What, worry about inflation? A new market outlook from private equity giant KKR suggests that while investors (particularly in the bond market) are positioning for higher inflationary risk as economies recover from covid-19, any risks from upward inflationary pressure will be “transitory.” Instead, writes KKR‘s Head of Global Macro & Asset Allocation Henry McVey, the deflationary impacts of technology and broader demographic shifts will likely outweigh the unprecedented increase in money supply.
“If there was ever a time to talk about inflation, now is that time. We have record money supply growth, a dovish Fed, and a new Secretary of Treasury who may be even more dovish than the current Fed chair,” KKR acknowledges in the newly released update to its 2021 market outlook, Another Voice.
In that report, the firm adds that besides the political changing of the guard in the U.S., inflation concerns have emerged as a result of inventory shortages across multiple global supply chains (i.e., the classic inflationary setup of “too much money chasing too few goods.”)
But, KKR notes, a heated inventory cycle unfolding in an environment of “abundant consumer dry powder” is typical of the early economic cycle pattern. They point to the 2003-04 and 2010-11 recoveries, where inflation surged early on in the recovery periods, driven by inventory cycles and consumer resilience. KKR notes that Treasury markets have historically overestimated the persistence of early-cycle inflation: in fact, 10-year yields and break-even inflation expectations peaked in the early years of the last two recoveries.
In other words: Don’t freak out
KKR believes that the effect of increases in commodity input costs and disposable income into core consumer inflation tends to be limited. Consumer goods make up less than one-quarter of the overall core consumer inflation basket. Meanwhile, they say, the pandemic is still muting pricing power in several categories holding outsized CPI weights, including apartment rentals, health care, and education. These categories have yet to bounce back, and have actually come under increasing pressure in recent months.
There are long-term structure factors to consider, as well. KKR maintains “a high degree of long-term conviction” that structural forces around demographics and technology will continue to expert long-term downward (i.e. deflationary) pressures on prices.
“As such, we are not concerned that inflation gets out of control this cycle,” KKR says. “Ongoing moderation in large services-based inflation categories, such as rents, healthcare, and education are also moderating forces. Remember, services account for roughly 60 percent of inflation inputs.”
KKR is holding fast to its economic outlook forecasting “reflation without runaway inflation” for the U.S. in 2021–i.e., a return to price normalization as vaccination and recovery efforts gather pace–but without the ruinous effects of runaway inflation. KKR is boosting its 2021 U.S. real GDP growth forecast to 6.5 percent from a previous 5.0 percent, and its 2022 U.S. real GDP growth estimate to 4.0 percent from 3.0 percent. The firm is also boosting its U.S. nominal 10-year interest rate forecast for 2021 to 1.5 percent from 1.25 percent, and its U.S. nominal 10-year 2022 forecast to 2.0 percent from 1.5 percent.
“Importantly, our longer-term macro framework still suggests that the uptick in inflation we are forecasting for this year and next is both transitory and largely in-line with past recoveries,” KKR writes. “Without question, being right on the direction and level of interest rates is incredibly important at this point in the cycle. However, from our vantage point, structural deflationary forces, including technology and demographics, still outweigh the increase in money supply and supply chain tightness that we are seeing in the goods segment of the market.
“To be sure, long duration debt and growth companies with higher P/E ratios will be more vulnerable, but that is not where allocations are leading us.”
Assets with collateral-based cash flows, including asset-based finance, infrastructure, and many parts of the real estate market should perform well in the faster nominal GDP environment that KKR envisions: a market call that KKR says remains “a table pounder” for the firm, particularly given the current, unusual backdrop of rising cyclical inflation, more stimulus, and higher commodity prices.
Given low rates and an anti-austerity environment, KKR says investors should back fiscal beneficiaries, particularly for ESG exposure. Climate change, as well as a (potentially) $3 trillion per year ongoing global investment in the transition to cleaner energy, remain clear areas of focus for many investors, KKR says. The firm also continue to prioritize opportunities that benefit from COVID-related structural tailwinds across education/work-force development, waste management, and industrial technology. Finally, amid geopolitical tensions [vis-a-vis China], as well as this winter’s devastating weather events in Texas, KKR sees infrastructure “resiliency” as an influential investment theme, particularly as it relates to supply chains and power distribution.
What to avoid
As for what KKR is advising its clients to steer clear of? Four words: long duration government bonds.
“We think that we are at an inflection point for traditional asset allocation. In particular, we think that government bonds can no longer fulfill their destiny as an income producer and a diversifier. This insight is not to be taken lightly, as government bonds have delivered performance on par with global equities during the last decade, though with much less volatility and better downside protection,” KKR writes.
Finally, KKR notes that the single biggest risk to its recovery outlook for 2021 is that something unsettles the bond market, challenging valuations across asset classes, due to a potential misstep around tapering by the Federal Reserve (or one of its global peers) in the second half of this year. Alternatively, a faster-than-expected increase in inflation could also endanger its current risk modeling. But the firm doesn’t see either the Fed or inflation ruining this thesis in the near-term.