By HENRY H. MCVEY Mar 08, 2018

As we position our portfolio for the later stages of the economic recovery, we are further tilting our asset allocation targets to take advantage of the many compelling opportunities we see abroad. To be sure, we believe that the opportunity set in the U.S. remains substantial, particularly as the recent tax cuts and de-regulation efforts are likely constructive for the positioning of U.S. corporations. However, much of this benefit now seems to be in the price from a tactical perspective. Maybe more important, though, is that strong pro-growth fiscal and regulatory policy amidst bigger deficits will likely inspire the central bank in the U.S. to become more aggressive than it might like to be, which represents a ‘diverging path’ relative to what we currently see in Europe and Asia. Moreover, our recent trips across these regions give us additional confidence that Europe and Asia appear to be increasingly elegant plays on many of our most important macro themes, including Deconglomeratization, Experiences over Things, and the Illiquidity Premium in Private Credit. In addition, many of our quantitative macro models are suggesting a heavier allocation to non-U.S. equities, Emerging Markets in particular. Finally, both implicit and explicit in what we are saying is that the U.S. currency has peaked in terms of structural outperformance, a trend we outlined in our 2018 outlook in January.

“Travel makes one modest. You see what a tiny place you occupy in the world.”

Gustave Flaubert
French Novelist

While many of the conversations we are having with investors in the United States these days are championing the merits of more U.S.-centric strategies, this approach just does not seem to dovetail well with the way we are seeing the world from an asset allocation perspective, particularly after several back-to-back trips to Europe and Asia.

Our shift in relative value towards more non-U.S. assets is consistent with what we laid out in our January 2018 outlook piece, You Can Get What You Need, and we are now using this current update after our most recent travels to further increase both our Europe and Asia weightings to 17% from 16%, while our U.S. weighting drops to 15% from 17% and a benchmark weighting of 20%. One can see this Exhibit 1, which looks quite different than the overweight we were advocating to the U.S. in recent years (see Insights: U.S. Equities: Begin the Process of Leaning In, September 2015).

Exhibit 1

In Our Target Allocation, We Are Increasingly More Constructive on Europe and Asia Relative to the U.S., Particularly for Dollar-Based Investors

Note: Asia includes All Asia ex-Japan and Japan. Data as at February 28, 2018. Source: KKR Global Macro & Asset Allocation analysis.
Travel makes one modest. You see what a tiny place you occupy in the world.

Gustave Flaubert
French Novelist

However, despite our optimism towards non-U.S. assets, we fully appreciate that the U.S. capital markets represent a formidable competitor. In particular, U.S. equity markets are generally overweight Technology stocks relative to many other markets, President Trump has ushered in a compelling corporate tax cut, and sentiment across both consumers and executives towards the future is booming.

So, in an effort to pressure test our thesis on regional preferences for non-U.S. assets, I recently made two trips to Europe and one to India. In addition, I also have drawn on the expertise of my colleagues Frances Lim, who leads the macro endeavor for the KKR Asian region out of the firm’s Sydney office, and Aidan Corcoran, who leads our European Macro & Asset Allocation effort out of Dublin.

Exhibit 2

With the U.S. Leading the Charge Across Equity and Credit, Financial Assets Have Outperformed. We Are Now Calling for Some Mean Reversion

Data as at December 31, 2017. Source: Goldman Sachs.

Our bottom line: Though the internal landscape does have certain macro bumps (e.g., Brexit, higher oil prices in India, increased risk of conflict on trade policy, etc.), our recent meetings with CEOs, CIOs, and dedicated macro folks give us additional confidence that our original thesis of an overweight to Europe and Asia is poised to play out well during the next few years. To this end, I note the following insights from these recent trips with Aidan and Frances, described in more detail below, that support our geographical bets as well as our asset allocation preferences:

  • Central bank policy is less hawkish outside of the United States (e.g., Japan and Europe), which makes it easier to lock in low-cost liabilities – a key macro priority for us in 2018. As most folks know, the Federal Reserve in the United States is working hard to normalize its short-term interest rates and its balance sheet. However, we continue to believe that the market is too dovish about the pace of tightening that is likely to occur in late 2018 and into 2019; we are now using six Federal Reserve rate hikes over this period, compared to four for market participants. By comparison, the European Central Bank is still expanding its balance sheet in 2018 – likely to the tune of $270 billion or more this year. Moreover, the ECB’s deposit rate is still negative, a situation that we believe can continue until 2019. Meanwhile, in Asia, the Bank of Japan recently reappointed Haruhiko Kuroda to a second term as governor, which we believe signals a continuation of accommodative monetary policy. Given this backdrop of diverging monetary policy amidst a synchronized global recovery, we think that there is a clear ‘call to arms’ for investors to canvas both Europe and Asia, Japan in particular, for sources of low-cost liabilities that can be used to buy assets with good free cash flow prospects, particularly if they currently trade at a complexity discount.
  • With surging deficits and threats of increased protectionism, the U.S. has become a more unpredictable place to hold assets. As we detail below, the U.S. government is adding fiscal stimulus – in the form of higher deficits – into the American economy at a time when it is already at full employment, which should lead to more volatility across U.S.-based financial assets, we believe. In fact, there is not another time that we can find outside of war that U.S. deficits have been so high and unemployment so low. Without question, we think that this additional stimulus could pressure the U.S. dollar, particularly if trade tensions accelerate. In Europe, by comparison, deficits are being reduced, and the region is running a huge current account surplus. Not surprisingly, the euro appears well-bid, and with QE poised to slow at some point, we see more upside risk than downside risk to the European currency. Meanwhile, higher real rates in many parts of emerging Asia should allow for greater monetary accommodation if and when economic and/or financial conditions deteriorate. Our bottom line: while the U.S. has clearly improved its competitive positioning in the global corporate arena with lower taxes, it comes at a price – one that we think could ultimately reverse some of the outperformance that the U.S. enjoyed during the most recent dollar bull market. If we are right, then investors should be diversifying both bond and equity positions into more non-U.S. assets.
  • Corporations in both Europe and Asia are benefitting more directly from our belief that China has already crashed in nominal terms. See below for details, but this viewpoint is significant because Japanese and European firms typically enjoy significantly more global operating leverage than their American counterparts (Exhibit 27), as they export more to China. By comparison, U.S. goods exported to China as a percentage of total exports are less than six percent, while U.S. exports to China as percentage of U.S. nominal GDP is just 70 basis points.
  • Our quantitative models for both European growth and EM Public Equity outperformance both suggest favorable outcomes for investors. As we describe below in more detail, our Emerging Markets timing model, which turned positive in January 2016, is now suggesting that we are entering into a more volatile mid-cycle phase of EM outperformance. Importantly, these cycles last years, not months, we believe. Within Europe, our GDP model is suggesting, similar to what we saw unfold with our U.S. quantitative GDP model in 2013, that outsized monetary policy represents an incredibly supportive tailwind to growth. Moreover, if the U.S. is any proxy, then strong monetary policy tailwinds should soon ignite the cyclical parts of the European economy as measured by our housing activity input.
  • Both Europe and Asia have emerged as elegant plays on two of our most important macro themes: ‘Deconglomeratization’ and ‘Experiences over Things.’ While we are bullish on these themes on a global basis, we are seeing signs of ‘break out’ type activity in Europe and Asia right now. We certainly picked up on this momentum during our recent whirlwind tour to India, the United Kingdom, and Ireland, and my colleagues Aidan Corcoran in Europe and Frances Lim in Asia concur with the view that these trends are expanding throughout both regions beyond just these three countries. Details below.
  • We also see the fixed income ‘Illiquidity Premium’ as a compelling feature to earn solid risk-adjusted returns in today’s low interest rate environment. In Europe, we see a surge in opportunities linked to Private Asset-Based Lending; hence, we are now using a six percent weighting, compared to a benchmark of zero. In Asia, our trip to India confirmed a burgeoning market for Private Direct Lending across the region. Specifically, within India, we favor structures that are backed by hard assets, with additional coverage being provided at the holding company level as well.

However, we did pick up on some key areas of mounting concern that we need to watch closely. First, rising oil prices could dent both growth and macro stability in Europe and Asia if prices move up much more from current levels. In India, for example, 80% of oil is imported, which makes the country’s current account deficit notably susceptible to higher oil prices. Importantly, our forecast is that oil inventories will drop more aggressively towards the OPEC base case than what agencies like the IEA are forecasting, which suggests crude oil prices are not returning to their 2016 lows (Exhibits 3 and 4). Second, investors are now assigning limited downside to geopolitical risks, which represents a change from prior visits. In particular, anxiety in Asia surrounding North Korea has largely abated, despite the low likelihood of near-term resolution, and our visit to Rome confirmed that investors underappreciated the chances of a populist parties gaining ground in the recent elections.

Higher input costs are also now a reality, and we are likely more concerned than the consensus that they may both sap consumer demand as well as dent corporate margins, a business headwind we heard loud and clear as it pertains to both the packaging and chemical sectors in the U.K. and India. Finally, if international growth further accelerates meaningfully from current levels, the ECB and BoJ could be forced to react more quickly (and not just jawboning) than we currently envision.

Exhibit 3

We Believe that OECD Inventories Are Getting Cleaned Up Much Faster Than the IEA and Its Peers Are Suggesting, Supporting Our View for Higher Medium-term Prices…

Note: our global production (surplus/deficit) projection is adjusted for the fact that OECD comprises ~48% of total world demand. Data as at January 29, 2018. Source: KKR Global Macro & Asset Allocation analysis, Bloomberg, Haver Analytics, IEA, EIA, Energy Intelligence.

Exhibit 4

…And Recent Data Supports This View as Total U.S. Inventories Are Decreasing at a Fast Pace

Data as at February 22, 2018. Source: KKR Global Macro & Asset Allocation analysis, Bloomberg, Haver Analytics, IEA, EIA, Energy Intelligence.

