Global Macro Trends

Where to Allocate in 2012

By Henry H. McVey, January 9, 2012

2011 offered numerous headwinds—from the rating downgrade of U.S. Treasuries to the continuing sovereign-debt crisis in Europe—so it shouldn’t come as a surprise that 2012 kicks off with its own share of risks. Our asset-allocation strategy for the year ahead entails overweight positions in global credit, real assets and alternatives—and underweight positions in government bonds, global public equities and cash. We believe the U.S. dollar will likely appreciate in the near term against the British pound and the euro, and perceive three macro risks worth hedging, which stem from a potential slowdown in Europe, loan loss reserves in China and tensions in the Middle East. Here we share these and other macro perspectives, addressing the key issue on investors’ minds right now: how to materially enhance returns through asset allocation in 2012.

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Sadly, Beecher’s plea is a tough one for many in the investment business to fulfill, but we nonetheless think it’s important to step back and compare opportunity sets across asset classes and regions of the world at least once a year. Our team recently completed this exercise with the following conclusions (all of which we will shortly discuss, in greater detail):

1. We recommend being significantly overweight credit-related fixed income, though positioning within the asset class does matter. As we’ll soon explain, we prefer corporates to government debt in almost every area of the world except emerging markets, where we prefer both. Our favorites remain mezzanine, high yield and emerging-market debt.
2. We recommend an overweight position in real assets, including gold, real estate and commodities. Among commodities, we prefer to sacrifice liquidity in certain instances in favor of owning assets that can deliver both return of and return on capital—as opposed to owning the more liquid but, in our opinion, highly inefficient commodity notes and indexes that investors commonly pursue.
3. We maintain that alternatives should constitute a greater share of an investor’s asset allocation in a Phase III environment.1 Some of our top choices are distressed and special-situation strategies, given ongoing deleveraging and headwinds in the financial services sector and in Europe.
4. To ‘pay’ for these overweight positions, we have to ‘take’ from somewhere. So, we recommend being significantly underweight global government debt. At their current levels, such safe-haven assets as German Bunds and U.S. Treasuries appear to offer little value as “shock absorbers” to a portfolio. Meanwhile, we remain skeptical of many higher-yielding sovereign bonds, as we believe that considerable risks lie ahead, including the possibility of European ratings downgrades and another Greek restructuring in 2012.
5. Our view on currencies remains that the U.S. dollar is still likely to appreciate in the near-term against the British pound and the euro. Among emerging market currencies, we prefer Asian currencies to European, Middle Eastern and African (EMEA) currencies.
6. We see at least three macro risks worth hedging in 2012. In Europe we expect an extended period of slower growth amid the volatility. Currently, however, the Euribor2 curve is pricing in a notable rebound in growth in 2013, so we think this mismatch in expectations is worth exploiting. In China we think that assumptions about loan loss reserves have been too rosy, and therefore deem it prudent to guard against this. Finally, we aim to own some upside calls in the event things do take a turn for the worse in 2012 and tensions surrounding Iran’s nuclear program escalate and causes oil to spike. See inside for details, but investors who are comfortable increasing their crude exposure at lower price levels could attempt to use the proceeds from writing out of the money puts to pay for upside calls.

Asset Allocation Overview

To illustrate our conviction levels of different investment ideas, the KKR Global Macro and Asset Allocation team (KKR GMAA) devised a theoretical benchmark, of which a 53% share represents global equities, 20% global government bonds, 10% global credit, 5% real assets, 10% other alternative investments and 2% cash (Exhibit 1). Against this theoretical benchmark, we articulate overweight and underweight positions for asset classes, regions and sectors in order to crystallize our key recommendations for 2012 and beyond.

Note that in our analysis we classify long/short equity strategies as “global equities”—not alternatives—because we firmly believe that a growing portion of global equity strategies should benefit from the flexibility to express negative views on stocks and to hedge, if necessary.

Exhibit 1 shows our overweight positions in global credit, real assets, and other alternatives—which we “pay” for by being significantly underweight government bonds and, to a lesser degree, global public equities and cash—while Exhibit 2 details our specific weightings by region, asset class and sector.

So what is the rationale behind our asset allocation strategy?

