By HENRY H. MCVEY Jun 26, 2014
Our updated asset allocation framework reflects the four big macro trends we currently see driving returns across the global capital markets. First, in the developed equity markets we continue to see a lot of reasonably valued mid- and large-cap stocks with excess cash balances and low leverage. This backdrop remains a constructive one for certain private and public equity investments, and it too suggests that corporate M&A activity is likely to remain robust. Second, in a low rate environment we think the sizeable illiquidity premium that has been created by heightened regulation throughout the banking system remains compelling. On the margin, Europe appeals more to us than the United States, which represents a change in our thinking. Third, many emerging market companies now need to restructure or recapitalize their balance sheets at the exact time that the cost of capital in their countries is going up. This backdrop should reward both credit and equity investors, particularly in countries where there is now new government and/or central bank leadership. Fourth, while tapering is on track, many central banks around the world still remain committed to keeping nominal interest rates below nominal GDP. In such an environment, we believe owning real assets that can deliver yield, growth and inflation hedging makes sense.
As a native Virginian and a graduate of the University of Virginia, I have come to view Thomas Jefferson as one of the U.S.’s most thoughtful Americans. In particular, his aforementioned advice that “nothing can stop the man with the right mental attitude” is certainly critical in all facets of life, including the investment business. In particular, an investor has to be able to bounce back when asset allocation and/or security selection decisions backfire or even just do not go as planned.
Moreover, in an environment where fiscal and monetary stimulus in the United States is now 4.5x what occurred post the Great Depression, we believe having the “right mental attitude” these days also means thinking outside the box. Indeed, with the Fed’s balance sheet at more than $4 trillion and the European Central Bank (ECB) cutting deposit rates into negative territory1, we are clearly living in unprecedented times – times that require both a strong historical perspective as well as a forward-thinking one.
Given the environment in which we find ourselves operating, we have purposely shied away from reacting too much to quarterly fluctuations in stock or bond prices that might otherwise encourage us to make significant changes to our strategic asset allocation framework. Rather, we have tried to stay the course on what we believe are the big important macro themes that could materially drive performance on a three- to five-year basis.
That said, we also acknowledge that economies and markets remain continuously in motion. As such, we thought it might make sense to put forth a mid-year update that reflects some key changes that we believe are now impacting the current macro and asset allocation landscape. See below for details, but our primary macro conclusions and target asset allocation changes are as follows:
- The global economic recovery has become less synchronous. In the 1990s and early 2000s, an acceleration in consumption from the developed economies drove export demand in the emerging market economies, which in turn stimulated demand in these same economies. However, our recent visits to Europe, Asia and Latin America suggest the global economy does not appear to be enjoying a “virtuous cycle” during this economic expansion. What’s different this cycle is that developed market economies – while improving – do not seem to be creating enough outsized demand to jump-start economic growth in EM exporter nations the way they did in the past. At the same time, many emerging market countries, including Brazil and India, have been forced to fight higher inflation through higher rates – and hence, are experiencing slower growth.
- We see new opportunities “emerging” in several developing markets. Many of them relate to corporate restructurings and deleveraging stories. As such, we are increasing our allocation to Distressed Debt/Special Situations to a 9% allocation from 7% and a benchmark weighting of 0%. See below for details, but our most recent trip to India crystallized our view that many parts of EM are now enduring a modern-day version of stagflation. Against this backdrop, banks are overweight bad corporate credit, in our view, and as such, there is a growing role for private lenders and restructuring professionals to step in and provide value-added capital to struggling corporations across a variety of sectors. Importantly, this opportunity set is just unfolding, particularly in Asia. Hence, whereas we have been highlighting the merits of special situations/distressed in Europe for quite some time, an incremental rotation towards restructuring opportunities in emerging markets now appears to make a lot of sense to us.
- We are reducing our Actively Managed Opportunistic Credit allocation by 2% to 4% from 6%. Given such strong performance in 1H14, our thought is now to trim Opportunistic Credit, which we introduced in January 2014 to allow a manager to toggle between high yield and bank loans. However, with tight credit spreads, low volatility and booming issuance (collateralized loan obligations in particular), we are seeking to take some profits in liquid credit at this point in the cycle. Within our remaining Actively Managed Opportunistic Credit, we favor basically a 50/50 split of loans to high yield. Details below.
- We maintain a 55% allocation to global equities versus a benchmark of 53%. Importantly, though, we are narrowing our focus within equity markets. To review, we thought many equity trading multiples were “ahead of themselves” coming into the year. However, with many growth stocks now deflated and overall earnings poised to reaccelerate, we think the market internals now look more balanced. In particular, we see a lot of what we believe will be performance leaders in the public equity arena trading just 13-17x earnings, and many of them still display solid cash flow profiles. Outside of the United States, we continue to favor Europe and Mexican mid-caps, while we are more constructive on internal domestic consumption stories in Indonesia and India.
