By HENRY H. MCVEY Jun 25, 2015
While we certainly appreciate that generating outsized returns has gotten more complicated as the cycle has progressed, we still see five distinct macro “disconnects,” or arbitrages that we view as attractive for long-term patient capital. First, given ongoing financial services de-leveraging, we still view the current illiquidity premium that has emerged in many lending arenas as quite compelling. Second, in an environment where central banks are holding nominal interest rates below nominal GDP, we favor real assets with yield, growth, and inflation hedging. Third, in pursuing rising GDP-per-capita stories in the emerging markets, we encourage folks to look beyond traditional public equities. Fourth, with China’s structural slowing now upon us, we see an increasing number of restructuring opportunities emerging across Asia, Europe, and Latin America. Fifth, in the developed markets we still see some opportunities in the corporate sector as many balance sheets remain under-levered and inefficient. To fund these five distinct macro disconnects, we continue to recommend a substantial underweight to traditional government bonds.
In today’s rapidly globalizing capital markets, there appears to be an increasing premium being placed on managers who can react quickly to changing world events, and when necessary, reposition an investment portfolio in a relatively short period of time. Without question, the ability to change one’s mind and move quickly in and out of investments should certainly be heralded as a positive development across the entire financial services industry. However, through painful trial and error, we have also learned that there is a balance. Sometimes the best thing an investor can do is just sit idle, letting one’s existing bets play out while avoiding the risk of diminishing the true courage of one’s conviction.
In our humble opinion, now is one of those times. Key to our thinking is that the major long-tail macro themes that we presented in January 2015 are still playing out nicely, and as such, we do not want to get distracted by any short-term gyrations in the marketplace. In particular, as we show in Exhibit 1, the combination of our massive underweight to government bonds, coupled with our substantial overweight to Distressed/Special Situations and other alternative asset classes, is still delivering strong performance. In addition, some of the more defensive repositioning we adopted in early 2015 relative to the 2012-2014 period has served us well, particularly as it relates to our return per unit of risk taken.
So the bottom line on our current asset allocation framework is that things just don’t seem to be too “broke,” so we are inclined not to try to “fix” them. That said, there is still a lot going on in the global markets these days, and as such, we wanted to use this mid-year update to reinforce some of our most important themes, as well as discuss some changes we are making on the margin. Our key beliefs, which we describe in more detail below, are as follows.
- We retain our 1700 basis point underweight to Government Bonds. From a strategic perspective, we still believe that the traditional role of government bonds as both an attractive yield vehicle and a portfolio “shock absorber” is just not that applicable in today’s low rate, central bank affected environment. Importantly, as we look ahead, we see several catalysts, including higher inflation, lower unemployment, and more robust wage growth by April 2016 to further confirm the merits of our massive underweight. Therefore, we are tweaking up our 2015 year-end yield target for the U.S. 10-year treasury to 2.6% from 2.4%. Our other interest rate forecasts, however, remain unchanged. Details below.
- Our biggest overweight remains Distressed/Special Situations at 15% versus a benchmark of zero. As the current asynchronous recovery unfolds, we continue to see lots of periodic dislocations that favor opportunistic capital that can be placed high up in a company’s capital structure, earn a respectable coupon, and potentially also enjoy some equity upside through options and/or warrants. From a regional perspective, China’s slowing now makes Asia the most attractive region for this specific investment opportunity, but we also think that some appealing situations now exist across Europe, the United States, and even Brazil.
- The one material change that we are making to our asset allocation in 2H15 is that we are raising Direct Lending to six percent from three percent versus a benchmark of zero. We pay for this increase by reducing our High Grade bond exposure to zero from three percent versus a benchmark of five percent. The catalyst for the increase: As we travel around, we continue to hear about more traditional financial intermediaries shrinking their footprints and backing away from non-traditional opportunities. The well-publicized unwind of GE Capital is certainly the highest profile example of late in this ongoing saga, but our international travels lead us to conclude that there are still an increasing number of lower profile exits occurring elsewhere around the world. Also, with dealer inventories now down 81%, we continue to see a convergence between the liquid and illiquid markets, particularly during periods of market stress.
- Across the rest of the portfolio, we continue to believe in overweighting both yield and growth. This drives our overweight in Real Assets, including Infrastructure, Real Estate, and Energy. It also dovetails with our approach to public equities. In particular, with greater than 65% of European equities trading with dividend yields above their corporate bond yields, we think this region of the world is still highly attractive. To this end, we are using recent stock price weakness to boost our European public equity allocation a percentage point to 16% versus a benchmark weighting of 15%. To “pay” for this increase, we further reduce our Latin American exposure to four percent from five percent and a benchmark of six percent.
- Selectivity in EM means thinking beyond just public equities. While we do think that many EM public equities could be in the process of bottoming, we still favor selectivity. As we discuss below, we still favor India, China and select parts of Mexico in the larger markets during 2015. Our bigger picture conclusion though, is that real estate and fixed income (both public and private credit) may make more sense than traditional public equities in countries where nominal rates and inflation are high. In our view, this potential investment arbitrage of owning private EM debt over equity in certain instances is still underappreciated by many investors, particularly in markets like India and Brazil.