• Emphasis on income: We want to materially raise the upfront income stream of our portfolio. Within our fixed income allocations we do this by significantly overweighting “spicy” credit, and within our equity allocations we want to do this by emphasizing dividend growth stocks. In addition, we are attempting to lower the portfolio’s overall volatility, which we believe is key to thriving in a Phase III environment3.
• Emphasis on real assets: While we do not anticipate a notable spike in inflation, our research leads us to expect more monetary stimulus in the U.K., U.S. and Europe in 2012 in the form of quantitative easing, which leads us to assume an overweight position in real assets. By gaining exposure to real assets through public (e.g., REITS) and private investments (e.g., infrastructure), we hope to obtain attractive capital appreciation and achieve return of capital along the way—an objective consistent with our desire to raise the overall yield in the portfolio.
• Emphasis on alternatives: By overweighting our alternatives bucket, our intent is to secure outsized positions in patient capital to take full advantage of the volatility in terms of both entry and exit points versus being beholden to it in a Phase III-type environment. Additionally, we want to be able to “play” across the capital structure as financing conditions fluctuate throughout the cycle. We also think we can use alternatives in many instances in order to capture key investment themes better. In particular, we desire exposure to special situations in Europe and consumer growth in Asia.
• Risk and market exposure: To be clear, we are comfortable having a beta at or slightly above benchmark, but we wish to accomplish this through thoughtful allocation. As Exhibits 1 and 2 show, our KKR GMAA target asset allocation portfolio’s chief sources of risk are overweight positions in credit, real assets, and other alternatives at the expense of sovereign debt and cash; however, our underweight position in global equities may help dampen some of this risk.

We realize that a potential shortcoming in our KKR GMAA target allocation strategy is that we are largely shunning government bonds, which have served—at least until recently—as “shock-absorbers” against volatility. But with real rates being negative in places like the U.S., and with sovereign credit ratings at risk in Europe, we are comfortable with our reduced exposure to this asset class. We also think that rating downgrades of developed economies are likely to recur as a macro headwind in 2012.

Alternatively, if the macro environment turns extremely favorable, our modest underweight position in global public equities could diminish performance against the benchmark. However, should that occur, we would expect our alternative investments and outsized credit exposure to perform above our current expectations.

Exhibit 4

Consensus European GDP Estimates Vary Greatly

GDP = Gross Domestic Product; EZ = Eurozone. Estimates as at January 4, 2012. Source: Forecasts and data furnished by research departments of BofA-ML, Capital Economics, Citigroup, CSFB, Deutsche Bank, ISI, JP Morgan, and Morgan Stanley.

The Macro Environment in 2012

Since our outlook for the macro environment in 2012 informs our positions on specific asset classes, let’s begin in the U.S., where we believe that GDP growth could be about 1.5–2.0% (Exhibit 3); that corporate earnings may be flat-to-down (negatively impacted largely by financials); and that inflation may stay in check, at roughly 1.75–2.25%. Given these assumptions, we think that an S&P 500 fair value of 1325—within a range of 1200–1400—is a reasonable prediction for 2012 (Exhibit 5). Yet we do acknowledge we are forecasting weaker-than-expected earnings in 1H12, and that as a result, we expect volatility to remain outsized in the near term.

We have also revised our traditional price-to-book-versus-ROE target matrix slightly lower (Exhibit 6) to adjust for the large financial weighting of the S&P 500 index (and our ongoing conservatism about this sector). The good news, though, is that valuations across the board have improved notably as the multiple on the S&P 500 contracted 13% in 2011 (and a full 41% from its peak in October 2009)4. At the same time, multiples in Europe and China have contracted by 15% and 30%, respectively (Exhibit 7).

Exhibit 7

2011 was About the Multiple, Not EPS

EPS = Earnings per Share; P/E = Price-to-Earnings ratio. Data as at December 31, 2011. Source: MSCI, Factset Estimates, S&P.

Exhibit 8

We Expect U.S. GDP to be in the 1.5-2.0% Range for 2012

Our GDP Leading Indicator contans eight variable inputs that contribute meaningfully to the forecast. A = Actual; E = Estimate; GDP = Gross Domestic Product. Data as at December 31, 2011. Source: Bloomberg, Haver, KKR.

