By HENRY H. MCVEY Jan 16, 2013
As part of our “changing playbook” thesis, we see four important macro themes worthy of investor attention in 2013. First, we believe that investors should begin the long-tail process of shifting their portfolios towards investments that perform better after interest rates have structurally bottomed. In particular, we now suggest a slow but steady move out of bonds and cash as we enter a more traditional cyclical growth phase in the economy. Second, we firmly believe that asset classes like mezzanine, special situations, and direct lending have emerged as elegant plays on the illiquidity premium being created by Wall Street’s downsizing. Third, in a world where many central banks are running nominal GDP significantly above nominal interest rates, we target significant overweight positions in investments like real assets, bank loans, and dividend-growing public equities. Finally, while emerging markets remain the growth engine of the global economy, we increasingly see government and central bank intervention in large corporations as an immediate threat to shareholder returns. CIOs should consider accessing emerging markets through concentrated public equities, local mezzanine debt, and/or even private company investments rather than owning traditional passive equity indexes or ETFs.
2012 was many things to many people, but in macro land, it was certainly the year of the acronym. OMT, or Outright Monetary Transactions; QE3, or Quantitative Easing III; ZIRP, or Zero Interest Rate Policy; and FC, or Fiscal Cliff. While we have had some difficulty remembering what each acronym stands for, we had no problem understanding that global central banks are using extreme monetary policy tactics to not only prevent deflation but also to compensate for political dysfunction across various regions of the world.
Overall, as we detail below in our 2013 outlook, we are somewhat pessimistic relative to the consensus on earnings growth in early 2013. However, we are probably more optimistic than the consensus in our belief that the global economic cycle, the private sector in particular, is still on track and will recover as we head into 2014. Indeed, after a short, sharp pause in 1Q13, we actually see a notable re-acceleration of economic growth and profits in 2H13.
In our view, cyclical industries in the U.S. like housing and autos are currently rebounding but in some cases remain far from peak levels; meanwhile, the energy and manufacturing sectors are enjoying several structural tailwinds that we think investors do not fully appreciate. And from an international vantage point, our recent visits to multiple emerging markets confirm that these economies, which we expect to account for 70%+ of global growth over the next 3-5 years, are starting to stabilize and even percolate again in some instances1. Finally, with some valuations having come down in recent weeks, we think prices on many risk assets are now attractive again.
Against this backdrop, we see four important macro themes worthy of investor attention:
- First, as part of our “changing playbook” thesis, we believe that investors should begin the long-tail process of shifting their liquid portfolios towards investments that perform better after interest rates have structurally bottomed. See below for details, but given where we are in the global monetary and economic cycles, we think a slightly different asset allocation “playbook” may now be required.
- Second, we firmly believe that asset classes like mezzanine, special situations, and direct lending to small and medium size businesses all have emerged as elegant ‘plays’ on the illiquidity premium being created by Wall Street’s downsizing. In our view, this is a major cyclical opportunity to earn compelling returns, particularly relative to low-yielding government and high grade bonds in the developed economies.
- Third, in a world where many central banks are embracing a policy of running nominal GDP significantly above nominal interest rates in an effort to aggressively reflate the economy (but quietly deflate the debt load!), we still support significant overweight positions in investments like real assets, bank loans, and dividend-growing public equities, including some cyclical areas (at the expense of defensive stocks). Whether it is income-producing real estate, oil wells, or certain growth dividend stocks, we believe investors should seek access to non-traditional, income-producing inflation hedges at a time when traditional inflation hedges such as TIPS are notably expensive.
- Fourth, we continue to believe that, while emerging markets remain the growth engine of the global economy these days, making money in these countries now requires a differentiated approach. As we travel around the world, we increasingly see government and central bank intervention in large corporations as an immediate threat to shareholder returns. And given that indexes in noteworthy markets like China and Brazil are chockfull of large capitalization ‘national champions,’ this risk is a major one, in our view. As a result, we are firmly of the mindset that CIOs should be creative and consider accessing emerging markets through concentrated public equities, local mezzanine debt, and/or even private company investments rather than owning traditional passive equity indexes or ETFs.
So, given these macro themes, how should investors think about asset allocation in 2013? As we detail in Exhibit 1, our strongest belief again this year is to allocate money towards riskier investments and away from developed market government bonds, which we view as expensive and less effective as a portfolio “shock absorber” at current levels, particularly given we think severe deflation is an unlikely outcome. All told, we are now allocating just 3% to government bonds versus a benchmark allocation of 20% (i.e., a 1700 basis point underweight). In 2012, by comparison, our allocation to developed market government bonds was 5%, so we have further reduced our long exposure by 200 basis points, or another 40%.
We are, however, making some changes to the outsized overweight to credit products that we championed in 2012. Specifically, as part of our “changing playbook” thesis, we are reducing our 5% allocation to high grade debt to zero, while our high yield allocation goes to 2% from 5%. Bottom line, much of the spread compression that we forecasted last year has largely played out on the heels of sluggish growth and QE3, and we now feel comfortable redeploying this capital towards asset classes with greater potential upside.
