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Global Macro Trends

Phase III: The Last Stage of a Bumpy Journey

By Henry H. McVey, October 18, 2011

The bear run that began in 2000 has played out like a triptych, with the third and final act now upon us that will, in our view, be marked by uncertain fiscal sustainability, shorter economic expansions and heightened capital-markets volatility. We believe this third act—which we dub “Phase III”—will require more opportunistic approaches to asset allocation and introduce a host of possibilities for such approaches.

Download this report in PDF format (2.8mb).


A physicist and Nobel Prize laureate by the name of Niels Bohr once said that “prediction is very difficult—especially if it is about the future.”

No doubt, there is a lot of truth to Bohr’s cynical quip: forecasting is somewhat of a necessary evil in the investment business, given that decision processes about capital allocation require that we almost always make today’s decisions about tomorrow. But there are several things investors can do to improve their chances of success. We focus on three.

First, we try to counter the uncertainties inherent in making predictions through consistency of process, meaning that we tend to look at the same data series month-in and month-out—rather than simply jump from one data point to the next just because it may support our existing thesis.

Second, we attempt to marry our top-down approach with bottom-up “checks and balances” by working closely with KKR’s in-house industry experts, senior advisers, portfolio companies and key business relationships. This part of the process helps not only to keep existing ideas accurate and up-to-date, but also to generate new ones.

Third, we try to develop high-level proprietary insights by leveraging KKR’s global franchise to our advantage. Collectively, KKR’s private-equity portfolio companies generate in excess of $200 billion in annual revenues, employ over 900,000 people globally and operate in 14 different industries. This informs our thinking, which we also hope will, in turn, be useful to our portfolio companies and our investors.

So what do we see from our perch these days? In this paper we comment about what tomorrow might look like and make a number of observations and recommendations.

We Have Entered an Investment Period (Phase III)
That Will Require a More Opportunistic Approach

We Believe Economic Growth Should Continue to
Slow in 2012

…Which Will Keep Many Indices in Flux.

After a Decade of De-Rating, Long-term Value
Has Finally Been Created in Equities.

Inflation Should Remain in Check, But the Environment
Will Reward Companies With Pricing Power

“Spicier” Fixed Income Could Emerge as the Asset
Class of Choice in 2012

Currencies Have Become a Key Differentiator

Allocations to Commodities Should Be Done with
a Fresh Perspective

Phase III: Here and Now

As Americans embraced the dawn of a new century, AOL was acquiring Time Warner in a $350 billion transaction, Britney Spears was the diva of pop, DVDs were just gaining popularity, the S&P 500 traded at 1527 and approximately 25.7 times expected earnings, and 10-year bond yields were at 6.19%. Fast forward to early-October of 2011, and French, Belgian, and Luxembourg governments are acquiring distressed bank Dexia in a €4 billion transaction, Justin Beiber is the new king of pop, iPads are all the rage, the S&P 500 is trading at 1160 and just 10.5 times expected earnings, and 10-year bond yields are at approximately 1.80%.

While then and now seem worlds apart, there are actually some notable similarities. An obvious one is that Vladimir Putin is again aiming to be the President of Russia. Another “back-to-the-future” moment is that we face yet another major debt overhang, with one critical difference: whereas the 2000 overhang came from the corporate sector, the current one is largely government-incurred. As Exhibit 1 shows, the last decade or so has seen a movement of debt from corporations (Phase I) to U.S. financial institutions (Phase II) to governmental entities (Phase III).

Exhibit 1

The Three Phases of This Debt Overhang: From Corporates to Wall Street to Sovereigns

Corporate Leverage = S&P 500 ex-Financials Net Debt-as-a-%-of-Assets; Wall Street Leverage = Average Assets-to-Equity for Goldman Sachs and Morgan Stanley; Government Leverage = United States: General Government Gross Debt % of Gross Domestic Product (GDP). Source: IMF WEO, Factset, S&P. As at September 30, 2011.

Exhibit 2

Expect Shorter and More Volatile Economic Cycles When Government Debt Load is Higher

Economic expansions from 1900 to 2011; Debt to Gross Domestic Product (GDP) is at the start of the expansion. Source: NBER, BEA, US Treasury, KKR. As at September 30, 2011.

As we attempt to figure out where we might be headed, we think it makes sense to look back and gain some perspective. We subscribe to the conclusions of a study conducted by Carmen Reinhart and Kenneth Rogoff on debt cycles and deleveraging (1). Their findings show that economies are seldom successful at cutting expenses and debt levels at the same time. In fact, they examined a group of 22 countries that tried to do just that—eliminate their debt overhang while still growing their economies—over a 30-year period (1970–2000). What they found was that just one country of those 22 was actually successful in doing so: the small African nation of Swaziland. We will not diminish Swaziland’s achievement in 1985, but their success is probably not directly applicable to economies the size of United States and Europe at this point in the cycle.

Exhibit 3

Debt Loads Affect Equity Valuations Too

GDP = Gross Domestic Product; P/E = Price to Earnings Ratio; E = Estimate. Source: IMF WEO, Factset. NTM = Next 12 Months. As at September 30, 2011.

History shows that debt overhangs tend to lead to shorter and sharper economic cycles than what we have experienced during much of the last 20 years. As Exhibit 2 shows, in Phase III we would expect the median period of economic expansion to trend back closer to 30–40 consecutive months, in contrast with the much longer expansion periods of 75 months or more that the U.S. enjoyed during the 1980s, 1990s and 2000s. We saw similar economic patterns play out in the U.S. from 1945 to 1960, when government debt began consistently exceeding 60%. A Phase III environment also means that both Europe and the U.S. are likely to face increased political unrest and social discord as they try to stimulate growth and reduce debt at the same time.

