KKR answers 7 of investing's toughest questions

If there is one thing that investors and journalists have in common, it's the art of asking tailored but impactful questions. And while the money management community may not have all the answers, they do have the tools and data at their fingertips to help get those crucial calls right. But too often, these research notes and media appearances are only relevant around big data points or consequential corporate releases. 

Then not too long ago, one of the Livewire team stumbled upon a UBS research note called "The Compendium". Written by UBS' team of global economists, it aims to answer – as succinctly as possible – the 10 most complex questions from clients. 

Sometimes, these answers are as short as a paragraph and at other times, they take a whole page plus charts. 

We loved the idea behind this document so much that we've pinched it and turned it into a wire of our own. I've collated the most relevant of these top 10 questions (and in some cases, made some extra tweaks) for Australian investors. Then, I asked Jeremiah Lane at KKR to tell us how his team would respond to each question. This wire is the summation of his answers. 

The Top 10 Questions: A Comparison

For full posterity, here are the 10 questions UBS answered in its most recent edition of The Compendium. Remember, these questions are fielded from internationally-based investors. The questions we have chosen to use are bolded and any tweaks after the dash. 

• Is a recession priced?
• How much will bank lending standards tighten and how much should that shift intended policy rate tightening?
• What are the implications of the falling US money supply?
• How sticky is global inflation?
• Was global growth accelerating/decelerating before the banking stress?
• Where could credit stress emerge next?
• Are labour markets finally cooling?
• How can earnings fall when nominal growth is still so strong? 
• Is CAPEX about to take off?
• How strongly will China's reopening spill over to the rest of the world?
• Will we see BoJ regime change? How to position? - amended to: Will we see greater regime change at central banks? How do you position ahead of any major changes?

Jeremiah's answers

Is a recession priced into markets?

On the other hand, we believe credit spreads look attractive relative to the past ten years, although they are historically tight to past recessions. But in terms of valuations from a price perspective, we see a high amount of upside in both high yield bonds and bank loans.

Will bank lending standards tighten and how much should that shift intended policy rate tightening?

On the other hand, it is a good time to be a lender. Capital is extremely scarce, and lenders can demand better terms: higher discounts, better pricing, call protection, and other protective covenants that help to manage.

How sticky is global inflation?

We believe that global inflation will remain elevated but will cool compared to the current levels. Additionally, not all elements of inflation will cool and normalise in a straight line fashion.

We believe that we will see a strong bifurcation between goods and services inflation. We also believe that services inflation will be stickier and elevated for longer, which is driven by a labour shortage and pressure on increased wages, while we expect to see a deflating goods trend, where we expect to see input costs and supply chain pressures ease against a backdropof slowing consumer demand.

Where could credit stress emerge next?

Such sectors include healthcare and retail which are feeling pressure from wages that are limited in how much they can extend to the end client. Instead, we are focusing on sectors that are best positioned to be price makers and pass along the impacts of inflation.

How can earnings fall when nominal growth is still so strong?

It is important to note, that we have observed some issuers be able to successfully pass along rising expenses to their customers - we define these as companies as price-makers and favor them in our portfolios.

How strongly will China's reopening spill over to the rest of the world?

Recent data leads us to see a stronger-than-expected recovery in China’s economy this year. Importantly, higher China GDP will also be an important cross‐current to the global economic cycle.

We now see a V‐shaped recovery in China in light of the positive momentum in consumer spending and mobility, as well as signs that the property sector is close to bottoming and have upgraded our outlook for 2023 GDP growth to +5.8%.

We think that the recovery will continue to gather speed in coming quarters, given that China households are still sitting on a large stock of excess savings, while monetary and fiscal policy has become significantly more simulative. 

As we think about extended impacts, China’s recovery (including outbound tourists) is good news for the global economy, especially when the advanced economies are facing mounting headwinds to growth. But all else equal, the combination of stronger GDP and higher commodity prices increases the potential for more restrictive monetary policy in developed markets.

Will we see regime change at central banks?

Following the U.S. regional and European banking stress, we saw the Fed progress with their tightening campaign, raising the Fed Funds rate by an additional 25bps to set the new rate to be 4.875%, in line with consensus. 

The new ‘dot plot’ pointed to just one more hike to 5.125%, followed but an extended pause through year-end ’23. This shift was much more dovish than consensus. But Powell was very open in his commentary about the uncertainties of the outlook. 

It was highlighted that the banking system stress has acted as at least the equivalent of a rate hike and probably more than that. Their new disposition is to be cautious on further hikes unless and until they see evidence that economic drags will be minimal.

And how does this affect your asset allocation strategy going forward?

From the KKR view, we expect to see one additional 25 bps rate hike for the rest of the year, followed by an extended pause from the Fed. For 2024, we expect the Fed to cut rates by about 125 basis points, bringing Fed Funds to 3.625% versus our previous forecast of 4.625%. 

Longer-term, we continue to see a neutral rate for fed funds of 3.125% this cycle, but our new forecast has rates reaching this level in 2025, versus 2026 previously. This shift in timeline is driven by the view that the banking stress will have a more pronounced impact on growth than expected. 

Overall, we stay in the camp of "Keep it Simple". There are lots of deployment opportunities that one can consider in a world where overnight rates are approaching 5%, and high yield and bank loan yields are nearly double digits. Within this, we are putting a pronounced focus on issuers that have strong downside protection and durability of cash flows – focusing on names that are price-makers and have large, defensive business models.

Learn more about investing in credit

For further insights from one of the world's most recognisable names in private equity and alternative investments, visit the KKC Australia website.

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