Given our view that the forward interest rate curve could increasingly be top of mind with investors by the end of 2013, we are adding a new 2% position to bank loans. As we detail below, we favor their floating-rate component, their relative value versus high yield at this point in the cycle, and the collateral that accompanies them.
We are also adding a 3% position to what we call direct, or non-bank, secured lending. Given the sizeable illiquidity premium that has been created by an 80% decline in Wall Street dealer inventory since 20072, we think the opportunity to pick up 350-400 basis points over liquid credit (and 9-11% yields unlevered in absolute terms) by tactically lending to small to medium-size businesses that need capital to restructure and/or fuel growth initiatives is among the most compelling risk-adjusted opportunities in the market today.
We are also lifting our European public equity weighting to 15%, in line with the benchmark, from 12% in 2012. According to research we discuss below, European valuations are now rock bottom relative to history (Exhibits 30 and 31), and equally as important, we now think expectations are much more realistic than a year ago (as evidenced by the ECB recently slashing its growth forecast).
We are also increasing our Asian public equity exposure by 2%, to 14%, from a neutral benchmark of 12%. Japan, India, Hong Kong, and even parts of the Chinese public stock market (which we traditionally dislike) all look interesting at current levels. Overall, we now are of the view that 55% of allocated assets should be in public equities versus 50% in 2012.
Within the currency arena, we favor the Mexican peso and several Southeast Asian currencies, including the Singapore dollar, against the U.S. dollar.
Our Target Allocation for 2013 Includes Greater Weightings Towards Bank Loans, Direct Lending, and Public Equities
Asset Class (%)
Old Target (%)
New Target (%)
Target vs Benchmark Difference (%)
Total Fixed Income
There are several risks to our forecast. As we discuss in our hedging section, we believe Iran represents a real threat, and as such, we review an oil-hedging strategy that we think makes some sense. Second, there is risk that China does not rebound quite as sharply as the market now thinks, so we like taking the other side of the forward swaps curve in China, which already suggests that growth will accelerate meaningfully in 2013. Finally, as part of our “changing playbook,” we think forward-year U.S. interest rate expectations could back up later next year as the economy finally starts to accelerate. So, we like shorting Eurodollar interest rate futures expiring in 2017 as a hedge against this risk.
Our GDP Outlook by Region
2013 Growth & Inflation Base Case Estimates
Real GDP Growth
-0.5 to +0.1%
1.5 to 2.0%
7.6 to 8.1%
3.0 to 4.0%
After a Sluggish 2012, Our Base Case is For Stronger Growth in 2013 and Beyond
Global GDP Proxy*
Key Economic Themes for 2013
For 2013, we believe strongly in the following macro views:
First, our models point towards a very slow first half of the year, followed by a notable rebound in the second half (Exhibits 4 and 5).
Last year, by comparison, we talked about downside risk and a potential significant second half slowdown. Ironically, we see the exact opposite pattern in 2013, where the risk to the economy is to the upside as we head towards the back half of 2013 and 2014. While we acknowledge all quantitative forecasting models have some inherent shortcomings (e.g., our EPS model can sometimes overstate or understate a trend), we believe strongly that both corporate earnings and GDP in the U.S. should start to benefit in 2H13 from lower gas prices, tighter spreads, and most importantly, a rebounding housing sector.
Our Models Suggest EPS Growth Could Sharply Rebound in 2H13
We Believe That Housing Improvements and Tighter Spreads Will Drive Latter Half of 2013 Growth
2013 Consensus Estimates are Aligned With Our Model Estimates; This Was Not the Case in 2012
We See an Uptick to Growth After a Sluggish 1H13
Working Age Pop. y/y
Output Per Employee
Real GDP Growth
Nominal GDP Growth
Household Formation: The 3-Year CAGR is Just 0.70%, Well Below the Pre-Crisis Average of 1.2%
A key part of our housing thesis is that overall residential investment as a percentage of GDP is still way below trend and should rebound. Importantly, what we think will drive it back towards more normalized levels is that household formation − one of best leading indicators for housing starts − is starting to re-accelerate towards its historical average (Exhibit 8). We think this is a multi-year rebound, as both Exhibits 9 and 10 underscore how far below trend the overall housing industry is, despite strong gains of late.
Household Formation Now Running Ahead of Completion of New Housing Units
We Think Housing Investment Is Still Heading Higher
Second, we believe the Chinese economy is re-accelerating, but investors must shift their focus towards growth in GDP per capita, not just growth in GDP.
We have spent a lot of time analyzing China macro data of late; in addition, we recently traveled to mainland China to discuss the country’s outlook with a variety of folks in the business community and government. Our bottom line: we now expect a slow but steady cyclical economic rebound to be in force by the end of the first quarter 2013. Specifically, our research shows that the Chinese economy can achieve 7.6-8.1% growth in 2013. However, we certainly do not foresee a sharp snapback towards 9-10% GDP growth, as we believe that China is dealing with important structural changes in its GDP drivers. In particular, we note the following:
- First, as one can see in Exhibit 11, the recent divide between Europe and Pan-Asian exports underscores European demand for Chinese exports has collapsed as austerity took hold on the Continent. This contraction is a big deal, since Europe has consistently been one of China’s leading trading partners.
