Last month KKR & Co. (KKR) celebrated its 40th year of existence. In that time the firm has grown from a three-way partnership of Henry Kravis, George Roberts and Jerome Kohlberg with $120,000 of total capital to a private equity and alternative asset management behemoth with over $120 billion in assets.
Bloomberg recently had an excellent interview with Henry Kravis and looked back over the past 40 years. In the interview, Kravis said that over the years the firm made some mistakes by not paying any attention to macro developments.
While valuation is still the overriding factor when KKR makes an investment, Kravis believes the firm needed to be aware of the macro situation, too. "About five years ago we set up a macro asset and allocation group, which has been invaluable and made a huge difference in how we think," Kravis said.
This can help us frame how we think as well.
Henry H. McVey is the Head of Global Macro & Asset Allocation for KKR and his outlook is regularly published on the firm's website. Back in January we looked at KKR's forecast for 2016 and it was pretty accurate predicting slower global GDP growth, so I was anxious to read the firm's recently released report, Adult Swim Only: 2016 Mid-year Update.
KKR remains cautious saying, "At the risk of being labeled Master of the Obvious, today's macro backdrop, which includes high P/E ratios on stocks and low yields on bonds, appears an extremely challenging one for investors looking for outsized returns in public markets."
The firm doesn't see much potential ahead for returns in the stock market. McVey notes P/E ratios are very high, and that the broader market's ratio has increased 51% since the market bottom in 2009. He is also not upbeat about the potential for earnings growth and suggests we may see multiples contract on stagnant earnings.
The report observes that valuation measures such as P/E, price-to-EBITDA and price-to-sales are in the 90th percentile of their historical ranges and the market is fully, if not over valued at current levels.
Streaks of seven or more years of positive S&P 500 returns are extremely rare and we are probably overdue for a bad year in stocks, according to McVey.
KKR continues to favor credit over equity in the current environment. "Within Liquid Credit, we generally favor Levered Loans over High Yield, though we acknowledge one must be flexible in the current environment of heightened volatility. We also like the flexibility we have through our new five percent position in Actively Managed Opportunistic Credit to pursue periodic dislocations and/or niche areas that might be overlooked by traditional benchmark seeking mandates."
This bodes well for business development companies and levered loan closed-end funds in the second half of the year. It also makes Blackstone/GSO Strategic Credit Fund (BGB), long a favorite of Real Money Pro's Doug Kass, a solid choice.
KKR likes real estate assets with the potential for yield and growth, especially non-core assets with the potential for improvements. It favors those situations with a flexible capital structure as well. As individual investors, we can capture those types of situations with Apollo Commercial Real Estate Finance (ARI), Colony Capital (CLNY) and Brookfield Property Partners (BPY).
McVey does not expect to see a major global correctional as much as a period of low returns. He looks for the economy to muddle along until late 2017, early 2018 when he expects a mild global recession. The biggest market risk right now, according to McVey, comes from the potential for excessive debt creation in Europe or China as well as "mounting geopolitical risks." He notes that we are seeing unprecedented "splintering of political harmony" around the world, which presents some risk to the global economy and markets.
As you can tell, this is not an upbeat outlook. McVey believes simplicity is overvalued right now and that remaining opportunities lie in complex and idiosyncratic situations. He thinks that, barring any shock, the global economy will just continue along at a very slow pace, which is very much in line with my "better, not good" outlook on the economy.
McVey suggests that more volatility is likely in the future and that public market valuations are full and returns on capital have probably peaked.
In his conclusion McVey writes "...Are we being too cautious? We do not think so; some selectivity seems required after 84 months of economic expansion amidst rising geopolitical tensions. Maybe more, though, is our view that the investment community now better understands that lower rates and more stimulus suggest slowing nominal growth and low returns now lie ahead."
KKR is one of the most successful investment and private equity firms in history. It has a very cautious view of the world right now and investors would be wise to follow their lead in these turbulent times.