Exhibit 5

The Recent U.S. Tax Cuts Offer a Significant Upside Boost to Corporate Earnings Growth

Data as at December 31, 2017. Source: KKR Global Macro & Asset Allocation analysis.

Exhibit 6

Europe, Too, Is Finally Seeing Positive Fiscal Stimulus After Years of Heavy Contraction

Data as at November 9, 2017. Office of the European Communities, Haver Analytics.

Overall, our big picture macro view is that we feel that the regime change that we first described in our January 2017 outlook piece, Paradigm Shift, is playing out nicely. Specifically, we continue to see four seismic shifts occurring across the global economy that we believe require a different investment playbook than what worked during the 2011-2016 period. They are as follows:

  • We believe that we have shifted from monetary policy to fiscal policy as a key determinant of growth and financial market conditions. The U.S. is leading the charge in this area, though Europe has become more fiscally supportive as well. If we are right, then this likely means faster growth, bigger deficits, and more of a reflationary bent across the global capital markets.
  • Second, we believe that we are transitioning from a period of re-regulation post the financial crisis in the U.S. to one of de-regulation. Financial Services should be a major beneficiary. Already, CLO risk retention rules have been repealed; at the same time, banks are now being given more latitude around leveraged lending guidelines. We also believe that Energy and select parts of Healthcare in the U.S. could also enjoy an additional boost as we relax regulatory requirements.
  • Third, our Paradigm shift framework suggests that global agendas are shifting towards more nationalistic ones. President Trump has certainly ushered in the America First era (and potentially took it to a new level with his recent announcements surrounding tariffs), but our travels lead us to conclude that there is now a more nationalistic bent across many countries in Asia and Europe, not just the U.S. This economic nationalism has likely put the brakes on assumptions of ever-greater trade facilitation in the West, while giving a boost to a greater role in the East for China in setting the global economic policy agenda. More inward looking mindsets across countries are also coincident with the rise of ‘political strong men,’ including President Donald Trump, President Xi Jinping, President Recep Erdoğan, President Vladimir Putin, etc. – all of whom have very different levers of power, sources of legitimacy, and domestic political restraints but share in having more latitude to pursue their more nationalist agendas. Given this geopolitical backdrop, investors are likely to further migrate towards large domestic economies that face less reliance on global trade and connectivity, we believe.
  • Finally, our base view is that within the capital markets, volatility will continue to transition out of the currency markets into the fixed income markets, sovereign debt in particular. This ‘baton hand-off’ is definitely under way in 2018, and we look for a continuation of this theme well into 2019. Key to our thinking is that market participants are too dovish on U.S. central bank policy, particularly as we head into 2019. Also, over time we do expect more volatility outside of the U.S. in interest rates, including India and Germany.

Given this backdrop, we believe that there are significant asset allocation implications for investors who agree with our Paradigm Shift thesis (Exhibit 7). Indeed, we believe that a new playbook is required – one that could look dramatically different from what worked in the first part of the current decade. Specifically, we advocate shorter duration and smaller positions in government bonds (hence, our 17% underweight in our asset allocation targets, our largest underweight since we have been providing asset allocation targets). Within Credit, we have tilted towards Opportunistic Credit in the Liquid Markets and Asset-Based Lending in the Private Markets. In Private Equity, we would advocate shifting from more of a Growth bias towards one that favors complexity, particularly around corporate carve-outs. Finally, within Real Assets, we increased our overweight even further in January, and we now favor both Infrastructure and Energy Income vehicles, including restructured MLPs.

Exhibit 7

Our 2018 Asset Allocation Reflects Our Preferences for International Equity Markets, Opportunistic Liquid Credit, and Yield and Growth in the Private Markets

Data as at February 28, 2018. Source: KKR Global Macro & Asset Allocation analysis.


In recent years my travel pattern has been to focus on one region per trip, either visiting Asia or going to Europe. However, I recently embarked on ‘New World/Old World’ trip that took me to India as well as to several spots in Europe. Interestingly, what I learned during my time outside of the United States is that there are several important macro themes that apply to both Asia and Europe, reinforcing our belief that an international overweight to Europe and Asia likely makes more sense at this point in the cycle than a U.S.-centric strategy. To this end, we note the following:

Central bank policy is less hawkish outside of the United States. While the Federal Reserve has clearly telegraphed that it is on course to reduce the size of its balance sheet by nearly $400 billion in total during 2018 (Exhibit 8), we believe that some investors may not fully appreciate how different the U.S. macro backdrop may look relative to Europe and Asia during the next twelve months. For starters, we are now forecasting the Fed will raise rates six times between now and the end of 2019 amidst stronger growth and upward trending inflation, compared to a market consensus of four hikes and a forecast of five times for the Federal Reserve (and we note that this is the first time we have been above the Fed’s dot plot) during the same period. Previously, we were using a forecast of four rates hikes, compared to a market view of 2.5 hikes at the time.

