Given shrinking tax bases, private capital will be key to these infrastructure priorities.
On the opposite side of the ledger, we are increasingly concerned about the path of globalization, urbanization, and some components of the sharing economy. To be sure, all three are likely to continue to grow, but the slope of the line could be quite different in the new world order we are envisioning. Our base view is that politics will shift towards the right as it relates to border security and cross-border flows, while socio-economic issues around income equality will shift sentiment to the left in the coming months. Key industries like technology and healthcare will become important national security concerns for most political leaders in both the East and West. If we are right about where we are headed, then globalization, urbanization, and the sharing economy are all likely to be caught in the cross-hairs of what could be a more vocal, political debate that extends across sectors, regions, and demographics.
Question #2: Can you give some color on the huge dispersion we are seeing across asset classes, and what does it all mean?
If there is a common refrain we hear from clients these days, it is that the S&P 500 and the Nasdaq seem to go up every day; at the same time, however, “my portfolio is going nowhere – and fast.” No doubt, as my colleagues Kris Novell and Brian Leung show in Exhibits 18 and 19, respectively, dispersions across style as well as between high yield, leveraged and bank loans have been quite substantial.
The Equity Market Has Bifurcated Into the Haves and Have-Nots
A Similar Scenario Is Playing Out in the Credit Markets
Our take: There is a big difference between the capital markets and the economy. Just remember that, as we noted earlier, the Russell 2000, which we view as a more reasonable proxy for Main Street, is down nearly 25% year-to-date, while the SPX is down about 11% but on an equal weighted basis, it has fallen around 20%. What is going on? Well, in our view, what’s going on is that a small subset of the overall index is driving returns. The YTD returns (as at May 12, 2020) for the five largest companies in the S&P 500 (Microsoft +15.76%, Apple +6.0%, Amazon +27.6%, Facebook +2.4%, Johnson & Johnson +0.9%) who comprise 21% of the total market cap highlight this performance skew between the broader index and select overweighted names. This type of bifurcation has happened before in 2000 (see below), but this occurrence feels more real as companies like Amazon gain market share. We believe that at some point, a lot of the good news gets priced in, which is where we think we are today.
Not a Recovery of Equals: Small Cap Stocks and Financials Are Not Confirming a Broad-Based Recovery
Market Cap Is Now Highly Concentrated
The performance dispersion at the industry group level in the S&P 500 is equally as large. Indeed, as we show in Exhibit 22, the performance differential between the top three and bottom three industries reached approximately 30 percentage points in March, which is the highest level since April 2009. This “Haves and Have-Nots” scenario is underscored by how on a year-to-date basis, the top three performing sectors – Retailing, Software, and Pharma/Biotech – have outperformed the bottom three – Autos, Energy, and Banks by an incredible 41 percentage points on average.
S&P 500 Performance Dispersion At the Industry Level Peaked in March 2020 At Approximately 30 Percentage Points
Year-to-Date, Retailing, Software, and Pharma/Biotech Have Outperformed Autos, Energy, and Banks by Approximately 41 Percentage Points on Average
Given these wide dispersions, the common refrain we then hear is “Well, should we buy what is cheap and hope for mean reversion?” Remember what legendary value investor Ben Graham intended when he wrote that, “The intelligent investor is a realist who sells to optimists and buys from pessimists.” Under normal circumstances, traditional advice would be to buy the cheap assets and sell the expensive ones, and then we just wait for the ‘invisible hand’ of mean reversion to rationalize the variant perceptions. Unfortunately, these are not normal times with normal circumstances. To this end, Brian Leung looked into whether now is the time to buy the Russell 2000, which has been quite hard hit from the downturn. In fact, things have been so bad that the Russell 2000’s trailing 5-year annualized total return actually turned negative last month (Exhibit 24).
Mean Reversion Is Not Always the Best Investment Strategy When It Comes to Smaller Cap Stocks
Consumers Are Under Significant Stress and Delinquency Rates Are Soaring in China
Interestingly, what he found was that it was a good decision to buy during the 2009, 2002-03 and 1940-42 periods, but the subsequent 12-month performance was more of a mixed bag during the 1973-75 and 1931-35 periods. One can see this in Exhibit 26. Said differently, the mean reversion trade that many investors are advocating is not 100% full proof in the near-term (i.e., over a 12-month period), despite the significant underperformance of late. So, we would still advocate selectivity at this point, with a preference for secular winners in technology, business services, nesting, and consumer value. However, we would not bottom-fish yet in ‘spicy’ financials or traditional consumer names where a weak job recovery, which is what we are forecasting, could act as a headwind to profits, including a significant increase in delinquencies. Already, we are seeing a notable spike in delinquencies in China, which appears to be much further along in its recovery than Europe and the United States. For longer-term investors (i.e., 5-year time horizon), however, the probability of success is much greater. We show this in Exhibit 27.
