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As we have highlighted for some time, our macro viewpoint remains that this cycle is different. Specifically, we see uneven supply constraints, higher levels of interest rates, and heightened geopolitical risks against a backdrop of slower real economic growth and sticky inflation. Overall, we believe that we have entered a regime change, where structural forces now warrant a different approach to portfolio construction. What is so challenging today for macro investors and allocators of capital alike is that the traditional relationship between stocks and bonds – where bond prices rise when stock prices fall – has broken down. Looking ahead, we are now firmly of the view that the macroeconomic narrative will soon shift from a singular focus on the impact of inflation on the global capital markets to one where investors are surprised by how unwelcome inflation adversely affects corporate profits. Importantly, we see inflation from food, oil, and services remaining robust, despite our forecast for deflation in the goods sector by 2023. Against this backdrop, our models suggest that Credit feels cheaper than Equities, and Public Equities appear more attractive than peer-to-peer Private Equity. Meanwhile, in Infrastructure and Real Estate, we do not expect prices to correct too much. Across all our portfolios, we think that a thematic bent continues to be required. Security, pricing power, de-carbonization, collateral-based cash flows, and innovation are all areas where we see significant opportunity to invest behind the ‘signal’ while many today are being swayed by the ‘noise’ of unsettled markets. Finally, from a deployment standpoint, we think that we remain in a walk, not run stance, until the Fed has inflation more under control and/or corporate profit estimates look more achievable.

A good half of the art of living is resilience.
Alain de Botton British Philosopher

Without question, current market conditions are about as choppy as I have seen during my career. The last time the Fed increased rates 75 basis points at one meeting was in 1994, when I was a young analyst covering financial stocks at Morgan Stanley. At that time, the Fed’s hand was forced to act decisively in order to try to regain credibility on its inflation fighting prowess as well as to blunt surging consumer demand. Today's backdrop, while similar, feels worse. Beyond rapidly tightening financial conditions, just consider that Target, one of America’s leading and best-run retailers, recently told us two months of `surprise’ freight in the first quarter led to an expense miss of fully one billion dollars, or that its inventories had ballooned 43% sequentially. However, as we show in Exhibit 1, Target is not alone, as Walmart, another leading retailer, is also suffering from inventory bloat. Not surprisingly, we are also seeing consumers aggressively increasing credit card balances to withstand the shock from rising inflationary pressures, including food, transportation, and energy costs (Exhibit 2). Unfortunately, as we detail below, we think the permanence of the war in Ukraine - and all its adverse consequences on humanity and the economy - is likely to be an enduring feature of the current recovery.

Consumers and corporations are not the only ones facing an uncertain and highly inflationary landscape where things are changing quite rapidly. Investors too are experiencing extreme upheaval. In particular, what makes today’s environment so tricky for macro investors and asset allocators is that the traditional relationship between stocks and bonds – where bond prices rise when stock prices fall – has broken down. One can see this in Exhibit 3. This development, which we think is more structural in nature, is a big deal, in our view. As a result, many investors will need to consider adding different types of investments to their traditional asset 60/40 allocation mix (see Section II; Question #6 for more details). Consistent with this view, we believe not only that forward returns are likely to be lower but that Bonds can no longer serve as shock absorbers or diversifiers when paired with Equities.


Leading Companies Have Too Much Inventory, Which Is Why We Forecast Goods Deflation in 2023

Bar Chart of Walmart and Target Inventory Levels
Data as at May 20, 2022. Source: WSJ.


Inflation Is Hitting Consumers Hard, Forcing Them to Tap Into Their Debt Capacity to Maintain Current Living Standards

Graph of Year over Year Change in Consumer Debt
Data as at March 31, 2022. Source: Federal Reserve, Evercore ISI.


The Relationship Between Stocks and Bonds Is Changing in Today’s Inflationary Environment

Graph of Rolling 24 Months Stock and Bond Correlation
Data as at March 31, 2022. Rolling 24 months correlations calculated using monthly total returns of the S&P500 Index and Barclays U.S. Aggregate Index.


In Normal Markets, Bonds Rally When Stocks Go Down. Today, That Is Not Happening

Bar Chart of Yearly Stock and Bond Performance Since 2002
Data as at May 26, 2022.Source: Bloomberg.

Overall, the current backdrop reinforces our larger narrative at KKR that we have entered A Different Kind of Recovery. Specifically, what this means is that we think we have entered a new investing regime – and we do not make this statement lightly.