Meanwhile, we look to negative GDP-growth estimates in Europe of -0.5% to -1.0% (Exhibit 4), with earnings falling more significantly than in the U.S. In Asia, by comparison, our research leads us to expect solid growth, though that should slow in 2012 relative to 2011. Specifically in China, we expect real GDP growth of 7.5–8.0%, inflation to remain below 4.0%, and ongoing accommodative tweaks to monetary policy.

Exhibit 9

Widening Credit Spreads & Elevated Commodity Prices are Key Drivers of our U.S. GDP Forecast

Our GDP Leading Indicator contans eight variable inputs that contribute meaningfully to the forecast. E = Estimate. Data as at December 31, 2011. Source: Bloomberg, Haver, KKR.

Public Equities

In the context of our modest underweight position in global equities, we recommend being overweight U.S. and Asian equities. Within the U.S, we feel that our Brave New World thesis5 will hold up relatively strongly in 2012 (Exhibit 10). In our view, earnings growth is likely to disappoint in 1H12, and we therefore expect equities with yield and growth characteristics to shine again during this period (Exhibit 11). Beyond yield and growth, we also favor companies that can benefit from pricing power: in an environment in which the producer price index (PPI) is often running above the consumer price index (CPI), we believe the ability to pass costs through to the end-user becomes a distinguishing feature.

Exhibit 10

We Expect “Yield And Growth” to Outperform
Again in 2012

Data from January 1, 2004 to December 31, 2011. Quarterly rebalanced equal-weighted basket based on the following criteria for the universe of the S&P 500: (1) Current dividend yield between 2-5%, (2) FY2 versus FY 1 earnings growth between 5-15%, (3) Rising trailing 12 months return on equity over the past year, (4) FY2 Price-to-Earnings ratio below sector average, and (5) Rising payout ratio or rising dividends paid or rising gross buybacks. Source: KKR Global Macro and Asset Allocation6.

Exhibit 11

If History Holds, We Expect the Trend of a Wide
Trading Range to Continue

* Current through December 31, 2011. Source: Bloomberg.

From a sector perspective, we expect continued underperformance in traditional financial-services companies—a view that comports with a low-interest-rate and post-crash environment (Exhibit 11). On the other hand, we think many parts of staples, healthcare, and energy should do well again in 2012 (Exhibit 13).

Separately, with Asia expected to account for 60% of incremental global growth in 2012 (Exhibit 14), we think it is worth having significant Asian exposure. Within Asia, our macro research shows that the appeal of Indonesia continues to stand out for long-term investors, while recent stumbles in India have finally depressed valuations to more enticing levels.

Exhibit 13

Earnings Revisions Drive Performance These Days

Data as at December 31, 2011. Earnings revision factor = number of upward revisions minus number of downward revisions divided by total number of estimates. Source: Thomson Financial, S&P, Factset.

Exhibit 14

China Makes Up a Third of Global Growth

Data as at September 30, 2011. Other Asia includes emerging Asia ex-China, Hong Kong, Korea, Singapore, Taiwan and Japan. Other Emerging Markets are all emerging markets excluding Asia and emerging countries within the Eurozone. Other Advanced Economies are the residual of countries not picked up by the other five categories. Source: IMF WEO September 2011.

By comparison, as Exhibit 15 shows, we think European bank and diversified financials will struggle again in 2012—a noteworthy point since financials account for 23% of the Eurostoxx 50 index (and banks were down on average about 42% in 2011) 7. Among the issues facing the financial sector in Europe, we believe, is that banks have not delevered enough, and our research shows that Greece is again on course to disappoint the Troika in 2012 (Exhibit 16). Without question, there is now value throughout the region, but as we discuss later, our viewpoint is that the opportunity set is much better played through the private side, including special situations and distressed lending.

Exhibit 16

Greece May Need to Restructure Again in 2012

IMF reports dated September 10, 2010; July 4, 2011; December 5, 2011. Source: IMF Greek Program Update Reports, KKR Global Macro and Asset Allocation team analysis.