KKR GMAA Target Asset Allocation Returns, Volatility, and Return/Risk Metrics
Importantly, as we look at the big picture, our approach to long-term investable themes still rests on our ability to find macro “disconnects,” or arbitrages where we think the upside/downside ratio is quite attractive. The good news, is that — though we are certainly later in the cycle — we see five distinct macro disconnects that we still believe in. They are as follows:
- First, as we mentioned above, we continue to take advantage of the illiquidity premium being created by Wall Street’s significant downsizing.
- Second, in today’s low yield environment, we continue to favor real assets that can provide yield, growth and inflation hedging.
- Third, we think that in the emerging markets one has to think more broadly than pure public equities. With high nominal rates but slower growth, corporate credit, particularly higher yielding private credit, can be a more pragmatic investment approach.
- Fourth, with China’s ongoing slowing, we see substantial investment opportunities to help restructure companies as they are forced to reckon with the reality that the China Growth Miracle that defined 2000-2010 is now over.
- Finally, in the developed markets we still see a lot of inefficient balance sheets where the cost of capital is still close to the cost of equity, opening the door for more buybacks, dividends and bolt-on acquisitions.
KKR GMAA 2015 Target Asset Allocation Update
Of course, as we describe in more detail below, there are certainly risks to our macro world view that bear watching, particularly after nine consecutive quarters of positive performance in the S&P 500 (which is the longest winning streak in 17 years)1. For example, we now feel that corporate mergers and acquisition activity seems a little frenetic, given that almost everything is technically accretive in today’s low rate world. Separately, we continue to watch China closely, as the macro data have been much weaker than expectations. At the moment, we think this slowdown is more of a negative for many of China’s trading partners than for China, but this view could prove too optimistic. Finally, at a time when 60%+ of the global economy is in easing mode, the Federal Reserve is embarking on its first tightening campaign since the Great Recession. With valuations now higher, volatility generally low, and the dollar breaking out, the risk of a synchronized global capital markets disruption has increased materially.
SECTION I: The Global Economic Outlook Remains Asynchronous
While we are making very few changes to our asset allocation targets this time, we have made and/or are making several notable tweaks to our 2015 economic outlook. Specifically, as we detail in Exhibit 9, we have reduced our U.S. GDP forecast to 2.4% from 2.7% on the heels of a weak start to 2015, including another negative first quarter GDP print again this year. As we show in Exhibit 3, we believe that weather in the Northeast has been an issue, while the ongoing slowdown in investment and hiring related to energy has also made a difference (Exhibit 4).
We see these growth headwinds to the U.S. economy as largely transitory. Our research on the last big supply-driven oil shock in the U.S. during 1986 also led to a temporary – and transitory – slowdown in both jobs and investment like the one we are seeing now in the United States (Exhibits 5-7). However, as the exhibits also show, consumers in 1986 began to appreciate the long-term benefits of lower gas prices by spending more a few quarters — though not immediately — after the initial supply shock. Our base is that a similar pick-up will occur during this cycle too by late 2015/early 2016.
Bad Weather Significantly Impacted Economic Growth On the East Coast During 1H15, Even Against Modest Comparisons
We Estimate That Oil Producing States Accounted for 18% of Total U.S. Job Growth in 2014; However, In 2015 This Trend Has Reversed Sharply
During the 1986 Bust, There Was an 18-Month Lag Between Oil Trough and GDP Peaking
Importantly, It Took Consumers Time to Start Translating Their Oil Savings Into More Spending Elsewhere…
…As Energy Investment Fell First, But Was Later More Than Offset by an Acceleration in Consumer Spending
In Europe, our recent trip confirms that things are progressing nicely (see below for more details), and we have actually boosted our European GDP forecast to 1.7% from 1.3% (see Thoughts from the Road: Returning to Normality, April 2015). Somewhat ironically, Europe – which faces structural demographic and labor force rigidity headwinds – is actually one of the few regions with upside potential to current growth expectations in 2015, driven by a weaker currency, lower rates and favorable comparisons.
Separately, we recently lowered our growth rate for Brazil (see Thoughts from the Road: A Perfect Storm, March 2015) to -1.5% from -0.75%. Without question, Brazil is one of the most challenging macro stories out there right now, as the local economy is being adversely impacted by a trifecta of fiscal tightening, the Petrobras scandal, and dismal hydro power conditions. Against this backdrop, we are using our mid-year update to boost our CPI estimate for 2015 to 8.2% from 7.3%. Recent trips to Sao Paulo confirm to us that the adjustment in administered prices is now more severe than we originally expected, thus we will likely push the headline CPI a full percentage point above our original estimate. Bottom line: We now allocate only four percent of our public equity exposure to Latin America versus five percent previously and a benchmark of six percent. Importantly, within Latin America, we skew our weighting distinctly towards Mexico, which we believe has better fundamentals amid important reform initiatives.
