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Earnings: Companies face ‘some margin degradation,’ strategist says

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KKR Balance Sheet CIO and Head of Global Macro and Asset Allocation Henry McVey joins Yahoo Finance Live to discuss the current market environment, margin pressure, big bank earnings, retail sales, deflation, and the outlook for global growth.

Video Transcript

- There's a lot coming at investors right now, from weak bank earnings to high inflation to rising interest rates. Joining us now for more insights on the road ahead for markets is Henry McVey, KKR balance sheet CIO and head of global macro and asset allocation. Good to see you this morning. It's been an interesting start, Henry, to earnings season to say the very least. But one of the key takeaways is that margins are starting to come under real pressure. Do you think more margin pressure has been fully priced into markets here?

HENRY MCVEY: I think we're going to have more margin pressure. I mean, if you look at the consensus from Wall Street, they're looking for 85% of companies to have rising margins next year. So people are off sides. That's likely not going to happen. You've got rising wages, higher input costs, and ultimately some slowing of unit volume. So our base view at KKR is that for the public markets, you are going to see some margin degradation. You've seen it also just within the financial services industry, which is where I started my career. You're seeing rising provisions and slower banking fees. And that's obviously caught people's attention.

- Henry, you say in your latest note-- it's Julie here. You say in your latest note current market conditions are about as choppy as of I have seen it during my career. And I followed your career at Morgan Stanley. You've been at this a long time. So I think that's saying something when you say it's as choppy as you have seen. You also talk about regime change in that note. So it seems like you and some of your other peers across financial services are kind of throwing out the playbook in some ways at this time. How do investors need to be thinking differently right now?

HENRY MCVEY: Yeah. You're hitting the nail on the head. So our base view of KKR is that there has been a regime change. We've been saying this for some time. We've been investing behind this. There are a couple of analogies that I would use over my 31-year career or things we should think about. One was when China built out its fixed investment in the early 2000s. They hoovered up all the oil and commodities that they could find. And you had input costs going up faster than output cost. And that's exactly what we learned this week with the PPI being above the CPI.

And so the action item for investors there is to find things with pricing power. There are parts of real estate that have that. There are parts of the industrial sector that have that. Parts of technology. But if you buy a price maker, you're going to do OK. If you buy a price taker, you're probably going to get hit. The second thing that you referred to-- just earlier in the 1990s when I did start in my career at Morgan Stanley, that's when the Fed was the last time they were doing 75 basis point increments. And it upset the apple cart and the bond market. And it hurt insurance companies.

And so that's another important analogy that we've been focused on. I'd say the good news is that insurance companies were better prepared this time. We also haven't seen the same level of exits where people redeem their policies. And that created some of the consternation back in 1994. But we do think we're going to have a higher resting heart rate for inflation. We don't think it's business as usual.

But given what we are doing in our real estate franchise, our infrastructure franchise, the focus on high free cash flow conversion private equity, we feel pretty good about it. But I do think when you-- Jamie Dimon and made comments about the hurricane. I think he's downgraded his storm forecast. But certainly with target having their inventories up 43% sequentially, that caught our attention. And it corroborated many of the views we've had in KKR for some time.

- What also caught my attention in your note, when you talk about looking for companies with pricing power, I look at a company like PepsiCo that reported earlier in the week that seems to still have some pricing power, and yet, as you point to in your note, you think there's actually going to be consumer goods deflation. And you point to something like Target and Walmart and the inventory builds as an example. Do you think we're starting to see that turn already? Or when do you think that is going to really start to-- because it doesn't seem like it's happening on the consumer durables or consumer staples side as of yet.

HENRY MCVEY: Yeah. Look, I mean, people still need to eat. They need to go to work. And so they're going to put gas in their car. They're going to have food and drink. And so what we're really focused on is there's kind of a matrix where one of the things you focus on is unit volume and the other one is pricing power. And so you try to optimize that. PepsiCo told you that they had both the unit volume right and the pricing. Some companies are going to increase prices too much. And that's going to slow unit volume. But by and large, where we are focused is the consumer durables is an area probably where during the pandemic people bought more goods than services. Our economy in the United States is largely a services economy.