We believe it is increasingly clear that many investors believe the U.S. and Europe can decouple in terms of economic growth and stock market performance. Perhaps this is true, but from current levels, we think that U.S. outperformance relative to Europe has gotten extreme (Exhibit 17). If history is a guide and the global economy remains interlinked (which we believe it will), then Europe will likely infect the U.S. with its cold to some extent, with implications for real GDP growth in 2012 (Exhibit 18).

Exhibit 17

European Equities Underperformance Versus the US
is Now At Extreme Levels

Data as at January 3, 2012. Source: Bloomberg.

Exhibit 18

ZEW Economic Sentiment Index Suggests More Downside Ahead for the US

Data as at November 30, 2011. Source: Bloomberg

Meanwhile, we also believe Japan will remain challenged and adversely impacted by a strong currency and difficult political choices. We are somewhat neutral on Latin America at this point, though we hope our 1H12 visit to the region will afford us better insights into opportunities in the region.

Fixed Income

With real U.S. rates at zero, we think that U.S. government bonds can no longer serve as meaningful shock absorbers for one’s portfolio, so we choose to be significantly underweight Treasuries for the first time in years. This is a bold statement for us to make, given that we’ve found Treasuries compelling in good and bad markets alike (Exhibit 19).

Exhibit 19

U.S. Government Bonds Have Been a Meaningful Shock Absorber in Good Markets and Bad…

Data as at December 31, 2011. Source: Bloomberg.

Exhibit 20

…But The Starting Point Today is Now Much Different Across the Fixed Income Markets

Data as at December 31, 2011. * KKR estimated. Source: Bloomberg, Factset, KKR.

Looking forward, we think the opportunity set among government bonds is diminishing whereas among “spicier” credit securities it remains significant8. Underlying our thinking is the possibility that one may be able to achieve a traditional equity-like total return in many parts of the corporate bond market in 2012—with less volatility than stocks. Meanwhile, as Exhibit 20 shows, current yields on 10-year U.S. Treasuries and German Bunds have fallen to paltry levels. In fact, nominal 10-year Treasury yields in 2011 were at their lowest official levels since record keeping began in 1871. According to data from Robert Shiller, the previous record low was set in January 1941 at 1.95%. Following that reading, the subsequent 10-year real return of long-term U.S. government bonds was a negative -3.1% annually, according to our calculations. Moreover, the theoretical upside of government bonds is truncated by today’s low yields. For example, even if 10-year U.S. yields fell immediately to parity with Japanese Government Bonds (or JGBs, which bear the world’s lowest yield of just 1%), the price upside would range in the neighborhood of just 8%.9

Exhibit 21

CDS Implied Core Europe Rating is Approaching BBB…

Exhibit 22

…And Periphery Implied Rating is B

“Core” countries: Germany, France, Netherlands, Austria, Finland. “Peripheral” countries: Italy, Spain, Belgium, Greece, Portugal, Ireland, Slovenia. Blue lines represent the weighted-average CDS spread, in basis points, of European sovereigns (weighted by contribution to ECB capital). Shaded areas represent the bond-implied CDS spreads, in basis points, of U.S. corporate credits segmented by rating tier. Data from December 1, 2009 thru January 4, 2012. Source: BarCap, Bloomberg, KKR Global Macro and Asset Allocation team.

Outside the U.S., we believe European sovereigns still do not represent great value, since fiscal austerity among European nations is likely to lead to lower-than-expected growth, which would ultimately increase the debt-to-GDP ratios of several countries in the coming quarters. Hence, we feel that the ratings—and thus future performance—of Europe’s sovereign debt are still at risk. As one can see in Exhibits 21 and 22, comparing European sovereign CDS spreads to corporate credit spreads shows that the CDS in many cases are now implying multiple-notch sovereign ratings downgrades. The CDSs may be overly pessimistic in their interpretation of Europe’s Economic and Monetary Union (EMU) core outlook, but we believe the historical AAA credit rating does not seem to match the current finances of the core either. As we detail below in our alternatives-allocation bucket, we would often rather approach Europe through special situations or distressed investing instead.

We tend to favor emerging-market debt—both corporate and sovereign—as we expect continued improvement in fiscal conditions across emerging-market debt instruments on both the sovereign and corporate side (Exhibit 23). If we are right, then the diverging trajectory of leverage trends between developing and developed markets may continue (Exhibit 24).