Finally, in China, we are using this opportunity to lower our 2015 GDP forecast to 6.8% from 6.9-7.0%. To date in 2015, the macro data have been even worse than our already conservative outlook. In particular, both fixed investment and export data have been sluggish (see our China section below for more details), but we do acknowledge growth in services is helping to cushion the blow. Our bottom line: We have not seen increased monetary stimulus leading to GDP and EPS improvements, and as such, we feel more comfortable with a more subdued outlook for the country.
Global Growth is Now a Two Horse Race Between the U.S. and China
Europe is the Only Region Where We Have Boosted GDP Expectations Since January
Overall, we continue to view this recovery as notably asynchronous, particularly relative to recent cycles. We see two primary issues. On the one hand, a pattern of higher savings and lower wages is now preventing developed market consumers from consistently being the engines of global growth that they were during the past few decades. On the other hand, EM consumers are still nascent in their consumption patterns, including low appetite for credit in places like Mexico and a high propensity to save in places like China. As such, EM consumers are not yet ready to assume the role of the world’s most important shoppers in the way that U.S. and European consumers did in the recent past.
The World’s Biggest Shoppers Still Reside in the U.S. and Europe, Not in the Emerging Markets
Access to Consumer Credit in Mexico Remains Subdued
Many of the World’s Biggest Savers Are in the Developing Markets
Consistent with this reality, we note that real global GDP growth has been just 2.4% since 2010, compared to 3.2% for the 1970-2002 period and 3.3% for the 2002-2008 period. One can see this in Exhibit 13. Of all the components of GDP, the trade-related ones have seen the most pronounced slowdowns. Further exacerbating the overall global growth slowdown issue is that – in an effort to reduce outsized debt loads – household and government spending have shrunk sharply in recent years, particularly relative to the 2008-2013 period (Exhibit 13).
Both Import and Export Activity Have Contracted Meaningfully in Recent Years. Meanwhile, Austere Conditions Have Dented Both Household and Government Spending
Given the Lack of Additional Global Demand, Currency Weakness Has Become a Tool for Increasing Competitiveness
The Big Headwind: Global Trade Is No Longer the Growth Engine It Once Was
DM Belt-Tightening Has Become a Headwind to Trade-Driven EM Growth
Not surprisingly, central banks around the world have resorted to unconventional monetary policies in an attempt to try to improve the situation. In many instances the “easy fix” has been to deliver currency weakness to stimulate exports and a little inflation, rather than embarking on the structural reform and investment that we think is required to fix the “hangover” that resulted from the excess spending and credit growth that occurred prior to the Great Recession. In the near term, we acknowledge that such aggressive central bank intervention can deliver a weaker currency, and as such, produce a better export environment for certain countries — but in local currency terms (Exhibit 17).
Export Growth in Local Currencies Has Rebounded Somewhat, But Actual Growth Remains Quite Tepid in U.S. Dollar Terms
However, for the entire global economy there is scant evidence that – after trillions of dollars of unconventional monetary policy – we have made enough structural changes to re-stimulate and sustain long-term demand trends. Indeed, as Exhibit 13 shows, household consumption is actually running 60 basis points below what it was during the last cycle, while government spending is running at just about half the level of the prior cycle.
Bottom line: We remain confident that the current economic recovery can last until 2017 or so, but there is mounting evidence that some of the growth we are seeing is currency-driven, central-bank manufactured growth – not the structural growth that is often associated with long-term, healthy, sustainable economic recoveries. Therefore, we are becoming increasingly worried that global politicians and central bankers need to do more to re-stimulate global trade by putting forth policies that stoke long-term demand improvements in both the developed and developing economies. If we are right, then higher volatility and lower returns are now in store for the investment community.
SECTION II: Key Themes/Investment Opportunities
In the following section, we provide an update on some of the key themes and macro trends that heavily influence our thinking around our high conviction asset allocation recommendations.
Higher Inflation, Some Wage Growth and Lower Unemployment Are Coming, Making Us Feel Better About Our Significant Underweight to Government Bonds
While we do not see structurally higher inflation, our forward-looking research does suggest that near-term inflation is poised to inflect upward by early 2016 – potentially more than the market now thinks. One can see this in Exhibit 18, which shows that U.S. headline inflation will move from -0.13% in April 2015 to 2.43%, or a change of 256 basis points by March 2016. Bond investors should also be aware that, unless the participation rate jumps meaningfully, we see unemployment moving towards 4.7% by March 2016, which is below the Fed’s long-term objective of 5.1% (Exhibit 19).
Our Analysis Suggests That Just the Stabilization in Energy Prices Will Cause a 2.6% Swing in Headline U.S. CPI by 1Q16
If the Participation Rate Does Not Increase Soon, the U.S. Unemployment Rate Could Fall Below the Fed’s Long-Term Objective by 1Q16
The third and final piece of the rate puzzle centers squarely on wage growth, a trend we are now monitoring closely. Importantly, according to some work done by my colleague Jaime Villa (Exhibits 20 and 21), wage growth should start to pick up right around spring 2016 – the same time that our research suggests cyclical inflation peaks and unemployment may go below the Fed’s long-term target.