The Subsequent 12-Month Return at Various Trailing Return Thresholds Are in the 20% Range, But the Hit Rate Is Not As High As One Might Think…
…However, Over a 5-Year Time Horizon, the Median Annualized Return Is 24%-26% With a Significantly Higher Hit-Rate of 95% or So
Our bottom line: Without question, the extreme performance dispersion that we are seeing across debt and equity markets will undoubtedly create some significant investment opportunities ― and sector and security selection will certainly matter more than in the past. If we are right, then we believe active management should outperform passive by a substantial margin. That said, our work suggests indiscriminately buying what is lagging is no guarantee of success. In a world where technology is upending traditional business models in a way that we have not seen since the last industrial revolution, there will likely be a lot of value traps this cycle, in our view. In fact, to borrow a joke from investor David Einhorn: “What do you call a stock that’s down 90%? A stock that was down 80% and then got cut in half.” That said, for top-down investors who buy at the aggregate level, there is a much greater probability of success for investors who can take a 5-year or more view on markets, as evidenced by Exhibit 27.
Against this backdrop, we believe the winning playbook for portfolio managers who choose individual securities across Public Equities and Credit requires four ingredients at this point in the cycle: 1) the courage to lean in during dislocations; 2) thoughtful thematic overlays to identify secular winners coming out of COVID-19 (e.g., digitalization, nesting, cloud, etc.); 3) the ability to lean into cyclical stories where the capital structure can withstand what we think will remain a tough economic environment for quite some time; and finally 4) patient capital that can stay rational when the capital markets become irrational.
For private investors, we think the tool kit is slightly more nuanced. Specifically, we think that Private Credit and Special Situations type investors will be increasingly required to take-over and improve companies when their debt is ultimately exchanged for equity. If we are right, then scale and industry operational expertise will be required. On the private equity side, we think dispersion creates more opportunity for public-to-private transactions, and we see more portfolio companies making acquisitions to grow their businesses. Overall, though (and similar to the public markets), we think the ability to both partner with secular winners and buy beaten-down companies with fixable capital structures will be the winning formula in the Phase II environment we are envisioning.
Question #3: Is this current market rally sustainable and how does it compare to past cycles?
Not surprisingly, we often get asked if this bear market rally off the lows on March 23rd is sustainable and how it compares to past cycles. Simply stated, this one has been big and fast, and in our view, it probably now requires some backfilling. However, as we also describe below, the market may not be as disconnected from reality as much as some folks with whom we speak may think.
To complete our research, we looked at 16 recoveries after a 25% or more correction since 1928 and found the following characteristics:
- Typical Recovery: After a sell-off of greater than 25%, the average recovery is 13% over one month, 27% over three months and 33% over six months. For context, the S&P 500 enjoyed a nearly 34% gain from the March 23, 2020 low (before retracing at the time of our publishing), so it is currently running well ahead of the typical recovery. The most comparable recovery is the November 2008 rally, when SPX was up by approximately 24% over seven weeks.
- To Retest, or Not to Retest? Our work shows that a full 75% of the time (in 12 of 16 instances), there was at least some sort of retest, if not an undercut, of initial lows (which was 2,237 on S&P 500 on March 23, 2020). The average peak-to-trough drawdown during a retest/undercut is 13%, and it usually plays out in about 30 days. That said, the retests/undercuts come in all shapes and sizes. Case in point: the 1962 retest happened a full two months after the initial low and took more than two months to resolve itself, while the 1933 retest occurred just two weeks after the initial low and resolved itself in about two weeks.
- Were There Exceptions to the Retest Thesis? Yes, the cleanest exceptions were 1982, 1942 and 1935, when the S&P 500 took off and never looked back.
- Why Are You Not More Worried About the Recent Low Being Undercut This Cycle? It’s very rare for S&P 500 to rally more than 30% and then experience a retest that undercuts its initial low. In fact, if we exclude the period following the Great Depression, we could not find an example where the market rallied 30% and then undercut the initial low. Said differently, a 30% rally off the bottom versus a 25% rally typically has more staying power. This factoid is why we are more comfortable than many investors that the lows are in for this cycle, albeit we are watching the markets closely.
- The Uber-Bullish Tails: There were two instances when it paid handsomely to hold on and ride the wave ― 1932 (market rallied 111% in two months) and 1933 (market rallied 121% in five months). We just do not think this is going to occur today, but it is important to note in case the Fed continues to expand its mandate into new and different types of risk assets (not our base view).
