By HENRY H. MCVEY Jun 27, 2016
We stick to our base case that we remain in an “Adult Swim Only” investment environment, as we see more asynchronous growth ahead. Against this backdrop, however, we still see significant opportunity. Private Credit has emerged as one of our favorite investment ideas in today’s current environment of low rates and uneven global growth. Not surprisingly, we also favor Real Assets that can deliver yield and growth, and our research suggests Private Equity is likely to outperform Public Equity at this point in the cycle. We are not advocating huge sector and style bets at present; rather, we would focus on opportunities where quality assets with complexity are trading at discounts to their intrinsic values. By comparison, we are growing increasingly concerned about the valuations of defensive and certain growth-oriented assets.
From our macro perch at KKR, it definitely feels like 2016 has emerged as a year of “Adult Swim Only.” Markets have cut a wide swath so far this year, enticing investors to buy and/or sell often at what was – in hindsight – likely the time to do the exact opposite of what one’s emotional core was suggesting.
Importantly, as we have seen with recent events in the United Kingdom, there is certainly more to making good investments these days than just understanding the fundamentals. Indeed, similar to other post-crisis periods in history, we are now seeing a notable splintering of political harmony – one that extends from Europe to the United States, Latin America, and even Asia. In our view, this shift in the geopolitical landscape could be a secular, not a cyclical, phenomenon.
We are sticking to our playbook that we are later cycle, favoring idiosyncratic opportunities over beta-related plays. We still prefer Credit to Equities, and within Credit, we are most intrigued by the opportunities we see related to periodic dislocations and/or structural changes across the banking system.
As we discuss in more detail below, our bigger picture belief is that financial assets with predictable cash flows could now be overpriced in many instances. On the other hand, “complexity” (i.e., stories that lack EPS visibility or some type of industry taint) now seems to be trading at a discount, particularly in unloved sectors of the market. In our view, this discrepancy may be one of the most important arbitrages in the market right now.
Coreen T. Sol
Despite the negative overhang of Brexit, we are not yet calling for a recession and/or bear market. However, similar to what we laid out in our January Insights piece, Outlook for 2016: Adult Swim Only, we still see more limited upside to financial asset appreciation than in prior years – and with higher volatility. If we are right, then an investor should expect a lower return per unit of risk across most asset classes. Key to our thinking is that – compliments of global QE – many asset price returns have been pulled forward amidst below average volatility, as central banks have driven yields down to record lows. Consistent with this outlook are two important global macro trends that we believe are worthy of investor consideration:
- First, with $9.9 trillion in negative yielding bonds, we think that there are now diminishing returns to QE at this point in the cycle1;
- Second, given the recent surge in debt financing across public and private capital structures, we believe returns on incremental leverage in many parts of the global economy may have peaked and may actually be declining in many instances.
That said, global central bank policy remains formidable, and of late, we are encouraged that the Federal Reserve is now more focused on the trajectory of currencies, the U.S. dollar in particular. Key to our thinking is that the dollar, when undeterred in its movement upward, can restrict financial conditions – sometimes more than what an actual rate increase might otherwise accomplish.
With these thoughts in mind, we are making a few tweaks, though no major changes, to our portfolio in an effort to reflect our latest thinking. In addition, we are also using this mid-year update to provide some additional color on where our conviction levels have increased and/or decreased. See below for details, but we note the following:
We are reducing Cash by three percent to four percent from seven percent versus a benchmark of two percent and adding three percent to Mezzanine/Asset Based Lending within our Private Credit allocation. See Exhibit 1 for details, but our total weighting in Private Credit related investments — including both Mezzanine/Asset Based Lending and Direct Lending — moves to 13% from 10% in January and a benchmark of zero across the two asset classes. Given the shift towards negative interest rates and ongoing and intensifying regulation of the banks, we are seeing a major spike in opportunities in the mezzanine and asset-based lending areas of the global economy, Europe in particular. Indeed, some of the more interesting risk-adjusted opportunities we are seeing from a direct and co-investment standpoint are now occurring in situations where banks have fallen away as the traditional lender of choice. Moreover, many of these opportunities are occurring when volatility heads higher, not lower; as such, we like the somewhat counter cyclical component to this offering.
More than ever, we feel confident about our outsized bet across Private Credit. As we mentioned earlier, we are seeing a variety of different opportunities across Private Credit (Direct Lending, Asset Based Lending, Mezzanine, etc.), which makes us feel comfortable with an allocation that is 13% outside our benchmark and could likely lead to significant tracking error over time. Our positive rationale rests on three pillars. First, with leveraged lending guidelines now being enforced more strictly, corporate and financial acquirers must look beyond traditional financial intermediaries to support their deals. Second, there is less capital available for small-to-medium-size businesses, as banks reduce their footprints amidst shrinking net interest margins and heightened regulation. Finally, we think that current deal terms now often favor the lender, not the borrower, which is different than 12 to 18 months ago.
We are moving five percent from Distressed/Special Situations towards Actively Managed Opportunistic Credit. Without question, we are seeing attractive opportunities in niche credit markets such as closed-end funds, certain CLO assets, and periodic "hung" loans. By comparison, we think QE is denting some of the Distressed/Special Situations opportunities that we originally thought might occur at this point in the cycle.
We continue to favor Real Assets with yield and growth, but we also think that certain commodities are bottoming. See below for details, but we believe that areas like infrastructure, real estate credit, MLPs, etc., remain potentially interesting investment opportunities for institutions and individuals looking to earn not only above-market yield but also some above-average growth in the value of the underlying assets. Meanwhile, our research also shows that several commodities have corrected towards the level of prior secular bear markets both in terms of price and time (Exhibits 57 and 58). Selectivity is still required though, and at the moment, we favor oil and copper over assets with fewer supply-side adjustments, including iron ore.