Our Analysis Suggests That Average Hourly Earnings Lag the BLS’ Employment Cost Index by 7 Months…
…So, If We Are Right, Wage Growth Should Accelerate in the Back of 2015
Importantly, the reflation theme that we are describing is not limited to just the United States. Rather, as we show in Exhibit 22, the market is anticipating that the entire G8 country complex should start to see some improvement in its inflation outlook by spring of 2016. Consistent with this view, we have the Fed first boosting rates in September of 2015, with a moderate increase schedule thereafter. While we are certainly not as optimistic as the Fed on the path of interest rate increases, we are more confident than the market that rate increases are indeed coming. One can see this interplay of what we view as variant expectations in Exhibit 23.
We Think the Global Deflation Scare Is Behind Us…
…Which We Think Gives the Fed the Go Ahead Signal to Begin Hiking Sometime in the Second Half of 2015
Against this backdrop of steadily evolving inflation expectations, we feel comfortable with our three percent allocation to Government Bonds versus a benchmark allocation of 20%. Importantly, though, our call is not that long-term bond yields are going to get unhinged. Rather, as we show in Exhibit 25, we now see a more modest move in U.S. 10-year Treasury yields towards 2.6% in 2015, up slightly from our prior target of 2.4%. Key to our absolute view on the level of U.S. rates this year is our relative call versus European rates. What do we mean? Well, we are still of the mindset that the U.S. Treasury rate will remain anchored by the German bund at this point in the economic cycle. History is on our side as we note that the Treasury yields have generally not traded more than about 150-200 basis points above the German bund since 1989. One can see this in Exhibit 24, which assumes a year-end bund yield of 1.0%, consistent with the current forwards curve.
Importantly, with the recent introduction of quantitative easing (QE) in Europe, we feel confident that Mario Draghi will keep 10-year German yields low by fully following through on his commitment to buy 60 billion euros per month of bonds through at least September 2016. To be sure, we do not think that yields will collapse back towards the historically low levels that we saw after the program was announced earlier in the year, but we do remain confident that keeping yields around current levels is critical to ensuring that the ECB’s program inspires the confidence required for sustained higher asset prices and increased corporate confidence.
With the U.S.-German Spread Near a Historic High, We Think It Will Prevent U.S. Treasury Yields From Sky-Rocketing
We Now See 10-Year Yields Moving a Little Higher Than We Expected Over the Course of 2015
Looking at the big picture, we want to underscore that Europe’s central bank-driven thirst for sovereign debt purchases is not an isolated event. Indeed, as shown in Exhibits 26 and 27, Japan too will likely again be a major buyer of sovereign debt in 2015. All told, according to the investment bank Morgan Stanley, total G4 supply is on track to fully shrink by 20% in 2015.
Quantitative Easing, Particularly in Europe and Japan, Remains Robust
G4 Supply Is on Track to Shrink – Through a Combination of QE and Smaller Deficits – by 20% in 2015
That said, we think that the efficacy of global QE is starting to wane with interest rates at such low levels. Moreover, with a little more economic growth and some inflation coming back into the system, our bottom line is that folks should massively underweight sovereign bonds and redeploy the capital elsewhere across their asset allocation frameworks.
Driven by Upside to Growth Estimates, We Remain Constructive on European Assets in 2015
Given that Europe is the only region where we have both boosted our growth prospects and added to our public equity allocation this year, we thought it might make sense to review what in our view is finally going right, particularly for a region that has experienced two recessions in the last five years.
What’s changed, we believe, is the following:
- First, after years of fiscal austerity, Europe’s fiscal drag has fallen to around zero from 70 basis points in 20132. This pullback cannot be understated, as the negative multiplier effect on GDP had ballooned to 1.5x versus a historical average of around 0.5x.
- Second, the euro is now down 11% on a trade-weighted basis (and fully 20% versus the USD) since peaking in March 2014.
- Third, lower oil prices are proving to be somewhat of a boon to both GDP growth and private consumption. All told, my colleague Aidan Corcoran believes that each ten percent decline in oil prices adds 20 basis points to GDP after about 12-24 months (Exhibit 28). So with oil now down 35% from the June 2014 peak in euro terms, this tailwind is quite meaningful.
- Finally, with ECB President Mario Draghi now buying 60 billion euros of sovereign bonds per month, financial conditions at least in the mainstream parts of the economy are extremely compelling relative to history3.
Though we have raised our 2015 GDP forecasts to 1.7% from 1.3%, there is still a good chance that we might need to boost our forecast even further by year-end. To get a feel for this upside risk, we updated our quantitative GDP growth model (Exhibit 29). As the charts indicate, a purely quantitative assessment of a lower euro, a positive oil shock, and lower rates all suggest something north of 2.0% growth. Moreover, the model is still suggesting that weak housing activity/pricing will hurt growth, but recent data suggest housing is turning more positive in almost all of the countries we have visited across the Eurozone during the past 6-12 months.
