How to Win the New Investment Ballgame – Barron’s

McVey started in the financial industry in 1991 and joined KKR in 2011 from Morgan Stanley Investment Management. He is co-author of KKR’s recent report, “Regime Change: Enhancing the ‘Traditional’ Portfolio,” and its midyear outlook, “Walk, Don’t Run,” which argues that the macroeconomic narrative is shifting from a focus on rising inflation and central bank policies to one in which inflation and financial conditions are crimping corporate profits.

In a world gone haywire with macro uncertainty, rising geopolitical tensions, and snarled supply chains, investors are struggling to deal with rapidly evolving financial conditions. McVey recently spoke with Barron’s by phone from KKR’s (ticker: KKR) offices in New York to learn his views on inflation, interest rates, China, and where he sees the biggest risks to markets. An edited version of the conversation follows.

Barron’s: Federal Reserve Chairman Jerome Powell has said that the central bank must accept the risk of recession to combat inflation. Do you agree?

Henry McVey: Powell is telling us that fighting inflation is more important than sustaining outsize corporate profit growth. That’s the right message because inflation, according to our estimates, will barely be below 8% by the fourth quarter of this year. That’s high, relative to the Fed’s 2% inflation target.

Where we might differ is that they see inflation falling faster in 2023 than we do. They’re at almost 2%, and their gross-domestic-product estimate for 2023 is close to 2%. Our latest model is pointing to less than 1% growth, with a clear downside bias if credit spreads widen further. So, there’s a real difference around the rate of change in declining inflation, as well as the overall economic momentum that they’re forecasting, relative to what we’re forecasting.

But neither of you is forecasting a recession, it seems. Or are you?

My base view for the S&P 500 is that we will have a corporate-profits recession. We see profit growth of negative 5% in 2023. Wall Street is using 9%. Embedded in the Street’s expectation is that 85% of companies are going to have expanding profit margins in 2023.

That isn’t going to happen, in my view. We’re going to see a fairly dramatic slowdown in economic momentum, particularly as it relates to the goods sector. So, yes, a technical recession is now likely. Sometimes, investors forget that the stock market is more levered to goods, while the economy is more levered to services, the true GDP composition. So, you could have a corporate-profits recession, and maybe the economy squeaks out minimal growth, but we are forecasting a notable deceleration in GDP, including the potential for a recession.

This isn’t news to KKR. The question is: What do you do from an investing standpoint? There is a path forward for investors, but it’s a lot different than in the past.

Take us down that new path.

In equities, it’s about a better mix between value and growth, not all growth. It’s about focusing on companies that can raise their dividends, that have pricing power, that have high cash-flow conversion. We’re bullish on short-duration fixed income, including short-duration high-yield, mortgages, municipal bonds. I really like our KKR Real Estate Select Trust [KRSTX], which has the ability to toggle between real estate credit and equity. Same thing with the KKR Credit Opportunities Portfolio [KCOPX], which provides exposure across KKR’s strategies in liquid and private credit.

Those are the types of things that make sense for individual investors. Embedded in what you’re buying, you have higher cash-flow conversion, more inflation protection, and the ability to tactically lean in and out of different asset classes.

What’s your outlook for the housing market?

We’re going to have a significant slowing in home-price appreciation. This isn’t 2007; you don’t have the leverage. The banks aren’t leveraged; the consumers aren’t as leveraged. There’s more equity in the mortgages, and there’s less supply.

What megathemes are you investing in?

Pricing power, collateral-based cash flows, the security of everything, the energy transition, revenge of services, and efficiency, including automation and digitalization.

Explain “the security of everything” and “revenge of services.”

Many investors are focused on energy security, which is front and center. But there’s a fundamental change going on globally, so we need to think about the security of everything. That involves data, health care, communications, and defense.

