We view 2024 as an important transition year in our Regime Change thesis. Specifically, for the first time since the onset of COVID-19, we are finally forecasting below consensus inflation for much of the next 12 months. As a result, tactical investors may want to position their portfolios to take advantage of this temporary disinflationary impulse. That said, our longer-term thesis about a ‘higher resting heart rate’ for inflation this cycle remains robust. Specifically, the four key pillars of our Regime Change thesis – a sizeable fiscal impulse, sticky labor costs, a messy energy transition, and a fundamental restructuring of global supply chains – all argue for a different approach to asset allocation, we believe, including a meaningful reduction in the role government bonds can play in a diversified global portfolio. Meanwhile, as we peer around the corner today towards what tomorrow might look like, we still see the push and pull of loose fiscal policy versus tight monetary policy, which are working against one another to heighten volatility as well as increase dispersions against a backdrop of rising geopolitical tensions. The capital markets are not immune to this tug-of-war mentality either, as corporate net issuance remains lackluster versus a flood of supply in the government debt markets. Against this increasingly complex backdrop, we think that all global allocators will need a ‘glass half full’ approach that encourages them to direct capital towards investment themes that not only have attractive growth characteristics but also serve as foils to some of the current obstacles to what was once a more synchronized and well-integrated global economy. The areas where we have the highest conviction thematically as we enter 2024 include our Security of Everything thesis, Digitalization, Industrial Automation, Intra-Asia Connectivity, and Global Infrastructure.
When we wrote our 2023 Outlook, our lead-in was “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.” Fast forward 12 months, and as we describe below, we continue to maintain our constructive tilt and suggest that one should view the investing landscape with a ‘glass half full’ lens.
Indeed, we want to reiterate again this year that for those allocators who want to roll up their sleeves and do some digging, there is still a massive amount of dispersion – the lion’s share of which has been caused by macroeconomic uncertainty − within and across asset classes/regions that can be harnessed to create substantial value for long-term investors (Exhibit 11).
Importantly, though, we still think that too many people are locked into the paradigm that the S&P 500 is trading at lofty headline valuations and the U.S. economy is topping out and headed for a hard landing. As a result, they are sitting idle, as they feel there is little to no value in the market beyond Cash (i.e., despite a strong year in risk assets, there is still a record $5.6 trillion of assets in money market accounts). We just do not see it that way, especially in the core investing businesses that KKR oversees. For starters, outside of the S&P 500’s ‘Magnificent 7 or 12’ (depending on your grouping preference), we think there are some very compelling Equity stories, especially ones that need capital to grow or reposition their businesses. Consistent with this view, the public-to-private and carveout opportunities that exist today weren’t available four to seven years ago, in our view. Meanwhile, Liquid Credit still looks cheap (especially relative to pension and insurance liabilities), and many parts of the Infrastructure sector where we traffic remain in a secular bull market on a global basis. Finally, between ongoing periodic dislocations as well as a growing number of required refinancings, there are a lot of capital solutions opportunities across Asset-Based Finance and Opportunistic Credit that earn an appealing coupon with some equity upside as well in many instances.
From our perch at KKR, we also believe that the opportunity set to invest behind some of the biggest mega-themes we have seen in years keeps the ‘glass half full’ for global allocators. Importantly, many of the investment opportunities we are highlighting also serve as compelling investment hedges and/or foils to some of the ails in the global economy these days (Exhibit 1). Hence, the famous Winston Churchill quote “A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty” has become our 2024 mantra.
EXHIBIT 1: While We Fully Acknowledge Some Global Macro Headwinds, Our Travels Continue to Uncover Some Powerful ‘Glass Half Full’ Themes to Invest Behind
Macro Headwinds vs. Tailwinds
EXHIBIT 2: Our Earnings Leading Indicator Has Bottomed and Is Now Suggesting Profits Will Mend
S&P 500 EPS Growth: 12-Month Leading Indicator
As we reflect on the past 12 months, there is little question that 2023 has been a roller coaster ride, especially given the ‘conundrum’ we are seeing where a strong fiscal impulse is at odds with extreme monetary tightening (Exhibit 3). One macro hedge fund portfolio manager, Scott Bessent, described it as a race car driver who has one foot on the pedal (i.e., fiscal policy) and – at the same time – another foot on the brake (monetary policy). Against these competing influences, we saw the collapse of several prominent banks in the spring, which created fears of a deflationary, deleveraging cycle. However, this macro shock only proved to be a head fake for investors worried about an economic collapse, as the narrative shifted by the fall to one of higher GDP growth and surging long-end rates, despite the lingering effects of Russia’s war in Ukraine and rising geopolitical tensions in the Middle East. Finally, heading into year-end, markets have snapped back in the opposite direction, betting on an aggressive series of Fed cuts and driving bond yields sharply lower.