The Impact of Changes in Oil Price and Euro Weakening on Eurozone GDP Are Significant, Even Before One Includes the Benefit of QE
Our Quantitative Model Suggests Our 1.7% Fundamental GDP Forecast Is Too Conservative
So, our bottom line is Europe still represents an attractive investment backdrop. GDP is moving from essentially flat to nearly two percent at a time when we think every 100 basis point increase in GDP translates into a 10-12% EPS growth. As such, we think that European corporate earnings could materially surprise on the upside in 2015. Initial indications are favorable, as the 1Q15 earnings season had the best earnings at the top line for five years, according to the investment bank UBS. As such, if Europe experiences any mean reversion of earnings relative to the U.S., the performance “catch-up” trade that we have been outlining to investors could still be quite substantial.
Eurozone: Earnings Momentum Has Finally Turned Positive After 48 Months in a Row of Downgrades
Trailing 12 Month EPS in the U.S. Is 27% Above 2007 Levels While Europe Is 19% Below
Beyond equities, we also expect European liquid credit, private credit and especially real estate to all perform strongly into the end of 2015. That’s the good news. The bad news is that we do increasingly wonder whether the near-term bullish macro tailwinds are actually too favorable to usher in some of the more structural changes that Europe needs to offset poor demographics and labor rigidity, particularly in countries like France and Italy. Together those two countries account for 37% of Eurozone GDP and while recent economic indicators have perked up, they will need to do much more structural reform if they are to keep up with some of their more economically flexible peers, including Germany, Ireland and Spain 4.
There are two other risks that we also think warrant investor attention. First, though we do not see Greece exiting the Union, we do think that this country’s saga will continue to periodically elevate the region’s risk premium during the next 12-24 months. Second, Russian aggression remains an ongoing threat, and so we expect occasional flare-ups to dent the prices of risk assets.
Recent China Data Makes Us Feel Confident About Our Large Overweight to Distressed/Special Situations
At the risk of sounding like a broken record, we continue to view China’s slowdown in fixed investment as a secular, not a cyclical, event. To review, there are two major influences driving our outlook for fixed investment. First, the export data we track continues to show that China’s low-end manufacturing is being ceded to other countries. This headwind clearly affects capital expenditures, logistics, infrastructure, and investment. To this end, we note that exports in China declined 2.8% year-over-year in the month of May. Second, in our opinion, China’s real estate market feels overbuilt and overleveraged at a time when low inflation is driving an asset allocation shift away from hard assets like housing towards the country’s stock market.
China Continues to Rebalance Away From Lower Value-Added Exports
This Transition Has Been Damaging to “Old China,” Particularly Manufacturing and Commodity-Related Exports
Moreover, as we look ahead, we think that the government is sincere in its pledge to make fixed investment a smaller percentage of GDP. As such, we expect fixed investment to grow in the mid-to-high single digits versus a nominal GDP of 8.5-10%. If we are right, then there is likely more downside to commodity-related inputs and activity surrounding China’s growth in this area.
Against this backdrop, we retain our bullish stance that a growing number of companies across several geographies will need to refinance and restructure their balance sheets. Importantly, during the great China Growth Miracle that defined the 2000-2010 period, many CEOs took the additional step of over-leveraging their companies using U.S.-dollar denominated debt. As such, we are already seeing interesting opportunities in more mature markets like Australia as well as in emerging countries like Brazil and Indonesia to refinance companies that clearly underestimated the rate of overall global growth as well as the strength of the U.S. dollar relative to their local currencies.
There Has Been a Broad-Based Deceleration in Chinese Investment Growth
China’s Fixed Asset Investment Is in Structural Decline, Which We Think Is a Major Macro Investment Theme
This backdrop is certainly helping performance as it relates to our sizeable 15% overweight to Distressed/Special Situations. To be sure, we believe that this opportunity set will take years, not months or quarters, to play out. However, the die has been cast as China now needs nearly eleven units of debt to generate one unit of GDP, nearly triple what it was a few years ago5. In our view, this ratio is unsustainable and is now in the process of reversing, with significant implications for the banks and corporations that have benefitted from China’s increased leverage in recent years.
Yield and Growth Investments: Our Brave New World Thesis Remains Resilient
One of our longest-held macro themes, which we term “Brave New World,” is that there has been a major demographic shift in investor preference – one that would drive individuals and institutions toward investments that could deliver both yield and growth. We introduced our Brave New World thesis circa 2004, and chose that name because we thought investors at the time would have had to be “brave” in order to shun sporty, high-flying telecom and technology stocks – all in favor of stable growers and payers.
Fast forward to today’s environment of very low yields and a renewed emphasis on return of capital, and now we find ourselves asking a totally different question: has this yield-and-growth story played out fully? Our answer is still an unequivocal “no.” At the risk of overstaying our welcome, we think it is worth considering that demographic forces remain extremely supportive of the yearn for yield, particularly as real yields have turned negative in many parts of the world.
Retirees Have a Strong Appetite for Dividend Yield
We See Demand for Yield and Growth Continuing as More Boomers Retire
In addition to the United States, we remain particularly focused on the dividend and growth opportunity in Europe. As Exhibit 38 indicates, more than 65% of European equities now sport a dividend yield that is higher than their corporate bond yield. In our view, this percentage is too high, and we expect some normalization in the coming quarters, particularly if we are right about positive earnings momentum in Europe.