We no longer see any rate increases in 2016, which also has implications for the U.S. dollar. If there is one area where our thinking has changed since the beginning of the year, it is around Fed hikes and the dollar. In particular, in its recent communications the Fed now appears to openly acknowledge that ongoing dollar strength could tighten global financial conditions towards an uncomfortable level. In essence, it appears that it has expanded its criteria for monetary policy changes to include not only domestic growth and inflation but also a multitude of foreign risks, China and Brexit in particular. In particular, it seems the Fed is now more concerned about deflation than inflation, and as such, a flat to weaker dollar helps the reflation trade by putting an implicit bid into commodity prices. To be sure, all the aforementioned commentary suggests a weaker dollar. However, after recent events in Europe, we see the dollar reemerging as a “safe haven” play against many currencies, including the GBP and the euro, in the second half of 2016.
We are still comfortable being underweight Public Equities relative to Private Equity at this point in the cycle. Since our January outlook piece (when we went underweight Public Equities for the first time since arriving at KKR) we have done a “deep dive” into the relative attractiveness of Private Equity versus Public Equity at the later stages of an expansion, and our conclusion leads us to own more Private Equity than Public Equity. Within Private Equity, we still favor consumer-facing investments, spin-offs, and restructurings. Overall, though, similar to public markets, we think valuations are reasonably full in many instances, and as such, some other levers are likely required to hit one’s return hurdle 84 months into the current economic expansion. Meanwhile, within global Public Equities, we have concentrated our overweight in developed markets into the United States, with equal positions in Europe and Japan. We also want to highlight that our macro dashboard is actually starting to flash a more positive signal towards the equities of Emerging Markets, which represents somewhat of a sea change after 68 months of underperformance. See below for more details.
We are less inclined to make big sector and style bets at this point in the cycle. From 2000-2010 an investor profited handsomely by being long China Growth (Materials, Energy and Industrials) at the expense of growth-oriented stocks and certain defensive stocks. From 2010-2015, doing almost the exact opposite produced rewarding results. Today, we see a world where growth and defensive investments appear quite expensive, but we are not yet certain that all “value” parts of the market fully reflect some of the structural caution we feel about China’s slowdown and/or the difficult position that many large global financial institutions now face. As such, we think that some balance of approach is required – one that is cognizant that the market may be overvaluing simplicity of story relative to complexity.
The investment community now better appreciates that there are limits to central bank intervention, negative rates in particular. Indeed, despite massive amounts of bond buying, European equities are now down about 20% during the last 12 months while Japanese equities have fallen about 30% during the same period. See below for details, but our conclusion is that investors now better understand that lower rates and more stimulus suggest slowing nominal growth and low returns likely lie ahead. In our view, this realization represents a sea change from earlier beliefs that more QE means that risk assets just look even more compelling relative to a risk free rate that is being “artificially” impacted by central bank intervention.
We continue to look for ways to mitigate risks. Though we have reduced our Cash position by three percent, we still remain overweight Cash by two percent (four percent versus a benchmark of two percent). In our humble opinion, when volatility is increasing and correlations are doing funny things, there is no substitute for Cash as an asset class. Meanwhile, we also think having some hedges makes sense. See below for details, but my colleague Brett Tucker believes that shorting the Chinese yuan and buying protection in High Yield credit default swaps (CDX) makes sense at this point in the cycle. We also think that the GBP has further downside if we are right that the United Kingdom may face a “stagflationary” type environment in 2017. Details follow.
KKR GMAA 2016 Target Asset Allocation Update
Looking at the big picture, our base case remains that we are still in an “Adult Swim Only” environment. Our indicators still point to the notion that we are later cycle, volatility is headed higher, growth versus value valuation divergence is extremely wide, and profit margins/returns on capital have peaked. To be sure, we feel better today than in January that the U.S. dollar will not restrict financial conditions as much as it has in recent years, but we remain increasingly concerned about the diminishing impact of monetary stimulus on economies around the world. Also, our research leads us to conclude that there is little to no evidence supporting increased capex spending from negative interest rates on the corporate side.
Meanwhile, public market equity valuations appear full in many instances, and we see limited expansion for price-to-earnings ratios from current levels. See below for details, but even with relatively generous assumptions, our five-year forward expectation for Public Equities is now just less than six percent. Finally, the rise of populism in Europe, the U.S., and China will complicate reforms needed to spur economic growth (tax reforms, sustainable pensions, focus on productivity). Instead, we see proposals to restrict trade, immigration and anti-business regulation and rhetoric. This viewpoint is important because it suggests a higher risk premium is now required to compensate for outcomes that support the politics of blame at the expense of the politics of growth.
Post-Crisis Returns of a Standard 60/40 Equities and Bond Portfolio Have Been Remarkably Strong…
…But We Now Wonder How Much Better It Can Get, Particularly When It Comes to Return per Unit of Risk
Against this backdrop, we are not suggesting asset allocators stop deployment of capital. In fact, that strategy itself actually has significant risks. Rather, we are saying we are in a different environment than 2011-2015, and accordingly, we prefer more idiosyncratic investments than beta-linked plays. We also like draw-down capital structures that increase our ability to “zig” when market sentiment makes us want to “zag.”
Recent Historical Performance Suggests Lower Returns and More Volatility Lie Ahead
Right now we are finding many of these opportunities in Credit and parts of Real Assets, and as such, we have significant overweight positions in these areas. Meanwhile, in Private Equity we favor divestitures, acquisition-driven stories that leverage cheap financing, and significant operational improvement stories. These more value-added approaches make sense to us in a world where nominal revenue growth is harder to find and valuations of quality businesses are generally expensive. Finally, with nominal lending so far ahead of nominal GDP in many countries, we like having the capital and expertise to help companies restructure, as credit creation growth diminishes towards a more reasonable level.
