Financial Recovery

Testing The Limits Of Reflation

And measuring the new ‘tilt’ toward portfolio construction

A new insight piece by global investment firm KKR measures what it sees as a ’strong global recovery unfolding.’ Read the full report here.

May 05, 2021 — NEW YORK–(BUSINESS WIRE)–Global investment firm KKR today announced the release of Testing the Limits of Reflation by Henry McVey, Head of Global Macro and Asset Allocation (GMAA). In the new Insights piece, McVey and his team delve into several key macro areas that they believe warrant particular attention from investors in a period of pronounced reflation.

“A strong global recovery is unfolding, and while the current macroeconomic environment is complex, the combination of looser monetary and fiscal policy, faster nominal GDP growth, and accommodative financial conditions gives us even more confidence in our ‘Another Voice’ investment thesis for 2021. Against this backdrop, our bottom line remains: investors must now look to create portfolios that can not only endure but also thrive as the global economy tests the limits of reflation,” said Henry McVey.

In the report, McVey updates his team’s macro and asset allocation framework to include the following:

  • An upgrade to both the GMAA team’s earnings forecast and year-end target for the S&P 500, reflecting stronger growth in nominal GDP.
  • A more conservative approach to interest rate assumptions as a result of faster growth and more government spending, as well as complications linked to supply chain disruptions, though the team does not see rates getting unglued at the long-end of the curve.
  • A view that while nominal rates are increasing, real rates – which the team believes are key to financial conditions – will remain at attractive levels through 2022, despite growing caution that a near-term pullback is likely.
  • A refreshed expected return forecast for the next five-year period, which suggests a lower return forecast must be offset by more creative macro and asset allocation strategies.

Excerpts from Testing the Limits of Reflation

If ever there were a time to champion the mantras of our founders George R. Roberts and Henry R. Kravis to build like and trust, act with integrity, and lead by example, we believe that now is that time. The re-opening we are envisioning will not be a straight line, and the pandemic has laid bare multiple inefficiencies – and more importantly, inequalities – that need immediate fixing, particularly in developing countries.

However, there are also reasons to be optimistic. Vaccine roll-outs are accelerating, and economic growth is poised to surge, which should boost both employment trends and income levels. Consistent with this view, we are upgrading our earnings forecast and year-end target for the S&P 500 and boosting our 10-year interest rate forecast for the next few years to reflect stronger growth in nominal GDP.

At the same time, we also have completed a refresh of our long-term expected returns, an important exercise that leads us to believe we have entered a new, more complicated era for global asset allocation. Against this backdrop, we continue to rely heavily on our Another Voice framework, which continues to suggest sizeable positions in Public Equities, Collateral-Based Cash Flows, and Private Investments.

Against this backdrop, our bottom line remains: investors must now look to create portfolios that can not only endure but also thrive as the global economy tests the limits of reflation...

One belongs to New York instantly, one belongs to it as much in five minutes as in five years – Tom Wolfe American author and journalist.

While author Tom Wolfe’s famous quote about how easily New York City can cast its spell on those who visit might seem somewhat outdated amidst the COVID-19 pandemic, we are increasingly confident that ‘Gotham’ – and many other global urban centers across Asia, Europe, and Latin America – are poised to begin to once again assert themselves as important hubs of interconnectivity and economic output. Modernization, industrialization, collaboration, and the arts and culture are still valid concepts of human society that – even in a post pandemic world – will again lure individuals back to large cities, we believe.

However, the re-opening we are envisioning will not be a straight line, and the pandemic has laid bare multiple inefficiencies – and, more importantly, inequalities – that need immediate fixing. Just consider that today nearly 44% of those unemployed in the United States have been so for 27 or more weeks. Statistically speaking, this sub-segment of the U.S. population typically has only a one in five chance of successfully securing a permanent position. Unfortunately, such socioeconomic inequalities are not restricted to just the United States. In Europe, for example, my colleague Aidan Corcoran’s estimates suggest that the COVID shock may have undone fully five years of progress on income inequality. Outside the developed economies, our concerns about human safety and well-being in several countries like India, Brazil, and Turkey are now even more pronounced.