Beyond public equities, we think that our focus on yield and growth is also playing out nicely in the Real Assets space. Indeed, in a world where many central banks are using QE to try to get nominal interest rates below nominal GDP, we think investors should own more cash-flowing, inflation-oriented hard assets, including infrastructure, real estate and parts of the energy food chain.
To be sure, we do not see a scenario where inflation runs away in the near term. Rather, in today’s low rate world, the idea of getting a sizeable upfront and recurring coupon from cash flowing hard assets with inflation protection features makes a lot of sense to us. Also, overweighting Real Assets in one’s asset allocation should give some optionality on current monetary policies not being so benign over time. Indeed, as Exhibit 39 shows, during past cycles when nominal interest rates were held below nominal GDP for long periods of time, an investor was usually rewarded for buying some form of inflation hedging optionality.
A Record Number of European Companies Now Have Dividend Yields Above Corporate Bond Yields
Central Banks Around the World Are Running with Aggressive Monetary Policy
Illiquidity Premium Still Compelling; Increasing Our Direct Lending Allocation to Six Percent from Three Percent
Given that the illiquidity premium has been a big theme of the KKR Global Macro & Asset Allocation team since our arrival, we are not going to spend a lot of time describing its evolution (interested parties can read our earlier pieces, Financial Services: The Road Ahead, Outlook for 2013: A Changing Playbook and Asset Allocation in a Low Rate Environment for further details).
However, we do want to underscore that the global macro backdrop as well as the regulatory environment continues to suggest that the outlook remains robust. We quantify this in Exhibit 40, which shows that the illiquidity premium has actually widened again in 2015. To be sure, many folks will point to General Electric’s exiting of its financial services businesses as clear evidence that capital is being withdrawn from key areas of the market. We agree, but it is the less well-publicized downsizing and wind-downs that we now see in increasing numbers across Europe, Asia and even Latin America that fully round out the picture.
The Illiquidity Premium Remains Substantial
Lower Inventories in the Broker Dealer Community Have Massively Dented Liquidity
Beyond the compelling opportunity set that we see in the illiquidity premium, the other big call we are making in Fixed Income is to remain flexible. As such, we continue to like our hefty allocation to Opportunistic Credit, which allows managers to shift dynamically among high yield, bank loans and structured credit. At the moment, we prefer rate-sensitive loans over fixed coupon bonds. However, if we are right that growth and inflation bounce back from depressed levels by early 2016, we expect to be able to rotate back more into High Yield.
We also may consider revisiting our underweight in Mezzanine credit. With bank regulation on leverage now sinking in across Wall Street, we are starting to see more mezzanine-like opportunities than in the past. To be sure, this trend is still in its infancy (particularly given that high yield and Business Development Companies (BDCs) are still cannibalizing parts of the traditional market in today’s low rate world), but we do notice that both sponsors and corporates are looking for new and creative ways to add almost equity-like capital to a deal structure under the new Fed guidelines. In addition, we see more mezzanine-like vehicles now being used to finance hard assets, including transportation equipment such as rail cars and ships, as Wall Street backs away from more complex originations.
Finally, as we have mentioned at the outset, we have reduced our three percent weighting in High Grade debt to zero. From our vantage point, investment grade spreads are not particularly attractive and absolute prices appear quite full in an asset class that has longer duration than high yield but offers little compensation in the form of yield for this risk. We do acknowledge that traditionally spreads have compressed in a stronger growth environment, but our view is that this cycle may be different. Key to our thinking is that high grade debt, like sovereign debt, has been one of the key beneficiaries of the recent central bank quantitative easing in the United States, a trend that is now finally poised to reverse course.
The Earnings Yield on Public Equities in India Appears Meager Relative to What Certain Debt Instruments Can Deliver
Emerging Markets: Think Beyond Just Pure Play Public Equities
Given that EM public equities have been one of the worst-performing asset classes for the five years ending 2014, we have recently been spending a lot of our time rethinking our more cautious case. As we detailed in a recent report (Emerging Market Equities: The Case for Selectivity Remains), our research prevents us from making an “all in” call. However, with margins and multiples having contracted sharply in recent years, we do think now is the time to start legging into certain positions.
So, what looks interesting to us at the moment? For starters, we retain a bias within EM for Asia over Latin America. To date in 2015, on a total return basis, EM Asia has already outperformed EM Latin America by over five percent (12.6% versus 7.2%) in local terms6. Since 2009, the gap between the two regions has been massive, with EM Asia returning nearly 152% versus 84% for EM Latin America in local terms7. Importantly, within Asia, we still favor cyclicals in India and laggard, lower beta and restructuring names in China.
In addition, we continue to advocate for interesting one-off EM public equity situations in other markets. For example, after the precipitous fall in oil prices, Nigerian banks now look interesting at less than half of book value in certain instances, while certain real estate plays in Mexico, particularly those with development skills (versus just being serial acquirers), appear attractive. Finally, with the recent pullback in India, we would be adding to positions.