- In addition, we think that China’s push to make itself a consumption economy is leading to higher domestic wages, which are in turn adversely affecting the country’s competitiveness (Exhibit 12). Consistent with this view, China’s exports of low value-added products (where wage costs are crucial) remain under pressure in certain instances, while products that are less reliant on low wages appear to be doing better.
- The Chinese government is trying to reduce the country’s reliance on real estate as a driver of growth. As Exhibit 13 shows, real estate as a percentage of GDP is already near what we believe is a structural peak, and as a result, the government is being forced to find new fixed investment drivers to fuel economic growth. To this end, they have committed a significant amount of resources to infrastructure spending. However, infrastructure spending does not have as large a multiplier effect as real estate, which has implications for the economy’s long-term growth trajectory.
China Exports to Asia are Strong, While Exports to Europe Remain Weak
Wages: China and Mexico Moving Closer
Real Estate Investment Can’t Become a Much Bigger Driver of Economic Growth in China
Given this changing dynamic, our bigger-picture view about China’s growth is that investors need to focus more on GDP per capita growth stories in China than opportunities linked to just GDP growth. From 2000-2012, hindsight shows that the right ‘call’ was to be long materials, industrials, and energy stocks that benefitted from high capital intensity. Today, by comparison, we believe the story is headed in a much different direction, and for private equity players in particular, we think there may be significantly higher returns for those managers who understand this shift.
What’s changed in our mind is that there appears to be a major focus by the government on more income equality, less corruption, and greater reform, so that the economy can get on a stable footing (Exhibit 14). With exports slowing and fixed investment at an outsized 50% of GDP, we feel China needs to focus on the quality and breadth of its growth, not just the overall magnitude. Importantly, this view has been reinforced by the exiting general secretary of the Communist Party of China, Hu Jintao, who recently stated that GDP per capita should double by 2020 versus 20103. This was the first time that GDP per capita was included in the economic growth targets for 2020 (versus just GDP growth in isolation). So, as the economy becomes more balanced in terms of income equality, we expect further increases in GDP per capita to lead to greater protein consumption (Exhibit 15), healthcare usage, and sales of retirement savings products.
While China’s GDP Has Grown, So Too Has Income Inequality
Demand for Oil and Soft Commodities Should Continue to Surge in China
Third, despite massive stimulus, we think that global inflation in the developed markets remains low in 2013.
Given that central banks around the world continue to deploy unprecedented amounts of liquidity, we believe it is important to “fact check” our thesis that inflation will remain low in the near term. So, what are we thinking? Our view is that a synchronous increase in global inflation can only occur after bank deleveraging in Europe has been completed (Exhibit 17). Indeed, while U.S. banks and brokers have largely completed their deleveraging cycle, the reconfiguring of balance sheets has not fully run its course in Europe (Exhibit 16). Besides banks having no desire to mark down impaired credit because of the associated hit to equity, one of the major issues has been that recently announced ECB programs have encouraged the banks to actually add to, not subtract from their government bond holdings4.
History Suggests That There is Likely to be Multi-Year Deleveraging in Europe
We Believe That There is a Strong Relationship Among Inflation, Deleveraging, and the Money Multiplier
Will Deleveraging Also Be Disinflationary in Europe? We Think So
Gauging Monetary Policy Relative to Nominal GDP Growth
Fourth, the European fiscal multiplier is now larger than in the past, which we believe means below-consensus growth in the region again this year.
Having been to Europe multiple times in 2012 to assess the macro situation, it has become increasingly clear to me that “this time is different” when it comes to the relationship between fiscal contraction (the independent variable) and GDP growth (the dependent variable). Specifically, over the past twenty or so years, a one percent contraction in the fiscal deficit traditionally led to only about a 50 basis point contraction in GDP5. Today, by comparison, the multiplier in Europe is closer to 1.25-1.75x, we believe (Exhibit 20). As a result, aggressive monetary policy is less effective in offsetting current fiscal headwinds. As the exhibits above show, we link a significant portion of this relationship shift to excessively high bank leverage as well as some of the structural rigidities imposed by a common currency.
The New Normal in Europe: A One Percentage Point of Fiscal Contraction Is Now Equating to 1.6% Slower GDP Growth
See Exhibit 21 for details, but given these views, we are again forecasting that Eurozone GDP will tilt to the low side of consensus for 2013. Our preliminary estimate for 2013 real GDP is a range of -50 basis points to +10 basis points versus a consensus of +10 bp. For all of 2012, we have been using an estimate of -50 to -100 basis points, and it now feels like growth will come in around negative 50-60 bp versus a start of the year consensus of -20 bp.
Growth Rates Slowly Improving in Peripheral Europe But Stagnant in Core
If our macro framework for Europe is right, then there are several important investment implications to consider. First, we think this means that traditional domestic consumption stories in Europe are likely to be challenged in the near to medium term. Second, given that the European governments will be required to reach deeper into more pockets of the private economy to pay for its programs, it is important to think through which investments could be adversely affected by governments over-stepping their traditional boundaries into the private sector. Finally, ongoing volatility on the Continent is creating significant opportunities for non-banking firms to provide capital to small and medium-size businesses that need specific capital to grow a division, complete a capital expenditure, or reimburse an existing line of credit.