Section II: Key Themes/Investment Opportunities
“Man is not born to solve the problem of the universe, but to find out what he has to do; and to restrain himself within the limits of his comprehension.” — Johann Wolfgang von Goethe
In the following section we detail some of our key changes and macro themes we think are worthy of investor attention.
In terms of key macro themes that we describe in more detail below, we note the following:
The Asynchronous Recovery Continues; We Make Further Downward Revisions to Global GDP
As we detailed a while back (see Investment Implications of an Asynchronous Global Recovery, September 2014), our base view remains that we are living in a slower growth, low inflation world where economic “lift-off” speed is hard to achieve. Thus far in 2016, we see nothing in the macro data that suggests we should change our view. In fact, even we have been too optimistic, and as a result, we feel compelled to use our 2016 mid-year update to again trim some GDP numbers. We note the following:
United States In April, we lowered our 2016e U.S. GDP to 1.8% from 2.2% previously. Incoming U.S. data have improved somewhat since then, but given ongoing Brexit-related market stresses, we want to keep our forecast positioned conservatively. Overall, the key recent structural story for the U.S. remains intact—namely, resilient consumer and government spending is offsetting the hit to the more cyclical parts of the economy from the energy bust and the strong dollar. What has changed in our thinking are the following considerations (Exhibit 5):
- We now see consumer growth trends as having plateaued at a high level (previously we looked for continued acceleration); and
- We now think investment and trade growth will continue deteriorating a bit further (previously we looked for some stabilization at low levels).
At the time of our GDP revision in April, consensus 2016 GDP estimates still looked too high at 2.2%. However, since then the consensus has come down towards our 1.8% estimate. Put another way, we are no longer as strenuously at odds with the consensus as we were in the first part of the year. At the same time, however, we continue to see little scope for an upside break-out to growth.
Our Current 1.8% GDP Forecast Assumes Consumption Growth Has Peaked, While Investment and Trade Are Continuing to Drag on Growth
Due to Resilient Core CPI and Recovering Energy Prices, We Are Now Above Consensus on Inflation for the First Time in Two Years
Consistent with our modest growth expectations, we have also recently adjusted down our interest rate expectations. Specifically, we have moved to no Fed hikes this year (versus two previously), and three hikes next year (down from four previously). Some factors influencing our thinking on Fed policy include the coordinated easing we expect from other global central banks in the wake of the Brexit vote, and the global pressures that we see constraining the Fed’s ability to hike without inverting the yield curve. Our evolving rates views lead us to lower our U.S. 10-year yield targets to 1.75% for 2016 (versus 2.6% previously) and 2.25% at the cycle peak in 2017 (versus 3.0% previously). Consistent with our more dovish outlook, we now think the U.S. dollar has entered a range-bound—albeit volatile—period that could persist for some time until the dollar reasserts itself for its next leg higher.
While our U.S. growth outlook remains muted, one thing that has been moving up of late is our inflation outlook. We now see U.S. CPI inflation coming in at 1.5% in 2016 (Exhibit 6), which is up from our January outlook of 1.25% and above the current consensus of 1.3%.
Europe In Europe, we are now looking for 1.3% growth in 2016, down from 1.9% at the start of the year. We now plan for a material hit to growth from the Brexit vote, which we believe will cut overall European GDP growth in half over the coming two quarters (from 40 basis points growth per quarter in 3Q16 and 4Q16 to under 20 basis points). Although the situation remains fluid, our big concern is that the European Union has a strong incentive to play tough with the U.K., meaning this situation may get worse before improving.
Interestingly, even prior to Brexit, our research indicated that several macro variables across Europe had deteriorated meaningfully, in our view. First is the strength of the euro, which has shifted from being a 10% tailwind at the start of the year to a two to five percent headwind throughout the first half of 2016. (Exhibit 7). Without question, the euro’s sudden reversal was a big part of Europe’s dismal first quarter earnings season. Just consider that in the first quarter of 2016, 20% of companies missed their revenue estimates, the worst revenue miss in 10 quarters2.
Second, European regulators have punished banks beyond what we expected to see – often with painful side effects. In fact, it looks like the regulatory tightening has effectively offset European Central Bank (ECB) accommodation, so that financial conditions in the Eurozone are worse now than they were at the start of the year, despite substantial further easing from the ECB. Third, we have moderated our view of the European residential construction sector. True, construction has been a tailwind to GDP so far in 2016 (Exhibit 7), but our research suggests that there is actually less future growth potential than we thought at the start of the year. Key to our thinking is that, while U.S. household headship rates (i.e., heads of household) fell meaningfully during the Great Recession, European headship rates continued to rise through the crisis, making the backdrop less positive as we look forward. Specifically, we forecast that the average change in U.S. housing completions could increase by 24% in the 2016-2020 period compared to 2015 levels. In Europe, we see only 13% upside over the same period. As such, we are now less excited about the sector’s contribution to future growth than we were at the start of the year (notwithstanding the improvement in building permits we saw in the Eurozone in the first half of 2016).
In terms of inflation, we are now expecting just 10 basis points of inflation for 2016, compared to our 1.0% forecast previously. This reflects our expectation of weaker demand following Brexit. In addition, oil remains a major headwind to inflation, and is down 20% year-over-year in euro terms. Moreover, we note that each of the four major inflation sub-categories, including food, alcohol & tobacco, energy, services, and non-energy industrial goods, has either deteriorated or stood still, in year-over-year terms, since December 2015.