- We retain our positive bias towards real assets, particularly those that provide low-cost inflation optionality. In an environment where many central banks are using quantitative easing (QE) to aggressively suppress nominal interest rates below nominal GDP, we strongly believe owning real assets that can provide a combination of yield, growth and inflation protection makes a lot of sense at this point in the cycle. Importantly, we continue to see much more value in private assets, particularly infrastructure and midstream, than in public notes and/or swaps. To be sure, we do not see inflation looming in the developed markets, but if we can find real asset strategies that provide yield, growth and low-cost inflation optionality, we still recommend purchasing them.
- We continue to significantly underweight government bonds and high-grade debt in favor of “spicier” credit. Our basic premise remains that non-traditional credit, including high yield, private credit, mezzanine, and special situations, will outperform low-yielding government bonds and high grade credit as long as we are right on the duration and pace of the current economic cycle. Since the recovery began in 2009, this strategy has unfolded favorably, though we fully acknowledge the strong performance of Treasury bonds in 1H14 tested our thesis. We remain undeterred; our base case for 10-year Treasury yields by December 31, 2014 remains 3.3% versus the current level of 2.7%. Further details below.
KKR GMAA* Revised 2014 Target Asset Allocation
KKR GMAA June 2014 Target (%)
Strategy Benchmark (%)
KKR GMAA January 2014 Target (%)
Total Fixed Income
Emerging Market Debt
Actively Managed Opportunistic Credit
Fixed Income Hedge Funds
Energy / Infrastructure
Distressed / Special Situation
Growth Capital/EM PE/Other
Overall, we still feel comfortable with our asset allocation framework, given the four big macro trends we see driving returns across the global capital markets. First, in the developed equity markets we continue to see a lot of reasonably valued mid-and large-cap stocks with excess cash balances and low leverage. This backdrop remains a constructive one for certain private and public equity investments, and it too suggests that corporate M&A activity is likely to remain robust. Second, in a low rate environment we think the sizeable illiquidity premium that has been created by heightened regulation throughout the banking system remains attractive. On the margin, Europe appeals more to us than the United States, which represents a change in our thinking. Third, we believe many emerging market companies should now restructure or recapitalize their balance sheets at the exact time that the cost of capital in their countries is going up. This backdrop could reward both credit and equity investors, particularly in countries where there is now new government and/or central bank leadership. Fourth, while tapering is on track, many central banks around the world still remain committed to keeping nominal interest rates below nominal GDP. In such an environment, owning real assets that can deliver yield, growth and inflation hedging makes sense, in our view.
In terms of risk, we continue to view China as a big risk. In particular, housing activity is slowing as the government tries to bring nominal lending rates back below nominal GDP. In addition, the country’s role as “manufacturer” to the world has clearly come under pressure as soaring wages have made the country less competitive with other low-cost labor rivals. Another risk we think investors should monitor is credit spreads, high yield in particular. In Europe, for example, periphery credit spreads are trading, on average, inside of core credit spreads. While we are not predicting spreads will blow out any time soon in either the U.S. or Europe, the research we detail below supports the thesis that high yield spreads can often act as an important signaling mechanism when the cycle begins to crest. Finally, credit spreads are also tight at a time when the risk-free rate feels low, U.S. inflation is bottoming, and volatility remains dampened.
DETAILS: KEY THEMES/RECOMMENDATIONS
This recovery will not be a synchronous one
“It has been said that arguing against globalization is like arguing against the laws of gravity.” Kofi Annan
There is little doubt in my mind that, as Kofi Annan’s quote suggests, globalization is an undeniable force in economics. However, when I focus less on theory and more on the reality of what I am seeing during my travels, my “gut” instinct is that globalization is not working the way it should, or at least the way folks in the investment business thought it should.
From my vantage point, there are at least three detrimental forces at work. First, developed economies are not growing fast enough to inspire a virtuous cycle where consumption increases in the U.S. and Europe ultimately lead to a demand increase in emerging market producer nations. Indeed, we are now five years into this recovery, with nominal GDP growth in the U.S. materially slower than in prior recoveries. In particular, as Exhibit 2 shows, shortfalls in consumer and government spending have been the primary factors keeping nominal GDP growth well below trend this cycle.
Among Other Things, Lackluster GDP Growth in the U.S. Has Helped to Dent a Virtuous Cycle in the Global Economy
Profit Margins Are High, But Earnings Relative to Trend Appear Reasonable
Second, many emerging market economies are being forced to run restrictive monetary policy, despite sluggish growth. The culprit, as Exhibit 5 shows, is stubbornly high inflation. Based on our recent trips to Brazil, India and Indonesia, we can confidently assert that lack of adequate infrastructure as well as high food and labor costs seem to be creating structural inflation headwinds that likely won’t be remedied overnight.