Exhibit 4

The Typical Aftermath of Secular Bear Markets Imply Wide Trading Ranges for Many Years

Chart represents the typical secular bear market based on Morgan Stanley Research sample of 19 such bear markets. Data as of 9/19/1929 to 3/25/2010. Source: Morgan Stanley Research.

Exhibit 5

Post-Crash Performance Characterized by a Wide Trading Range

* Current through October 4, 2011. Source: Bloomberg.

In keeping with more erratic economic trends, we also believe strongly that investors should expect wider trading patterns amid heightened volatility. As Exhibits 4 and 5 show, significant bear market swoons (a la 2008) follow a typical pattern of busts, booms and then range trading. We believe that we are now in the “hangover phase,” which is often characterized by volatile market behavior. The good news is that, with the recent sell-off, the S&P 500 has now largely fulfilled the “next correction” phase. What’s required, though, is more time for the correction cycle to run its course, since the declines experienced during April–October of 2011 spanned just six months, versus an average historical correction period of 13 months.

In broad view, the environment that we are forecasting has significant implications for almost anyone who allocates capital. Demand for hedging features will almost certainly continue to increase in the foreseeable future, while the ability to thoughtfully consider the timing of capital deployments and realizations becomes increasingly critical to sustaining superior long-term returns in a Phase III environment. It also means that investments that can return capital throughout the investment cycle would likely better serve investors, since annual capital appreciation is no longer a foregone conclusion. Bottom line: while there is significant opportunity to create value in today’s markets, we are deeply convinced that investors should assume a more opportunistic mindset in the near-term.

How do we emerge from this current period of stagnation? There is no surefire remedy, but we do see two potential catalysts to economic growth. First, we know that Corporate America and its regional equivalents in Europe, Asia, and Latin America must be the drivers of growth and investment in the global economy. Unlike governments and consumers in developed markets, corporations are flush with cash, have low debt balances, and are experiencing rising productivity. In order to achieve strong growth, governments worldwide—particularly the U.S.—need to step back and promote a business-friendly and less uncertain regulatory environment that could allow for corporations to have confidence and more predictability to begin hiring and deploy the cash on their balance sheets. Without more robust corporate-led hiring and investment, the U.S. faces the prospect of relying on an overly levered government (manifest in government’s debt as a percentage of GDP at 98.0%) or overreaching consumption (which, as a percentage of GDP, stands at 71.1%) to heal the current economic malaise (Exhibits 6 and 7).

Exhibit 6

Government Can’t Be the Driver of Growth

GDP = Gross Domestic Product. Source: Congressional Budget Office. Data from 1960-2013.

Exhibit 7

…Nor Can the Consumer

Source: Federal Reserve. Through 2Q2011.

Rebalancing is also the key to global economic growth: the world would benefit from an increase in Chinese consumption as a percentage of China’s GDP and a trimming of American consumption as a share of U.S. GDP (Exhibit 8). Passing the baton of consumption from the U.S. to China is paramount not only for generating absolute global economic growth—but also for correcting much of the lopsidedness that has resulted in significant surpluses and deficits throughout the world. As Exhibit 9 already indicates, Chinese reserves have burgeoned to near record highs even as U.S. unemployment and indebtedness continue to hover at outsized levels.

Exhibit 8

China And the U.S. Need to Rebalance Their Economies

*Exports are on a gross basis and as a result, total GDP will exceed 100%. GDP = Gross Domestic Product. Source: China National Bureau of Statistics, Bureau of Economic Analysis.

Exhibit 9

China Reserves Now at Outsized Levels

Sources: IMF, Bloomberg. As at September 20, 2011.

Economic Growth Will Continue to Slow in 2012

According to our research methodology, we believe corporate earnings growth will reside in negative territory during 2012 versus a consensus forecast of up nearly 14%. Importantly, we come to almost the same conclusion even if the European crisis subsides in short order. Driving this view is our 7-factor model, which we use to predict S&P 500 earnings growth. This model now suggests an earnings decline of around 12% next year (Exhibit 11), driven largely by the lack of a rebound in home prices. Our fundamental research, however, points to a slightly better outcome, with earnings down about 5%. Average aggregate EPS growth tends to fall about 30% or more during a typical garden-variety recession, but neither our quantitative modeling nor our fundamental analysis suggest a decline of that magnitude this time. Why? Because it would be hard for housing-related activity to plummet precipitously from current levels (Exhibit 10). All told, we think a GDP estimate of positive 1.25% for 2012 is a reasonable target for the type of corporate earnings environment we envision next year.

Exhibit 10

U.S. Housing Transaction Volumes Remain Weak

Source: Bloomberg. Through August 1, 2011.

Exhibit 11

Our Analysis Shows Slower than Expected Growth in 2012

The Earnings Growth Leading Indicator (EGLI) is a statistical synthesis of seven important leading indicators to S&P 500 Earnings Per Share. Henry McVey and team developed the model in early 2006. A = Actual; E = Estimated. As of September 23, 2011. Source: KKR, Bloomberg.