So there's a very bullish undertone, which is service is going to rebound. You saw this last week in the jobs report. Professional services is up. Travel and leisure. Health and wellness. Education. Those things are going to do OK. We're not calling for armageddon. This is not 2007 where you have a massive bank deleveraging or a housing market that's been fueled by speculative mortgages. What we're having is, as I mentioned earlier, it's a regime change, where we've got, one, is too much money went into the system. That's point one post-pandemic. Point two is we've got geopolitical risk that are creating commodity spikes that are hard to forecast.

And the third really is around we have a supply side shortage of housing. Housing is about a third of CPI. And what you saw from the CPI report is that that number is very sticky. And that's why when we look at the Fed's forecast for next year, they've got 2% growth and 2% inflation. We're below the Fed on growth and we're above the Fed on inflation. We'll see where the dust settles. But the data right now is I think confirming our thesis about this different type of recovery.

And that's really our message to our investors, which is this isn't a time to just go to the sidelines and do nothings. Prices are down. There is some opportunity. But it's a different playbook. And I would just encourage people to spend time either reading the note or thinking through what worked the last decade. It was getting long growth. It was getting long investment grade debt. We don't think those are going to be the leadership sectors this time. It's going to be a more diversified portfolio, more upfront yield, more cash flow, and more pricing power across these asset classes.

- If the Fed comes out in a few weeks here, Henry, and raises rates by 100 basis points, do you think that serves as a shock to the economy in a bad way?

HENRY MCVEY: I'm in the camp of 75. These are big increments. 100 is a big number. Ultimately, it's art, not science to get-- what's the Fed trying to do? They're trying to get their interest rate to the neutral rate to kind of neither have too much inflation or too little. But growth is slowing as we're doing that. So I probably would do another 75 and then keep the option open for 50.

Our forecast, unfortunately, is that inflation gets down to only about 7% by year end. And next year it's about 4%. And so there's going to be a delicate balance that the Fed needs to achieve. So they may do 50. The market, it's kind of going there. I think if we get some other really strong economic reports between now and the end of the month, maybe they can do 100. But that wouldn't be my base case right now.

- One of the other areas where you guys are looking is at the energy transition, which I know has been a common theme, a common investing theme that a lot of people are looking at right now. Policy doesn't necessarily seem to be on your side right now. We're just seeing a step back to some of the climate change legislation from Joe Manchin. Is that going to be, though, an obstacle? Or do you think that industry is going there anyway?

HENRY MCVEY: I think industry-- well, there's a lot embedded in your question. Very good. No, it's a great question. It's hugely important to us. And so I want to spend a little bit of time on it. One is the biggest opportunity for a firm like KKR that employs over a million people through its portfolio companies-- we own over 200 companies globally-- is to move our footprint from brown to green. And that decarbonization effort is probably the most meaningful thing for the environment and for the economy.

So that's how you play defense and you make your companies better. And we're certainly committed to that that's a massive CapEx upgrade spin cycle that's going to take place. You can count on that. I was just looking at some of the data this morning from Malleus research. And it really confirms that. The second thing is on the forward spin. A couple of things to unpack there.

We think that's somewhere between a $70 and $80 trillion opportunity over the next couple of decades. A lot of that will come out of Asia. About 2/3 of that spinning will come out of Asia. And a lot of it will come in the form of power generation, but also in things around technology. So I do think we're headed there. I think what I would probably push back on is it's going to be a very bumpy journey because you can't have energy transition without energy security.

And one thing we've learned from Russia-Ukraine conflict or the war where they've been invading is that it's going to create issues. The second thing is a lot of the renewable inputs are in hard, difficult places in the world. And as you extract them, the costs go up and there are political issues. So I think we're all very bullish about this theme. It's just going to have some puts and takes. And there's also a lot of capital went in that area.

And so you just have to really focus. I mean, we have a huge global infrastructure business. We do this across real estate and also across private equity. And I think we're patient. But we're picking our spots. But again, one of the best things that to fix the environment is actually the existing companies improving their footprint. And I think you'll see KKR take a leadership role in that part of the business as well.

- Well, hopefully we can check in with you on all of that as that's ongoing. Henry McVey, great to get some time with you this morning. KKR balance sheet CIO and head of the global macro and asset allocation team there. Thank you so much, Henry.

HENRY MCVEY: Thank you so much for having me. Have a great weekend.

- You too. Thanks.