State of Play

No doubt, war is a human tragedy. It requires heavy reflection on what has transpired and how it can be avoided in the future. However, the current situation also demands that, as fiduciaries, we delve deeply into what the implications are for all our constituencies, including our portfolio companies, our limited partners, and our employees. From our perch at KKR, we believe that the pandemic started – and the war in Europe has now accelerated – structural shifts in the global economic system that warrant investor attention. For starters, we began this cycle with ‘sticky’ inflation that is both broad-based and accelerating; the Russia/Ukraine war as well as the recent surge in Omicron cases in China should only intensify this headwind in the near-term. Yet, surging inflation is occurring at a time when central banks will lag to tighten financial conditions, which means real rates will likely lag this cycle. We are also seeing a further splintering of supply chains. Importantly, we believe that Russia’s attack on Ukraine may only reinforce the notion that security of energy, communications, healthcare, and data is not only an economic priority but a geopolitical one as well. It also has the potential to reinforce populism, geopolitical rivalry, institutional distrust, and political tumult, all recent trends we’ve written about that have significant long-term economic implications. Against this backdrop, we strongly advocate for macro professionals and asset allocators to prioritize inflation protection and pricing power by overweighting collateral-based cash flows, including Infrastructure, Asset-Based Finance, and Real Estate. We also expect Private Equity with high cash flow conversion characteristics as well as opportunistic strategies across both liquid and private Credit to perform well in this new macroeconomic environment we envision.

At KKR our hearts and minds go out to all those individuals adversely affected by the war against Ukraine. War is many things, but foremost it is a human tragedy. Unfortunately, as we detail below, the adverse human element of war will only be exacerbated by knock-on economic realities that are likely to further extend the pain and suffering, we believe.

From our perch at KKR, uncertainty around the situation remains high. However, the Ukraine crisis does not fundamentally alter the macro environment we have been forecasting for some time. Rather, it just aggravates the existing narrative we laid out in our A Different Kind of Recovery thesis. Specifically, we still see higher headline nominal GDP growth this cycle, but the underlying mix is increasingly shifting towards inflation relative to real growth. This reality is taking place against a backdrop of central bank tightening, ongoing supply chain disruptions, and liquidity withdrawal.

Not surprisingly, we have spent a lot of time of late discussing what all of this means for investing. Simply stated (and as we laid out in our January Outlook piece), we think that the pandemic started – and the war has now accelerated – a regime shift that warrants investor attention. To this end, we want to highlight the following five points that support our latest thinking

1. First, we are again lowering our global GDP forecasts for 2022, including the U.S. and Europe. At the same time, we are raising many of our already-above consensus inflation forecasts. However, we make no changes to our China forecasts, given our already conservative economic outlook. In general, we believe that growth is the greatest challenge Europe is facing, while in the U.S., inflation is presenting the toughest challenge, driven by the trifecta of surging wages, rising rents, and broad-based commodity shortages. Importantly, as we will discuss later in the note, our cycle indicator moves firmly towards later cycle, which generally portends lower returns amidst slowing earnings and multiple compression.
2. Second, we now have even higher conviction in several significant new structural forces at work that we think will redefine the current global economic footprint. See below for details, but we enter this crisis with interest rates near the lower bound of history; we are also seeing a splintering of supply chains, driven by political regionalization, COVID-19, and war. As a result, inflation, driven by wages, housing, and commodities, will likely be more ‘sticky’ than central bankers had been forecasting. Just consider that we forecast core PCE inflation to be above the Fed’s two percent target on a year-over-year basis for essentially three years ending December 2023 (and it could be longer). By comparison, core inflation ran above the Fed’s target in just four of the 48 running quarters between 2009 and 2020. This unfortunate economic reality will fuel more populism and distrust of those in power, we believe. Finally, the ‘weaponization’ of economic policies for war now means a more sustained blurring between the fault lines that once distinctly separated geopolitics from macroeconomics during the rise of globalization in recent decades. Ultimately, we see some greater form of economic polarization as the most plausible outcome.
3. Third, the macroeconomic and asset implications of the current environment could end up being quite profound over time, we believe. We advocate shortening duration, leaning into collateral-based cash flows, and overweighting opportunistic vehicles across liquid and private markets. We continue to steer away from high beta growth equities with low cash flow conversion prospects. Overall, portfolio diversification matters now much more than in the past 10 years.
4. Fourth, these macroeconomic trends are also likely to reinforce other recent trends. We envision that more economic polarization and inflation will reinforce populism, further challenging the authority of those in power. These trends will also enhance already high institutional distrust as families see their purchasing power declining amidst higher prices. The regionalization of supply chains will add a new dimension to geopolitical rivalry that investors must consider as more industries and sectors become ‘strategic’ from a national security perspective.
5. Finally, the democratization effects of trade many envisioned post the creation of the WTO in 1995 may now be replaced by ‘like-minded blocks’ rather than global markets. Nowhere is this trend more on display than in Europe, as the surprising speed and unity of governments, businesses and individuals in expressing outrage over the invasion of Ukraine may have reinvigorated NATO, and ultimately could meaningfully change energy policy, defense spending, supply chains, and even consumption patterns. The war is also more likely to accelerate and intensify the dynamic between China and the industrialized democracies that has been building for several years, including the mutual hardening against economic and technological dependence on each other. Consistent with this view, we think that the definition of ‘security’ for governments and corporates extends beyond the military playing field to include data, search, payments, communications, and healthcare.

EXHIBIT 1

We Expect Real Rates to Remain Below Pre-Pandemic Levels, Even as Nominal Rates Rise Towards 2.75%

EXHIBIT 2

In General, We Are Entering a Regime Change

EXHIBIT 3

We Are Generally Below Consensus for Growth and Above Consensus for Inflation

Looking at the bigger picture, we think we are entering another uncertain period, driven by tightening financial conditions, a new form of war that includes both military action and unprecedented – for an economy of Russia’s size – economic sanctions, and more supply chain disruptions, driven in part by a surge of Omicron cases in China. The technical picture too is also important, as many investors are still overweight high beta growth and tech stocks (which remains one of our Pans; see Picks and Pans in A Different Kind of Recovery).

EXHIBIT 4

Our Earnings Model Is Now Suggesting a Notable Slowdown in 2023. If Inflation Stays High, It Could Feel Like Stagflation in Many Parts of the World

EXHIBIT 5

Our Forecast Has the S&P 500 Reaching Just 4,750 on $236 of EPS in 2022 and 4,840 on $242 of EPS in 2023

If there is good news, we think that the marriage of a solid top-down macro framework with sound bottom-up analysis is very well positioned to deliver both outsized relative and absolute performance. Importantly, though, we are following a different playbook than the one we used after past crises. Key to our thinking is that global central banks are entering this difficult macroeconomic period near the lower bound of their rate targets; by comparison, in 2001, 2008, and 2020, central banks had both more interest rate and balance sheet capacity to serve as cushions. Meanwhile, inflation will continue to run hot for some time, adding another layer of complexity for all politicians especially elected officials, we believe.

As such, deployment should be at a walk, not run, pace; by comparison, at the outset of the pandemic, our bias was to lean much more into the uncertainty. From an asset allocation perspective, we continue to focus on pricing power stories, with a particular bias towards Infrastructure, Real Estate, and Asset-Based Finance areas. We also prefer more value and defensive-oriented Global Equities and favor opportunistic approaches to both traded and non-traded Credit. Finally, we would spend some capital to hedge that long-rates catch up to the ‘sticky’ inflation we are forecasting. And in all decisions, investors must incorporate social, geopolitical and societal lenses, given the turbulence in each.

DIACLAIMER