Developed Markets PMIs Have Picked Up, While Emerging PMIs Remain Sluggish
CPI Has Been Rising Modestly In Emerging Countries Since 2012, But Falling in Developed Countries
Third, as we have documented in several recent pieces (China: Repositioning Now Required and Outlook 2014: Stay the Course), the Chinese economy is structurally slowing. We linked the slowdown to three factors: 1) anti-corruption initiatives; 2) a forced decline in nominal lending growth rates back towards nominal GDP growth; and 3) increased competition across many of China’s export
businesses. Though we think the current leadership is doing the “right” things from a macro perspective, China’s issues now run deep after a decade of excess. As such, we see little reason that these macro headwinds should reverse course in the near term.
Against this global growth backdrop, we have made several noteworthy changes to our regional GDP forecasts. In the United States, we have raised our inflation forecast to 2.0% from 1.7% on the back of higher oil prices and tightening capacity in certain areas. By comparison, we have lowered our 2014 U.S. GDP to 2.4% from 2.8% for several reasons. First, as has been well documented, adverse weather during first quarter 2014 was a major deterrent to growth. Second, while autos, energy and manufacturing continue to be economic star performers, continued lack of mortgage credit availability is now putting downward pressure on our U.S. forecasting models. Both our new and old housing forecasts are outlined in Exhibit 7.
We Have Lowered Growth Forecasts Across the Board, Except in Europe
2014 Growth & Inflation Base Case Estimates
GMAA Target Real GDP Growth
Bloomberg Consensus Real GDP Growth
KKR GMAA Target Inflation
Bloomberg Consensus Inflation
7.2% to 7.5%
2.5 to 3.0%
We’ve Updated Our Housing Forecast to Reflect Slower Construction Patterns
U.S. New Housing Construction (000 units)
New Forecast Detail
Separately, we have also trimmed our Brazil GDP forecast to 1.0% from 1.5%. The consensus remains, in our view, too optimistic at 1.8% growth in 2014. Major influences affecting our Brazil forecast are the significant declines in both business and consumer confidence in recent months. Meanwhile, given ongoing supply constraints affecting the economy, we have raised our inflation forecast to 6.5% from 6.1% and a consensus forecast of 6.4%.
In Europe, our GDP forecast remains unchanged at 1.1%, but we have trimmed our inflation forecast to 0.75% from 1.0% on the back of ECB President Mario Draghi’s most recent comments. Though we respect his most recent initiatives to thwart outright deflation, we do expect ongoing bank deleveraging to adversely affect the region’s ability to deliver higher inflation in the near to medium term.
Finally, as we detailed in our China note from February (China in Transition), we are now using 7.2% to 7.5% GDP growth in 2014, compared to our prior estimate of 7.4% to 7.7%. Anti-corruption initiatives, slowing real estate sales, and weaker low-end exports all continue to weigh on growth at a time when the government is trying to reduce nominal lending growth back towards nominal GDP levels. We have also lowered our inflation target in China to 2.5% to 3.0% from 3.0% to 3.5%, driven by not only lower food prices but also increased concerns about excess capacity in the system.
...But our forecasted duration for this cycle still appears reasonable
“Remember, it is hard to really hurt yourself falling out of a basement window.” Anonymous
As we described earlier, the synchronicity of this recovery is certainly not consistent with recent economic expansions. By comparison, the pacing and the duration of the cycle actually appear more in line with history. Specifically, if we use the U.S. as a proxy, we are now 60 months into an economic recovery, compared to an average of 95 months for the past three recoveries (Exhibit 8). Put another way, we still see more running room in terms of the duration of this economic expansion, even if it is running at a painfully slow pace versus history.
At the moment, our base forecast is unchanged: The current U.S. recovery will extend through 2017, which would be about in line with the past three economic cycles. However, when we do have a downturn, we actually do not expect the earnings fall-off to be as dramatic as what we experienced in 2001/2002 and 2007/2008. Key to our thinking is that we just do not see the same type of outsized earnings growth from one sector that we did during the 2000 cycle. To review, in 2006 the financial sector accounted for 50% or more of total incremental earnings growth (with energy being the other big driver). As a result, when credit deteriorated and leverage collapsed, the downward earnings trajectory was historic. By comparison, as we look towards 2015-2016, no one sector is expected to account for more than 20% of total incremental earnings growth. As such, we think the next earnings downturn is likely to be more modest than what occurred from June 2007 through September 2009 (Exhibit 9).