By comparison, as we show in Exhibit 9, the ECB is still on course to add around 270 billion euro-denominated bonds to its balance sheet in 2018. Moreover, its deposit rate is still negative 40 basis points, compared to a U.S. overnight rate of 1.42% (and we expect it to hit 2.375% by year-end 2018). Recent central bank minutes further underscore the disparity in approach. On the one hand, the ECB recently stated that it “continues to expect them [interest rates] to remain at their present levels for an extended period of time, and well past the time of our asset purchases.” On the other hand, the Federal Reserve changed its guidance in January 2018 to state that it would make “further gradual adjustments” in interest rates; its prior statements mentioned just “gradual adjustments.” Importantly, this more hawkish stance was evident even before the Congress submitted its budget, which materially increases both the prospects for growth and higher deficits in the United States.

Exhibit 8

The Fed Balance Sheet Is Expected to Shrink by $394 Billion in 2018 (Compared to a $1.1 Trillion Increase in 2013)

Data as at January 2018. Source: Cornerstone Macro.

Exhibit 9

The ECB Is Set to Add Around 270 Billion of Euro-Denominated Bonds to Its Balance Sheet in 2018

Data as at 4Q17. Source: ECB, KKR Global Macro & Asset Allocation analysis.

Meanwhile, in Japan, the BoJ continues to expand its balance sheet as inflation is still well below its two percent target and as such, it is still committed to overshooting its inflation target through aggressive monetary policy. While Governor Kuroda’s five-year term is set to expire on April 8, 2018, he has already been reappointed to another term, which we view positively. Maybe more important, though, is that we continue to believe that the institutional directive of the Bank of Japan – under almost any scenario – will be to lag the global tightening cycle, as it is likely to maintain easy monetary policy for much longer than its counterparts. In particular, we expect a continuation of Quantitative and Qualitative Easing (QQE) with Yield Curve Control (YCC), with a target around zero on the 10 year-yield, albeit at a more measured pace of buying than in the past. One can see this in Exhibits 10 and 11, respectively.

Exhibit 10

The BoJ Continues to Expand Its Balance Sheet, Making It Amongst the Most Accommodative Central Banks in the World

Data as 4Q2017. Source: Bank of Japan, Haver Analytics.

As my colleague Frances Lim recently indicated to me after an in-depth macro trip to Tokyo, ultra-easy monetary conditions in Japan are beginning to change corporate behavior and there has been steady growth in corporate capex spending in recent years (Exhibit 13), a trend we expect to continue in the current environment of an extremely tight labor market. Said differently, unlike in the U.S. (where we view a tight labor market as potentially problematic), we view Japan – a country desperate for reflationary trends – as a direct beneficiary of tight labor markets and faster growth. Indeed, if the global backdrop is beginning to shift from one of disinflation to one of reflation, then Japan – more so than almost any other country we invest in – should benefit mightily for years.

Exhibit 11

The Fed’s Path Towards Normalization Is Now Way Ahead of Europe and Japan

Note: Fed rate represents KKR Global Macro & Asset Allocation estimates. Others are consensus as per Bloomberg. Data as at February 23, 2018. Source: Bloomberg, KKR Global Macro & Asset Allocation analysis.

Exhibit 12

While Financial Conditions in the U.S. Are Tightening, Japan Continues to Be Extremely Accommodative…

Data as January 31, 2018. Source: Bloomberg, Morgan Stanley.

Exhibit 13

…And We See Corporate Behavior Changing: Corporate Capex Has Been Rising Steadily Since 2010

Data as 4Q2017. Source: Ministry of Finance Japan, Cabinet Office of Japan, Haver Analytics.

So, our bottom line is that while we agree with many investors that we may be enjoying a synchronized global economic recovery, monetary policy in 2018 is about as divergent as we can remember. Not surprisingly, our call to action is to overweight regions and asset classes where monetary policy is currently more accommodative. Within Europe, we currently favor Spain, Germany, and France, while in Asia our top picks include India, Japan, and Indonesia.

Despite a more hawkish central bank, holding local assets in the U.S. has gotten riskier. One of the most underappreciated aspects of investing, we believe, is getting the currency right. It can have a huge impact on returns, particularly around turning points. Importantly, we believe that we are at one of those turning points, with our call that the dollar is now peaking after a 79 month bull run. One can see this in Exhibit 14.

Exhibit 14

While We Acknowledge That the U.S. Dollar Could Bounce Tactically in 2018, We Believe that the USD Is Structurally in the Process of Peaking

Data as at February 28, 2018. Source: Federal Reserve, Bloomberg.

Exhibit 15

U.S. Net Issuance Is Projected to Be $1.05 Trillion in 2018 and $1.15 Trillion in 2019

Data as at February 28, 2018. Source: Global Macro & Asset Allocation, U.S. Treasury.

