By HENRY H. MCVEY, RACIM ALLOUANI May 19, 2022
In a world faced with tremendous macro and geopolitical uncertainty amidst rapidly changing financial conditions, the temptation is to fall back on what has worked in the past. Yet, as we discussed in some detail in our 2022 Outlook, we believe that we are entering a new environment for investing, an environment where structural forces – in particular the changing structural relationship between stocks and bonds – demand a new approach to portfolio construction. Key to our thinking is not only are forward returns likely to be lower for risk assets such as Public Equities, but also traditional Fixed Income may no longer serve as a shock absorber, or diversifier, when paired with other asset classes in a diversified portfolio. Against this more challenging backdrop, however, we still believe that there are compelling opportunities to build upon a traditional ‘60/40’ portfolio to deliver attractive risk-adjusted-returns in the environment we envision. Specifically, we think that adding asset classes such as Private Real Estate and Private Infrastructure can enhance the Equity part of the ‘60’ portfolio, while Private Credit can bolster the ‘40’ segment of the Fixed Income portfolio. At the same time, we also think that the increasing democratization of alternative asset classes is creating a compelling opportunity for all investors to harness the illiquidity premium in a potentially more thoughtful way.
The present is the ever moving shadow that divides yesterday from tomorrow. In that lies hope.
—Frank Lloyd Wright, American architect, designer, writer, and educator
In today’s world of heightened uncertainty in the global capital markets, the natural inclination for an asset allocator might be to go back to what has worked or seemed ‘safe’ in the past. To many investors, the ‘safe’ impulse would definitely be to migrate existing portfolios to the traditional ‘60/40’ mix of assets, which comprises 60% Equities and 40% Bonds. As Exhibit 1 shows, the ‘60/40’ has delivered not only solid absolute performance in the past, but has also done so with a much better return/risk ratio than either asset class in isolation. All told, through December 31, 2021, the 3- and 10-year annualized returns of the ‘60/40’ portfolio have been 17.5%, and 11.1%, respectively. The risk-adjusted returns (or Sharpe ratios) of this simple allocation have reached impressive levels of 1.67x over the last three years and 1.41x over the last 10 years. This risk-adjusted performance has been materially ahead of the individual asset classes that compose the benchmark. It has also bested the performance of many CIOs who have tried to diversify away from the benchmark by seeking sources of alpha.
Is the Golden Age of the ‘60/40’ Portfolio Over?
Why has this outperformance happened? In theory, the equities component of the benchmark aims at delivering capital appreciation in line with the growth of the overall economy, while the purpose of the bond component is to provide income and act as a stabilizer, or shock absorber, in times of market or economic stress. Also, it has performed better in recent years than other more diversified portfolios that both institutional and individual investors have embraced because stocks and bonds have been negatively correlated.
Whether or not one subscribes to the ‘60/40’ portfolio theory, this benchmark has become a de facto measurement tool for most CIOs. Indeed, most of the CIOs with whom we speak across major pools of liquidity, including pensions, endowments, insurance companies, and increasingly individual investors, use the ‘60/40’ (or a ‘70/30’) as a form of benchmark to measure whether their asset allocation, manager selection, and/or security selection preferences are adding value to the overall process. Not surprisingly, this form of ‘score keeping’ has become an important part of how CIOs and their investment teams are compensated over time.
A Regime Change Is Occurring
Importantly, however, as we look ahead, all our macro and portfolio construction work at KKR suggests that we are entering a new environment for investing. Specifically, we are now seeing rising interest rates, higher levels of inflation, and heightened geopolitical risks against a backdrop of slower real economic growth. As such, we have spent time analyzing whether past performance is a prologue for future performance. Our bottom line, similar to what we laid out in our 2022 Outlook (see A Different Kind of Recovery), is that this time is different. As such, we firmly believe that we have entered a regime change, where structural forces now warrant a different approach to portfolio construction, including a re-examination of the merits of the ‘60/40’ allocation. Key to our thinking, as we discuss below in more detail, is that the structural relationship between stocks and bonds, particularly during volatile markets, is changing. In particular, we believe that not only are forward returns likely to be lower but also that Bonds can no longer serve as shock absorbers or diversifiers when paired with Equities (Exhibit 3).