Fiscal & Monetary Policies Test The Limits of Reflation

In terms of what is new in this latest piece, we drill down on four key areas of macro focus that we think warrant investor attention, as fiscal and monetary policies test the limits of reflation. They are as follows:

  • We are upgrading both our earnings forecast and our year-end target for the S&P 500. Specifically, we are lifting our 2021 fair value forecast to 4,320 from 4,050, based on S&P 500 earnings per share of $185, compared to $174 previously and a current consensus of $181. We also introduce a 2022 forecast of 4,620, along with $207 in earnings next year versus a consensus forecast of $205. Our new price target assumes a forward P/E of 20.9x (approximately 1.8x below current level). As we detail below, the composition of earnings is shifting heavily towards more cyclical parts of the economy, we believe. Importantly, though, while we are boosting our target for 2021 and 2022, we would not be surprised to see some consolidation after such a strong first four months of the year.
  • We are also increasing our U.S. 10-year interest rate forecast for 2021 to 1.75% from 1.50%. Our 2022 forecast goes to 2.25% from 2.00%. We model rates, GDP, and inflation out to 2025 to better understand the path of interest rates. We still do not see rates getting unglued at the long-end of the curve, but we do expect that faster growth, more government spending, and complications linked to supply chain disruptions (think the Suez Canal) all combine to make us want to take a slightly more conservative approach to rates. That said, we are not changing our long-held framework that predicts some ongoing consistency in the relationship between nominal GDP and nominal interest rates. Also, there are some important technical offsets we have found that may limit the upward pressure we are forecasting for rates. Details below.
  • While nominal rates are increasing, real rates – which we believe are key to financial conditions – will remain at attractive levels for the foreseeable future. As part of our deep dive on real rates, we compare to past periods to see what it means for asset class returns. See below for details, but our punch line is that we are still in an extremely accommodative backdrop for financial assets, Equities, Real Estate, and Infrastructure in particular. To be sure, our sentiment indicators are signaling an increased risk of a near-term correction after such a strong start to the year, but our work gives us additional confidence that now is the time in the cycle to maintain overweight positions in collateral-based cash flows (e.g., Infrastructure and Real Estate) and Equities.
  • Given the changes we have made to our equity and interest rate forecasts, we have refreshed our expected return forecast for the next five year period; not surprisingly, sporty margins, high multiples, and low interest rates still all suggest lower returns ahead. That said, we still see opportunity in many portions of the market. In particular, as part of our shift towards including more Real Assets in portfolios via our focus on collateral-based cash flows, we think that the case for Infrastructure and Real Estate have strengthened materially. We also see significant differentiation in the Public Equity markets, as we expect Small Cap and Emerging Markets to finally best the S&P 500. See below for details.

Access the full report here.

 

 

 

About Henry McVey
Henry H. McVey joined KKR in 2011 and is Head of the Global Macro and Asset Allocation team. Mr. McVey also serves as Chief Investment Officer for the Firm’s Balance Sheet and oversees Firmwide Market Risk at KKR. As part of these roles, he sits on the Firm’s Investment Management & Distribution Committee and the Risk & Operations Committee. Prior to joining KKR, Mr. McVey was a managing director, lead portfolio manager and head of global macro and asset allocation at Morgan Stanley Investment Management (MSIM). Learn more about Mr. McVey here.
About KKR
KKR is a leading global investment firm that offers alternative asset management and capital markets and insurance solutions. KKR aims to generate attractive investment returns by following a patient and disciplined investment approach, employing world-class people, and supporting growth in its portfolio companies and communities. KKR sponsors investment funds that invest in private equity, credit and real assets and has strategic partners that manage hedge funds. KKR’s insurance subsidiaries offer retirement, life and reinsurance products under the management of The Global Atlantic Financial Group. References to KKR’s investments may include the activities of its sponsored funds and insurance subsidiaries. For additional information about KKR & Co. Inc. (NYSE: KKR), please visit KKR’s website at www.kkr.com and on Twitter @KKR_Co.