Exhibit 24

Emerging Economies Getting Less Indebted, Developed Economies Getting More Indebted

Data as at September 20, 2011. Source: IMF World Economic Outlook.

Real Assets

We recommend significant exposure to real assets, but approach matters a great deal. In our opinion, too many investors are accessing commodities through inefficient notes and swaps. One can see the heart of our argument in Exhibit 25, which shows that the relative total return on the GSCI Total Return Swap since 2004 has been decidedly negative, due to contango or the upward sloping futures curve. On an absolute basis, the GSCI total return was just 8.5% from 2004 thru 2011, while the spot return was 147.5% during the same period. By comparison, in today’s dynamic energy market, we think there is significant opportunity to attain more direct commodity exposure, such as through ownership of “non-core” producing assets at attractive valuations. If structured properly, we believe that investors can enjoy healthy, continual dividends and still maintain leverage to the commodity upside in the event of rising inflation or a geopolitical shock.

Additionally, we think that there is a significant opportunity in real estate, given the current low rate environment (see Exhibit 26). In keeping with our Brave New World thesis, we’re inclined to favor REITs as inflation hedges, but there also seem to be attractive total-return opportunities in the private market by providing capital to owners that need to de-lever, term out, or refurbish facilities.

Exhibit 25

GSCI Total Return Swap Has Not Created Much Value
for Investors Since 2004

The GSCI total return index measures the returns accrued from investing in fully-collateralized nearby commodity futures, while the GSCI spot index measures the level of nearby commodity prices. Data as at December 31, 2011. Source: Goldman Sachs, Bloomberg.

Exhibit 26

Inflation Hedging Power of Real Estate is Strong in a Low Rate Environment

Data from 1Q1978 to 3Q2011. Correlation of US Consumer Price Index quarter-over-quarter change against NCREIF Total Rate of Return on Real Estate10 and NAREIT Equity REITs quarterly total returns. Source: Bureau of Labor Statistics, National Council of Real Estate Investment Fiduciaries, Federal Reserve Board, Bloomberg.

10

We still tend to favor maintaining some gold in our portfolio, particularly as central banks worldwide try to improve their competitive positioning by devaluing their currencies. Among soft commodities, we still reserve a preference for corn, though we do not expect 2012 to be a bonanza year. Global corn production is expected to grow in 2012 and replenish inventory levels, which are at their lowest level as a percentage of global demand since 1973 (Exhibit 27). Over the longer term, we note that China accounts for 22.1% of world consumption, up from just 15% in 1980,11 and has now moved from being a net exporter of corn to a net importer.

Exhibit 27

Corn Inventories Now Low Relative to Demand

Data as at December 31, 2011. Source: United States Department of Agriculture.

Currency

Contrary to public opinion, we still think the much-maligned U.S. dollar will continue to appreciate in 2012 (Exhibit 28). In our view, tighter fiscal measures in Europe, though good for the balance sheet over the long-term, are bad for growth in the near-term—and hence for the euro. We expect continued underperformance of the British pound as the impact of fiscal austerity takes its toll on growth and the Bank of England continues to expand its balance sheet.

Among emerging-market currencies, we would generally rather trade relative value in 2012 as opposed to our traditional Emerging Market over Developed Market currency call. At present, our research leads us to believe that Asian currencies should outperform those closely tied to Europe within the regions of Europe, the Middle East and Africa (EMEA). Apart from higher export exposure to Europe, EMEA countries may be vulnerable to deleveraging by European banks. Meanwhile, Asia is expected to account for no less than 60% of global GDP growth in 2012.

Exhibit 28

US Dollar Likely to Rally Further

Data as at December 31, 2011. Source: Bloomberg.

Exhibit 29

Asia FX May Outperform EMEA Again

Data as at December 31, 2011. Average performance for Chinese renminbi, Indonesia rupiah, and Philippine peso versus average performance of the Czech koruna, Hungarian forint, and Polish zloty. Source: Bloomberg.

