Where we're finding relative value in 2023

In recent months, my team at KKR has spent a lot of time alongside our portfolio managers looking at relative value across both equities and credit. Our models tell us that now is the time to begin to lean into risk assets. We think a fair amount of bad news has been priced into markets, unless one thinks a 2008-style banking collapse is imminent. 

We don’t think 2023 will be like 2008. As a result, we are suggesting going from a "walk" to a "jog" or even a "run" in terms of deployment by the end of 2023.

Having said this, as we start picking up the pace towards increased deployment, we favour being a lender at first. 

In this wire, we share why we think it's time to add risk and - most importantly - when. 

Today's better buy

Our models today suggest credit is the better buy at current levels, especially if an allocator has the ability to build a broad-based portfolio across both private and public markets. We see several factors at work. 

First, many large bank lenders are "hung" with loans, which is preventing them from extending credit as much as in the past.

Second, tighter capital standards by regulators and higher loan loss reserves are
forcing financial institutions to hold more capital and issue fewer loans. 

Additionally, after the Federal Reserve and other central banks bought up a huge amount of government issuance as part of their pandemic-era quantitative easing programs, things are now starting to move in reverse. Government securities are now displacing riskier debt on bank balance sheets. 

All of these factors have helped push credit yields to their highest levels relative to S&P earnings yields since the COVID-19 outbreak.

Against this backdrop, it feels like a pretty good time to build positions across private credit, as unlevered returns are now in the low double digits, as well as liquid credit, given the convexity the asset class offers at current levels. 

Answering the pushback

Some have suggested spreads need to widen a lot more to make the opportunity as attractive as it was in the past. We don’t necessarily agree, as the issue this time is inflation. As a result, the risk-free rate, which we view as the proper mechanism for capturing higher-than-expected inflation trends, has increased materially. 

For spreads to widen in an inflationary environment, we would generally need to see some deterioration in corporate margins (particularly when the term structure of corporate debt looks relatively benign). That would make it unlikely that we see spreads widening without nominal GDP slowing and risk-free rates falling simultaneously. 

Said differently, we think that yields today are at quite attractive levels, which have historically made good entry points for longer-term investors.

Importantly, within credit, we are espousing our "Keep It Simple" thesis. Said differently, we prefer moving up in the capital structure, keeping duration in check, and not stretching on leverage. To this end, we favour the highest quality collateralised loan obligation (CLO) AAA liabilities, senior direct lending, and some high yield. 

We also continue to like collateral linked to nominal GDP growth, for example, real estate credit. Importantly, given the different convexities of the products (i.e., high-yielding debt is trading at a material discount to par), we think that a multi-asset class credit solution (including both private and liquid securities) could make a lot of sense in the macroeconomic environment we are entering.

What about equities?

To be sure, even though credit as an asset class looks more attractive in relative terms, we also see emerging value in equities. 

We are particularly cognisant of the fact that the Russell 2000, which is where many large-cap buyout firms play, looks attractively priced relative to large-cap U.S. equities. In fact, we believe that small caps will finally begin to outperform the S&P 500 on a consistent basis.

In terms of sector preferences across equity indices, we like energy as a structural long against technology, as the index weightings rebalance over the next few years. Our work shows that when sectors become larger than 20% of the S&P 500, they tend to lag. 

For example, the collective underperformance that began for energy in the early 1980s, technology in 2000, and financials starting in 2007. 

Beyond energy, we also believe that industrials and large-cap pharmaceuticals will perform well on both an absolute and relative basis.

In summary

Looking at the bigger picture, we think that now is the time to diversify more across asset classes. Central to our thinking is that we are leaving a period of low growth and low inflation in favour of lower real GDP and higher nominal GDP, albeit with more volatility. If we are right, we think macro and asset allocation should be overweight small cap equities, mortgages, high yield, high-quality CLO liabilities, and opportunistic private capital.

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