For those inclined to a bottom-up perspective, we would make the following two points. Within the U.S., consensus estimates assume that nearly 50% of the incremental growth in earnings is likely to come from financials and energy (Exhibit 12). Given weak trading volumes, deteriorating credit and lower oil prices, these forecasts seem too optimistic to us. Second, as Exhibit 13 shows, 37% of total global growth is supposed to come from Asia (with China being the largest contributor) at a time when central banks are still striving to dampen domestic inflation. This, too, is a forecast that merits attention.

Exhibit 12

48% of 2012 Consensus EPS Growth From Financials & Energy Appears Aggressive

2012E EPS Y/Y

Contribution To 2012 Earnings Growth

Consumer Discretionary



Consumer Staples









Health Care






Info Tech






Telecom Services






S&P 500


EPS = Earnings Per Share; E = Mean Consensus Estimate. Source: Factset, S&P. Data as at September 21, 2011.

Exhibit 13

2012 Global Growth Is A Bet On Asia ex-Japan

2011E Nominal GDP

2012E Nominal GDP

2012-2011 Nominal GDP

2012 Nominal GDP Growth

Contribution To 2012 World GDP Growth













Euro Area






Other Europe
























Other Advanced Economies











GDP = Gross Domestic Product; E = IMF Estimate. Nominal GDP in US$ Billions. Source: IMF World Economic Outlook September 27, 2011, KKR.

Equity Valuations Are Reasonable, but Global Imbalances Are Likely to Keep The Risk Premium High In The Near Term

When we shifted our focus from researching financial-services companies to macro and portfolio strategies in 2003, we began examining the anatomy of bull markets, and what we found was that there are really two types of bulls: earnings-driven and valuation-driven. The former benefit from more growth in earnings (versus falling interest rates), generate less overall total return than their valuation-driven brethren, and usually end in a recession. One can see the varying characteristics of each in Exhibit 15. For those who keep tabs, we have been—at least until recently—in an earnings-driven bull market. However, as Exhibit 14 highlights, earnings revisions are now negative, a pattern that will likely need to reverse to sustain an upward advancement in stocks.

Exhibit 14

S&P 500 Performance Tends to Follow Earnings Revisions

Note: Earnings Per Share (EPS) Revisions are calculated as: Number of Upward Revisions to estimates minus number of Downward Revisions to estimates divided by Total number of estimates. Source: Factset, S&P. Data as at October 5, 2011.

Exhibit 15

Anatomy of a Bull Market

S&P 500 Performance

Average Bull

P/E Led

Earnings Led

Annualized Price Performance




Annualized P/E Expansion




Annualized Real Earnings Growth




Annualized CPI Inflation




Annualized Δ in Dividend Yield, basis points




Length (Years)




P/E = Price-Earnings Ratio; CPI = Consumer Price Index. Based on cycles between 1928 and 2007, and defined as bull markets that end between two months after to 12 months prior to the start of a recession. Source: S&P, BLS, Federal Reserve, Factset, Stock Market Data Used in “Irrational Exuberance” by Robert J. Shiller.

Also supporting our view that equities lack a near-term catalyst are recent reports by the Institute for Supply Management (ISM). The ISM Manufacturing index hit 51.6 in September versus a peak of 61.4 in February this year, and it is now potentially showing signs of contraction. In past cycles, equities tended to struggle when the ISM indicators decelerated toward or below 50. Using Exhibits 16 and 17 as roadmaps, we now believe that we are transitioning from deceleration to contraction.

Exhibit 16

We Are in the Later Stages of the ISM Cycle

Source: KKR

Exhibit 17

Headline ISM Cycles: Average Change P/E and EPS Growth

P/E = Price – Earnings Ratio; EPS = Earnings Per Share. Headline ISM cycles from 1949 to 2011. Source: Institute for Supply Management, S&P, Factset, Bloomberg, KKR.

Alongside slowing growth in the U.S., we see two other macro issues that are worthy of investor attention in the near-term:

“Sticky” Inflation In EM Is Keeping Central Bankers from Stimulating Growth

Despite the recent downdraft, we remain strong believers in emerging-market growth and return potential. As seen in Exhibit 18, consumption in emerging markets is overtaking developed markets, and we see no reason for this trajectory to change course. However, we do worry that cyclical inflation in countries like China and India could remain higher than what governments and central banks desire in the near term. And we should not forget that inflation can be difficult to control in emerging economies because it is much more tightly linked to volatile commodity inputs. In China, for example, food accounts for 30% of the consumer price index (CPI), with pork accounting for nearly half of the total. In the U.S., by comparison, total food costs are less than 15% of the overall CPI calculation (Exhibit 19).

Exhibit 18

EM Consumption is Now Surpassing DM Consumption

EM = Emerging Markets; DM = Developed Markets; E = Estimate. Data as at September 9, 2009. Source: Morgan Stanley Research.

Exhibit 19

Different Inflation Drivers in Different Economies

CPI = Consumer Price Index. Source: CEIC, BLS. China weights as at August 2011, US weights as at February 2011.

Exhibit 20

Money Supply Growth at Near-Low Levels in China

Data as at August 31, 2011. Source: The People’s Bank of China, Bloomberg.

Exhibit 21

China Can’t Promote Growth Until Inflation Dissipates

LA = Left Axis; RA = Right Axis; CPI = Consumer Price Index. Source: Bloomberg. Data as at August 31, 2011.

The CPI in China is currently running at 6.1%, down from 6.5% in July, but still above a target of 5% for the year. Why this matters so much is that central bankers in China can’t promote growth strategies until inflation trends begin to dissipate. In the interim, governments are being forced to reduce the money supply—and subsequently loan growth—in an effort to curb inflation, but so far, inflation trends have remained persistently high (Exhibits 20 and 21). At the moment, our base case is that China will shift toward a neutral policy stance sometime in 2012, but we do not believe it will move toward a loose monetary policy the way it did after 2008. What we’re implying is that China cannot act as a growth engine during a time of global growth deceleration until inflation subsides meaningfully.