Other Alternatives

We advocate substantial allocation to other alternatives for three reasons. First, as we mentioned in our earlier commentary about Asia,12 we wish to gain exposure to many of the most compelling “big picture” themes through more targeted approaches, such as private equity, as opposed to public markets, which are characterized by a heavy representation of financial-services companies. In China, for example, 76% of the public-market index comprises slow-moving, state-run enterprises (54% of which are financials); meanwhile, consumer discretionary stocks make up only 3% of public equity markets in China13. Moreover, some of the best consumer plays in China are not yet even publicly listed.

State-run enterprises in countries like China and Brazil have adversely affected emerging market performance since 2010, a trend that we expect will continue. One can see this in Exhibit 30. Given that Brazil, Russia, India and China make up nearly 45% of the total emerging-market public benchmark, we think that there is a tremendous opportunity for asset allocators to gain significant relative outperformance through 1) allocating more to private investments with better growth profiles within core BRIC markets; 2) allocating to smaller, faster growing countries/companies outside the BRIC arena (Exhibits 31 and 32).

Exhibit 30

Some of the Best Performance from Asian Investors
is Coming From Alternative Sources

Data as at December 31, 2010. Asia Emerging Market Private Equity & Venture Capital return is an end-to-end calculation on a pooled basis based on data compiled by Cambridge Associates net of fees, expenses, and carried interest. Source: Cambridge Associates, Bloomberg.

Exhibit 31

BRICs Have Underperformed the Rest of
Emerging Markets

Data as at December 31, 2011. BRIC countries are Brazil, Russia, India, and China. Source: MSCI, Bloomberg.

Exhibit 32

BRICs Make Up Slightly Less Than Half of the
MSCI Emerging Market Index

BRIC countries are Brazil, Russia, India, and China. The MSCI Emerging Markets Index consists of Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. Data as at December 31, 2011. Source: MSCI, Factset.

Exhibit 33

Distressed Refinancing Needs in Europe
Remain Formidable

Data as at December 1, 2011. Leveraged Loans = European Leveraged Loan Index; High Yield = Bank of America Merrill Lynch European High-Yield Bond Index. Source: S&P LCD European Weekly Secondary Report dated December 15, 2011.

Second, we also desire access to flexible private capital, including special situations and distressed opportunities (Exhibit 33). Why? Our recent trip to Europe confirmed our view that GDP growth will likely be negative in 1H12. That’s the bad news. But valuations are now 0.5 to -1.0 standard deviations below their normal levels on a relative and absolute basis, and so amid the wreckage lies opportunity—especially for those who hone in on the right key themes, which we believe include government downsizing, global services, leisure, exporters, and energy efficiency. Further, the breadth and depth of the current banking crisis means there could be significant opportunities for alternative managers to step in and replace traditional financial intermediaries throughout the capital structure.

Third, in the U.S. we see a variety of opportunities to pursue. In our view, headwinds to earnings power in the financial sector, coupled with more scrutinizing regulatory oversight, is likely to keep volatility high in the public markets, which should create compelling opportunities to dis-intermediate traditional lenders. Additionally, we believe the current situation is creating attractive opportunities to invest in less afflicted sectors, including healthcare, consumer, and commodity-related companies. From a thematic perspective, we think demographics, energy infrastructure, pricing power, data proliferation, and a reshaping of the financial services landscape all warrant investor attention.

Hedging Ideas

President Harry Truman probably had it right when he said that “A pessimist is one who makes difficulties of his opportunities and an optimist is one who makes opportunities of his difficulties.” We perceive a few such “difficulties” worth hedging to make for “opportunities,” should the world become more precarious in 2012.

For starters, we think that the weak link in the global economy remains the European sovereign situation, and we propose hedging exposure to this region in three ways. First, our investment in distressed European assets is a direct way to take advantage of (as opposed to falling victim to) the need of European financial institutions to delever. Second, our view is that we are willing to pay a premium to enter into some form of a put spread on public equities in the region, of which one can see the range of potential offerings in Exhibit 34. And the third hedge for Europe that we favor is the Euribor curve (Exhibit 35), which seems to imply that the ECB will revert to monetary tightening by 2013. We disagree with this prognosis and believe there is a significant opportunity to take advantage of this overly optimistic view in 2012.