Given this view, we think that investors may need to add different types of investments to their ‘60/40’ mix to protect their purchasing power in this new environment we envision. At KKR, we traffic mainly in private investments. As such, we have created some alternative asset allocation strategies, described below in greater detail, that we believe can be value-added to ‘60/40’ portfolios, especially if we are right about the correlation between stocks and bonds breaking down. If there is good news, our research shows that there are opportunities to add value on both the Equity and Bond sides of the ‘60/40’mix. Our bottom line: It is not business as usual in the investment management business and now is the time for all investors to revisit their asset allocation game plan on a prospective basis.
The Relationship Between Stocks and Bonds Is Changing in This Inflationary Environment
Portfolio Construction Shifts for the New Investing Regime
So, as we described above, without question, the 2010s were a golden decade for the ‘60/40’ investor. In particular, the stars were perfectly aligned for the ‘60/40’ allocation to perform strongly after the Great Financial Crisis of 2008. Stocks rose and rates fell; thus bond prices rose and the stock-bond correlation was muted.
However, we believe each of these premises will be at risk in the next decade and are now beginning to turn. Let’s start with stocks.
1. Enhancing the ‘60%‘ Capital Appreciation Component
Stocks have had a good run to say the least. Just consider that the S&P 500 compounded at 26% over the 3-years ending 2021, was up 16.6% for the 10 years ending in 2021, and delivered positive returns in 17 of the last 19 years (including nine times in the last decade). Not surprisingly, public valuations now screen high compared to history. Importantly, however, as we look ahead, the macro environment could be less favorable. In particular, the performance of stocks in inflationary environments deserves careful attention. In the most salient historical precedent that we could find, the 1970s decade, stocks returned just 0.4% in real terms if one subtracts the average inflation rate (7.5%) from actual nominal returns (7.9%). Back then, value stocks provided most of the index uplift, but overall returns were barely positive.
After Decades On a Declining Trend, Rates Are Starting to Rise
Stocks Seeing Signs of Turbulence After a Decade-Long Bull Market
The 2010s, the Golden Decade of the ‘60/40’
Public Equities Yielded Negative Real Returns in Inflationary Environments, While Private Real Assets Have Shown Higher Resiliency (Albeit On a Shorter Timeframe)
Looking at the bigger picture, we note that across all inflationary periods since 1928 (defined as years where inflation was above the median level of 2.7% and increased over the year by more than one percent), US Equities, as measured by the S&P 500, returned on average 4.2% in nominal terms (-1.7% in real terms), compared to 13.9% in nominal terms (11.5% in real terms) in non-inflationary periods.
In addition to today’s tilt of the overall index towards growth stocks, we think that index-level forward returns could also be challenged by the high level of concentration in just a few names. All told, the top five names of the S&P 500 now account for 20.2% of the index. The closest comparison was in March 2000, when five of the names in the index accounted for 18.4% of the total. History shows that in such instances regulatory scrutiny, the law of large numbers, and other forces at work, usually lead to weaker performance by these large companies – and hence, of the overall index.
Looking ahead, we believe that thoughtful portfolio construction will now involve enhancing the equity component with asset classes that are more likely to appreciate in an inflationary environment. So, our suggestion is to improve the 60% tranche of the typical ‘60/40’ portfolio with more yield and inflation protection through the use of alternative investments. Asset classes that we at KKR believe are the best portfolio enhancers are Real Estate and Infrastructure. Specifically, we believe reducing the allocation to public stocks to 40% while adding 10% to Private Infrastructure and 10% to Private Real Estate will provide benefits to all allocators of capital trying to navigate the new investing regime we are forecasting.
Real Estate performance is comprised of two main components: property value appreciation and recurring cash flows. All else being equal, property values should appreciate with inflation. When inflation accelerates, construction costs should also rise and the development of new properties therefore becomes more uncertain. This limits new supply and puts upward pressure on property prices. On the recurring cash flow side, income should also appreciate, especially for properties with leases that reset frequently (e.g., multi-family residential favored over long lease offices). Finally, the debt structure of properties matters and those with fixed rate, long maturity debt would fare better. For these reasons, exposure to sectors with supply demand equilibrium and long term thematic demand drivers historically have appreciated in value even in rising rate environments. While each property type, location, and property is unique and resists broad generalization, those aspects of the asset class coupled with careful investment selection by a dedicated manager give us more comfort than broad equities.