Fifth, we think that correlations continue to unwind.
After multiple quarters of global stocks trading as a “Market of One,” we now expect correlations to remain lower in 2013 (Exhibit 23). Key to our thinking is that one intent of Quantitative Easing III (QE3) in the U.S. and the Outright Monetary Transaction (OMT) effort in Europe is to use excess liquidity to create more stability in the financial markets, even at the expense of global growth. An appropriate analogy, we believe, is to think about a bowling alley where the gutters have been filled with foam. The net result may be slower economic growth, but the risk of a “gutter ball,” or financial accident, has been greatly diminished.
Stock Correlations Are Falling, Implying that Stock Picking May Once Again Be Important
Stock Correlations are Now Below Long-Term Average in All Regions Except Europe
Against this backdrop, the correlation among stocks should drop and remain lower until these policies wear off and favor stock picking again. Some recent work done by Merrill Lynch on this topic (Exhibits 22 and 23) seems to support our view. If correlations do fall and remain low, it could finally improve the difficult backdrop that has hampered the global long/short equity industry in recent years.
Asset Class Review
Global Equities: As we detailed above, we have raised our global equity allocation to above benchmark for the first time. We still expect a lot of volatility over the next few years as governments deleverage in a Phase III environment, but we think the time to reduce equity exposure has largely passed. Trading multiples are now at the level where they can act as a buffer rather than the detriment they were for the decade following the year 2000. Both Exhibits 24 and 25 support our view that the valuation and return profiles of stocks at current levels appear compelling for longer-term investors.
We Believe That the Era of Multiple Contraction Is Now Over
NTM Forward P/E
Current vs Average Since 1990
Average 1990- Current
Asia x Japan
Stock Returns: Entry and Exit Points Matter
S&P 500 P/E Entry Level
Subsequent Average Annualized Nominal S&P 500 Price Returns (%)
Given this view, we feel comfortable stating that – under our base case – the S&P 500 appreciates about 11-12% in 2013 towards 1550 from its current level of 1400 (Exhibit 26). In addition to forecasting positive earnings growth this year (which we did not in 2012), we are also using a slightly higher multiple to reflect the positive impact of heavy central bank intervention on the equity risk premium. We also think that the sustainability of the recovery, which includes strength from cyclical sectors like housing, autos, and energy, may become more obvious as we move through the second half of the year. Finally, as we show in Exhibit 30, the quality of earnings composition is set to rise significantly in 2013 as financials become a much smaller piece of the overall mix.
Despite a Weak Economy in 1H13, Stocks Could Continue to Rally
2013 S&P 500 Estimates
S&P 500 (Rounded)
Low End of Fair Value
High End of Fair Value
EPS of $105-$110 with a Multiple of 13.0-14.5x Gets Us to SPX Range of 1375-1600
As Real Yields Rise Above 1%, P/E Multiples Should Rise Towards 14.5 From 13.0
As Exhibit 27 shows, our upside scenario is that stocks can move as high as 1600 in 2013 on the heels of better earnings and a hair more of multiple expansion. By comparison, our downside scenario incorporates a view that the equity risk premium rises again, driving the multiple back down towards 2010-2011 levels of around 13.8x earnings. In all instances, we also use price-to-book as an important input as we believe that P/B is effective and a less volatile metric than P/E. As one can see in Exhibit 29, our P/B-based valuation target is around 1550, which is essentially in line with our official target. In terms of sectors, we believe financials are likely to lag, and as a result, we are more inclined to own railroads, tower companies, healthcare services, and certain consumer names, housing-related ones in particular.
Our Price to Book Analysis Suggests 1550 is a Reasonable Level for the S&P 500 to Attain in 2013
S&P 500 (P/B x BV)
We Expect Earnings Quality to Improve as Financials Become Less Significant
Separately, given absolute and relative valuations, we no longer think that Europe is an underweight position. As a result, in 2013 we have reduced our underweight position to zero from minus three percent. That said, selectivity matters in Europe, as we still expect its financial services sector to lag (Exhibits 31 and 32). In addition, we expect certain consumption stories to lag as austerity continues to take its toll on the region, particularly in Italy and Spain. By comparison, we favor energy services, healthcare, staples, and export-led stories in Europe. Many of these sectors now have stocks that trade at reasonable valuations, have compelling dividend yields, and modest to solid growth profiles. We also still view emerging Europe as an important growth engine that may recently have been overlooked by some folks in the investment community.
European Valuations Are Near Decade Lows
…Which is True From Multiple Vantage Points
Importantly, across both the U.S. and Europe, we still subscribe to the belief that individual stock selection should favor securities with 2-5% dividend yields and 5-15% earnings growth (Exhibit 33). See our earlier report Brave New World: The Yearning for Yield Across Asset Classes, December 2011, but we retain our strong view that there is a demographic shift taking place that favors multiple re-valuation for companies that can serve this duel mandate of growth in earnings and yield. One can also see this in Exhibit 34.