The S&P 500 Has Had a Big Bounce Off the Bottom. About 75% of the Time Following a Bounce, the Market Backfills to Catch Its Breath
Relative to Past Cycles, We Are Now Ahead of Schedule in Terms of the Recovery
So, what is the punch line? As our data shows, the S&P 500 has run ahead of the typical recovery. No doubt, each recovery is different, and this one will be dependent not only on economics but also epidemiology. However, for longer-term investors with a three-year or more horizon, our work shows that, while we are ahead in terms of performance relative to past cycles, staying the course is probably the best approach. One can see this in Exhibit 30 which shows that stocks were in positive territory in every circumstance except for two – and no negative outcomes since the 1940s.
Each Recovery Is Different, But Our Work Shows a Lot of the Near-Term Appreciation Has Occurred. However, Longer-Term Investors Should Stay Invested and Add on Pullbacks
Beyond looking at history, we also think it is important to look forward because of the uniqueness linked to this downturn. So, as part of this exercise, we took a stab to see how earnings might play out over the next few years until a vaccine allows a greater return to normalcy. One can see our forecasts in Exhibit 33. As we poll our portfolio companies, what we are finding is that while consumer-facing industries are most exposed to the coronavirus shutdowns, there are also second-order casualties as well. The most obvious example we can find: The demand destruction we are seeing for oil is driving an epic downturn in Energy, one that actually makes the 2015/16 oil patch meltdown look fairly tame. One can get a sense of the demand fall-off we are forecasting in Energy in Exhibit 31, albeit supply is now actually coming off the market quite nicely.
As Part of the Slowdown, We See Oil Demand Dropping Mightily
However, Energy is not alone. Empty malls/offices/hotels and higher delinquencies will hurt both commercial and residential REITs, while suspension of buybacks and lower net interest margins will weigh on financials. Meanwhile, we still expect defensive sectors to fare better on a relative basis, but the unique nature of this shock means that they will likely see bigger declines than during the GFC.
Taking into Account the COVID-19 Impact, Our Base Case Has S&P 500 EPS Falling Sharply to $101 per Share in 2020, Followed by a Rebound to $151 per Share in 2021
Cyclicals Should Account for the Bulk of EPS Contraction, But Main Street Consumer-Facing and Traditionally Defensive Sectors Are Getting Hit Hard As Well This Time
So, when we bring it all together, we now forecast $101 in EPS for the S&P 500 for 2020, down almost 40%. Implicit in our forecast is that the coronavirus creates multiple fits and starts in the economy through the first quarter of 2021. Thereafter, we expect easing comparisons, better medical options, and a greater understanding surrounding business protocol to allow the S&P 500’s earnings to rebound to $151 per share. Importantly, just as the market capitalization of the S&P 500 is dominated by just a handful of stocks, so too are its earnings.
What does this all mean for valuation? Well, as the 2020 EPS estimate will likely be historically bad, we expect the market to look past 2020 and anchor equity valuations to 2021 and beyond. To forecast 2021 S&P 500 fair value, we believe an implied equity risk premium (ERP) framework could be useful, as it takes into account not only earnings, but also cash payout (dividends and buybacks), the level of interest rates, and the future path of cash flows to arrive at a more comprehensive assessment of valuation. The other obvious benefit is that it de-emphasizes the historically bad 2020 EPS number.
Our work shows that the equity risk premium widened to multi-year highs of six percent at the end of March, up from 5.2% at end-2019 and the post-GFC average of 5.5% (Exhibit 34). Ultimately, non-financial variables such as the availability of rapid testing and a potential treatment/cure for COVID-19 will govern how fast economic activity (and thus investor sentiment) can rebound. However, our analysis of historical cycles suggests that equity risk premium has on average declined by approximately 0.5%, one year after a price trough, (Exhibit 35). If we conservatively assume the ERP normalizes back to the post-GFC average of 5.5% and that 85-90% of lost EPS is recouped by 2025 (as opposed to lost forever), our calculations suggest S&P 500 fair value is in the 2860-2920 range (implying 19.0-19.4x our 2021 EPS of $151 per share). The bad news is that with markets already ripping higher to the 2,850 range today, our framework suggests only limited (one to three percent) fundamental upside from current levels (Exhibit 32).