We Are Now in the 60th Month of Economic Expansion
We Think the Next Earnings Correction Will Be Less Dramatic Than the 2007-2009 Period
S&P 500 Earnings Bear Markets
EPS Peak to Trough
Average Since 1900
Average Post War
Our U.S. GDP Forecasts for 2014-2017e Assume That Growth Falls Off in 2017
The U.S. Economy Will Soon Have to Face the Impact of Higher Interest Rates
Importantly, we continue to watch influences that could drive upside or downside to our base case. To this end, we thought it might be worth mentioning what is going better – and worse – than anticipated so far since we laid out our initial macro framework in October 2011 (see Phase III: The Last Stage of a Bumpy Journey). On the one hand, the U.S. consumer is now in much better shape than our original baseline. Net worth has risen a record $26.2 trillion to $81.8 trillion, or 47% above the trough of $55.6 trillion in March 20092. Not surprisingly, as consumers have repaired their balance sheets, net charge-offs have plummeted (Exhibit 12), while debt service obligations have declined precipitously (Exhibit 13).
The Consumer Credit Environment Has Become Very Benign as Charge-Offs Have Declined Dramatically
The Household Debt Service Ratio in the U.S. Has Declined by Nearly 30%
On the other hand, corporate margins appear high relative to GDP growth as corporate executives have worked tirelessly to maximize efficiency in their companies. However, given that there are so few levers left to pull on the cost side, we feel strongly that when GDP growth does slow, margins – and hence EPS growth – will likely both fall much faster than folks suspect. Importantly, we already feel like we got a “sneak preview” of what might happen when consensus margin expectations for 2014 contracted a full 1.6% on an expected sales decline of just 0.4% (i.e., a 4x decline in margins relative to sales). One can see this in Exhibit 15. So if we are right and we do get a more sustained slowdown in GDP during 2017, we feel strongly that negative operating leverage and its subsequent impact on earnings growth could surprise both analysts and executives with its abruptness.
Corporate Profit Growth Is Outpacing GDP Growth by Levels Not Seen Since the 1990s
Expectations for Margins in 2014 Have Fallen Much Faster Than Those for Sales
2014 Bottom Up Consensus S&P 500 Earnings Estimates
Consensus EPS Estimate
Contrib. to % Chg
$ EPS Chg
So, what’s our bottom line? Our base view remains that we have passed the midpoint in the recovery, and we are now likely fast approaching the two-thirds marker in the next few quarters. As such, from an investment standpoint, we believe that the macro tailwinds will no longer be enough. The micro is now required, in our view. Specifically, with the economy on the back half of its growth trajectory, we are considering migrating more towards companies that 1) can drive revenue growth; and/or 2) have the potential to repair margins; and/or 3) have the ability to use cash to drive acquisitions, buybacks or growth capital expenditures.
Further Raising Distressed/Special Situations Allocation to 9% from 7% and a Benchmark Weighting of 0%
I am neither a math major nor am I an economist, but I do know I am witnessing something new – and potentially extraordinary – on the macroeconomic front as I travel around the emerging markets. Specifically, I am seeing a growing convergence between distressed investing and traditional private equity across many of the emerging market countries I visit. For example, what I saw in India during my most recent trip was that the bulk of the near-term opportunities are helping entrepreneurs delever and/or restructure as they face the reality of slower structural growth.
In many instances these deals are large and chunky, requiring not only expertise in financial engineering but also in operational capability. This insight is important, we believe, because many investment managers in emerging markets are currently set up to either do public investing and/or private equity, not the restructurings, recaps, and deleveraging that we think are now required. As a result, we think many firms, particularly in the alternative space, will be forced to overhaul their models. In particular, we think the ability to move up and down the capital structure and provide corporate partners with value-added financial and operational expertise will transition from being a luxury offering to becoming a prerequisite for success in the new era of EM investing we now envision.
In our view, there are two important catalysts that are now driving the opportunity set we see unfolding across several key emerging markets. First, because of quantitative easing, emerging markets have had easy access to credit – too easy, in our view. As a result, capital was not allocated properly in many instances, which has dented the earnings power of the corporate sector. In addition, poor capital allocation has clogged many countries’ banking systems, and now fresh capital is needed to “fix” the problem.
Second, the global liquidity cycle is starting to actually turn in some instances. Already, the U.S. is now tapering to the tune of $10 billion per FOMC meeting, while the Bank of England is poised to finally lift rates3. This viewpoint on liquidity is significant, in our view, because it now means that the cost of capital in many emerging market countries is going up for the first time since before the Great Recession. If we are right in this view, then many corporations across the entire EM spectrum may be forced to restructure and/or delever to incorporate more expensive funding costs.