Exhibit 22

5-Year Sovereign CDS Spreads

CDS = Credit Default Swaps. Source: Bloomberg. Data as at September 28, 2011.

Exhibit 23

2011E Nominal GDP Growth Minus 10-Year Government Bond Yield, Basis Points

E=IMF estimate. GDP = Gross Domestic Product. Source: IMF WEO, Bloomberg. Data as at September 27, 2011.

The European Debt Crisis: Banks Need More Capital

We aren’t exactly certain what American author Henry Miller was referring to when he said that “chaos is the score upon which reality is written,” but his comment certainly befits what we’re seeing in Europe these days. Fiscal austerity, working hand-in-hand with fits and starts of debt reduction, is increasingly straining the confederation of nations that define the European Union. In our humble opinion, the European debt crisis has emerged as the single biggest macro concern in the marketplace. Naturally, it is also eerily consistent with our Phase III worldview about government debt as the Achilles heel of global growth (Exhibits 22 and 23).

At this point, we think that a European recession could already be underway, and thus expect continued relative underperformance in the near-term. Further, we do think there is a potential roadmap for dousing the firestorm created by the sovereign debt crisis, and we cannot overstate the need of European banks for more capital. According to Morgan Stanley, 205 European banks that its analysts track have a combined $23.7 trillion in assets supported by just $1 trillion in equity capital. That is just too high a ratio of assets-to-equity, particularly when one considers what happened to the U.S. financial system in 2008 when leverage was at similar levels.

Our belief is that a capital injection into European banks is desperately needed and may need to come from local governments and/or the European Financial Stability Facility (EFSF). We would also like to see the EFSF work with the private sector to lever up, buy bonds in the open markets and become the first lien in the event of losses. Ultimately, we maintain that certain asset prices—Greek debt in particular—must be marked down to more realistic levels, while others need to be ring-fenced and protected (Exhibit 24). This plan of action would hardly be a panacea for what ails Europe, but we feel it should provide enough near-term stability to soothe the panic gripping the region.

Exhibit 24

Greek Financial Services System Under Stress

Source: Bank of Greece. Through July 31, 2011.

Exhibit 25

Stocks Getting Structurally Cheaper

Year End Trailing P/E

Year End 10 Year US Treasury Yield (%)










LA = Left Axis; RA = Right Axis; P/E = Price-Earnings Ratio. Current as at September 27, 2011. Source: Factset, Bloomberg.

Long-term Value in Equities Is Finally Emerging

While the aforementioned macro issues represent important considerations, we believe we are finally at the lower end of the trading range we envision for Phase III. Using the S&P 500 as a proxy, we would recommend aggressively acquiring stocks below an index level of 1050, and, as we discuss later, we think 1250 would be a reasonable level for today’s fair value of stocks (Exhibit 25). We do not make this statement lightly, as we have just endured a decade of dismal returns in public equities. But our point is that we are finally returning to a time of “stocks for the long run,” a term originally coined by Wharton professor Jeremy Siegel in 1994. There are several factors shaping this view.

First, as Exhibit 26 shows, the 10-year rolling return for stocks through the third quarter of 2011 was 2.8%, 780 basis points below average, and essentially on par with the 1930s. Anyone who believes in mean-reversion investing has to consider the current starting point for equities at least somewhat attractive. Second, the dividend yield on stocks is now finally on par with 10-year government debt yields (Exhibit 27). And third, price-to-earnings multiples are so low that we are finally poised for a period of sustained multiple stability and potential expansion, in contrast with the 50% or higher contraction we have experienced since 2000.

Exhibit 26

10-Year Rolling Average for Stock Returns is Now at Historically Low Levels

As of October 4, 2011. Source: FactSet, S&P, Stock Market Data Used in “Irrational Exuberance” by Robert J. Shiller.

Exhibit 27

Stocks Yielding as Much as Bonds

As of September 30, 2011. Source: FactSet, S&P, Federal Reserve, Stock Market Data Used in “Irrational Exuberance” by Robert J. Shiller.

Our analytics show that we are at price-to-earnings level at which it has paid to bet on stocks for solid long-term returns. Exhibit 28 indicates that the annualized return for buying stocks with a trailing price-to-earnings (P/E) ratio of 12–14 times, which is where we are currently trading, is 8.9% on a 1-year basis, 6.7% on a 3-year basis, 6.2% on a 5-year basis, and 7.4% on a 10-year basis. That’s the good news.

The unfortunate news is that the catalyst for a significant and sustained upward revision in sovereign-credit ratings that would lead to outsized equity returns needs to stem from notable improvements in government leverage ratios and GDP growth trends. As we showed earlier in this report (Exhibit 3), equity valuations are heavily influenced by sovereign debt loads. In addition, the level of sustainable GDP affects valuation levels too. One can see this relationship in Exhibit 35. Regrettably, we see no signs of near-term change in these two factors as current government spending trends in most developed markets are still headed upward, which is likely to keep growth below trend in the near-term. If and when they are corrected, however, we believe that these events could serve as the turning point for a major sustained P/E-driven bull market in equity valuations.