Retirees Have a Strong Appetite for Dividend Yield, Particularly if It Has the Potential to Grow
Demand for Yield and Growth Stocks Remains Robust
In Asia, for 2013, we are now overweight the region, targeting a 14% allocation versus a 12% benchmark position. Our favorite markets continue to be those in Southeast Asia, given the relative health of these economies as well as their lack of dependence on foreign economies for growth. At the moment, we think Thailand and the Philippines both look interesting. Both countries have relatively strong domestic demand stories with growing middle class populations that are likely to benefit from the lagged impact of low real interest rates over the past two years. Also, both countries have decent pipelines of infrastructure projects that should boost investment growth7.
Within the larger emerging market economies such as China, Brazil, and India, we think overall valuations are much more interesting at current levels. We also think that much of the global liquidity released by central banks is increasingly finding its way into the emerging markets, China and India in particular. That said, we do still believe that investors should heavily skew their positions towards non-state-run companies. Key to our thinking is that, while growth in large emerging economies will be well above the global average, their stock markets may lag because they are increasingly filled with large state-run companies that cater to the government, not shareholders. One can see the performance differential between Chinese state-run companies and non-state-run companies in Exhibit 35. A similar story has been playing out in Brazil recently as well (Exhibit 36).
Non-SOEs in China Have Outperformed SOEs…
Petrobras Has Been a Major Laggard in the Brazil Market
Valuations Also Now Appear to Reflect Many of the Global Risks
NTM Forward Price-to-Earnings Ratio
Avg 2005- Current
Global Fixed Income: Without question, our biggest investment theme in 2012 was to try to arbitrage the yield differential between government bonds and other credit-related investments. Our thinking was twofold. First, we did not believe that global central banks would allow significant deflation to take hold. Second, we thought there were enough growth underpinnings to the global economy to keep it from entering a synchronized recession.
While we think this thesis still holds, the risk-reward no longer looks as favorable as spreads on high grade and high yield are no longer falling in lockstep with declines in the risk-free rate (Exhibit 38). We link the breakage in relationship to the fact that investors are now focused on the absolute level of overall credit yields versus the relative value of credit spreads to the risk-free rate (Exhibit 39).
Investment Grade Spreads Haven’t Budged Despite Move in Treasury Yields
High Yield No Longer As Attractive at This Point
in the Cycle
So, in search of higher yields with great spread tightening potential, we are allocating fresh capital (3% target in 2013 versus 0% in 2012) to what we call “unconventional,” or non-bank lending. In an unlevered format, we think there is potential to earn 9-11% with a duration risk of 3-5 years through direct secured lending. What’s driving this opportunity is that Wall Street’s downsizing is presenting investors globally with a tremendous opportunity to pick up significant incremental yield by lending to small and medium size businesses that have been “orphaned” by a shrinking financial services footprint. At the risk of being labeled “Master of the Obvious,” the benefit of 300-400 basis points of illiquidity premium that one can obtain through the direct, non-bank lending market is extremely compelling versus a 7% hurdle rate for many pensions and a 1.6% 10-year “risk-free rate” in today’s market environment (Exhibits 40 and 41).
Does a 350 Basis Point Illiquidity Premium Make Sense in a Zero Real Rate Environment?
A Significant Illiquidity Premium Also Exists in the Loan Market
We Believe that Mezzanine and EMD Still Offer Rewards in Today’s Low Rate Environment
Looking ahead, we expect stronger growth than the consensus in 2H13 and 2014, and as a result, we think that forward interest rate expectations are too low (Exhibit 44). Moreover, our view is that if and when the Fed moves, history has shown that hikes are not a gradual process. So, as we show below, our forward estimates for Fed Funds in late 2015 and beyond are now significantly higher than the implied futures curve.
Given this view, we think adding a new 2% “starter” position to bank loans makes sense as part of our fixed income allocations. At the moment, we still have a mix of bank loans and high yield in our fixed income allocation. However, as one can see in Exhibit 45, loans look cheap relative to high yield at current levels, they should act as a better rate hedge, and we think that having collateral as a backstop makes sense as the quality of high yield paper being brought to market deteriorates later in the economic cycle. As such, we could see increasing our bank loan position further as we transition through 2H13 and 1H14.
Only in 2015 Do We Expect To See Material Changes in Rates…
…But Fed Funds Rates: Our Forecast Is Significantly Above Market Expectations for Late 2015 and Beyond
Virtually No Spread Between High Yield and Levered Loans
Separately, within international fixed income, we continue to favor emerging market debt as an asset class of choice, which we reflect via our 5% target allocation again in 2013 (unchanged from 2012) versus a benchmark allocation of 0%. Simply stated, we think that emerging market debt is in the process of being re-rated upward, while our longer-term view is that local emerging market sovereign and corporate debt will increasingly become part of more mainstream benchmarks. Given this view, we still think the long-term secular trend in overall yields in the asset class are headed lower, despite having already enjoyed significant spread compression in recent years.