Against this macroeconomic backdrop, we think the opportunity for principal investors to lend to corporate entities high up in the capital structure during what we believe are near-trough EBITDA multiples is compelling. Moreover, in addition to what can be earned from restructuring the debt, we have seen several instances where a sliver of equity upside can be earned. As such, the net total return is now on par with private equity, though the placement in the capital structure is often more favorable.
Our bigger picture conclusion is that the traditional lines between traditional private equity and distressed investing in EM are likely to blur over the next three to five years. In a country like India, for example, the yield on private corporate debt is now upwards of 18-20% (and in some instances, one can get equity participation), up from 14-16% during my last visit4. As such, that return profile is now consistent with a more traditional P/E–like investment. Meanwhile, the deal sizes are now big enough to warrant attention from traditional private equity players, many of whom have previously focused more on just the equity portion of a company’s capital structure.
In our view, the convergence of both returns and investment opportunities means that alternative asset managers will increasingly need to move towards a structure that rewards solution-oriented firms that can deliver both principal and agency expertise across a firm’s entire capital structure. To be sure, few firms offer this broad-based capability today, but if I am looking through my macro lens correctly, then this is where the industry is likely to head over the next three to five years.
Asian Companies Are Now Beginning to Feel the Pinch of Slower Growth and Higher Interest Costs
Brazilian Consumer Debt Service Obligations Are Now at Levels That We Think Will Result in Credit Deterioration
Credit as a % of GDP Has Ballooned in Many EM Countries
Chinese Companies Now Face Tougher Funding Issues
From an asset allocation perspective, our macro viewpoint is significant because it reinforces our decision to further increase our overweight to Special Situations & Distressed Investing at this point in the economic cycle. From a regional standpoint, our recent travels to Europe confirm to us that the upcoming bank stress test has already brought an end to the “extend and pretend” mentality that has defined European banks over the past few years. As such, we believe that the ECB’s new role as supervisor to the European banking sector is bullish for accelerating the pace and scope of asset dispositions in the region.
However, as we mentioned earlier, what has us most excited about increasing our weighting to this asset class is what we are now seeing in the developing economies. Specifically, our strong belief is that we are just starting a long-tail credit cycle in the emerging markets, Asia in particular. We fully acknowledge that these investment opportunities will likely be lumpy and complicated, but we also think the opportunity to earn attractive risk-adjusted returns is as high in this area as in any other area of our asset allocation universe.
Reducing Actively Managed Opportunistic Credit; Continue to Exploit Arbitrage in Private Credit Market
At the risk of sounding like a broken record, we still think that the fixed income arena offers investors a tremendous arbitrage. Specifically, we continue to favor spicier investments, including high yield, levered loans, mezzanine and private credit at the expense of sovereign bonds and high grade debt. Since our arrival at KKR in 2011, this strategy has generally served us well as we have been able to pick up incremental spread and return as investors have gained confidence about the pace and duration of the economic cycle.
Performance Across Fixed Income Has Been Strong
Sovereign or Credit Spreads Have Tightened Across
Importantly, we do not see defaults spiking in the near to medium term, and as such, we still like being pretty far out on the risk curve in credit. Also, as we describe in more detail later on, we do not see interest rates moving materially higher over the next 12-24 months.
However, with the economy 60 months into its expansion, credit spreads tight and rates low, the prudent thing to do, in our view, is to take a few chips off the table in the liquid part of our spicy credit portfolio. As such, we are reducing our Opportunistic Credit account by two percent to four percent from six percent. See Exhibits 22 and 23 for details, but our base view is that volatility in the credit markets is now being underpriced. Moreover, as Exhibit 24 and 25 underscore, spread compression has been significant in recent years.
Implied Volatility Is Low Across Many Asset Classes
Implied Volatility Relative to Realized Volatility Has Also Compressed
Investment Grade 3 Month Price Volatility
High Yield 3 Month Price Volatility
High Yield Credit Spread Compression Has Been Significant…
...But Is Now Running Out of Momentum
Looking ahead, we see three possible concerns with regards to credit allocations, particularly on the liquid side of a portfolio. First, the risk free rate feels compressed at a time when a) economic fundamentals appear to be turning more positive, and b) the Fed’s liquidity momentum will be slowing. Second, by almost any measure credit spreads are now quite tight, so any external shock to the macro outlook could quickly force a reset. Third and finally, the implied volatilities in both high grade and high yield are actually below the three-year moving average, which signals to us heightened investor complacency.
Our bottom line: we do not think the credit cycle is over, but at this point we are inclined to redeploy capital towards investments that benefit from a negative turn in the credit cycle (e.g., Special Situations/Distressed) rather than investments that are levered to the cycle remaining robust (e.g., liquid credit) . Also, we continue to favor global private credit because the illiquidity premium generally gives us a greater total return cushion if the absolute level of rates backs up more than what we currently expect.