S&P 500 Implied Risk Premium Widened Out to 6.0% At the End of March, Up From 5.2% At the End of 2019 and the Post-GFC Average of 5.5%
Historically, 12 Months After a Price Trough, the Implied Equity Risk Premium Tends to Decline by About 0.5%
Based On Our Assumptions, S&P 500 Fair Value Appears to Be in the 2860-2920 Range
Our bottom-line: The scale and speed of the global economic policy response have been breathtaking. There have been nearly 4,100 basis points of central bank rate cuts year-to-date, $9.9 trillion of global fiscal stimulus in the pipeline, and the Bank of England will now buy bonds directly from the UK government; at the same time, the Federal Reserve is indicating it will buy High Yield Credit if necessary. Consistent with this view, we believe there will be a bid to financial assets as money supply is growing 10-15% at a time when the economy is shrinking 15%. However, despite the benefit of the stock market being a discounting mechanism, uncertainty remains high, and as such, we suggest investors resist the urge to think that financial asset prices will sustainably decouple from dire economic fundamentals. If we are right about our Phase II framework, there will be multiple opportunities to lean into the dislocation.
Maybe more importantly, though, is where an investor is spending time looking for deployment opportunities. Our strong belief is that now is not the time to own lots of deep value stocks with potentially broken business models. Rather, we suggest seeking out businesses with resilient capital structures, low fixed costs and durable pricing power; and where possible, invest behind long-term thematic opportunities that could thrive in the post-crisis world (e.g., e-commerce, nesting, wellness/preventive care, and ESG/infrastructure). Another option in the Phase II environment we envision is to be a provider of solutions to good companies with bad capital structures that have been unduly punished in the near-term because of the onset of COVID-19.
Question #4: Are you still positive on Credit and what does the current low rate environment mean for asset allocation?
In general, we still like Credit as a notable overweight as part of our overall asset allocation target portfolio. There are several key underpinnings to our thesis. First, Chairman Powell indicated numerous times during his last briefing that he remains committed to keeping credit flowing. “We will keep doing that aggressively and forthrightly, as we have been,” he also said similarly in an NBC interview. “When it comes to this lending we’re not going to run out of ammunition. That doesn’t happen.”
Second, the yield on Credit relative to Equities still appears to favor Credit. One can see this in Exhibit 37 remembering that the spread on Credit does not include the additional basis points that one receives from the risk free rate, while the earnings yield on Equities is gross of capital expenditures.
In Terms of Asset Allocation Decisions, We Favor Dislocated Credit
Third, on a volatility adjusted basis, Credit is likely much more compelling than Equities. Finally, we believe that, with interest rates so low, more macro and asset allocation professionals will move away from a traditional 60/40 portfolio mix (60% stocks, 40% bonds) towards one that replaces some portion of the bond mix with some form of Credit rather than Sovereign Debt. The reality is that, with rates so low, traditional Sovereign Debt is not well-positioned to serve its two primary functions as an income producer and as a shock absorber in the event of a market downturn. Finally, given the size of the deficits we identified earlier in the paper, it is not perfectly clear to us that the risk-free rate is still truly risk free. Moreover, the low absolute starting points – by definition – limit some of the potential for principal gains, which has not really been the case since the great bond bull market started in 1982.
Meanwhile, given the terrible performance of inflation hedges such as pure commodities during the past decade, we also think that more allocators are considering reducing or removing Real Assets from their benchmarks. We can’t disagree in the near-term, given our view on the direction of inflation. That said, there is an extraordinary amount of money being injected into the system by global central bankers, so, some hedge protection is still necessary, we believe. Indeed, asset class diversification is actually more important today than it was before the pandemic, in our view, and as such, some form of inflation protection will likely be required on a longer-term basis. To this end, we still favor a noteworthy allocation to Infrastructure, Gold, and TIPS.
Given that so many investors are now thinking through how asset allocation might change in the new environment that we envision, I asked Frances Lim to update her expected return analysis and also look into what low rates mean for asset allocation on a go-forward basis. Not surprisingly, we conclude that low rates make the traditional 60/40 portfolio less capable of delivering attractive absolute returns. One can see this in Exhibits 38 and 39, respectively. Consistent with this view, Frances’ 5-year expected returns for the U.S. 10-year Treasury is now marginally negative, down substantially from the 4.7% 5-year return she published last year. One can see the divergence in Exhibit 39, which underscored the impact of starting forward return projections at 64 basis points for the 10-year versus 1.8% last year when she did her prior update.
The Lower the Starting Yield, the Lower the Subsequent Return
Long Bonds Have Only A Little More Juice
What else can we glean from our work here? As Exhibit 40 also shows, forward returns for the S&P 500 have not changed much from the October 2019 update. Why? For starters, the markets have corrected, and we do have a greater lift from multiple expansion while the negative drag from earnings over the next year (from the shutdowns and a soft economy) largely offsets any re-rating.