In 2012, we think that the S&P 500, which we use as a proxy for global markets, should earn approximately a 13% return on equity (ROE). Based on historical comparisons, that level of return on equity should equate to a price-to-book valuation of around 2 times (Exhibit 29). Using a $625 billion year-end 2011 estimate for S&P 500 book value, we assess a fair value estimate of around 1250 for the S&P 500.

Exhibit 28

Stock Returns: Entry and Exit Points Matter

S&P 500 P/E Entry Level

Subsequent Average Annualized S&P 500 Price Returns (%)

1 Yr

2 Yr

3 Yr

5 Yr

10 Yr





























































P/E = Price-Earnings Ratio. Data from 1913 to September 2011. Data as at September 30, 2011. Source: Bloomberg, FactSet, S&P, Stock Market Data Used in “Irrational Exuberance” by Robert J. Shiller.

Exhibit 29

Our Analysis Suggests Modest Near Term Upside to Stocks

Price-to Book




S&P 500 for BVPS of $625 *




ROE = Return on Equity; P/B = Price-to-Book; BVPS = Book Value Per Share; E= KKR Estimate. Through September 23, 2011. Source: S&P, Factset, Ned Davis. Excluding outlier periods around 1950 and 1980. *KKR Estimated BVPS at year end 2011.

Within equities, our recommendation is to focus on areas of extreme undervaluation in order to capture the maximum value in such a volatile asset class. By our measures, Germany looks categorically cheap (Exhibit 30) and the U.S. looks attractive (Exhibit 31), as do certain emerging markets (Exhibit 32). Our comparative stock-versus-bond model, which screens for overbought or oversold conditions in the momentum of stock prices relative to bond prices, has indicated that either stocks are oversold or that bonds are overbought in the U.S.—but in fact, we think both are true (Exhibit 33).

Exhibit 30

Germany Is Cheap

P/E = Price-Earnings Ratio. Source: Factset. As at September 30, 2011.

Exhibit 31

Valuation of US Stocks Looks Reasonable Again

P/E = Price-Earnings Ratio. As of September 30, 2011. Source: FactSet, S&P, Stock Market Data Used in “Irrational Exuberance” by Robert J. Shiller.

Exhibit 32

Certain EM Countries Beginning to Screen Attractively and Trade Below Historical Averages

As at September 2011. Using S&P/Citigroup BMI Emerging Markets Index for emerging market equities. Source: Bloomberg, S&P.

Exhibit 33

Near Term, Stocks are Oversold, Bonds are Overbought

Proprietary Stock/Bond Momentum Indicator. Source: Factset. Data as at September 28, 2011. Source: FactSet.

We are also predisposed to focus on companies experiencing secular growth for several reasons. For starters, in the slow-growth environment we envision for Phase III, we believe that strong top-line earnings growth will be rare. Additionally, U.S. investors are currently paying little premium for the outsized growth relative to the market (Exhibit 34). This narrowing of valuations is the exact opposite of what investors saw during the late 1990s and early 2000s, a period when investors were willing to pay almost any price for equities experiencing solid long-term-growth. We believe a similar story holds true outside the U.S. as well.

Exhibit 34

Valuation: Little Premium for Growth

P/E = Price – Earnings Ratio. Source: Factset, S&P. As at October 5, 2011.

Exhibit 35

GDP Environment Matters for Valuation

Normalized Price-to-Earnings valuation ratio = Price divided by average of past 5 years EPS. Study from 1900 to 2011. Source: BEA, Historical Statistics of the United States, Factset, S&P, Bloomberg, Stock Market Data Used in “Irrational Exuberance” by Robert J. Shiller.

Inflation Outlook: Still Greater Downside Risks, but Focus on the Pricing Power in the Interim

Given the twin forces of deleveraging and excess monetary stimulus, one could make equally strong cases for inflation and deflation. However, as we describe below, we maintain our outlook for moderate inflation with downside risks.

We tackle the inflation/deflation debate from two perspectives: capacity utilization and the monetary environment. Exhibit 36 illustrates that excess capacity in the U.S. remains high, which is conducive to low or negative inflation. Moreover, the correlation between labor-force growth and inflation is high, suggesting further downward pressure on consumer prices (Exhibit 37). In accordance with this view, one should consider that real income growth, which was a major factor in the inflationary spiral of the 1970s, has been stagnant for over 20 years: U.S. median household income was $49,445 in 2010, essentially unchanged from $49,076 in 1989 (in 2010 dollar terms).

Exhibit 36

Excess Capacity

Through August 31, 2011. Source: Federal Reserve, NBER, Bloomberg. Shaded areas indicate recessions.

Exhibit 37

Slowing Employment Growth Implies Lower Inflation

LA = Left Axis; RA = Right Axis. Long term inflation and labor force growth represented as 10-yr annualized growth. Source: Bureau of Labor Statistics. Through August 31, 2011.

From a monetary standpoint, we believe we are on the cusp of a major deleveraging cycle. Barring any major currency devaluation, deleveraging is almost always disinflationary and often deflationary. Given that total U.S. debt as a percentage of GDP is at a record 336% as of June 2011 versus a historical average of 280% over the past 20 years and a prior peak of 299% in 1932 (Exhibit 38), we argue that debt levels must come down. Unless things play out differently this time, economic growth trends and asset valuations should be negatively impacted. Also, the amount of debt required to generate a dollar of GDP appears to be at unsustainably high levels (Exhibit 39).

Exhibit 38

The Elephant in the Room: US Debt % of GDP

GDP = Gross Domestic Product; GSE = Government Sponsored Enterprises. Data through 2Q2011. Source: BEA, Federal Reserve, Morgan Stanley Research and “The Statistical History of the United States” by Ben Wattenberg.