A Yield Comparison of Originated vs. Traded Leveraged Loans Suggests the Illiquidity Premium Is Still Significant
Our Analysis Suggests That Both the Illiquidity Premium and the Default Premium Still Appear Outsized
Equities: Narrow the Focus
After a fairly lackluster first six months in global equities, we now think the multiples on many stocks appear more reasonable for several reasons. First, earnings growth appears to be reaccelerating after a slow start to the year (Exhibit 29). Second, as Exhibit 30 shows, we still think that there is upside to M&A cycle. Key to our thinking is that, with valuations still reasonable, companies are now able to use their excess cash flows to grow their businesses and earnings. Initial indications appear positive, given that nearly 80% of the acquirers’ stocks exhibit positive price performance on the day of the announcement (Exhibit 31).
Multiple Expansion Got Ahead of Schedule in 2013…
…But Earnings in 2H14 Are Now More Supportive
The M&A Cycle Has Begun to Accelerate
Since October 1, 2013, 79% of Acquirers Have Exhbited Positive Returns on Day of M&A Announcement
Importantly, while some of the folks we speak with think now is the time to bottom fish in beaten down growth names, we disagree. Our base view is that tapering is a mild but important form of tightening, and as such, the discount rate used to value hyper growth stocks in areas like social media and biotechnology should be higher. As Exhibit 32 shows, the market has done a good job of de-rating speculative parts of the market without ceding a lot of ground in aggregate. In fact, the average underperforming stock in the Russell 2000 is down a full 15.9%, though the index itself is only down 40 basis points year-to-date. We also think it is worth highlighting that in both 1994 and 2004 (additional periods of changes in Fed policy), shares of crowded high growth stocks were also beaten down badly.
Crowded Growth Investments Tend to Underperform Around Changes in Monetary Policy
YTD Russell 2000
Russell 2000 Index Return (%)
Number of Stocks Outperforming Index
% of Market Cap Outperforming Index
Average Return of Outperforming Stocks (%)
Number of Stocks Underperforming Index
% Market Cap Underperforming Index
Average Return of Underperforming Stocks
Growth in India, Indonesia, and Mexico is Driven by Internal Demand
In the emerging markets, we think the competitive landscape is changing meaningfully in two areas. First, we strongly favor internal domestic consumption stories over investments linked to the China growth miracle. Second, we think focusing on countries that are embracing new political and/or economic reforms makes the most sense at this point in the cycle. Right now India and Mexico (mid-cap stocks in particular) certainly meet these criteria, in our view, but we are also watching the upcoming elections in Indonesia with a close eye.
Bottom line: We still remain constructive on equities on a 12-24 month basis. While Fed tightening will likely keep asset prices from soaring the way they did in 2013, we think the path ahead is still upward. No doubt, there will be more bumps along the way, but history shows that markets tend to peak sometime after the Fed starts raising rates. One can see this in Exhibit 34. However, we think that this cycle peaks earlier than the historical average, given that the economic expansion is already 60 months in duration. In addition, because tapering is now occurring, we think it may represent a marginal change in the flow of capital out of the global capital markets.
The Market Typically Peaks on Average 29 Months After the First Rate Hike. We Think It Will Be Sooner This Time
Historical Bull Market Cycles – S&P 500
S&P 500 & Fed Funds Rate Hike
Date of Trough
Date of Peak
First Fed Rate Hike
Months From First Fed Funds Hike to Equity Market Peak
If Past Relationships Hold True, This Economic Cycle Has More Room to Run
Real Assets: Stay the Course
John Maynard Keynes once said that “by a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” While he wrote this in 1919 in response to post-World War I economic policies, we think his comment remains valid today, given that the developed world is again awash in indebtedness—much of it government-related. Moreover, with growth lagging as well as a general unwillingness to cut social benefits, some amount of heightened inflation trends could be needed to lower the debt burden at some point.
If our macro assessment is right, then implementing an inflation hedge that protects against Keynes’ alleged “confiscation of wealth” would therefore make sense, we believe. At the moment, we continue to favor private assets that can provide yield, growth and inflation protection. Within energy, we continue to favor what we call “bonds in the ground,” or energy-related assets that can provide a steady stream of production, particularly those that benefit from higher commodity prices. In addition, we favor energy delivery assets, including midstream, transportation/logistics, and safety-related. Within real estate, our base view is that core pricing has gotten more difficult, and as such, turnaround stories and/or certain international markets, including Mexico and Europe, may make more sense. We also think that there is a bullish case to be made for global infrastructure. At this point in the cycle, however, we favor infrastructure assets that depend less on leverage and more on operational opportunities to generate returns.