Overall though, our bigger picture message is that harnessing the attractive component of rising GDP-per-capita in the emerging markets is more complicated than it seems. It requires that an investor work hard to truly identify the right themes – and equally the appropriate vehicles – to deliver on key macro tailwinds. In too many instances investors fail to appreciate how levered a country or regional index is to one company, sector, and/or local trend. As a result, the risk premium associated with the investment, particularly in the public equity space, can be vastly understated, which has – more often than not – led to disappointing investment results.
We also believe that investors in EM should consider some non-traditional EM structures, including distressed, Asian PE, real estate, and parts of EM private credit. Our experience has taught us that these vehicles may be more elegant ways to take advantage of the opportunity set that we now see across EM, particularly as China slows. Importantly, in the case of credit and real estate, high nominal rates in many EM countries often allow investors to earn ongoing coupons that dwarf what is available in the public equity markets – and still be higher up in the capital structure. Using the Indian market as a proxy, one can see the potential disparity of returns in Exhibit 42. Overall, our strong conviction about using more targeted vehicles as well as non-traditional approaches is not new for us. Indeed, it has served us well during our tenure as a global asset allocator during a highly unusual time across the global capital markets, and as such, we continue to find it attractive, particularly for institutional accounts with a heavy international focus.
Unlike in the U.S. Where Equities Offer a Substantial Yield Premium to Government Bonds, Indian Equities “Yield” Much Less Than the Local Risk-Free Rate
SECTION III: Risks
Risk comes from not knowing what you are doing. Warren Buffet
72 months into an economic cycle, now is not the time, as Warren Buffet so succinctly puts it, to “not know what you are doing.” In our humble view, now is the time – as we described in our 2015 Outlook piece Getting Closer to Home – to start peeling back some of the more speculative positions in one’s portfolio. Key to our thinking is that the economic cycle in the U.S, which we consider the most dynamic in the global economy, is now somewhere between its middle and later stages.
Moreover, while we think that the Federal Reserve will be quite measured in its tightening cycle, higher short-term rates often foreshadow the end of a cycle. One can see this in Exhibit 45. Importantly, while the historical data in this exhibit suggest that the average bull market has peaked 30 months after the Fed began tightening, we actually think it could be sooner this cycle. Why? At the risk of being labeled as a Master of the Obvious, we note that the Fed is starting its tightening campaign much later this cycle than in the past. We also note that, if we exclude long cycles that defined the Great Moderation during the 1980s, 1990s and 2000s, the average market peak is closer to 16 months after the first Fed hike.
We Are 72 Months Into the Current Economic Expansion
We Believe There Is Considerable Time Left in the U.S. Equity Bull Market
Another risk we are watching closely is whether China’s stimulus actually leads to positive earnings momentum. If it does not, then the various Chinese stock markets appear to be way ahead of themselves in terms of valuation. In particular, ChiNext, the Chinese Growth and Technology Index, which is already trading at a 116.9 P/E multiple and a 13.5 price-to-book ratio, looks quite vulnerable. One can see the magnitude of the moves throughout Chinese equities in Exhibits 46 and 47. Interestingly, China has started easing programs, including some QE-like initiatives, before it has actually cleaned up its banking system. By comparison, in many other regions of the world (the U.S. in particular after Great Recession), the banks issued equity and cleaned themselves up first before the QE liquidity spigot came on.
Many Chinese Stocks Have Enjoyed Substantial Upward Revaluations…
…Particularly Growth and Technology Stocks
Brokerage Account Openings in China Have Surged, Adding Further Support to the Bull Run in Chinese Equities
Chinese A-share Margin Debt Now Stands at RMB1.7trn, Or 3.2% of Market Cap and a Full 8.6% of Free Float
Importantly, though, growing speculation in equity markets is not limited to just China. As Exhibit 50 shows, corporate profitability has gone missing in the Russell 2000, despite performance that remains quite stellar. Maybe it is indeed different this time, but history has shown that strong equity performance without some eventual earnings growth usually ends in tears, not smiles.
Loss Makers Are Now a Major Driver of Performance in the Russell 2000
M&A as a Percentage of GDP Suggests We Are Now Approaching Peak Levels
Finally, investors should be respectful that we are entering a period of transitioning monetary policy. On the one hand, the Bank of Japan and the European Central Bank are ramping up their purchases. All told, including emerging market activity, we estimate that 60%+ of global GDP is now in monetary easing mode. On the other hand, the Federal Reserve is slowing its purchase activity of longer duration bonds as well as raising rates at the short end of the curve by year-end, we believe.
We Think That the Dollar Could Have Another Compelling Year as the Bull Market Still Has Room to Run
Central Bank Differentiation Will Also Be a Key Theme in 2015
Against this backdrop, we view the dollar as an important hedge. We also view Cash, which we now hold at three percent in the portfolio this year versus a zero balance in the 2012-2014 period, as more of a strategic asset to not only dampen volatility but also to be called on in the event of a market pullback. As Exhibit 54 shows, economic expansions have only lasted longer than six years on three occasions. Hence, we think the idea of having a little extra dry powder makes sense at this point in the cycle.