Our overall optimism towards emerging market debt is predicated on the fact that, despite having significantly higher yields than developed market sovereign debt, EM fiscal balances are in much better shape (and likely to remain so for some time). One can see this in Exhibits 46 and 47. In our view, this arbitrage remains extremely compelling. There is also the potential for ratings upgrades in many emerging market countries at the same time that many developed market countries face potential ratings downgrades.
Emerging Markets Remain Much More Attractive than Developed Markets in Many Respects
Gross Government Debt % GDP
Government Expenditure % GDP
Fiscal Deficit % GDP
Current Account % GDP
Real GDP Growth
Developed Economies Still Struggling With Their Debt Loads
Currency: Focus on the Structural Longs in 2013. In line with our view that China, Brazil, and India will all be in some form of recovery mode, we think that many Asian and Latin American currencies will perform strongly in 2013. Importantly, against an unsettled global backdrop, we believe central banks may prefer to battle potential increases in inflation through currency appreciation versus traditional interest rate hikes because of the disadvantage higher rates can cause when almost the entire developed world has embraced a zero interest rate policy (ZIRP) and quantitative easing (QE).
Given that many emerging currencies have already seen significant appreciation this year, we believe we should scale into these positions. In particular, we would not be surprised if weakness/volatility caused by the upcoming U.S. debt ceiling negotiations provides investors with a short-term opportunity to add positions in currencies like the Mexican peso and Singapore dollar, which rank among our favorites (Exhibits 48 and 49).
We Like the Mexican Peso as It Appears Undervalued, With a Relatively High Carry and Leverage to the U.S. Economy
As Growth and Inflation Pick Up, the Singapore Dollar Tends to Appreciate
We also agree with the growing consensus of investors who anticipate a substantial Japanese yen sell-off in 20138. Key to our thinking is that as the tail risks have diminished, changing trade dynamics with China are impacting the country’s trade balance, and monetary policy appears poised to become much more accommodative, particularly relative to the U.S.9 However, given the degree of central bank intervention around the world, we are starting to wonder whether it could be the Japanese stock market (US dollar hedged), not the currency, which does better in 2013.
Real Assets: Focus on Yield, Growth, and Inflation Hedging. There is no change to our thesis surrounding the importance of yield, growth, and inflation-hedging in today’s macro environment. As we show in Exhibits 50 and 51, the United States is running an explicit reflationary policy of holding nominal interest rates below nominal GDP. Though this relationship was slightly more stretched back in the late 1970s, it is again near record levels.
We are also dealing with far more liquidity injections by the U.S. government than in the past. In the U.S. alone, monetary and fiscal stimulus as a percentage of GDP has breached the 40% threshold, nearly 5 times what was put into the system after the Great Depression (Exhibit 52). Moreover, the latest round of quantitative easing is tied to unemployment, which we do not see changing quickly, given that new business formation is still running 35% below the historical average (Exhibit 53).
Holding Fed Rates Below Nominal GDP Growth Would Be a Straightforward Way to Control Government Financing Costs
History Shows That Pinning Fed Funds Below GDP Growth Leads to Rising Inflation Rates
Putting Fiscal and Monetary Stimulus in Historical Context
2008-2012 Fiscal and Monetary Stimulus
Economic stimulus checks
Bush Home Owners Bailout
Fannie Mae and Freddie Mac Bailout
Emergency Economic Stabilization Act of 2008 (TARP)
American Recovery and Reinvestment Act of 2009
Obama Home Owners Bailout
Small Business Loans
Quantitative Easing I
Quantitative Easing II
Extending Payroll Tax Cut
Quantitative Easing III **
Quantitative Easing IV **
Total Stimulus % GDP
New Business Formation Has Been Lackluster Relative to Recent Revenue Trends
So, not surprisingly, we see at least three reasons why do we think real assets should be a bigger proportion of an overall portfolio. First, many real asset investments look especially compelling because they now offer appreciation and attractive return of capital along the way. It wasn’t always this way. As we discussed in our April 2012 Global Insights note The Twin Role of Real Assets, we see in the marketplace a growing number of real estate and oil production investments being structured so that investors can get a dividend yield of at least 4–8 % upfront, in addition to inflation hedging and the potential for capital appreciation. The income component has always been germane to public real estate investment trusts (REITs), but now we increasingly see investment managers in private real assets pursuing attractive dividend yields and still retaining the potential for capital appreciation. In particular, we think that – with many mature energy companies now focused on natural gas “shale plays” – there is a significant opportunity for investment managers in today’s market to buy older oil production operations at attractive prices, resuscitate their wells, and use the proceeds to create a sizeable dividend stream for investors.
Positive Yield Inflation-Hedging Vehicles Are Differentiated in This Environment
Rising Oil Prices Often Move in the Opposite Direction of Corporate Earnings
Second, we think traditional inflation-hedging instruments have gotten much more expensive. As we show in Exhibit 54, one now has to pay for the privilege to lock in some inflation protection using a standard Treasury Inflation Protected Security (TIPS). By comparison, we still see good value and strong rental incomes in certain parts of the residential housing market and non-core commercial real estate in the U.S. Third, as we show in Exhibit 55, certain real assets, oil-related ones in particular, tend to perform best when rising oil prices dent profitability in the corporate sector. As history has shown, this happens particularly around geopolitical shocks that diminish growth trajectories and increase risk premiums.