To be sure, the dollar may periodically rally in 2018 when investors begin to appreciate more our view that the Federal Reserve will be hiking faster than market expectations. However, current U.S. policy could be potentially dollar destructive, not dollar supportive, over the longer-term, we believe. Key to our thinking is that the U.S. deficit should be shrinking, not expanding, at this point in the cycle. One can see this in Exhibit 16, which shows that there has been no other time – excluding periods of war – where unemployment has been so low and deficits have been so high relative to GDP. The actual dollar amount of the potential deficit is also massive in absolute dollars. Indeed, as my colleague Brian Leung shows in Exhibit 17, the U.S. budget deficit is projected to reach $774 billion in 2018, surging to $1.1 trillion in 2019, which would be the largest budget deficit the U.S. has run since 2011. Importantly, the $326 billion jump from 2018 to 2019 would be the largest year-on-year increase since 2009.

Exhibit 16

The Combination of Tax Cuts and Budget Deal Could Increase the Budget Deficit to 5.6% of GDP in 2019

Data as at February 12, 2018. Source: Department of Labor, Department of Commerce, CBO, Goldman Sachs.

Exhibit 17

All Told, the Budget Deficit Is Projected to Jump 42% Between 2018 and 2019

Data as at January 2018. Source:

Exhibit 18

The U.S. and Euro Area Have Divergent Approaches to Fiscal Policy, Particularly Post 2018…

Data as at October 10, 2017. Source: IMF, Statistical Office of the European Communities.

Exhibit 19

…And Current Account Balances Are Also on Divergent Pathways, With More Than Six Percentage Points of Differential At a Time When the U.S. Is Imposing Trade Tariffs

Data as at September 30, 2017. Source: Bureau of Economic Analysis, European Central Bank, Haver Analytics.

Separately, if we transition from developed to developing markets, we note that in emerging markets real rates are notably higher than in developed markets. One can see this in Exhibit 21, which shows a solid improvement in recent years. As a result, they have more flexibility to ease and still not approach such dramatically low levels of interest that other parts of the world now endure.

Exhibit 20

Inflation Is Rising, But Generally Remains Under Control in the Emerging Markets…

Data as October 11, 2017. Source: IMF WEO estimates, Haver Analytics.

Exhibit 21

…As Emerging Markets Have Retained Positive Real Yields

Data as at February 28, 2018. Real 3m yield = 3m LIBOR rate - inflation. Source: Bloomberg.

Our bottom line: where you hold your assets can often be almost as important as which assets you hold at certain times in the cycle. Now is one of those times, we believe. As such, we prefer to hold more European and Asian assets. Already, in 2018, the penalty for owning dollars has cost investors 2.4% in total return, which has been particularly significant for holders of 10-year U.S. Treasuries (which are down 3.7% YTD before any currency penalty). Moreover, volatility in U.S. assets is likely to increase against a backdrop of larger fiscal and current account deficits, and as such, return per unit of risk for U.S. assets, which has been stellar in recent years, is likely to also come under pressure, particularly if there is more follow through around emerging markets trade tariffs.

Both Europe and EM are benefitting from our belief that China has already crashed in nominal terms. As we have been describing since late 2016, our base case is that China has already bottomed in nominal terms. One can see this in Exhibit 22, which shows that nominal GDP declined to 6.4% in 2015 from 19.7% in 2011 before recovering to 11.1% in December 2017.

Interestingly ─ and somewhat to our surprise ─ on our recent trip to India, we heard several businessmen corroborate this view. In particular, because China has taken out capacity in several important cyclical, ‘old economy’ industries, it is leading to better profit growth not only in China but also in key Indian sectors such as steel and chemicals, many of which had been suffering from a lack of pricing power. To be sure, stymied credit extension will prevent China from V-bottoming (and we should not ignore that China is in fact tightening financial conditions), but the country’s attempt to boost its PPI and industrial profits is helping other countries in Asia, India in particular. It has also helped to limit NPL formation, which helps the economy to better embrace a more realistic cost of capital for new projects.

Exhibit 22

Nominal GDP in China Fell 67% from 2011 to 2015; as Such, China’s Economy Has Already Crashed, in Our View

Data as at December 31, 2017. Source: China National Bureau of Statistics, Haver Analytics, Bloomberg, KKR Global Macro & Asset Allocation analysis.

Exhibit 23

By Shrinking Capacity in the Industrial Sector, China Has Enabled Profits to Increase; This Development Is an Important One, We Believe

Data as at December 31, 2017. Source: China National Bureau of Statistics, Haver Analytics.

Exhibit 24

Improved Supply Demand Balance Has Lifted Utilization Rates, Prices, and Profitability…

Data as at December 31, 2017. Source: China National Bureau of Statistics, Haver Analytics.

Exhibit 25

…It Has Also Helped China Address Its NPL Problem

Data as at December 31, 2016. Source: China Banking Regulatory Commission, Haver Analytics.