If the S&P 500 Delivers Another Positive Year in 2015, It Would Be Highly Unusual Relative to History
In terms of buying outside downside protection, we continue to look for smart ways to hedge our pro-cyclical allocation. However, the VIX is now oscillating between 12% and 17%, and S&P 500 “skew” (or premium of downside puts over the at-the-money level) remains very elevated. Therefore, our research leads us to believe that put spreads versus outright puts are the more attractive vehicles in the current environment. We would also note that short dated hedges appear more attractive, as the term structure (or time premium) to the volatility curve is steeply upward sloping—making hedges longer than a few months largely uneconomical.
An additional hedge we believe is worth considering in case something “goes bump in the night” is buying puts and/or put spreads on a biotechnology index. Although we acknowledge that shorting bull markets rarely works, we do see the biotech index now hitting all-time highs, while corresponding measures of implied volatility remain quite low. Indeed, as one can see in Exhibit 55, the price-to-book ratio of Nasdaq Biotechnology index is now at nearly 8 times, having more than doubled in under five years. Interestingly, though, as Exhibit 56 shows, the implied volatility of this index remains well anchored in the 25% to 30% range. These two fact patterns seem somewhat disconnected, and in our view, therein lies the hedging opportunity, given lofty valuations and ebullient sentiment.
The Nasdaq Biotechnology Index Has More Than Doubled in Less Than Five Years…
…But Volatility Remains Well Anchored in the 25%-30% Range
SECTION IV: Conclusion
As the cycle progresses, finding the “obvious” macro and asset allocation themes gets more complicated. Valuations are up, liquidity is abundant, and overall supply, particularly corporate equities and sovereign debt, is actually shrinking in many instances. As such, we are certainly cognizant that generating outsized returns has gotten more complicated.
However, we still see five distinct macro “disconnects,” or arbitrages that we view as compelling investment opportunities for long-term patient capital. First, given that we still think that the cycle can extend into 2017 as well as the current low level of absolute rates, we have increased confidence that it still makes sense to pursue investment vehicles that harness the illiquidity premium. To this end, whether it is in the emerging markets or developed markets, we continue to see examples of traditional financial intermediaries that are downsizing their footprints and their appetites for complex transactions.
Our Target Portfolio Is Up 3.7% YTD Through May 31, 2015
…For an 150 Basis Points of Outperformance Versus the Benchmark So Far in 2015
Second, in a world where central banks around the world are pinning nominal interest rates below nominal GDP, we think cash-flow producing real assets that provide yield, growth and some low cost inflation protection appear attractive. At the moment, we prefer mature oil wells, parts of infrastructure, and non-core real estate.
Third, we encourage folks to approach emerging markets with a more selective eye. To be sure, public equities may be the easiest way to pursue the broad-based rising GDP-per-capita thesis that investors champion. However, a public equity allocation might not be the most productive. Rather, we are championing alternative ways to access the emerging markets, including private credit, real estate, private equity and distressed.
Fourth, with China’s ongoing slowing, we see substantial investment opportunities to help restructure companies as they are forced to reckon with the reality that the China Growth Miracle that defined 2000-2010 is now over. Without question, this trend is bullish for non-traditional providers of capital who can provide solutions to complex originations, including direct lending, debt-to-equity swaps, and recapitalizations.
It’s Also Important to Be Able to Take Advantage of Public Markets as Sellers Are Often Too Rational and Less Willing to Transact When the Market Is Washed Out
Finally, the public equity markets are still littered with companies whose inefficient balance sheets make their cost of capital equivalent to their cost of equity. These sub-optimal capital structures mean that there are opportunities for investors to still own companies that can generate substantial value for shareholders via dividends, buybacks, and acquisitions (Exhibit 60).
Despite Being Later in the Cycle, Inefficient Balance Sheets Are Still Rewarding Acquirers For Doing Deals
Several Macro Indicators Support our Decision to Get “Closer to Home” in 2015
Ultimately, while we are quite bullish on our five top-down macro themes, we want to reiterate that we have generally turned more defensive relative to the 2012-2014 period. We are not bearish per se, but we do want to be respectful of the current cycle’s duration – and the potential excesses that come with long-tailed, liquidity driven, economic expansions. Reinforcing our view is that, as we show in Exhibit 59, there is certainly some quantifiable benefit to knowing when to lean in and out during each and every cycle. So, with in mind, we remain comfortable with the same advice – and the title for that matter – that we laid out in January, that – even with the confidence that we have in our five distinct macro disconnects, 2015 should mark the beginning phase of getting one’s portfolio “Closer to Home.”
1 Data as at May 31, 2015. Source: Bloomberg.
2 Data as at December 31, 2014. Source: OECD Economic Outlook 96 Database.
3 Data as at March 18, 2015. Source: Bloomberg.
4 Data as at December 31, 2014. Source: ECB, Haver Analytics.
5 Data as at December 31, 2014. Source: People’s Bank of China, China Bureau of National Statistics, Haver Analytics.
6 Data as at April 30, 2015. Source: MSCI, Bloomberg.
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