Looking at the bigger picture, our core belief is that Brexit is an event with significant consequences for the European economy that will only become fully apparent with the passage of time. In our view, the recent vote in the United Kingdom was really a referendum on important socioeconomic issues, including immigration, trade, and productivity. As such, we would argue that this shock will be measured in years, not in months or days as was the Lehman crisis in 2008, or even Grexit in 2011. Lehman involved a real and present danger to the global financial architecture, while Grexit introduced FX redenomination risk into an undercapitalized European banking system. Our bottom line: we see the U.K.’s recent decision to exit the European Union as a significant and durable challenge to democracies around the world, but not something that will ultimately prevent investors from deploying capital in the region over time. In fact, we are likely to see some interesting opportunities amidst the dislocation and reorganizations that are bound to occur as many corporations, multinationals in particular, adapt to the new environment.
Even Before Brexit, Four of Five Key GDP Drivers Had Turned Less Supportive
U.S. Household Formations Have Greater Potential Than in Europe, as We Expect U.S. Headship Rates to Recover From Their Dramatic Fall
Brazil We are sticking to our GDP forecast of -3.75% for 2016, but we are adjusting upwards our inflation forecast to 8.0% from 7.5% this year. Unfortunately, despite the potential for permanent change in government, the real economy remains challenged. Importantly, we think consumption will continue to contract as the labor market has deteriorated significantly in recent quarters. All told, the unemployment rate has increased to 11.2% from 6.5% at the end of 2014.3 Moreover, real wage growth is now in negative territory, which combined with falling employment and tighter credit availability creates strong headwinds for consumption, which accounts for 63% of GDP.4
On the inflation side, we acknowledge that 1) we have seen some improvements as the Brazilian real has strengthened 16% year-to-date in 2016;5 2) the output gap has put downward pressure on market-based prices. However, the downward adjustment in administered prices has been slower than we anticipated, more than offsetting the two aforementioned improvements in inflationary trends. As a result, we are adjusting our CPI estimate upwards to 8.0%.
China We do not think China can escape the impact of Brexit and are lowering our GDP estimate by 10 basis points to 6.4%. After raising our GDP estimate in line with consensus of 6.5% in April, we think it will be hard for authorities to achieve their 6.5% target for the year, as Brexit will put further pressure on U.K. as well as Euro-area trade activity.
We Still See the Current Growth Environment As Challenging
Our Base Case Is That the CAGR of Global GDP Remains Under Three Percent Thru 2020; We Have Modeled in a Modest Slowdown in Late 2017/2018
The Global Economy Is Now Slower Growing and More Volatile…
…While U.S. Wages Are on the Upswing
Low Rates => Low Returns => More Creativity Required
At the risk of being labeled Master of the Obvious, today’s macro backdrop – which includes high P/E ratios on stocks and low yields on bonds – appears an extremely challenging one for investors looking for outsized returns in public markets. In particular, we just do not see how traditional pensions, endowments, and individual investors are going to meet their historical returns bogeys in a world when $9.9 trillion of liquid fixed income instruments now have a negative yield6. The magnitude of this macro headwind is well laid out in Exhibit 15, which shows how little of the Barclays Global Aggregate subsectors yield north of three percent relative to before the Financial Crisis. Not surprisingly, against this backdrop of already low rates, we now forecast U.S. government bonds to deliver just a -0.3% annualized total return in our base case during the next five years. One can see our base, bull, and bear case forecasts in Exhibit 13.
Our Return Forecast for Traditional Fixed Income Suggests Investors Will Have to Look Elsewhere for Returns
Public Equities Too Now Face More Limited Upside, in Our Opinion
In 2007, $20.1 Trillion, or 82% of the Lehman / Barclays Aggregate Subsectors Yielded Over Three Percent. Today That Number Stands at $8.3 Trillion or Just 17%
When a Recession Does Happen, Multiples Decline by a Little More Than 30%
For stocks, we too forecast more modest returns than in the past. One can see this in Exhibit 14, which lays out a base case of 5.5% on an annualized basis over the next five years for the S&P 500. This more modest outlook, compared to 12.6% during the prior five years (2011-2015), is largely predicated on our view that multiples will contract after the 51% increase they have enjoyed since the market bottom in March 20097. We are still forecasting some form of recession in late 2017/2018. If we are right, then multiples typically contract around 34%, on average, during a recession. One can see this in Exhibit 16. Importantly, though, our recession forecast for late 2017/2018 is much more modest than what we certainly saw in 2001 and/or 2008/2009, and as such, we expect less degradation of earnings and multiples this cycle.
Seven Consecutive Years of Positive Performance for the S&P 500 Is Highly Unusual
The S&P 500 Appears Fully Valued by Many Historical Metrics
Performance This Cycle Is Well Above Historical Norms
The S&P 500 P/E Is Now Up 50% From September 2011
Not surprisingly, if our base case is correct, then investors are going to need to think of more creative ways to generate returns that meet their mandates. Within Private Equity, for example, we think that there is going to be a major shift towards transactions that reflect a highly differentiated view on the direction of an industry, major cost cutting opportunities, and/or business repositioning initiatives. In Credit, we expect more dollars to seek out complex situations in areas where traditional banks no longer participate, which is why we maintain such a constructive view on Direct Lending. It also speaks to our recent decision to boost our weighting in Actively Managed Opportunistic Credit, which we view as an efficient vehicle to harness volatility to our benefit in an effort to boost returns. Otherwise, with risk-free rates as well as nominal growth rates at such low levels around the world, the potential for financial assets to generate the same level of returns as they did in the past seems misguided, we believe. One can see the magnitude of the downward pressure on returns that has already occurred thus far in Exhibits 21 and 22, respectively.
Returns for Financial Assets (Treasuries, Private Equity, MSCI ACWI and High Yield) Have Been Falling Since 1995
Besides Lower Absolute Rates, the Secular Slowdown in Nominal GDP Has Also Been a Headwind to Risk Asset Returns
China’s Growth Is Structurally Slowing => Whither Globalization?
