KKR’s McVey on the Changing Macro Playbook

Privcap: Your allocation targets are based on an environment in which interest rates have already bottomed? Why?

Henry McVey, KKR: The title the of the report is “A Changing Playbook,” and if you think about bonds -I think we’ve been in a secular bull market since 1982 in bonds, which is a bold statement, but I think it’s right. And today when I look at real yields, real yields are actually negative on 10-Year Treasuries to the tune of about 90 basis points. So, if you buy a 10-Year Treasury today you’re getting 1.8, 1.9 percent yield. Real yields within that are negative, and their inflation expectation is around 2, 2.5 percent. That to me to does not seem to represent great value, and I also think it represents the end of the secular bull market. So, we’ve been in a period in the 80s and then the 90s and probably too much in the 2000s when people were over-allocated to equities. There’s been a huge snap-back where they went into fixed income. More recently you’ve been able to own fixed income, particularly credit, where you’ve gotten an equity-like return but with the volatility of fixed income. Our base view going forward is that the least attractive part of the fixed income market is the government bond market. Think about a government as a company: it has no cash flow from operations right now and a lot of cash financing needs where it’s having to go out to the market to pay for its leverage. If it was a corporate credit, you would say that’s not that attractive. At the same time, when you look at most corporations around the world, they actually have very low leverage, and strong cash flow from operations. So to me, that’s an arbitrage for investors, and if you’re willing to actually go a little bit further and take some illiquidity risk, you can pick up 300 to 400 basis points of yield. So, think about the food chain: government bonds at 2 percent, high yield around 6 percent, and then there’re things in the private credit market at 9 to 11 percent. That’s a huge arbitrage, and I guess we’re confident enough at KKR in the economy that we don’t think the economy’s going to unravel, where taking some of that corporate risk seems to make a lot more sense to us than taking small government yields with high government leverage.

Privcap: What have been the biggest changes to your target allocations from a year ago?

McVey: We have for the past bit of time been saying that corporate credit, and more importantly some of the private credit, would do better than government bonds. I think what’s changed in my thinking is that the Fed is signaling to the market that it no longer wants you to hold cash or deflation assets, and that’s really what I think its most recent statements about quantitative easing and tying the Fed target to the unemployment rate are about. I mean, these are extreme measures, and I think what they’re trying to say to the market is, we’re going to try to do reflation, and we don’t want you to own assets that do well when you have deflation, because that’s really been the Fed’s problem. It wants investors to put money into assets that will help to generate economic growth, and I think the Fed is now at a point where they’re willing to do anything to generate economic growth, sustainable economic growth. So when you think about KKR’s target asset allocation, yes, we’ve always had a notable underweight to government bonds. What we’re starting to do is a slow process of changing our allocations, so we’re adding a little more of bank debt, which has a floating rate component to it, so if rates do go up, they should hold in there better than some traditional high grade bonds, and if you look at bank loans relative to high grade, it seems to me that relative to history, it’s a pretty good time to do that. We’ve also started to add a little more into equities, which do better if you have a stronger economy, some inflation hedging capability, and then we’ve retained two big themes. One is the move towards private credit, where we think the illiquidity premium is attractive. Two is towards things in the private energy sector and the private real estate market where we feel like we can buy very attractive assets, create income, create inflation hedging, and create growth. I think if an institution or an individual thinks about an overall asset allocation, that to us seems like a very attractive mix in the current environment.

Privcap: Is corporate lending an activity that institutional investors participate in as an asset class?

McVey: Well you’re right, it is complicated, and I think that’s why the asset class probably is not as big today as it should be. But our base view is, there’s been a structural shift. Wall Street balance sheets have gone from $300 billion down to about $50 billion. That’s a massive decline in terms of the inventories that they held for their customers, so as they’ve had to deleverage, small- and medium-sized businesses that want to grow or restructure or do acquisitions need financing sources, and that has created a significant opportunity for pensions and endowments and other types of investors to come in and provide that capital. In a market where you can get 9 percent to 10 percent unleveraged yields as payment for that risk that you’re taking, that seems incredible attractive to us. So we see a significant opportunity to go in, work with our clients, and create a lending product that allows these small- and medium-seized businesses to grow. If you think about the U.S. today, new business formation is running 35 percent below historical average -it’s a shocking statistic. And if you think about job growth, 70 percent of job growth comes from small- to medium-sized businesses. So if we want to fix the problems in the U.S., part of that is allowing the lifeblood in the small- and medium-sized businesses to grow, and they need access to capital, and so I think there’s an unmet demand and there’s a lack of supply right now.

Privcap: Why do you believe that emerging market growth is best captured by niche stocks and private equity?

McVey: As part of my job, I spend a lot of time on the road. I go to Brazil and China and India, and all these emerging markets. As the world has gotten more dysfunctional, you’ve seen a lot of central banks or governments really lean on their big state champions, their national champions in the public markets, who either create jobs or keep prices at attractive levels for their citizens. That’s sometimes coming at the expense of shareholders. And so if you take the Chinese market, 71 percent of the Chinese market is state-run companies. Well most people who invest in China want to invest in China because they want exposure to consumption. Consumption is 3 percent of the market in China. So as an investor, you have to say, “Yes, I have the right idea, but then there’s the execution of the right idea.” And I guess what we’re proposing at KKR is to think outside the box in terms of what is the right idea for accessing that vehicle. I think we all agree on the theme, and so from my vantage point, I think about concentrated public equities with a focus on consumption. I think that emerging market debt is interesting. I think there are things that in a semi-private market, and even the private market, and so as a firm, we’ve tried to look for different facets and different avenues to really take this investment theme and make it work on behalf of our clients in ways that are maybe non-traditional. But I would argue that a lot of the move into passive ETFs in the emerging markets, you saw this with the performance of the Chinese market last year or the Brazilian market last year. Investors have been disappointed. They’re not disappointed in their overall growth, but they’ve been disappointed in the performance of public equities.

Privcap: What have been the hardest macro trends to read?

McVey: There are a couple. I would say one is watching inflation, because on the one hand, you have a massive amount of government stimulus. If you take the U.S., we put in monetary and fiscal stimulus five times what we did during the Great Depression, yet there’s no inflation. So the other side of that trade, is that as there’s deleveraging. That creates disinflation, and so there’s this tension point. Right now, our basic view is inflation will stay low, but we think over time that could increase. So that’s one trend we’re very focused on, and the numbers of lots of stimulus leading to no inflation is not intuitive, but that’s, that’s our base view. The second is this interrelationship between Europe and Asia. When you do austerity in Europe, that creates slower growth in the form of consumption going down as people have to tighter their, their belts on spending. I think that is conventional wisdom. The offset of that is that ripple effect from Europe not buying has been flowing through the global economy. Our job at KKR has been to try to identify where that is going to affect demand, and one of the clear areas you’ve seen has been in the China export economy. Almost 20 percent of China’s exports go to continental Europe, so that’s a big deal. So, one of the things that I’ve done by just moving around and travelling so much and interviewing companies and politicians and central banks is really trying to understand these relationships. I think the message that we’re trying to relay, at least from our perch as a global firm, is that you have to understand the entire macro picture to make an investment, whether you’re thinking about Europe, Latin America, Asia or the U.S. The days of kind of an isolated economy with a great investment story – there are a couple of those. But I think understanding the macro backdrop, even to make the micro investment, we think is of paramount importance.