These positive developments in China are significant, in our view, because they support our belief that 1) the significant macro headwind faced by Asia from 2011 to 2015 (when nominal GDP fell nearly 70%) has now abated; 2) Asia should be an overweight in terms of both deployment and positioning in global asset allocation accounts. It also has implications for U.S. and European capital markets. Specifically, it leads us to believe that wide valuation differences between Defensives versus Cyclicals in non-U.S. markets will continue to narrow. Already, one can see the reversal we are predicting has begun to unfold nicely in Exhibit 26.

Exhibit 26

If We Are Right That China Has Bottomed, Then Europe’s Cyclical Stocks Should Continue to Outperform

Note: Average Across P/E, P/B and Dividend Yield. Data as at December 31, 2017. Source: MSCI, IBES, Morgan Stanley Research.

Exhibit 27

Companies in the Eurozone and Japan Are More Sensitive to Global Growth Compared to Other Firms

Data as at December 2017. Source: Goldman Sachs Research.

Our quantitative models for both European growth and EM Public Equity outperformance both suggest favorable outcomes for investors. While we have traditionally managed money using fundamental analysis, quantitative inputs have increasingly become an important part of our macro framework. To this end, we take comfort from two important insights that our proprietary models are underscoring. First, as we show in Exhibit 29 below, three of our five indicators have turned up in our EM model. We view this quite positively, as the model has demonstrated a strong ability to capture long-term turning points in EM outperformance (as well as underperformance).

Exhibit 28

It Has Been a Long, Hard Road in EM. However, We Now Believe a Structural Turn Is Occurring

Data as at February 28, 2018. Source: MSCI, Bloomberg, Factset, KKR Global Macro & Asset Allocation analysis.

Exhibit 29

EM Is Now Entering the ‘Mid-Cycle’ Phase of Its Recovery Wherein Relative Valuation Is No Longer Compellingly Cheap, but Momentum Has Turned and Fundamentals Are Improving

Data as at December 31, 2017. Source: KKR Global Macro & Asset Allocation analysis.

Exhibit 30

MSCI EM Is Up 24% on an Annualized Basis Since 2015, Outpacing the S&P 500, Which Is Only Up 16.8% Annualized During the Same Period

Note: Returns are Gross USD. Data as at December 31, 2017. Source: Bloomberg.

Interestingly, of the two indicators that are not green, one is valuation, which has turned less constructive after the trading multiple gap between developed and developing markets shrunk to a five multiple from seven in recent quarters. While a two multiple point contraction is significant, we do take some comfort that a five multiple point discount is still quite compelling in absolute terms.

Meanwhile, in Europe our model still suggests a strong tailwind from central bank support. Indeed, as one can see in Exhibit 31, the ECB’s zero interest rate policy (ECB ZIRP) is the single biggest driver of the positive outlook we are envisioning. Interestingly, our U.S. model looked eerily similar in 2013, suggesting to us that Europe has several attractive years of growth ahead.

On a more ‘micro’ perspective, we see several things in the macro data that make us constructive. First, though one of the drags in the model in Exhibit 31 is housing activity, our leading indicator for our leading indicator in housing (and we acknowledge it is always dangerous to lead a leading indicator) has inflected upward. One can see this in Exhibit 33. Second, unlike in recent years, the recovery we are now seeing in Europe is extremely broad-based. One can see that in Exhibit 32, which shows the cross-country growth trajectory has narrowed materially. We view this constructively because in the past, the gap between Germany and its European peers had approached extreme levels, in our view.

Exhibit 31

Housing (e.g., Residential Mortgages and Residential Permits) Is Still Not Yet Fully Contributing to the Eurozone Recovery

ZIRP = zero interest rate policy. Data as at December 31, 2017. Source: KKR Global Macro & Asset Allocation analysis.

Exhibit 32

Cross-country Variation in GDP Growth Rates Is Near All-time Lows; This Data Point Underscores Our View that All of Europe Is Recovering this Time

Data as at 3Q17. Source: Eurostat, KKR Global Macro & Asset Allocation analysis.

Exhibit 33

Building Permits Are on the Upswing in Parts of Europe…

Data as at September 30, 2017. Source: Statistical Office of the European Communities, Haver Analytics.

Exhibit 34

…While Eurozone Construction Output Growth Is Also Improving

Data as at November 30, 2017. Source: Statistical Office of the European Communities, Haver Analytics.

Both Europe and Asia are elegant plays on two of our most important macro themes: ‘Deconglomeratization’ and ‘Experiences over Things’. Without question, being on the ground in Asia and Europe several times in recent weeks has given us additional confidence that we are pursuing the right macro themes. Indeed, given that valuations are quite high in aggregate, we have been more focused on complex situations where an investor may be able to acquire an asset at a discounted price relative to its intrinsic value. Without question, this mindset is the backbone of our ‘deconglomeratization’ thesis.

There are several forces at work, we believe. First, as we show in Exhibit 35, return on capital for many global firms has been in secular decline, with European firms being the weakest performers. Poor management execution, increased competition, and heavier than expected infrastructure costs are all to blame. Second, as we show in detail in Exhibit 36, many multinationals, particularly those in Japan, just have too many subsidiaries. Indeed, fully 25% of the Nikkei 400 in Japan have 100 or more subsidiaries. As a result, there is a significant opportunity to unlock value by spinning out underperforming divisions and/or seeking outside partners to help create value.