EXHIBIT 3: Stimulus Conundrum: Today the Fiscal Impulse Is the Gas Pedal, Whereas Monetary Policy Is the Brake
Fiscal and Monetary Policy as a %ile of Historical Range
EXHIBIT 4: Capital Markets Conundrum: Net Issuance Has Contracted Massively, Except When It Comes to Government Bonds
Capital Markets Liquidity, Trailing Twelve Months, as a % of GDP
During all of these ups and downs, we at KKR continued to subscribe to our Regime Change playbook (see Regime Change: Enhancing the Traditional Portfolio). To review, our thesis rests on four pillars – sticky labor costs, heightened geopolitics, a messy energy transition, and overheated fiscal impulses – that suggest there will be a ‘higher resting heart rate’ for inflation this cycle. This backdrop requires, we believe, a dramatic shift in one’s asset allocation towards assets more linked to nominal GDP, not to over-indebted financial assets like government bonds linked to the low inflation, low growth world we are leaving.
EXHIBIT 5: Real Rates Will Tighten in 2024, Despite Lower Inflation. This Backdrop Is Why the Fed Can Ease (But Not as Much as the Market Now Thinks)
GMAA Projection: Real Rates vs. Potential GDP, %
EXHIBIT 6: Despite Record Tightening at the Front End, Central Bank Balance Sheets Will Remain Plump With Assets for Quite Some Time
G4 Central Bank Balance Sheets as a % of GDP, Dollar-Weighted
To date, our Regime Change approach to asset allocation, including being short duration, owning collateral, and being higher up in the capital structure, has served us well. In fact, it has largely been a one-way trade in our favor. However, buyer beware in 2024: Next year will be different for two reasons. For starters, we are uniformly above consensus on growth (except in Europe) and uniformly below consensus on inflation (except in Japan). Also, rate of change matters, and our models are suggesting lower year-over-year inflation prints for at least the first six months of 2024 (Exhibit 7). Moreover, we think that in 2024 nominal growth will likely slow (we actually have a mild recession in the second half of the year in our base forecast), and goods inflation could be negative, as we show in Exhibit 8. Meanwhile, unemployment will tick up, we believe, and long rates should rally a little further as the Fed finally cuts rates at the short end. So, our punch line is that, from a tactical perspective, fixed income instruments may continue to benefit from a disinflationary impulse in the first half of 2024, which could be compelling for short- term investors in the U.S.
EXHIBIT 7: Our CPI Model Begins to Flatten out Around Mid-Year 2024
Core CPI Leading Indicator, %
EXHIBIT 8: Core Goods Will Be Deflationary in 2024, While Core Services Will Begin to Come Off the Boil
Core Goods and Services Inflation, 2020-2024e
However, we see this positioning in inflation trends as temporary, and we do not want to confuse the cyclical with the secular. For long-term investors, we still believe that there will be a ‘higher resting heart rate’ for inflation this cycle, compliments of the supply side factors driving our Regime Change thesis, which warrants a different approach to macro and asset allocation, including overweight positions in collateral-based cash flows such as Infrastructure, Energy, Asset-Based Finance, and Real Estate Credit.
Meanwhile, within the equity side of the traditional 60/40, we also think that control-based Private Equity investing can likely play a bigger and more important role in helping to generate higher returns in a world where our overall expected returns have fallen (see Section IV where we address expected returns as well as Regime Change: The Role of Private Equity in the ‘Traditional’ Portfolio). Key to our thinking is that, despite a higher cost of capital, owning control positions with operational improvement opportunities can best the performance of a passive index by a good margin if our macroeconomic forecasts are correct. Indeed, history is on our side; as Exhibit 9 shows, the value of the illiquidity premium has increased when public markets have reverted towards more modest levels of return. The time to be bearish on Private Equity is not today; rather, it was actually in late 2021 and early 2022, when we believe several growth-oriented PE investors over-deployed their capital relative to trend amidst record low rates (and did not hedge in many instances).
EXHIBIT 9: The Excess Return of Private Equity Is Greatest When Public Equity Market Volatility Is Highest. We Link These Better Results in Private Equity in Tougher Markets to Operational Improvements and Better Entry Prices.
Average 3-Year Annualized Excess Total Return of U.S. Private Equity Relative to S&P 500 Across Public Market Return Regimes
EXHIBIT 10: Deployment Pacing in Private Equity Matters a Lot. The Time to Be Cautious Was in the Second Half of 2022, Not 2024, in Our View
U.S. Buyout Deal Activity, US$ Billions and Deal Count
Finally, we really like flexible capital in the Credit markets. Yields are at attractive levels in absolute terms, the quality of the debt in large liquid markets like High Yield is higher, and periodic dislocations are creating ample opportunities to lean in and out of various Credit products. Moreover, as economic growth slows, dispersions tend to increase within and across asset classes, a backdrop that tends to favor more flexible capital than the past regime where QE ‘artificially suppressed’ the rate of interest.