While we still expect that China could account for more than one-third of incremental global growth, our bigger picture conclusion remains that the Chinese economy is structurally slowing, driven by disinflation, declining incremental returns, demographic headwinds, and the law of large numbers. Against this macro backdrop, we expect the government to continue to push for more domestic-oriented growth, including more insourcing of intermediate goods, higher value-add products, and services. One can see how much China has already slowed down its imports, intermediate goods in particular, in Exhibit 23.
China Is Maintaining Share by Exporting More High-End Goods. However, It Is Also Importing Less as It Builds Local Competitive Advantages
China’s GDP Growth Will Rise and Fall with Stimulus, but the Structural Trend Is Downward Sloping
If we are right, then we think that there are two important investment implications. First, global trade as a percentage of GDP should remain more muted than in the past. Already, we note that global exports as a percentage of GDP actually peaked in 2008 and now total around 22%, a percentage we expect to fall into the high teens during the next five years. One can see recent trends in Exhibit 25 and Exhibit 26, respectively.
Global Trade Has Actually Declined in Recent Years
Both Global Import and Export Activity Have Contracted Meaningfully
Second, we think that the global flows are likely to be less dynamic than in the past. Already, as one can see in Exhibit 27, foreign direct investment (FDI) as a percentage of GDP has been flat to down since the Great Recession. From what we can tell, we think that this change is somewhat of an expression of the populism that we also see in politics (e.g., Trump protectionism, Brexit, Catalonia nationalism, etc.). It also reflects increased savings in places like the U.S., as consumers, who drive 70% of the economy, seem less certain about their future.
The Trend in FDI as a Share of GDP Has Been Flat at Best Since the Great Recession
Outbound FDI in EM Is on the Rise, While the DM Are Showing a Downward Trend. We Believe M&A Activity by China Is a Key Factor
French Banks Have Cut Lending Outside of France by More Than Half in Recent Years
While Technology Is Still Increasing Global Inter-connectivity, Many Other Macro Trends Are Actually Headed in the Opposite Direction
Interestingly against this backdrop, EM countries actually have become the FDI provider of choice to the global economy. All told, EM is rapidly approaching 50% of all outbound FDI, which is up from just 10-20% before the Great Financial Crisis. Put another way, they are now spending accumulated wealth from the early 2000s boom. The bad news is the trend – to some degree – seems to suggest they are finding fewer profitable investment opportunities in their domestic economies.
What does all this mean for investors? First, we see more bids for corporate properties coming from emerging market counterparts, China in particular, during the next few years than strategic buyers in the developed markets. If we are right, this trend has significant implications for global M&A as well as industry consolidation. Second, we think that China’s secular slowdown means that we not only have slower global GDP growth but also slower nominal revenue growth. This viewpoint is important because it means that companies can’t lever up as much for buybacks, deals, and capital expenditures in this type of environment versus past cycles. Third, we expect the trend towards less liquidity across the global capital markets to continue, driven by smaller bank balance sheets and larger global banking regulations. Finally, we expect a secular trend towards government favoring national champions in important sectors such as banking and technology in key markets, including China and Europe.
Still Bullish on the Consumer, but the Bifurcation Between Services and Manufacturing Appears to Be Getting Too Wide
As we laid out in our January 2016 outlook piece, we are constructive on the global consumer. We see record low debt service burdens in the U.S.A., and our recent trips to Europe lead us to believe that Europeans are spending their “oil dividend” faster than in the United States, albeit the Brexit vote will likely put a stop to this.
That said, our top-down work on the consumer confirms that it is not business as usual. Specifically, there is still a strong ongoing shift towards experiences (i.e., services) and away from things (i.e., goods), apparel in particular. Also, consumer behavior patterns are reflecting a heightened propensity to save more this cycle than in the past. One can see the magnitude of these trends in Exhibits 31 and 32, respectively. Another important consideration is the change in the composition of the U.S. consumer community. Indeed, as Exhibit 34 indicates, the U.S. population of spenders is becoming not only older but more diverse.
All Told, Consumers Have Actually Spent Most of Their Income Gains
We See a Clear Trend of Spending on Experiences Over Things
Consumers Have Increased Their Savings Rates Materially
Whites Over 65 and Hispanic Segment Cohorts Are Now Gaining Wallet Share
If there is a growing concern we have, it’s that we are beginning to wonder whether the bifurcation between our bullish view on services and our more cautious view on manufacturing has largely run its course. Indeed, as Exhibits 35 and 36 show, respectively, the gap between the current two-tiered economy now appears to be getting extreme. We fully acknowledge that manufacturing now makes up only 15% of U.S. GDP8, but given that we are 84 months into an economic expansion, we would like to be seeing a more broad-based recovery than what is currently unfolding.
Services Payroll Growth Looks Peaky, While Goods Payroll Growth Has Rolled Over…
Interestingly, even within services, we are seeing several notable trends that we believe are worthy of investor attention. For starters, just consider that average payroll growth in services per month has been 126,000 year to date, which is down meaningfully from the 188,000 average observed over the past three years. This 33% decline relative to trend has important implications for the outlook of the overall U.S. labor market, as the services industry has accounted for 87% of total jobs created since mid-2014. All told, the service sector has created 4.6 million jobs out of the total 5.3 million jobs. By comparison, the entire Government and Goods producing sector has created just 714,000 jobs during this period. Importantly, within the 4.6 million jobs created, 45% have been tied to just two categories: education and healthcare and professional/business services. One can see this in Exhibit 37.
…This Wide Spread Has Been a Powerful Late-Cycle Indicator
So, where do we go from here? Our base view is that U.S. services in aggregate peak in late 2017/early 2018, and when it does, we do not think that the manufacturing sector is strong enough to offset the weakness in services. Importantly, though, we expect a more modest pullback in the United States than what we saw in 2007. Key to our thinking is that the U.S. savings rate today is more than double where it was in 2007 and on par with 2003 levels (which is when the last recovery started). Moreover, the debt service burden for U.S. consumers today is at a record low.9 As such, we think that – contrary to popular opinion – the next U.S. recession could be much more mild than what we saw in 2001/2002 and 2008/2009.