Exhibit 39

Now, More Than Ever, it Takes Money to Make Money

GDP = Gross Domestic Product. 2000’s = 1999 to 2009. Source: BEA, Federal Reserve, Bloomberg.

Those concerned about inflation rising out of control tend to believe that a greater money supply (known in economics as M1, which includes currency and bank reserves) automatically translates into rising prices. However, we also think investors should consider that an increase in M1 (which the Fed has been boosting via its asset purchase programs) does not necessarily translate into more money in circulation (also known as M2, or the broader money base) if the money multiplier is short-circuited by lack of consumer and business confidence. In addition, as Exhibit 40 shows, even rapid M2 growth—to the extent it materializes—does not automatically translate into runaway inflation.

To date, monetary and fiscal stimuli as a percentage of GDP has exceeded 30% this cycle, nearly 4 times what the government spent during the Great Depression. However, they have not yet translated into significant loan growth or asset price increases. On the contrary: banks have continued to shrink their private-sector loan books while expanding their holdings of low-yielding U.S. government debt.

Exhibit 40

Little Relationship Between M2 Growth and Year-Over-Year Inflation

CPI = Consumer Price Index. Data from January 1960 to August 2011. Source: BLS, Federal Reserve.

Exhibit 41

Banks are Extending More Credit to The US Government, But Not the Private Sector

Data as at September 14, 2011. Source: Federal Reserve.

Another consideration in the inflation debate is to understand what actually constitutes inflation in the U.S. and why we think inflation would likely not rear its head. At the moment, nearly 31% of the U.S. inflation index comprises direct housing inputs (ex-heating, etc.). The main driver of the U.S. Consumer Price Index (CPI) index is what’s known as an “owner’s equivalent rent”: the amount a homeowner would pay to rent—or earn from renting—a home in a competitive market. Since the rental market is being bolstered by waning interest in home ownership, we could see inflation creeping in through higher rent prices, though it is hard to imagine we’ll have runaway inflation amid sluggish wage growth and challenging economic conditions. By comparison, food constitutes approximately 14% of the overall U.S. CPI composite, compared to 30% or more in emerging economies like China.

In order for our concerns about inflationary pressures to rise, we would need to witness some combination of the following four phenomena:

  1. A decline in banks’ Treasury holdings in favor of private-market loans, which is a bullish indicator for economic and wage growth (Exhibit 41 confirms this has not yet happened);
  2. An increase in loan growth that is commensurate with the money supply (Exhibit 42 indicates this is only happening at a very slow clip);
  3. A diminishment of excess factory and labor capacity (whereas to date, unemployment is unacceptably high and capacity utilization remains well below average); and
  4. A collapse in the dollar, which could usher in a period of runaway inflation (although to date, we do not share this prognosis, since the pound, euro, and yen all face similar—if not worse—monetary and fiscal headwinds than the U.S.)

Exhibit 42

M1 Up, But Bank Credit Growth Remains Weak

Source: Federal Reserve. Through August 30, 2011.

Exhibit 43

Falling Margins Likely to Pressure Earnings Growth Amid Rising Input Costs

LA = Left Axis; RA = Right Axis; EPS = Earnings Per Share; CPI = Consumer Price Index; PPI = Producer Price Index. Shaded areas indicate periods of US recessions. Source: S&P, Bloomberg, Factset. As at October 10, 2011.

What do we think inflation might look like in the near future? If the 1930s were a period of extreme deflation and the 1970s were a period of extreme inflation, we think that the next few years could fall somewhere in the middle. With the rise in consumption throughout emerging-market economies, we could see continued upward pressure on producer prices as demand for commodities continues to rise. At the same time, cheap labor and excess capacity could curb consumer prices and compress corporate margins. Already, the spread between the CPI and PPI in the U.S. is at record lows. (Exhibit 43).

With knowledge and background in macroeconomics, we attempted to forecast inflation but found that 1) it is difficult to do so well; and 2) our forecasts would likely prove no better than what forecasts already exist. In particular, the Economic Cycle Research Institute (ECRI) Future Inflation Gauge (FIG) has proved quite effective over time. Currently it suggests that core inflation will remain low over the next few years, in the 1.5–2.0% range (Exhibit 44). We acknowledge some upside risk to inflation over the near-term as the recent surge in corporate earnings growth circulates back into the economy (Exhibit 45). Yet we think the effect will be transitory, since we expect growth to slow meaningfully next year.

Exhibit 44

ECRI US Future Inflation Gauge Points to Core CPI in the 1.5-2.0% Range

LA = Left Axis; RA = Right Axis; CPI = Consumer Price Index; ECRI FIG = Economic Cycle Research Institute Future Inflation Gauge. Data from July 31, 1999 thru August 31, 2011. Source: ECRI, Bureau of Labor Statistics, Bloomberg.

Exhibit 45

Corporate Earnings Growth Leads Inflation

LA = Left Axis; RA = Right Axis; CPI = Consumer Price Index; EPS = Earnings Per Share. Dashed line indicates KKR forecast. Data from July 31, 1999 thru June 30, 2014 (Estimated). Source: S&P, Factset, Bloomberg.

“Spicier” Fixed Income Could Emerge as the Asset Class of Choice in 2012

Our school of thought is that rates are likely to stay lower for some time in many of the world’s largest markets, including U.S. Treasuries (Exhibit 47). This view, which we have long held, comports with our outlook for low inflation (see previous section entitled “Inflation Outlook: Still Greater Downside Risks, but Focus On The Pricing Power in The Interim”).

