KKR's McVey on China, Europe, EM, and a U.S. Recession

Okay, so here's what I'd say on China. Our view is that China has already had its crash per se. I think many people are worried about the debt load and that China is going to slow down. If you look at it in nominal terms, which is inflation-adjusted, think about KKR; we have lots of businesses in China. We've already seen a crash. Nominal GDP went from 25% to 6%. That's a massive falloff. It's rebounded about 100% to 12%, and now it's starting to settle in. Many sell-side economists focus on real GDP, and it has slowed down, but in nominal terms—which is revenues, paying your people, generating profits for your investors—we've already seen that. So from our standpoint, it's more just a steady growth trajectory from here, albeit at a slower pace. In other words, the China bears are looking for a correction in all the wrong places. They're looking down the road instead. They should be looking in the rearview mirror from a growth trajectory standpoint. I would argue that the debt growth in China is still going at an extraordinary rate. It's approaching probably 300% of GDP by 2018. Does that concern you? It does, it does. But I think when you're looking for a big growth slowdown, if you run a business, dropping from 25% to 6%—that's a pretty significant falloff that has already occurred. This chart helps illustrate the point: here's China's nominal GDP. Clearly, it peaked several years ago, and there's the crash, like you say, beginning to stabilize. I think that's why recently in Europe you see better trends from the global economy, and some of that reflects China coming off the bottom. We're not looking for a surge; we're just saying it's stabilizing at a lower level. With a little inflation coming back to the system, you'll see that in the revenues of companies.

Yeah, I mean, we try to do both. I was just in Milan, Berlin, and London. We also do a lot of quantitative work to try to see if there's a disconnect or a match. For about the last year and a half, our quantitative models have been showing very strong growth, and the single biggest factor in that is monetary policy. That's exactly what we saw in the US when Janet Yellen and company were driving monetary stimulus; it's just a huge impulse. What you're starting to see in Europe right now is that monetary stimulus shifting to the cyclical economic areas, like housing. So you'll see a little more lending, a little more improvement. I heard there was a mention of copper, those types of things, where it lifts the economy. It's this baton handoff where monetary policy acts as an ignition switch, and the fire it's lighting is the cyclical part of the economy. So right now, we've got a more constructive view, or we have had, on Europe. Germany is the epicenter of that. Germany really is a global player playing within a Euro region, and they're benefiting the most of all the places we play in Europe. Let's see if we can bring up a chart that helps illustrate this point. The idea fundamentally is that monetary policy in Europe has gone from being a headwind back in 2012—look at what it sucked out of GDP, in basis points—to a tailwind. There are two forces at work: one is the ECB and the monetary stimulus, and then this chart you just brought up shows the government going from austerity to actually becoming a contributor to growth. It's pretty amazing: you had a 150 basis point drag, and now that's shifting all the way up to a positive. Mathematically, that would give you almost 170 basis points of lift just from the government not kind of strangling growth. I mean, ultimately over time you do have to pay your debts, and you can't just have spending, but I think they've eased off the austerity, and that's also helping.

I think what we would say is, one, if we do have a pullback economically, it will look nothing like what we had last time, where you had massive bank leverage, everybody owned a home, and that crash ate up their equity. From our standpoint, we have a pullback in 2019 where GDP goes closer to zero, more akin to what happened in 2001 than 2007. But it's not pleasant, but not as painful as 2009. What I would say is it's really about compression of margins. Ultimately, we have a much more modest forecast for inflation globally, including the US. Within that, we see margins compressing, and within the US consumer, we're most focused on the lower end. That's where we see some trends that are not quite as positive as what you see at the aggregate level.

We are seeing, one, it's being driven by activists in the public markets. If you look at the Wall Street Journal today, all the articles are on people forcing companies to sell subsidiaries. Corporations later in the cycle want to right-size their footprint. Many of them are selling off subsidiaries that are underperforming or trying to create value because activists are driving them. That's a great opportunity for what we do. Japan is on fire right now. We're seeing a lot of activity in Europe as well. Recently, yesterday, we announced two transactions in the US, one predicated on activism and the other on a breakup story. Is this fundamentally good for public equities? Definitely. I think that you're seeing a lot of value created. When the cost of capital was so low right after the crisis, a lot of firms expanded into areas where they shouldn't have been. Right now, as the economy gets more mature, CEOs are rationalizing their footprint. We've talked about this idea that you should embrace complexity and dislocation in the past.

In our mind, look, we've had eight and a half straight years up in the S&P. There's only one other time in history that's happened. So just to keep it simple, multiples have expanded 40% plus. You'd go where you haven't had the same benefit of multiple expansion. The second thing: in emerging markets, we are seeing margins starting to improve. Some of that is predicated on China, but some of it is that after the taper tantrum, governments got their houses in order. They took their real rates up, inflation has come down a little bit. It's just a better backdrop. A lot of investors are skittish about investing in emerging markets because of the currency risk. We're changing our call. We have been dollar bulls. What we laid out this year is that the dollar is somewhere between fair value and full value. We spend a lot of time as a firm thinking through for our investors how we want to hedge that. In aggregate, we're probably not at the same concern level that we were over the past. Joining KKR in 2011, from 2011 to 2016, that went from being a headwind to a tailwind. Remember, currencies are generally about 30% of the total return in EM overall, so you have to get that right. Embedded in investing in emerging markets is that you have to have a macro view.