Education, Healthcare and Professional/Business Services Have Accounted for 45% of All Payrolls Created Since Mid-2014
Lower Rates and Increased Regulatory => More Complex Transactions Move Off Market
In our humble opinion, we may have reached an inflection point where central banks have gone too far with their unconventional policy tools. In particular, we think that central bank authorities are underestimating the negative impact of QE on the financial services system in the developed markets. At its core, we think that negative interest rates challenge two basic premises of financial/economic theory. They are as follows:
- A bank should earn more, not less, in net interest margin during periods of stress to offset any potential increase in loan loss provisions; in laymen’s terms, a higher net interest margin acts as an important “shock absorber” during periods of stress.
- A borrower should have to pay some economic rent commensurate for risk associated with the ability to borrow money; otherwise, it either encourages fear at one extreme, or potentially reckless behavior (greed) at the other extreme.
Given the shortcomings associated with negative deposit rates, we are not surprised to see that the earnings power of European financials, whose earnings became subject to the ECB’s negative rate policy in July 2014, are responding poorly. One can see the magnitude of the hit to earnings in Exhibit 38. To be sure, European banks are also being squeezed in today’s QE-driven environment by low asset yields and increased regulation, but negative rates notably exacerbate an already uncomfortable environment. A similar scenario is now also playing out in the U.S. Indeed, as Exhibit 39 shows, the notable increases in capital charges is further denting an already low return on equity in the sector.
Besides questioning the efficacy of recent central bank policy, we also wonder whether recent regulatory burdens are perhaps becoming too onerous with their intended objectives. Just consider that a full reading of the Dodd-Frank banking oversight document that was introduced in the aftermath of the Great Recession is now actually longer than reading 15 copies of Leo Tolstoy’s classic novel War & Peace put together.
Against this backdrop of heightened complexity and increasing regulation, almost all the banks with whom we visit are responding to higher capital charges and more oversight by shedding assets and streamlining businesses. All told, the investment bank Morgan Stanley estimates that banks have reduced their balance sheet assets by four to five trillion since 2010 (and taken out $20 billion of net aggregate costs, despite adding massively to compliance and legal infrastructure).10 To put this in context, a four-to-five trillion reduction is the equivalent of five or more firms the size of Morgan Stanley exiting the industry.
There have also been major fines associated with the Financial Crisis that have made less capital available for consumers and corporations to borrow from banks. Indeed, failures in customer reporting alone have cost the world’s top 10 investment banks $43 billion in fines from 2009 to 2015, making it the single most expensive compliance issue (Exhibit 43). As a percentage of equity, compliance related issues destroyed 14% of total bank equity during that time.11
Banks’ Ability to Absorb Credit Losses Already Has Been Impaired
Because of Stress Tests, Banks Have Built Over $100 Billion of Common Equity Between 2012 and 2015, Deteriorating Their Core ROEs by 100 basis points
Our bottom line: If traditional financial intermediaries are going to struggle to earn a respectable net interest margin amidst increasing regulatory pressures, then there is a high likelihood that more and more complex transactions move off market. This migration might be good for investors (see below, but we think that an investor can earn a premium rent in terms of yield, despite being high up in the capital structure), though we think it will continue to create ongoing profitability issues for the traditional global financial services system. This insight is important because financial services companies not only provide the required credit creation to fuel economic growth, but they also represent a significant portion of the global capital markets (both market capitalization and EPS).
Regulatory Costs and Challenging Markets Have Reduced European Bank Balance Sheets by 25%; There Is Likely More Degradation Ahead
If Rates Stay Low, Then U.S. Bank Consensus EPS Could Fall by 17% or More by 2017
Seven Years of Fines Have Taken a Heavy Toll on Banks, Wiping Out the Equivalent of 14% of Equity Capital
Fines for Ten U.S. and European Banks Between 2009 and 2015 Totaled $150 Billion
Section III: What Does This All Mean for Asset Allocation?
In the following section we detail how we think some of the aforementioned macro views shape our asset allocation decisions. They are as follows:
Staying Closer to Home on Style Bets, but Complexity Appears Attractive Relative to Simplicity
When we arrived at KKR in 2011, our basic macro playbook originally revolved around our thesis about China slowing more than expected (China’s Rebalancing Act, July 2012) and yields staying lower for longer than expected (see Brave New World: The Yearning for Yield Across Asset Classes, December 2011). Today, however, both of these thematic trends now seem to be better understood as well as priced into the market.
A Review of the 21st Century; We Now Think Complexity Looks Cheap, While Simplicity Appears Expensive
So, while we pause to better appreciate what is the next big trend that the market may be underappreciating, we think that now is not the time to make big style, currency, and/or EM/DM bets. The issue, as we see it, is that many high quality properties have gotten expensive; yet, on a sustained basis, we do not yet see a catalyst for the “value” part of the market to bounce back and hold its gains. As such, our inclination is to get a little closer to home in terms of large stylistic wagers until we gain more visibility into what the next new powerful regime is.
However, as we mentioned earlier, we do believe that complexity appears much more reasonably priced than simplicity (particularly when it is attached to a stable stream of EPS), which the market seems to crave in the current environment of global macro uncertainty. A good example of our logic can be seen in Exhibits 45 and 46, respectively. One can see that growth and defensive stocks have gotten quite expensive in Europe, so we do not think now is a time to overpay for growth. On the other hand (and given our strong belief that China is structurally slowing), we are not yet totally convinced that all the beaten up, laggard segments of the markets, including parts of industrials and mining, are yet fully cheap if current macro trends persist. Rather, we prefer some selectivity across all sectors and regions of the market.