Alternatives: Leveraging Patient Capital. Within the alternative arena, we retain an overweight position again this year of a 15% allocation versus a benchmark of 10%. We see a significant opportunity for patient capital to take advantage of some of the key macro themes in the market, particularly relative to shorter-term liquid strategies. For starters, patient capital is better able to leverage the volatility that we expect in a Phase III environment by entering and exiting positions more meaningfully than shorter-term managers, who must manage to a monthly or even weekly target return and drawdown profile. Importantly, we think that the volatility associated with government and bank deleveraging is a secular, not a cyclical, phenomenon. Finally, given the deleveraging in the private and public sector, patient capital should be able to take advantage of distressed and special situations to earn non-correlated returns.
No doubt, the alternative arena is large and diverse. To this end, we break our allocation into three major areas: Private Equity, Special Situations/Distressed, and ‘Other.’ Details on all three areas are below.
Private Equity: We are not making any changes to our 5% allocation to private equity, which covers both developed and developing markets. Within U.S. private equity, we see healthcare, consumer, and non-traditional financials as significant opportunities. In Asia, we retain our view that CIOs will increasingly begin to allocate money away from passive equity indexes towards private and semi-private equities that are actually linked to big macro themes like consumption, wellness, and retirement savings. Indeed, as one can see in Exhibit 56, alternatives in Asia continue to notably outperform the public indexes. Moreover, as Exhibit 57 shows, many of the large EM indexes like China actually have very little direct exposure to longer-term growth markets like retail consumption.
Alternatives Continue to Outperform Public Market Indices
State-Owned Enterprises (SOEs) Make Up 71% of the China H-Shares Index and Have Little Direct Exposure To Pure-Play Consumption Stories
Hang Seng China Enterprises Index (H-Shares Index)
Special Situations/Distressed: While we think that global Quantitative Easing III could dampen the potential return from traditional distressed opportunities, the special situation environment should remain robust for several years, we believe. Instead of traditional “fire sales” from bank balance sheets, in both Europe and the United States we see banks choosing not to extend traditional credit lines that many businesses typically count on to run their operations (Exhibit 58). As a result, in our view, there are opportunities for non-traditional providers of capital to step in and earn attractive mid-teens returns in non-correlated investments. We also see opportunities in non-traditional mortgages, non-agency MBS in particular.
In Europe, We See Opportunities for Non-Traditional Providers of Capital
Looking ahead, we also think there will be growing opportunity for distressed and opportunistic credit in the Asia-Pacific region. From what we can tell from our travels, the lending binge that occurred throughout Asia following Great Recession is starting to lead to some interesting opportunities. Already, we have seen some notable distressed situations in Australia, and we expect to see more across the less-developed markets in the region in coming years.
Other: In our ‘other’ bucket, we retain our selective bias towards what we believe are differentiated, uncorrelated investments. For example, as we travel in emerging economies like Brazil and India, we think that the initiatives by private equity and other financial intermediaries to develop mezzanine credit instruments, often with some equity upside, are among the more compelling long-term opportunities. True, this market is nascent and a global investor should be willing to take local currency risks, but we think that a large and growing number of entrepreneurs and businessmen across the emerging markets want to tap into a more sophisticated capital markets system that allows them greater choice beyond just traditional equity or bank loan products. If we are right in our macro view, then investments in the mezzanine credit market may start to appeal to not only local investors but also to global investors, particularly those who want to earn a large recurring coupon and enjoy some equity upside without a lot of the volatility and misconfigurations often associated with traditional emerging market equity indexes.
We also favor a small allocation to growth capital that targets high-risk ventures in areas such as technology, nutrition/wellness, and biotechnology. While these investments are inherently high risk, we feel comfortable being somewhat aggressive with a small allocation of capital, given that so much of the overall portfolio is linked to income-producing growth investments.
Hedges: What Could Go Bump in the Night. As an ongoing process, we look for hedges that can protect our portfolio in low-cost or efficient ways. At the moment, we highlight the following three hedges as worthy of investor attention. First, we are concerned that tensions between Iran and Israel could escalate in 2013. If we are right, then some form of oil hedge makes sense. To this end, we aspire to own some upside calls in the event that oil spikes as things take a turn for the worse in 2013. An example of this type of hedge could be $105 calls of December 2013. Given that these proposed insurance measures aren’t especially cheap these days, one could at present write some $75 puts to “pay” for the upside insurance. Our view is that oil below $75 a barrel represents good value for long-term investors, particularly in a period of aggressive monetary stimulus and rising drilling costs. One can see this trade roadmap in Exhibit 59.
Hold-to-Expiry Returns of Selling Dec’13 WTI Puts at $75 and Buying Calls at $105
Second, while our recent visit to China gives us confidence that there is a limited chance of a hard landing, it remains a risk. So, we like the idea of betting against the recent uptick in China’s 5-year swap rate. From what we can tell, this market is signaling that a rapid re-acceleration is likely, which is not what we concluded during our post-Thanksgiving visit. One can see this apparent disconnect in Exhibit 60.