EXHIBIT 11: Excluding Large Cap Growth, Both Dispersions as Well as Absolute Valuations Remain Compelling Across Many Parts of the Global Equity Markets
Cross-Asset Valuation Percentiles, Relative to 20-Year Average, %
EXHIBIT 12: There Are Multiple Parts of Credit That Appear Attractive Today for Total Return-Oriented Investors
Yield to Maturity, Last 10 Years
By comparison, we remain long-term cautious on the role of ‘risk-free’ government bonds in diversified portfolios to serve as reliable shock absorbers. If we are right, then we think that the ‘40%’ segment of the 60/40 portfolio probably contains too much government debt. As a result, we think investors who are following this allocation plan may want to use any cyclical rally from today’s levels to lighten up. The reality is that governments, more so than corporations and individuals, are now more heavily indebted. Moreover, there is – compliments of sizeable deficits – still a lot of supply coming to market at a time when the Fed and most of the banks in its network own trillions of dollars of bonds that have unrealized losses. As such, if bond prices do rally more than we expect, then these interested parties become natural sellers, we believe. We also keep in mind that, even amid the recent rally in bonds, the stock/bond correlation has remained quite elevated, validating our thesis that bonds are not portfolio shock absorbers in the regime we envision.
EXHIBIT 13: We Are Now Only 14 Months Into a Bull Market Recovery Since the Lows in October 2022. We Believe in Staying the Course
Median S&P 500 Price Return After >25% Drawdown, Based on Drawdowns Since 1940
EXHIBIT 14: Central Bank Tightening Should Be Less of an Issue in 2024
Consensus: % of Central Banks Hiking / Cutting Rates
Where do we go from here? Our punch line is that, despite all the crosscurrents swirling around us, we are still taking a ‘glass half full’ approach to our risk tolerance as we think about global macro and asset allocation preferences for 2024. So, although a lot of optimism is now in the price, we remain focused on the following tailwinds:
1. We still think that the bear market in Equities actually ended in October 2022, and while there are plenty of considerations, returns tend to be above average after a 25% decline in the S&P 500. One can see this in Exhibit 13. It is more than history being on our side. What continues to be different is that central bank balance sheets are still near record levels, which allows them to act as important shock absorbers during periods of stress. As a result, there is still a lot of money in the system, despite money supply growth being negative in many parts of the world. We think this bullish reality is still largely underappreciated by market participants and helping to support asset prices. One can see this in Exhibit 6, which shows that there is still a much bigger cushion relative to prior cycles.
2. As we detail below, we think earnings for the cycle already bottomed in 2Q23, despite our forecast for significantly slower nominal GDP in 2024. See our questions section, but our work shows EPS can increase as nominal GDP cools. Consistent with this view, our KKR Cycle Indicator (Exhibit 30) suggests that we will next move from contraction to early cycle recovery (albeit with some bumps along the way), which we view positively.
3. Outside of government bonds, new issuance supply remains near record lows. As a result, the technical bid for parts of Credit and Equities remains compelling. To be sure, we worry about certain refinancings, but consumers have termed out their debt (especially prime consumers with mortgages) while Private Credit has become a more viable solution for many corporate borrowers. Perhaps most importantly, the lion’s share of the maturity wall for corporate debt has now been pushed out towards 2025-2026 and the bulk of debt maturing in the near-term tends to be higher grade (e.g., the market with the greatest near-term maturity need outside of IG is European HY, which is dominated by senior BB).
4. We also think central banks are closer to the end of the tightening campaign. Consistent with this view, we think that bond prices have troughed for the near-term. The disinflationary impulse of 2024 will only help our thesis short term, although we do not think bonds will rally as much as they have in past cycles.
5. Finally, our ‘glass half full’ approach to investing this cycle also applies to our thematic tilts (and importantly, we think these themes win in a disinflationary or a reflationary environment). Despite a lot of consternation and handwringing amongst investors, rising geopolitical and macroeconomic headwinds are actually creating significant opportunities for allocators willing to invest behind the solutions to the challenges that are plaguing the global economy. Though not exhaustive, Exhibit 1 identifies some of the areas where we are finding significant and compelling opportunities that require billions of dollars of capital investment to overcome new macroeconomic and geopolitical headwinds that were not persistent during the prior decade.
David McNellis, Frances Lim, Aidan Corcoran, Paula Campbell Roberts, Racim Allouani, Changchun Hua, Kristopher Novell, Brian Leung, Deepali Bhargava, Rebecca Ramsey, Bola Okunade, Patrycja Koszykowska, Thibaud Monmirel, Asim Ali, Ezra Max, Miguel Montoya, Patrick Holt, Allen Liu