Also, given the need to stimulate improvement in the housing market, we expect government-related intervention to focus on holding down long-term interest rates at historically low levels. In Europe, by comparison, we think that some of the more levered countries are likely to face ongoing funding difficulties. Supporting our thinking is that debt loads and GDP projections for 2012 are still too high across the region. Countries like Spain and Italy are at high risk and must either grow and/or reduce debt levels to avoid the fate of some of their weaker brethren. As Exhibit 47 shows, both countries are now dangerously close to the 6% funding threshold that has tipped over countries like Greece, Ireland, and Portugal toward much more difficult macro-economic environments.

Exhibit 46

Government Debt No Longer Looks Risk Free

GDP = Gross Domestic Product; E = IMF WEO Estimate. Source: IMF WEO. As at September 22, 2011.

Exhibit 47

At Some Point, Deficits Do Matter

Yellow line represents 6% funding threshold. GDP = Gross Domestic Product. Source: IMF WEO, Bloomberg. As at September 30, 2011.

In the near term, we think that the concept of “risk-free” will become increasingly associated with corporate—rather than sovereign—indebtedness, a notion backed by the fact that corporations appear to be in sound financial shape, having significantly delevered after the 2001–2002 downturn, while governments in Europe and North America have continued to lever up. One can see the magnitude of the different leverage trajectories in Exhibit 48.

Exhibit 48

Government and Corporate Balance Sheets Have Headed in Different Directions

LA = Left Axis; RA = Right Axis; GDP = Gross Domestic Product. Source: IMF World Economic Outlook, Factset, S&P. Data as at December 31, 2010.

Exhibit 49

Average Expected Returns and Discount Rate Suggest There is Opportunity in Non-Traditional Fixed Income

Data as at September 30, 2011. Source: Standard and Poors.

Consistent with our thesis of Phase III—and with our view that we are likely to endure a modest recession at worst in 2012—we also think that there is significant investment opportunity in the corporate fixed income market, including bank loans, debt, high yield debt and mezzanine debt. We also hold that distressed and special-situation investors should have plenty of possibilities to consider as banks, governments, and select corporates delever during Phase III.

Underpinning our favorable outlook for fixed income are a host of factors. First, the discount between what investors can earn on certain parts of the corporate capital structure relative to the risk-free rate and to equities seems too high, in our opinion. If we look at the current risk-free rate of about 2% and the equity risk premium of 4%, then the implied total return on stocks is around 6% or so. But an investor can earn 9-13% returns in certain parts of the fixed income markets, potentially with less volatility (Exhibit 51). In other words, we think the illiquidity premium associated with some of the “spicier” fixed income products doesn’t really need to be 300–800 basis points over equities and 700–1100 over the risk free rate.

Second, as Exhibit 49 highlights, the discount rate and return assumptions that most pension-plan sponsors use is now so low in absolute terms that it affords them a lot of downside protection in loans, high yield, and mezzanine debt, even if there is some erosion of capital through defaults.

Third, many of the above-mentioned asset classes return a significant amount of capital to investors each year in the form of coupons or repayments, which is critical to supporting annual cash spending ratios and commitments at this point in the cycle.

Exhibit 50

Banks Will Need to Shed Assets

ECB = European Central Bank. Source: ECB Data through July 31, 2011.

Exhibit 51

Corporate Market Appears to Offer Better Yields and Potentially Less Risk

* = KKR Estimated. Data as at September 30, 2011. Source: Factset, KKR.

Currencies Have Emerged As an Important Differentiator

In addition to sovereign bond yields, currencies too have emerged as an important “release valve”, often identifying, and in some cases altering, many of the global imbalances we see in the world today. If we are right (and we believe we are), then investors need to better incorporate currencies into their global-macro and asset-allocation strategies. One needs to look no further than Exhibit 52 to find that the currency effect on total return can be as much as one third of the entire total return in some years.

Within the currency market, we have a fairly simple thesis. As Exhibit 53 shows, the world is bifurcating into “haves” (i.e., countries with the ability to raise short-term rates and attract capital) and “have-nots” (countries trapped by low rates, weak economies and outsized entitlements). Of course, we would aspire to more stakes in the haves—and some of our long-term favorites include the Singapore dollar, Mexican peso, and Chinese yuan.

Exhibit 52

Currency Impact on Emerging Market Equity Returns From a US Investor Perspective

Currency Impact = (MSCI EM Gross USD Returns - MSCI EM Gross Local Returns) / MSCI EM Gross Local Returns. Source: MSCI, Bloomberg. Through Dec 31, 2010.

Exhibit 53

Haves Versus Have Nots

BRL = Brazilian real; TRY = Turkish lira; IDR = Indonesian rupiah; AUD = Australian dollar; PLN = Polish zloty; KRW = South Korean won; EUR = euro; GBP = British pound; USD = US dollar; JPY = Japanese yen. Data as at September 20, 2011. Source: Bloomberg.

Within the cohort of have-nots, we believe that the dollar is poised to regain some of its losses in the short-term, as evidenced by the fact that many developed-market economies are now beginning to exhibit similar economic weaknesses as the U.S. Further, regions like Europe are now considering cutting rates after pledging to raise rates just months earlier. That said, while a bounce-back may be in order, the U.S. dollar faces major structural headwinds in a Phase III environment. Its government suffers from both fiscal and trade deficits, and its central bank has been among the most aggressive in terms of its commitment to bailouts and quantitative easing policies. Additionally, as sovereign funds and central banks in emerging markets diversify away from the dollar, it is likely to face ongoing pressure.