Exhibit 35

Rate of Returns for FDI Declining in Many Areas of the Global Economy, Europe in Particular

Data as at December 31, 2016 or latest available year. Source: National Statistics, OECD.

Third, activist funds in the public markets represent an important contributor to our thesis. Without question, the increase in dollars raised in this segment is accelerating the streamlining of corporate structures. One can see this in Exhibits 39 and 40, respectively, which show both an increase in the velocity of divestitures as well as the number of CEO changes.

Exhibit 36

Japan Has Emerged as One of the Most Compelling Pure Play Examples on Our Thesis About Corporations Shedding Noncore Assets and Subsidiaries

Data as at 2017. Source: Macquarie.

Exhibit 37

Activism Is on the Rise in Both Asia and Europe

Data as at January 2018. Source: The Activist Investing Annual Review 2018.

Exhibit 38

There Has Been a Steady Increase of Assets in the Activist Space; This Trend Is Bullish for Our Thesis Around Corporate Carve-Outs

Note: Does not include multi-strategy activist hedge funds. Data as at January 2018. Source: 2018 Global M&A Outlook, JP Morgan, HFR.

Exhibit 39

The Number of European Union Spin-off Announcements So Far This Year Is Close to Decade Highs; This Increase Is Consistent With Our Deconglomeratization Thesis

Note: 2017 data is annualized. Data as at February 22, 2018. Source: Morgan Stanley European Equity Strategy Chartbook.

Exhibit 40

Management Change Announcements Remain on an Uptrend in Europe

Data as at February 22, 2018. Source: Morgan Stanley European Equity Strategy Chartbook.

Meanwhile, while ‘Experiences over Things’ is not a new theme for us, the pace of implementation appears to have accelerated across both Asia and Europe in recent quarters. In India, for example, cinema is exploding, with new air-conditioned multiplexes. There is also the continued focus on wellness and beauty, including a notable increase in experiential healthy dining options. As Exhibit 42 shows, increased travel by both locals and foreigners remains a secular theme throughout Asia, a trend we heard several times during our time in Mumbai. Estimates are now that international tourist arrivals are forecast to increase by 331 million to reach 535 million by 2030 (a 4.9% increase per year), making Asia the region with the highest absolute gain in arrivals.

Exhibit 41

Travel and Tourism’s Total Contribution to Global GDP Is on the Rise

Note: The direct contribution of Travel and Tourism to GDP reflects the total spending within a particular country on the sector by residents and non-residents for business and leisure purposes and spending by governments on Travel and Tourism services directly linked to visitors, such as cultural (e.g., museums) or recreational (e.g., national parks). Data as at 2016. Source: Travel & Tourism Economic Impact 2017 World.

Exhibit 42

Asia Pacific Tourists Accounted for More than 25% of Total International Arrivals in 2016

Data as at 2016. Source: UNWTO.

Technology is certainly playing a role in the inflection point we are describing, but our on the ground meetings lead us to believe that there is much more going on. For example, in Japan and Germany, both Aidan and Frances report that aging demographics are boosting the use of later stage healthcare offerings, while younger individuals in India and China are embracing more wellness and leisure. All told, Chinese millennials now spend three times as much on leisure as the average Chinese citizen. One can see this in Exhibit 44.

Exhibit 43

The Trend Towards Greater Spending on ‘Experiences’ Is Accelerating in Europe Too

Experiences includes Recreation and Culture, Other Recreational Items and Equipment, Gardens and Pets, Package Holidays, Restaurants and Hotels, Personal Care, Personal Effects n.e.c. Data as at September 30, 2017. Source: Eurostat, Haver Analytics, KKR Global Macro & Asset Allocation analysis.

Exhibit 44

Chinese Millennials Save Less, and Allocate Three Times More of Their Income to Leisure

Data as at December 31, 2016. Source: Goldman Sachs Global Investment Research.

Exhibit 45

Spending on Experiences Rather Than Things Is Increasing as More People Ascend Into the Middle Class in India

Data as at May 2017. Source: McKinsey.

Exhibit 46

A Young Indian Population With a Rising Median Income Will Focus More on Personal Care and Convenience

Data as at February 2018. Source: Citi Research Securing India’s Growth Over the Next Decade, Euromonitor.

We also see the fixed income ‘Illiquidity Premium’ as a compelling feature to earn solid risk-adjusted returns in today’s low interest rate environment in both Europe and Asia. Interestingly, in both Europe and Asia it has been poorly performing banks that have created opportunities for Private Credit investors in recent quarters across both the performing and non-performing parts of these markets. In India, for example, we spent a lot of time reviewing unsecured credits with influential promoters that use the non-bank market because it offers both speed of execution as well as the ability to tackle complex capital structures. As we show in Exhibits 47 and 48 these loans offer high rates of returns because they embed a significant credit risk premium. All told, this premium can reach 1000 basis points or more in some transactions, compared to a more ‘modest’ 300-400 basis points for inflation and currency risks.