Defensives Are Nearing All-time Relative Valuation Highs Across an Average of P/E, P/BV and DY. We Think That This is Unsustainable
Relative Valuation of Momentum Long Versus Short Baskets Has Begun to Unwind; We See More Ahead
Still Prefer Credit Over Equities, and Within Credit, We Favor Private Credit
As we indicated upfront in our asset allocation table in Exhibit 1, we are underweight Public Equities and overweight Credit. Our base view is that Credit will return in line or better than equities with much less volatility and the visibility on the total return stream will be much higher. We also note that, as we show in Exhibit 47, Credit looks more attractive than Equities using our simple fair value model.
Credit Is Pricing In a Significant Risk Premium Relative to Equities
As Credit Conditions Tighten, the Illiquidity Premium Is Becoming More Prevalent Across Different Asset Classes
Within Liquid Credit, we generally favor Levered Loans over High Yield, though we acknowledge one must be flexible in the current environment of heightened volatility. We also like the flexibility we have through our new five percent position in Actively Managed Opportunistic Credit to pursue periodic dislocations and/or niche areas that might be overlooked by traditional benchmark seeking mandates. More important, though, is that we feel strongly that Private Credit will continue to be a star performer. Our basic premise is that — given the asynchronous world that we now live in — economies, markets, and flows are likely to continue to periodically seize up when macro shocks occur. If we are right, then these dislocations create excellent times for asset-based lenders to deploy capital that fills the gap increasingly being created by a smaller, simplified, and more regulated banking system. Maybe more important, though, is just the steady stream of deals that are now having to be negotiated off market, given less commitment to this part of the lending industry by traditional financial intermediaries. Key growth markets now include aircraft leasing, alternative energy financing, acquisitions, and capital spending investments.
Lower Inventories in the Broker Dealer Community Have Massively Dented Liquidity
Levered Loans Are Less Volatile but Have a Similar Return Profile
Private Equity Over Public Equities
We remain underweight Public Equities, with a notable preference for the U.S.A over all other regions, Asia-ex Japan in particular (Exhibit 1). Key to our thinking is that the U.S. is largely a domestic focused, consumer economy. As a result, it will likely suffer less from the unsettling macro trends that we now see unfolding in both China and Europe. We also continue to advocate an equal weight in Private Equity. Importantly, as one can see in Exhibit 51, what we found is that low return environments for Public Equities have actually historically been decent environments for Private Equity. From what we can tell, it seems single-digit return environments for Public Equities tend to be markets where fundamentals are good enough to support deleveraging and operational improvements, but not so good that it is difficult for PE to keep pace with public alternatives. Also, buyout opportunities tend to increase as the forward-looking total return in public equities decreases. One can see this in Exhibit 52.
Private Equity Often Outperforms Public Equities in Low Return Environments…
…And the Number of Buyout Opportunities Increases as Forward-Looking Market Returns Diminish
The Outperformance of Private Equity Relative to Public Equity Grows as Equity Markets Soften
…But Public EM Getting More Interesting
At the moment, we are underweight both Latin America and Asia-ex Japan. However, as we show below, our dashboard for Emerging Market equities is finally trending more positive. Specifically, unlike when we wrote our EM report back in May 2015 (see Emerging Market Equities: The Case for Selectivity Remains), valuation is now more compelling, and we believe that momentum could turn positive by the fall if the recent uptick in flows continues.
Our Rules of the Road Suggest EM Valuation Now Looks Attractive Relative to DM, But We Have Not Gotten a Formal BUY Signal
While our quantitative measures seemed poised to give us a “buy” signal, recent visits to the various EM regions where KKR does business still lead us to believe that more reform and restructuring is needed for fundamentals to really turn. As such, we continue to suggest that investors focus on domestic stories where 1) consumption as a percentage of GDP is sizeable; and 2) government-driven reforms are being implemented to the benefit of citizens and shareholders. If we are right, then countries like Mexico and India, both of which meet our aforementioned prerequisites for success, should continue to perform well. By comparison, we remain cautious on China as well as many of its trading partners in Southeast Asia.
It Appears EM Public Equities Are Close to a Bottom on a Relative Basis…
…And Look Cheap Relative to History
Separately, we are increasingly intrigued by potential “turnaround” stories in EM, Argentina and Brazil in particular. Indeed, recent changes in governments have led to a marked swing from leftist/populist governments to more market-friendly center-right administrations. We view the economic agendas as ambitious and think the economic teams are quite capable. However, the key issues are executing on reforms, getting inflation (and inflation expectations) to head back down via budget consolidation and setting the debt/GDP ratios on a sustainable path.
So far, markets have been very favorable to both of these new administrations, but we are more encouraged by Argentina than Brazil. We still think that Brazil faces major issues around unemployment, high and inflexible social outlays, corruption, and vague tax policies, and we do wonder whether there is still a lot of capital that wants to get out of the country. In Argentina, our research and travels lead us to believe that we are still in the very early innings of the turnaround, and as such, foreign capital is largely still underweight this country in terms of exposures.
Real Assets: Yearn for Yield Thesis Intact, but Would Now Take More Commodity Risk in Oil and Copper
In the past quarters we have been almost singularly focused on real assets with yield – often at the expense of more pure commodity plays. At this point, however, we are changing our thinking. There are several reasons for our shift in outlook to include more pure commodity-linked private investments. First, as we detail in Exhibits 57 and 58 respectively, commodity price declines across many categories are now in line with previous bear markets in terms of both price and time.