Infrastructure is akin to Real Estate in that the return on investment derives from asset value appreciation and its recurring cash flow components. While the type of infrastructure asset, location, and regulatory regime will be unique and dictate the sensitivity to inflation, there are common traits. Most infrastructure assets (values and cash flows) have an explicit link to inflation through regulation and concession agreements or contracts (e.g., regulated utilities and toll roads). Other types of assets are often in a position to pass through the impact of inflation to customers.
The benefits, in our opinion, of what we are suggesting to investors could be quite significant over time. Both infrastructure and real estate assets often have inflation indexation increases embedded in their cash flows; the replacement value of their assets increases in a rising nominal GDP environment; and they often have the ability to pass through costs more easily than many parts of the broader equity markets. For those who have longer-term capital to deploy, the value of the illiquidity also becomes significant in a world where aggregate returns are falling. In our view, these attributes could materially boost the performance of one’s equity portfolio over time, particularly if traditional public equity performance mean reverts.
To be sure, both Private Real Estate and Private Infrastructure have admittedly been less battle-tested through inflationary times. Nonetheless, going as far back as reliable data allows — 2004 for Infrastructure and 1978 for Real Estate — we find that, on average, those asset classes were more resilient to an inflationary backdrop than public stocks (albeit in milder inflation regimes). Exhibit 7 shows Infrastructure and Real Estate returning similar nominal returns in both high inflation and low inflation environments, and real returns that are only one to two percent lower in high inflation than in low inflation periods. Beyond the lack of historic data going back to hyperinflationary periods, their structural and pricing mechanisms make us optimistic for the future resiliency of these asset classes to rising inflation.
U.S. Bonds Yielded Negative Real Returns in Inflationary Environments, While Private Credit Has Shown Higher Resiliency (On a Shorter Time Frame)
2. Enhancing the ‘40%’ Income and Hedge Component
The highest risk to the bond bucket is a rising rate environment coupled with a response to higher inflation that affects bond values, particularly those with longer duration. Looking at highly inflationary periods from 1928 for US Bonds, Exhibit 8 shows us that US Bonds suffered drastically — returning 2.5% in nominal terms (-3.5% real) compared to 7.3% in nominal terms (+5.2% real) in non-inflationary times.
In order to preserve the income-generating nature of the 40% component while shortening the overall duration, we believe that shifting some of the fixed income allocation to floating rate assets such as loans would be appropriate. The floating rate nature of loans would link the income component to rates (and indirectly to inflation via central banks’ monetary policy).
While leveraged loans embed more credit risk than treasuries or mortgages, we believe that – in the face of the current interest rates outlook — tilting the balance between rates risk and credit risk offers a safer posture. Here again, going the private route via Private Direct Lending would allow investors to lock in an illiquidity premium (two to three percent) that could absorb the eventuality of lower growth driven credit losses.
Similar to other private alternatives, Private Credit relies on a shorter history (starting in 1987) than public stocks and bonds. That said, private credit assets are floating rate and the income to the investor will mechanically increase with rising short-term rates in response to rising inflation. Our view is that underlying borrowers will need to be in a position to make interest payments, whether fixed or floating. Ensuring that borrowers have pricing power to pass through potentially rising input costs will be critical. Carefully monitoring profit and EBITDA margins in these early stages of potentially longer lasting inflation is paramount in order to identify companies and subsectors able to preserve margins should inflation reset at a higher level.
The portfolio enhancing benefits of adjusting the 40% bond component of the traditional ‘60/40’ portfolio warrant investor attention in our view. We believe that reducing the traditional fixed income component to 30% while adding a 10% allocation to Private Credit will provide important flexibility and yield enhancing characteristics.
