Change is in the air. And according to KKR’s latest economic outlook, private equity investors need to change the way they are operating, shifting their focus away from long-duration investments like high-yield bonds and venture capital toward hard assets such as energy, infrastructure and real estate. In their mind, a new investment playbook is needed as the old strategies that have worked so well in this cycle are unlikely to keep working.
Why?
Because the expansion is getting long in the tooth, an epic bout of monetary policy stimulus is fading, and fiscal stimulus in the guise of tax cuts and spending hikes is hitting the economy at a time when it’s running beyond its natural speed limit. And thus, KKR analysts worry that investors are not only ill-prepared to deploy capital into an environment of structurally rising interest rates, but also that the risk of a faster-than-expected rise in interest rates isn’t fully appreciated.
While US stock indices are ebullient, GDP growth hot and the job market strong, various economic measures are flashing amber: Inflation is picking up, the yield curve is compressing (a strong signal the bond market is worried), and trade tensions are continuing to rise amid the broadest embrace of political nationalism since the 1930s.
The last time I covered KKR’s outlook, they warned that a new recession was around the corner. This time, they outline ways to brace for the trouble that is coming.
According to Henry McVey, KKR’s Head of Global Macro & Asset Allocation, this includes favoring “more upfront yield in the portfolio.” Which is akin to choking up on the bat but still swinging away.
He has cut the firm’s allocation to long-duration government bonds—widely viewed as the safe-haven offset to riskier investments—to zero versus the 20% allocation in the strategy benchmark, on the belief that these bonds can no longer “satisfy their traditional roles in an asset allocation framework as either a ‘shock absorber’ and/or relevant income stream,” given current yields and pricing.
Things are different this time. Bonds may not rally when stocks decline in the next economic downturn. Thus, in order to secure portfolio diversification and cut risk, alternatives are needed.
McVey thinks markets are set to reward complexity over simplicity. Thus, increased allocations to categories like traditional PE, Actively Managed Opportunistic Credit, asset-based finance, and distressed/special situation investments.
They also believe that energy and infrastructure present great opportunities, especially in the mid-stream US energy segment. A need for pipeline and other pump-to-market infrastructure is becoming clear, a topic I recently covered in depth as crude oil continues to flirt with the $70-a-barrel level.
Venture capital was singled out for derision as its allocation was cut to zero. McVey and team note the area has been “awarded too much money to deploy at a time when valuations appear full,” with observations in Asia drawing parallels to the late 1990s mania in the United States. Will Didi Chuxing be the new Pets.com?
Other notable points of concern include:
*Credit conditions, and thus bond yields and spreads, could deteriorate faster than anticipated with KKR’s forecasts showing revenue and profitability pressure materializing over the next 12 months.
*There exists a deepening rift between the US and China as a “handful of unconventional politicians” deploy “less traditional diplomatic strategies.”
*Technology stocks could come under pressure, resulting in a cascade of negative impacts on everything from public equity indices (which are growing more and more sensitive to the vagaries of a handful of mega-cap stocks like Apple and Amazon) to M&A and VC activity.
Overall, KKR via McVey is sounding a defensive tone, warning that growing headwinds are “likely to unsettle the global capital markets for some time” ending a long period of calm as earnings growth slows due to the higher cost of capital, tightening financial conditions, and late-cycle pressures on margins from higher input costs and wages.
The temptation is to dismiss these warnings as emanations from Cassandras in suits.
But history was bound to catch up: The current economic expansion has lasted 108 months, second only to the 120-month run between 1991 and 2001. Since 1900, the median expansion has lasted only 37 months. Asset valuations are at or near historic highs, as shown in the chart from Goldman Sachs above. And we are at the tail end of the Great Moderation, where a combination of globalization, low interest rates and disinflation has bolstered profits, lifted asset prices and kept volatility low.
That isn’t to say the good times can’t continue—just that the path forward is getting narrower. McVey and his cohorts are hoping that with US growth trends enjoying a lift from President Donald Trump’s tax cuts, productivity will get a lift from increased fixed investment spending. Creating a scenario where both wages and profits could rise.
If that doesn’t pan out, McVey admits they are still carrying too much portfolio risk.
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