Revenge of services is unfolding quickly, as we saw Target ’s (TGT) excessive inventories. This signals to the market that we’re going to have a slowdown in goods-buying. We are forecasting goods deflation next year, by almost a half-percent. At the same time, we have services inflation. Professional business services, financial services, healthcare services, travel and leisure, hospitality—those are going to do well. The propensity to spend in that part of the economy is higher at this point in the economic cycle, and that’s something investors should take advantage of today. We think that job growth is going to slow. But we are still understaffed in the services area, and staffing companies will continue to do well, given the labor shortages that we’re forecasting.

How should investors think about asset allocation?

A lot of times, investors think about their portfolio choices as between stocks and government bonds, which is often called the 60/40 formula (60% equities and 40% bonds). We’re advocating for more diversification. We suggest owning some real assets and infrastructure, either privately or publicly, through funds or exchange-traded funds. We’re focused on owning some convertible preferred stocks or outright preferred stocks. They are higher up the capital structure, get you more yield, and have some upside potential, given the recent selloff. In credit, having a combination of mortgages and municipal bonds makes sense. Bottom line: This isn’t the time to overconcentrate; that chapter just closed.

When the Fed started raising rates, the attractiveness of being overweight duration by owning growth equities and investment-grade debt ended. The decision to reposition is a tremendous opportunity for investors, particularly individuals. They can add diversification in their 401(k)s, or through their financial advisors, or through their Fidelity or Charles Schwab accounts. At current levels, something simple like the S&P 500 Dividend Aristocrats
[NOBL], an ETF that tracks companies with a long history of consecutive dividend increases may make sense.

One of your out-of-consensus calls is for higher prices for oil, which actually has slipped over the past few days. Why?

Even if you didn’t have Russia’s invasion of Ukraine, if you look at inventories, relative to days of demand, it would suggest that West Texas Intermediate should trade at $110 a barrel. Add geopolitical risks and the longer-term skew is to the upside, relative to history. The market expects a dramatic decline in the price of oil in 2023 and 2024, based on the futures curve. We think inventories are going to stay tight, even if economic growth slows, as we think it will.

The average refinery is 40 years old. New refineries aren’t being built because of ESG [environmental, social, and corporate governance] considerations, and Russia has been knocked out of a lot of the key deliveries of oil and natural gas to Europe. Finally, the energy sector has underspent on capex [capital expenditure] in the U.S. and globally, so the supply side isn’t responding to the demand signals at higher prices.

What’s your outlook on China?

When I started following China in the 1990s, its nominal GDP growth was around 20%. When I joined KKR in 2011, it was 19%. Today, that number is probably 6% to 7%, so it’s down two-thirds. That’s a fundamentally different investment environment. The opportunities, while still compelling, have changed since KKR started investing in the country.

Most of our focus today is around the rise of the Asian millennial. China has more than 300 million millennials, and their household formation, including buying preferences, is different. The way they think about health care, financial services, food safety, water safety—it’s all different. It is more sophisticated, they are more brand-conscious, and they can use technology to not only research preferences but also buy and sell things much more quickly. There’s an attractive opportunity to partner with local entrepreneurs to help them with more services-based lifestyle investment ideas. These ideas are more domestic-focused. In the past, the China story used to be more about exports. It also used to be more about traditional domestic consumption, including in-store retailing. That’s not what we’re seeing now.

What are the biggest risks on the investment horizon?

The near-term risk is that of a policy mistake—that the Federal Reserve overtightens. The Fed is moving in 75 basis-point [three-fourths of a percentage point] increments. The European Central Bank just said it is going to lift rates by 50 basis points. These are fundamental shifts in central bank strategy. The less-understood and potentially more influential risk is that the Bank of Japan moves away from controlling the yield curve. This change, if it happened, would ultimately lift all global rates, negatively impacting portfolios by raising the global discount rate. We just got a taste of that risk when the ECB dramatically shifted its policy stance.

Thanks, Henry.

Write to Lauren Foster at lauren.foster@barrons.com