Consistent with our investment thesis that Credit looks more compelling than Equities, Frances’ work shows that High Yield looks much more attractive today. Specifically, spreads have widened, while duration has lengthened relative to our last update. In step with this view, we see a lot more “fallen angels” that are now issuing new bonds with 7.5 to 10 year durations. Given that these securities are now about 10% of the market (and likely to increase as a percentage of total), High Yield duration has already increased to 3.9 this year from 3.1 last year. The implied default rate is also now at 9.0% versus 3.3% last year, while the expected recovery rates are now closer to the bottom of the range at 32% versus 48% last year, according to our analysis.
Lower for Longer Across Most Asset Classes Except High Yield
Our bottom line: Author Robert Frost is famously known for writing, “I took the road less traveled, and that has made all the difference.” While the current news flow can be quite overwhelming, now is probably the time to do as Frost suggests and step back, take a walk, and reflect on where asset allocation is headed. For us at KKR, our primary conclusion on the outlook for asset allocation is that interest rates are so low that a formal rethinking is warranted. Specifically, we believe that the traditional 60/40 asset allocation mix will not deliver the same returns that it did in the past, and as such, allocators will need to be much more creative in their approach. Upfront yield, particularly if it is linked to collateral, will likely matter more on the Fixed Income side of the portfolio, while pricing power and cash flow conversion will be points of differentiation in the Equity portfolio.
Meanwhile, given the huge amount of liquidity global central bankers are inserting into the system, we all need to watch closely for any hints of inflation. We certainly expect more disinflation in the near-term, but the implications for monetary policy, economic growth, and capital market assumptions could be quite dramatic if inflation were to make any sort of comeback during the next three to seven years. As such, we would not fully rid one’s portfolio of inflation hedges, despite the growing risk of near-term deflation across the global economy. In the interim, Gold, TIPS, and Infrastructure appear to be asset classes that could thrive in most environments, we believe.
“Do not follow where the path may lead. Go instead where there is no path and leave a trail.” Ralph Waldo Emerson
As we enter Phase II, a period we characterize as one of rolling dislocations, we reiterate our call to arms that investors should own some secular growth plays as well as some good companies with bad capital structures. This approach in the slower nominal GDP environment that we are forecasting should provide significant differentiation to investors who can invest across capital structures, products, and geographies.
Post World War II, the Average U.S. Corporate Tax Rate Was 42%. Today We Are At 21%
The Economic Pain from the Pandemic Is Not A Level Playing Field
Importantly, Phase II likely will also be the period where we transition from the benefits of swift central bank activity towards the stark reality that nominal GDP growth will likely be lower for longer. Against this backdrop, there will be more political posturing around who is going to pay for this bail out, including the sizeable government deficits. As Exhibit 41 shows, more complicated tax plans are likely part of the equation. We also expect more nationalist approaches to global supply chains, which likely means tougher policies surrounding immigration (i.e., a political shift to the right). On the other hand, within most economies we expect an intensifying focus on the socio-economic divide that is being created by this pandemic (i.e., a political shift to the left).
Phase II Will Be Defined by the Upcoming De-Leveraging
We Should Expect More Downgrades Across Some of the Most Sizeable Parts of the Credit Market in the Coming Months
For investors, our message is clear: think differently about this new regime and ‘leave a trail, not follow a path.’ Also, be humble and compassionate, as one seeks to fulfill his or her fiduciary responsibility to the constituents being served. Phase II will likely be with us for some time, and amidst the hardship, there is a significant opportunity for portfolio managers to create value by leveraging the top-down investment framework that we have laid out in this essay. To this end, we look forward to navigating these tricky times together.
1 The Council on Foreign Relations-convened independent task force co-chaired by John Engler and former Commerce Secretary Penny Pritzker released The Work Ahead in April of 2018.
References to “we”, “us,” and “our” refer to Mr. McVey and/or KKR’s Global Macro and Asset Allocation team, as context requires, and not of KKR. The views expressed reflect the current views of Mr. McVey as of the date hereof and neither Mr. McVey nor KKR undertakes to advise you of any changes in the views expressed herein. Opinions or statements regarding financial market trends are based on current market conditions and are subject to change without notice. References to a target portfolio and allocations of such a portfolio refer to a hypothetical allocation of assets and not an actual portfolio. The views expressed herein and discussion of any target portfolio or allocations may not be reflected in the strategies and products that KKR offers or invests, including strategies and products to which Mr. McVey provides investment advice to or on behalf of KKR. It should not be assumed that Mr. McVey has made or will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client or proprietary accounts. Further, Mr. McVey may make investment recommendations and KKR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this document.
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