Exhibit 54

Correlation of Asset Classes with Inflation

Inflation: Y/Y% Consumer Price Index (CPI); Expected inflation: T-bill rate as proxy; Unexpected inflation: Inflation - Expected inflation. For additional information regarding the chart and basis for the data shown, please refer to Page 19 Table 6 within Facts and Fantasies about Commodity Futures.  Data is quarterly from July 1959 through 2004. Source: Gorton & Rouwenhorst, Facts and Fantasies about Commodity Futures Draft: February 28, 2005.

Commodities Should Be Approached With a Fresh Perspective

Most asset allocators we know continue to want to increase their exposure to real assets, commodities in particular. Their chief concern is the desire to increase their exposure to inflation hedges, given the surge in global money supply. Though we do not see an immediate concern for significant inflationary pressures, there is no question that commodities’ greatest strength is their role as an inflation hedge. As shown in Exhibit 54, the correlation of commodities with inflation as well as changes in inflation is positive; by comparison, stocks and bonds typically have a negative correlation with inflation and changes in inflation expectations. Separately, commodities can also act as an important diversifier, particularly during periods of heightened geopolitical tension.

Nonetheless, commodities do have their drawbacks, including their performance during periods of economic weakness. Their correlation in times of market stress tends to rise from essentially zero with a traditional 60/40 (stock/bond) portfolio to more than 40%. They have also become increasingly correlated with other asset classes, including most equities (Exhibit 55), and negative “roll down” costs can be a major headwind when the asset class is in contango. Therefore, while we do agree that commodities are an important part of any thoughtfully constructed portfolio, we’re inclined to a 5–7% allocation as more appropriate, rather than the 10% or more that some investors espouse. In addition, we recommend focusing on non-traditional allocation strategies to gain commodity exposure, including greater ownership of physical assets in place of futures.

Exhibit 55

Commodities are Now Increasingly Correlated to Equity Markets, Especially EM Equities

As at September 30, 2011. Source: Bloomberg, using S&P 500 for US equities, BarCap US Agg for US bonds, S&P GSCI for commodities and S&P Emerging Markets index for EM equities.

Exhibit 56

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

Inflation rates measured by US Consumer Price Index (CPI). Data from December 31, 1978 to December 31, 2009. Past performance is no guarantee of future results. Source: Bloomberg, MSIM.

Another point to consider is that real estate can also act as an important inflation hedge, assuming we are correct that rates are likely to remain low in the U.S. for the foreseeable future. One can see its strong correlation to inflation in a 0–4% interest rate environment (Exhibit 56). Ironically, if deflation does not settle in, the ability for real estate owners to raise rents amid low financings costs would be attractive.


Our macro view boils down to one key imperative: make volatility your friend, because it won’t be going away anytime soon. Phase III is the third and final phase of this extended deleveraging cycle, and it means that investors will have the opportunity in the next few years to make highly lucrative investments owing to opportunistic circumstances as well as structural shifts.

In a series of upcoming papers, we will examine more closely specific asset classes and their expected returns. For now, we recommend exploiting weaknesses in equities in order to tactically establish long positions in German, U.S. and emerging-market equities. We still favor an overweight position in fixed income and currently believe that the bank-loan, high-yield, and mezzanine areas all represent good to extremely compelling value. Near-term, we favor tactical long positions in the dollar and short positions in the euro. Within commodities, we recommend non-traditional investments that are not afflicted by the adverse correlation factors we previously discussed.

Looking ahead, we think that the recapitalization of European banks—if done properly—could equate, at a minimum, to a 5% upswing in global equity valuations overall. Less U.S. government intervention will also, by our perspective, contribute positively to market performance, while falling inflation in China remains a key variable on which to focus.

Finally, we expect recent weaknesses in commodities to alleviate some inflation concerns, and we expect deleveraging to gain momentum. Thus, we remain comfortable in our assumption that deflationary risks overshadow the possibility of inflation in 2012.

1 Reihnhart, Rogoff, “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises,” April 2008

Important Information

The views expressed in this presentation are the personal views of Henry McVey of Kohlberg Kravis Roberts & Co. L.P. (together with its affiliates, “KKR”) and do not necessarily reflect the views of KKR itself. The views expressed reflect the current views of Mr. McVey as of October 17, 2011 and neither Mr. McVey nor KKR undertakes to advise you of any changes in the views expressed herein. In addition, the views expressed do not necessarily reflect the opinions of any investment professional at KKR, and may not be reflected in the strategies and products that KKR offers.

This presentation has been prepared solely for informational purposes. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither KKR nor Mr. McVey guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.

There can be no assurance that an investment strategy will be successful.  Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such.  This presentation should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.

The information in this presentation may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this presentation, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.   Performance of all cited indices is calculated on a total return basis with dividends reinvested. The indices do not include any expenses, fees or charges and are unmanaged and should not be considered investments.

Neither KKR nor Mr. McVey assumes any duty to, nor undertakes to update forward looking statements. No representation or warranty, express or implied, is made or given by or on behalf of KKR, Mr. McVey or any other person as to the accuracy and completeness or fairness of the information contained in this presentation and no responsibility or liability is accepted for any such information.  By accepting this presentation, Recipient acknowledges its understanding and acceptance of the foregoing statement.

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