History Shows That Pinning Fed Funds Below GDP Growth Leads to Rising Inflation Rates Over Time
More Investment/Infrastructure Needed to Boost Long-Term GDP Growth In EM
By comparison, we continue to basically eschew liquid commodity notes and swaps for several reasons. First, given all the ongoing improvements in production, we are not particularly bullish on commodity prices from current levels. As such, we do not think a pure long-only strategy makes sense. Second, we continue to think that the current structures offered by most Wall Street firms are inherently flawed. As Exhibit 38 shows, the S&P GSCI has woefully underperformed underlying commodity prices for quite some time.
S&P GSCI Has Underperformed Commodity Prices for Quite Some Time
Long-Dated Natural Gas and Oil Could Be an Interesting Investment Play
For portfolios restricted to purely liquid investment options in the real asset space, however, we believe that there are two options worthy of pursuit. First, we believe that long-dated natural gas and oil could be an interesting investment play. One can see this in Exhibit 39. Second, we continue to believe that certain master limited partnerships represent an attractive play on our yield, growth and inflation thesis. Within the sector, our favorite areas remain MLPs that generate revenues from “toll taking” exercises (e.g., pipelines or midstream), not the more speculative exploration and production type entities.
Update on our Interest Rate Outlook: Staying the Course
Without question, it has been a wild ride in the U.S. rates market this year. To review, we entered 2014 wondering if our year-end 10-year target of 3.3% was too dovish, as it implied essentially no rise in yields versus 2013. However, since then, the yield on the 10-year Treasury has fallen to a low of 2.5%5, and now we actually find ourselves questioning if we’re too hawkish.
Interestingly, though there is growing concern about deflation in developed markets, this year’s bond rally has actually been about moderating economic expectations. Indeed, one can see this in Exhibit 40, which shows the move down in rates has come almost entirely from falling real yields, not declining inflation expectations. Put simply, investors have downgraded their expectations for real growth and the Fed’s reaction function to that growth.
The Decline in 10-year Yields Have Been Driven by Real Rates, Not Falling Inflation Expectations
Declining Net Issuance Across Most Major Fixed Income Categories Is an Important Factor
Not surprisingly, key issues driving this moderation in growth expectations have been winter weather and Fed-speak about lower terminal rates. While the recovery from the winter setback has been frustratingly slow, what may have been a more important influence on investor expectations were former Chairman Bernanke’s comments at recent closed-door meetings. During these meetings it has been reported that he suggested that investor perceptions about the timing and pace of Fed rate hikes are too aggressive. We believe this viewpoint is certainly important, as it’s in seeming direct opposition to current Fed Chairman Janet Yellen’s first press conference, where she suggested rate hikes could come as soon as early 20156.
Technical factors, including supply constraints, are also weighing on rates, in our view. As Exhibit 41 shows, U.S. bond supply has been falling across most categories. Moreover, this lack of supply is occurring at a time when the Fed is still purchasing $35 billion of bonds per month (plus reinvested dividends), and the fiscal deficit in the U.S. is shrinking. Separately, demand for U.S. sovereign debt has been stimulated by the widening gap between U.S. and European rates. One can see this in Exhibit 44.
The Market’s Policy Rate Assumptions for 2016 Look Too Complacent
Marked Acceleration in Core CPI of Late
There Is a Widening Gap on Rates Between the U.S. and Europe
Despite Tapering, the Fed’s Balance Sheet Continues to Grow
At the moment, we are sticking to our 3.3% year-end target as we believe that the fundamentals are turning more hawkish. Key to our thinking is that there has been a significant upswing in recent inflation readings. Indeed, as Exhibit 43 shows, core CPI has been running at a 2.8% annualized rate in recent months, which is a major break versus a multi-year downtrend. In fact, we have decided to revise up our 2014 inflation forecast to 2.0% from 1.75% previously, which marks the first upward revision to our CPI outlook since coming to KKR back in 2011.
Growth fundamentals are also improving, including stronger recent readings on payrolls, jobless claims and housing starts (Exhibit 46). Importantly, investor expectations for 2H14 now look relatively modest, so rates seem primed to move higher on any continued improvements in the data.
2014 on Pace to Be the Strongest Year for Job Generation Since 1999
U.S. Loan Growth Has Accelerated Meaningfully in Recent Months
Bottom-line: We still feel good about a 3%+ year-end target for the 10-year yield. No doubt, some technical factors have been weighing on rates recently, but ultimately we think it’s fundamentals that matter most, and those fundamentals are starting to suggest modestly higher rates. However, as our forecasts indicate, we expect a gradual – not a dramatic – increase in rates because 1) we see little structural inflation in the system at this point, and 2) we expect the Fed to move in baby steps, not quantum leaps.
Risks: Where to Focus
As we have indicated above, we feel confident about the pace and duration of the current economic cycle. We also think that we are finally reaching acceleration speed. In fact, barring a major downturn in 2H14, this year will be the fastest year of monthly job additions to the U.S. economy since 1999 (Exhibit 46).