Exhibit 35

Euribor Futures Imply ECB Returns to Tightening
Mode in 2013. We Disagree

ECB = European Central Bank. Data as at January 4, 2012.
Source: MSCI, Bloomberg.

As for China, regardless of whether its economy slows in 2012–2013 as much as the “bears” suggest, our macro research shows current assumptions surrounding non-performing loans in China are too optimistic. All told, Chinese banks increased lending by 31.7% year-over-year in 2009 and 19.9% in 2010, but as Exhibit 36 indicates, non-performing loans have remained surprisingly subdued. We expect recent trends to reverse course as banks are forced to acknowledge that the lending bonanza in 2009 was rather extreme. Another point to consider is that Chinese banks still trade at a significant premium to their global peers (Exhibit 37). If, unlike our base case, China ends up experiencing a “hard landing,” China’s banks would likely not retain the same valuation premiums they enjoy over those of their developed-market counterparts.

Exhibit 36

There is Risk of an Increase in Non-Performing
Loans in China

NPL ratios as of 3Q2011, loan growth data as of November 30, 2011. Source: Haver, The People’s Bank of China.

Exhibit 37

Chinese Banks are Not Cheap in Hard Landing Scenario

Data as at December 31, 2011. Source: MSCI, Bloomberg.

Finally, we think Iran remains a global “hot spot.” To that end, we aspire to own some upside calls in the event that oil spikes if things do take a turn for the worse in 2012. Our favorites tend to be the $112 calls of December 2012. Given that these insurance measures aren’t especially cheap these days, at present we are willing to write some $80 puts to help pay for all the upside insurance. Our view is that oil below $80 a barrel represents good value for long-term investors, particularly in a period of excessive monetary stimulus—and amid the rise of emerging-market consumption trends in China and India14. One can see this trade roadmap in Exhibit 38.

Exhibit 38

Hold-to-Expiry Returns of Selling Dec’12 WTI Puts
at $80 and Buying Calls at $112

WTI = West Texas Intermediate Crude Oil. Returns expressed as a percentage of Dec’12 futures price of $96.54 as of December 20, 2011. Analysis assumes puts are sold at the bid price and calls purchased at the ask price. Data as of December 20, 2011. Source: Bloomberg, KKR Global Macro and Asset Allocation analysis.

Summary

In 2012, our base case is that volatility remains high and that capital should be deployed with that in mind. On one hand, we expect to see more struggles in Europe, and we also see downside earnings risks in the U.S. in 1H12. On the other hand, global equity valuations have decreased significantly in recent months (for example, U.S. multiples are down 41% from its peak in October 2009)15, and inflation is finally falling in Asia, which supports our prognosis for a soft landing in China16.

In this environment, we typically like the advantages offered by owning high-yielding corporate credit (as opposed to low-yielding government debt), as well as more volatile public equities. We see this yield-improvement trade as one of the most significant opportunities in the marketplace today. Additionally, we think that the yield and return profiles across many commodity-related investment opportunities are still quite compelling. We therefore believe real assets are poised to enjoy another strong year.

Meanwhile, we believe global public equities are likely to remain bumpy, and we feel that the view that Asia and the U.S. can decouple from Europe is misguided, particularly since global financial institutions remain inextricably linked. Correlations seem likely to remain high, especially if our prediction materializes for further rounds of quantitative easing in Europe, U.K., and the U.S. in 2012.

In our opinion, the downside risk to our positioning is that cash, U.S. Treasuries, and German Bunds all again may outperform while global growth slows sharply. In that type of environment, our call to shift into high-yielding corporate credit and emerging-market debt would seem misguided. We believe growth will slow in 2012, though the recent wave of central-bank interventions worldwide has removed much of the tail risk that shocked the global economy in 2008, in our opinion.

There is also a significant upside case for the global capital markets that one must consider. With valuations relatively compressed, any good news on Europe or global growth could lift risk assets to significantly higher valuations than our base case projects. However, we see Greece restructuring again in 2012; we predict that it will take months and not weeks for the new European treaty proposal to be ratified; and we remain concerned about slowing global growth. Thus, we prefer keeping a measured risk profile at this point in the cycle.