KKR’s McVey Sees Fed Turning Off ‘Liquidity Spigot’ Next Year

(Bloomberg) -- KKR & Co.'s Henry McVey has four words of caution for investors anticipating a never-ending flood of central bank liquidity into financial markets: “There is a limit.”

As soon as next year, governments will reach a “tipping point” at which point they can no longer easily sell new debt, McVey, KKR's head of global macro, asset allocation and balance sheet investments, said in an interview Friday on Bloomberg Television. The so-called bond vigilantes of old, buyers once preoccupied with inflationary risk, will object to additional borrowing when federal debt reaches 150% of gross domestic product.

“I don't think we're going to see the bond vigilantes today, because the bond vigilantes are being overrun by the central banks,” McVey said. “But ultimately that liquidity spigot will turn off by 2021.”

That's potentially a problem on two fronts: for the countries counting on stimulus spending to buoy economies battered by the coronavirus pandemic, and for investors who've bought stocks and bonds on the belief that central banks won't let prices fall. By some measures, governments around the world have already spent the equivalent of 50% of global GDP on programs to fight the fallout from Covid-19, and there's more to come in Europe and possibly the U.S.

Most of that debt has been soaked up by ballooning central-bank balance sheets. The recognition that buying can't go on indefinitely is one reason the Trump administration is pushing to restart the economy “even though we're not seeing the rate of new cases decline the way some would want,” McVey said.

At the same time, the denominator in the debt-to-GDP equation is shrinking. McVey expects a 10% drop in demand over time because of the pandemic, greater than the 5% decline he figures is implicit in current stock prices.

Eventually, he said, governments will raise taxes to curb rising deficits or the sheer amount of outstanding debt may constrain the economy. Either would slow growth in personal incomes.

“The money's not free,” McVey said.

KKR research shows the odds of sovereign defaults rise “materially” once the debt-to-GDP ratio exceeds 150%. Last month, the Congressional Budget Office estimated that U.S. federal debt would swell to 108% of GDP in the fiscal year ending Sept. 30, 2021, up from 79% in 2019.

To inform his macro outlook, McVey draws on data from the 175 companies in KKR's private-equity portfolio as well as on-the-ground observations from offices in 25 countries. He said the pandemic has entered what he calls Phase II, a period of 12 to 18 months that will be marked by deleveraging of corporate balance sheets and smaller increases in stock prices.

The lesson for investors is to “get your themes right” and pick companies whose business models are built to accelerate in a pandemic economy, not buy equity or credit indiscriminately, McVey said. He added that New York-based KKR will be “very aggressive” on infrastructure investing and sees opportunities for leveraged buyouts of public companies in Europe.

©2020 Bloomberg L.P.