As Inflation Rises, the Stock-Bond Correlation Is Turning Positive, Weakening the Hedging Properties of Bonds Vs. Stocks
3. Beyond the Stock-Bond Correlation
As noted earlier, one objective of the traditional ‘60/40’ portfolio has been for the bond component to act as a stabilizer to the growth component. This implies that the stock bond correlation should be negative when one needs it (if stocks fall, the bond component partially shores up portfolio value). The reality is that the stock-bond correlation has been highly unstable over time and very regime-dependent. While it has been slightly negative (-0.10) since the 2000s, it was significantly positive (+0.40) from 1980 to 2000, whereby the hedging properties of bonds evaporated. The stock-bond correlation is also higher when inflation rises, as we have witnessed in recent months (Exhibit 9).
Our bottom line: We think that increasing diversification to enhance portfolios so there are ‘more ways to win’ is important in the environment that we believe we are entering. In a stagflation scenario where inflation rises and growth falters, bond prices would mechanically fall and equities would follow suit. In such instances, asset classes like Private Real Estate and Private Infrastructure with lower dependence on growth and superior inflation properties could act as ‘risk-off’ beneficiaries. Exhibit 10 shows that over the past four decades, Real Estate and Infrastructure correlations to Equities has been moderate (0.15-0.50).
Traditional and Private Assets Classes Correlations
4. Conclusions and Suggestions
As we noted at the outset, we believe that the macroeconomic environment has shifted meaningfully. In fact, we are calling it a regime change, a conjecture that we do not make lightly. As part of this transition, we have a growing conviction that overall forward returns will likely come under pressure for traditional asset classes like Public Equities and Bonds. Hence, our strong belief is that now is the time for all investors to revisit their asset allocation, including portfolio construction.
Overall, our work shows that there is a significant opportunity to not only protect but also potentially enhance the equity sleeve of portfolio returns by adding Real Assets, including Private Real Estate and Private Infrastructure. Meanwhile, we believe that adding Private Credit can also help enhance returns on the fixed income side of the ledger.
Importantly, we think that the merits of a ‘40/30/30’ portfolio relative to the traditional ‘60/40’ are valid in most environments, though they shine in a higher inflationary environment. Given this view, we think that this piece should serve as a call to arms for portfolio managers and CIOs to revisit their current asset allocations.
Why do we think this? To illustrate (Exhibit 11), we ran a traditional ‘60/40’ portfolio against our suggested ‘40/30/30’ portfolio in three differing scenarios: low inflation, high inflation, and all periods (regardless of inflation). We substituted 20% of the Public Equities sleeve with a combination of 10% Private Real Estate and 10% Private Infrastructure, and replaced 10% of the traditional Bond allocation with 10% of Private Credit. Noting again that the observation period for private asset classes is shorter than for public stocks and bonds, the private alternatives enhanced ‘40/30/30’ portfolio significantly reduced portfolio volatility while maintaining or improving returns in all environments. In low inflation environments, volatility is reduced by 2.5% and returns reduced by a mere 50 basis points, significantly increasing the expected Sharpe ratio. More importantly, in high inflation environments, volatility in the ‘40/30/30’ portfolio was reduced by 3.7% while returns were enhanced by 2.8%, improving the Sharpe ratio by almost 0.4x.
The ‘60/40’ With Private Markets Outperforms the Traditional ‘60/40’ On a Risk-Adjusted Nominal Return Basis in All Environments
How We Suggest Enhancing the Traditional ‘60/40’ Portfolio
So, in today’s world of heightened macro and geopolitical uncertainty, we suggest that allocators of capital revisit whether the underlying characteristics of their existing portfolios may be changing. From our perch at KKR, we firmly believe that what has worked in the past, particularly in the last decade of returns being enhanced by the negative correlation of stocks and bonds, will not be as effective in the new macroeconomic environment we envision. As such, there is the potential to enhance the traditional ‘60/40’ mix of assets by using Real Assets and Private Credit to bolster both the performance and the durability of one’s overall portfolio, including maximizing the potential for an increase in its reward per unit of risk. Moreover, given the increasing democratization of alternative asset classes, we see an increasing opportunity for all investors to capture the value of the illiquidity premium in a potentially more thoughtful way than in the past.
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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