That said, risk assets have had a sizeable run, and we now think it makes sense to start to identify potential warning lights that can prevent a portfolio from being overweight risk at a time when the macro backdrop is turning. We certainly watch a variety of indicators, but our primary preference is to focus on high yield spreads. Key to our thinking is some work done my colleague David McNellis, underscoring why we think high yield spreads are so important. Specifically, as Exhibit 48 shows, high yield has generally done a good job of alerting investors when to lean in or lean out in terms of risk posture. From what we can tell, the one time high yield spreads gave a false signal was in June 2013, when they sold off fully 96bp in response to the “taper tantrum,” but then equities went on to have a strong year. The lesson we draw is that credit signals aren’t as meaningful if they are driven by central bank posturing. Rather, it matters much more when spreads widen in response to economic fundamentals.
If You Want to Be Prepared for Equity Market Stress, Then Focus on High Yield Spreads
S&P 500 Level
S&P 500 3mo Max
Drawdown vs. 3mo Max
JPM HiYld STW Level (bp)
JPM HiYld STW 3mo Min (bp)
Increase vs. 3mo Min (bp)
S&P 500 Level 6mo in Future
% 6mo Future Change
Credit sell-offs foreshadow more equity stress to come
Bad signal from taper tantrum
Most resilient credit response yet this cycle
Overall, our base view remains that we are in a strong environment for risk assets. As such, we continue to champion an overweight in equities, Europe in particular. Within the emerging markets, we have clearly moved our focus towards markets where internal demand is driving results – not an over reliance on a China growth miracle, in our view. Within EM equities, Mexican mid-cap stocks and Indian cyclical names appear attractive for long-term investors. Not surprisingly, in addition to having strong central bank leadership, both these countries are in the early stages of significant political reform that we believe could materially lift productivity on a five-year basis.
KKR Target Asset Allocation Performance Relative to Benchmark
Within credit, the current market backdrop of tight spreads, robust issuance, and low volatility lead us to reduce our liquid credit position. However, with the illiquidity premium still high and our confidence in the economic cycle still robust, we retain our overweight to private credit and mezzanine.
In our alternatives bucket, we continue to see substantial opportunity in the special situations/distressed markets. China is structurally slowing at a time when the cost of capital is rising in many EM countries. As a result, we now see many middle-market companies that need to restructure, delever, and/or reposition their businesses to face the new reality of more moderate global growth. To be sure, this investment opportunity set will be lumpy, but we think it is among the most attractive in our current asset allocation arsenal. Separately, we continue to favor standard allocations to private equity and growth investing. Importantly, we favor a broad-based regional approach to the PE allocation process, as our base view remains that this recovery will not be a synchronous one.
Real assets also remain a priority for us. To be sure, this viewpoint is not linked to a sudden spike in inflation. Rather, we think the private real asset market is providing the opportunity to get long growth and inflation protection, but also retain the privilege of getting paid along the way in the form of high current dividend. In a world where real rates seem extraordinarily low and monetary policy is loose, real asset investments appear to make a lot of sense to us.
Given these views, our overall asset allocation thesis is to still “stay the course,” retaining a bias towards risk assets. Interest rates are low, growth appears reasonable, and we expect corporate M&A to push prices higher over the coming 24 months. Moreover, we still see ample opportunity to take advantage of illiquidity premiums and/or funding shortages that are occurring across a variety of markets at this point in the cycle.
In terms of risks, we fully acknowledge that U.S. monetary policy is poised to change direction after a multi-year shift downward. At the moment, though, we still worry less about rates spiking up and more about communication “snafus” from either the Fed or the Bank of England. Separately, China’s macro headwinds are substantial, and part of performing well in the asset allocation game in the months ahead, we think, will be by not emphasizing investments that depend on a notable improvement in China’s growth trajectory.
1 Data as at May 31, 2014. Source: Exhibit 45 and the ECB, Bloomberg.
2 Data as at March 31, 2014. Source: Federal Reserve Board, Haver Analytics.
3 Data as at June 17, 2014. Source: Bloomberg, Federal Reserve Board, Bank of England.
4 Data as at May 10, 2014. Source: Bloomberg.
5 Data as at May 31, 2014. Source: Bloomberg.
6 Data as at March 19, 2014. Source: Federal Reserve.
The views expressed in this publication are the personal views of Henry McVey of Kohlberg Kravis Roberts & Co. L.P. (together with its affiliates, “KKR”) and do not necessarily reflect the views of KKR itself. This document is not research and should not be treated as research. This document does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of KKR. This document is not intended to, and does not, relate specifically to any investment strategy or product that KKR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own views on the topic discussed herein.
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