Chinese 5-Year Swap Rate Already Implies a Significant Re-Acceleration in Growth
The third risk we want to hedge against is core to our “changing playbook” thesis. Specifically, we think it could become more of a consensus view that U.S. interest rates back up in 2H13 as the economy re-accelerates. If so, the Fed could begin raising rates sooner than currently expected in the 2015-2017 period. Our preference is to bet on higher Eurodollar futures rates in June of 2017. Refer back to Exhibit 44 for details, but the market is pricing Fed Funds at about 1.4% by that date, while we think they could be as high as 4%. Keep in mind that the Fed generally raises rates by at least 200bp per year when it is tightening (25bp per meeting x 8 meetings per year), so for us to be accurate that rates are higher than 1.4% by June 2017, the Fed only has to start hiking by late 2016, which is a good risk-reward bet in our view.
There remains little question that we are living through a time of extreme uncertainty in the global economy. To prosper, we think it is important to have well researched, durable investment themes that stand the inevitable shocks linked to deleveraging in the developed markets as well as the inevitable tensions from trying to integrate two billion new citizens into the developing markets.
Similar to last year, our highest-conviction themes for 2013 center on just a few simple macro concepts that we believe can deliver attractive returns on both a relative and absolute basis. For starters, we see real assets as an important overweight because we think there is significant upward re-rating potential for real assets that can produce income, grow earnings, and provide inflation hedging. Separately, we think the opportunity to use “spicy” credit, including mezzanine and direct lending, to arbitrage the punk yield offered by highly levered governments in developed markets is also compelling. In particular, the 300-400bp illiquidity premium that can be picked up via direct lending to middle-market corporate customers and in special situations is a highly unusual opportunity that will eventually be arbitraged away. We also like floating-rate bank debt as part of our “changing playbook” thesis. Finally, we want to use private equity, concentrated public equities, and debt in the emerging markets to outperform what we see as inherently flawed index compositions in key markets like China, Brazil, and India.
Our other big asset allocation theme in 2013 is that excessive monetary policy suggests a slow but steady move out of bonds and cash. While it might not feel this way, we are shifting from a deflationary environment towards one where protecting purchasing power amid extreme reflationary monetary policy makes sense. No government or central bank is going to openly acknowledge that they are defeasing debt loads by holding nominal rates at record lows relative to nominal GDP, but that is exactly what they are trying to do. And given the starting point on interest rates, we think a major asset allocation shift is slowly about to unfold.
While we are confident in our key themes and asset allocation framework, we also believe that hedges are a key part of any thoughtful portfolio construction. To this end, we like our oil-hedging strategy as well as protecting against a potential further slowdown in China. A China slowdown is not our base case, but because the country accounts for nearly 1/3 of global growth these days, we think hedging against any unexpected fall-off in growth is prudent. On the other hand, we also want to hedge against a back-up in U.S. interest rates, as economic strength in 2H13 could unsettle a market that is currently complacent about the risk of any Fed tightening before 2017.
- 1See Exhibit 3 of our July 2012 Global Insights note entitled China’s Rebalancing Act available at www.kkrinsights.com.
- 2Data as at August 31, 2012. Source: Bloomberg.
- 3“Way forward for new leadership,” China Daily Asia Pacific, December 3, 2012.
- 4“Stocks Surge on ECB’s Plan for Europe,” Wall Street Journal, September 6, 2012.
- 5IMF World Economic Outlook October 2012, Chapter 1 Global Prospects and Policies, Box 1.1, Are We Underestimating Short-Term Fiscal Multipliers? http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/c1.pdf
- 6The returns presented reflect hypothetical performance an investor would have obtained had it invested in the manner shown and does not represent returns that any investor actually attained. The information presented is based upon the following hypothetical assumptions. Hypothetical backtests such as this one may carry risks of survivorship bias and look-ahead bias. Certain of the assumptions have been made for modeling purposes and are unlikely to be realized. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in achieving the returns have been fully stated or fully considered. Changes in the assumptions may have a material impact on the hypothetical returns presented. Hypothetical back-tested returns have many inherent limitations. Unlike actual performance, it does not represent actual trading. Since trades have not actually been executed, results may have under- or overcompensated for the impact, if any, of certain market factors and may not reflect the impact that certain economic or market factors may have had on the decision-making process. Hypothetical back-tested performance is also developed with the benefit of hindsight and does not reflect any impact of fees or expenses. Other periods selected may have different results, including losses. There can be no assurance that the strategy will achieve profits or avoid incurring substantial losses. Past performance is no guarantee of future results
- 7Sources: “Philippines plans record infrastructure budget for 2013”, Reuters, July 9, 2012 and Thai Government press release dated October 5, 2012.
- 8“Goldman’s O’Neill: Expect More Yen Weakness in 2013,” Wall Street Journal, December 20, 2012.
- 9In Japan, Mr. Shinzo Abe was appointed President of the Liberal Democratic Party (LDP) on September 26, 2012 and was elected Prime Minister December 16, 2012. He has campaigned on a reflation strategy of unlimited easing until an inflation target of 2-3% is achieved.
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. 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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