To be sure, India is an interesting play on Private Credit, but our recent trips to Indonesia underscore that the opportunity is broad both in terms of geography and sector. Moreover, because Sydney is her home base, Frances can attest that compelling opportunities have emerged in several developed markets in Asia where KKR operates, including Australia.

Exhibit 47

India’s Rates of Return Make It a Meaningful Play on Our Yearn for Yield Thesis

Data as at February 28, 2018. Source: Bloomberg.

Exhibit 48

There Is a High Credit Risk Premium in India

Data as at February 28, 2018. Source: Central Statistical Office, Haver Analytics.

On the non-performing side in Asia, we continue to be more selective. Non-performing loans in China do not appear to offer a lot of cushion to foreign investors, while India is still in the early stages of enacting its bankruptcy laws. That said, we are encouraged that the government is finally forcing the state banks to rid themselves of zombie assets, and as such, we do expect some interesting properties to be revitalized in key sectors in India such as power and industrials.

Exhibit 49

Assets Are Now Consistently Being Disposed of in Europe By the Banking Sector

Note:*2017 is annualized; Specialized includes certain structured and asset backed products, shipping, infrastructure, energy and aviation. Data as at September 30, 2017. Source: PwC Portfolio Advisory Group Market Update.

In Europe our strong preference today is for Asset-Based Lending. We still like the Direct Lending and NPL markets, but we see more cyclical tailwinds in the hard asset market right now. Key to our thinking is that there is a change going on in the banking sector, which one can see in Exhibit 49. Specifically, as book values have again begun to grow throughout the European financial services industry, publicly traded financial intermediaries have finally started to ‘reposition’ their portfolios, including selling performing hard assets with onerous capital charges as well as seeking out capital-relieving joint ventures with third party investors, including alternative asset managers. ‘Last mile‘ residential construction in areas such as Spain and Ireland has been a particular focus of ours of late within Asset-Based Finance. We also view Asset-Based Finance as an elegant play on our desire to lock in low-cost liabilities in today’s QE-driven market, allowing investors to earn above-average spreads. Finally, we are seeing an increased opportunity set in the B-piece segment of the commercial mortgage market, driven by ‘new’ retention rules that notably favor investors with long duration liabilities who value the benefits of cash flowing hard assets.


As we move into later cycle positioning, our asset allocation advice is to tilt toward many of the compelling opportunities we see outside the U.S. To be sure, we believe that the recent tax cuts and de-regulation efforts are constructive for the positioning of U.S. corporations. However, much of this benefit now seems to be in the price on a tactical perspective. Maybe more important, though, is that strong growth will likely challenge the central bank in the U.S. to become more aggressive than it would like — all else being equal. Moreover, U.S. central bank policy now looks dramatically different than what we are seeing in Europe and Asia, Japan in particular.

Exhibit 50

The Size of the Combined Fed and ECB Balance Sheets Will Likely Peak at $9.9 Trillion in June 2018

Data as at February 28, 2018. Source: KKR Global Macro & Asset Allocation team, U.S. Treasury.

Exhibit 51

As a Result, the Term Premium, Which Has Fallen to Unsustainably Low Levels, Should Keep Heading Higher in the U.S.

e = KKR Global Macro & Asset Allocation estimates. Data as at February 28, 2018. Source: Historical data based on Kim and Wright model published by U.S. Federal Reserve.

Beyond diverging monetary policy, our recent trips across Europe and Asia give us additional confidence that these regions appear to be elegant plays on many of our most important macro themes, including ‘Deconglomeratization,’ ‘Experiences over Things,’ and the ‘Illiquidity Premium’ in Private Credit. Meanwhile, many of our quantitative macro models are suggesting a heavy allocation to non-U.S. equities, Emerging Markets in particular. Finally, both implicit and explicit in what we are saying is that the U.S. currency has peaked in terms of outperformance, a trend we outlined in our 2018 outlook in January.

Exhibit 52

Equity Valuation Metrics Show That Europe, EM and Japan Have Lower Valuations At Present Than the U.S.

Data as at February 28, 2018. Source: Factset, Bloomberg.

Overall, we believe that we are at an important inflection point in global asset allocation. On the fixed income side, we are aggressively advocating shortening duration (as measured by our 17% underweight to government bonds), while on the equity side, we are advocating more money flow into non-U.S. companies (and we are now at our widest allocation towards non-U.S. since we began providing target asset allocation models in 2012). Not surprisingly, both directives stem from our strong belief that investors should spend less time championing the benefits of a global synchronous recovery and more time understanding the difference in monetary policy that the current global growth dynamics are creating. If we are right, then the upside to these asset allocation changes could be as significant as we have seen since the introduction of quantitative easing (QE) following the onset of the great financial crisis (GFC). Therein lies the opportunity, we believe.