Commodities Have Experienced a 40-85% Price Correction…
…Over the Past Four to Ten Years
Second, as we mentioned at the outset (and we describe in more detail below), we think that the next leg of the dollar bull market is likely to be more measured than in the past but with significant bouts of volatility. Moreover, there could be a pause in 2016 before it even reasserts itself upward. Third, we are starting to see behavioral changes on the supply side in certain areas that give us confidence. To this end, we note the reduction that we are forecasting in areas such as oil and copper (bullish) versus areas where supply still seems somewhat outsized, including iron ore (bearish).
That said, we are not arguing that investors should abandon key markets in Real Assets that can deliver yield and growth. In Real Estate, for example, we still favor non-core assets with the potential for operational improvements and/or asset dispositions. Flexible capital structures too are a must, we believe, at this point in the cycle. In addition, similar to our thesis on Direct Lending, we favor off-the-run, complex real estate lending opportunities that previously were controlled by Wall Street firms with large securitization footprints. Meanwhile, in Infrastructure, overall prices are high, so one has to be disciplined. Our advice is to focus on opportunities where cap rates can fall by taking measurable – but not outsized – development risks. In Energy, our view is that that we want to back large conglomerates that are selling non-core assets to raise cash, repay debt or streamline footprints.
Currencies: Dollar Pauses and Two-Way Volatility Before It Reasserts Itself
Simply stated, we look for the dollar to remain in a volatile trading range in 2H16. Key to our thinking is that dollar again becomes a safe haven currency after Brexit, largely offset by a growing realization that global uncertainty prevents the Federal Reserve from hiking in 2016. Our bigger picture conclusion is that the current cycle most closely resembles the 1995-2002 period, which too enjoyed a pause after 54 months (Exhibit 59). If history holds, then the current “pause” or period of two-way volatility and divergences would reassert itself when the equity markets roll over in 2017/2018 and would likely later be linked to economic and capital markets risk aversion — not Fed hikes as the consensus now thinks. Without question, we are getting a window into the dollar’s safe haven status with Brexit.
We are less inclined to think the 1980 cycle is a good comparison because that time period was one of rapid inflation and strong labor force growth. As a result, the Fed tightened rates sharply to 20% from 9.5%. The only similarity today versus 1980 that we can find is that both periods endured an oil spike and subsequent collapse. Brent rose from $14 per barrel in 1978 to $79 per barrel at the end of 1979, before gradually falling back to $10 per barrel in 1986.
There Have Been Three Major Dollar Cycles Since 1970
We Think the Current Cycle Will More Closely Resemble the 1995-2002 Period, Which Included a “Pause” Along the Way
Against this backdrop, we are still focused on a few other currency crosses that appear attractive versus the dollar. Specifically, we expect 1) the CNY to depreciate further as China keeps monetary policy easy to accommodate restructuring and rebalancing of the economy; 2) the JPY will continue to strengthen as the deflationary forces remain strong amidst uneven growth. 3) the EUR to head lower as the ECB continues on the path of quantitative easing in a post-Brexit environment. Finally, we think that the GBP is headed lower versus the dollar, as the reality of the country’s leave decision sinks in with investors, and BoE responds with rate cuts and additional measures.
Risks/Hedges: What Could Go Bump in the Night?
As we indicated earlier, we still do not see a global recession until late 2017/early 2018. So, based on historical precedents, we do not envision a major sustained global market correction. As such, we think that the greatest near-term risk to the global capital markets would be some form of unexpected shock. Beyond mounting geopolitical risks, our base case is that any major shock to the system this year would likely come from excessive debt creation and/or debt levels. Not surprisingly, this type of framework leads us to places like China and Europe. All told, debt-to-GDP in China is now 255%, up from 186% five years ago; moreover, we estimate that credit creation during 1Q16 was $1.2 trillion, or the equivalent of 47% of GDP on an annualized basis.12
The good news for investors looking to hedge is that, unlike six months ago, the CNH 12-month forward points have collapsed. To review, forward points capture the rate differentials between the U.S. dollar and the offshore yuan and can be viewed as the embedded “negative carry”, or cost, to shorting the CNH in the forward market. As we show in Exhibit 61, forward points have retraced from 5.3% in January to just 2.4% today. In addition, implied volatility has come down across the term structure in the CNH options market. One can see this in Exhibit 62, where the level of implied volatility for making a devaluation bet (as measured by the implied volatility cost of the three-month 25 delta USD-CNH call) has been almost halved to just 7.2% today from 13.3%. So, when taken together (i.e., lower volatility and less negative carry), we view the positioning in this trade as “clean,” especially in light of recent Chinese economic data starting to roll over, following the strong first quarter data which reflected China’s massive lending surge.
We Continue to Think Currency Shorts in China’s Offshore Yuan (CNH) Is One Way to Mitigate Some of the Risk We See in Asia
China’s Currency Has Retreated Amidst Lower Volatility, Providing a Good Opportunity to Hedge
Separately, given our preference for Credit over Equities, we think spending some hedging dollars on buying generic protection makes sense. Specifically, we like paying (buying protection) in High Yield CDX. From the market’s low in early February, U.S. High Yield option-adjusted spreads (OAS) have tightened from 830 basis points to 560 basis points over. As one can see in Exhibit 63, this broad-based tightening was led by the energy subcomponents which rallied more than 1000 basis points.
So, at approximately 400 basis points in aggregate for the index (currently 429 basis points) we feel there is good risk reward in paying for insurance. One can see the attractiveness of the opportunity in Exhibit 64. Key to our thinking is that this recovery in energy credit has probably come too far, too fast. As such, in aggregate, we now we think the CDX index has downside to tighten to 350 basis points in an extremely bullish scenario, but also the potential to widen back to 600 basis points, even without a recession. As such, this 4:1 upside to downside ratio makes us think it is worth carrying some of this protection, if purchased at the right level, especially if one is long leveraged credit. The High Yield CDX contract has a duration of approximately 4.5 years, so one would need approximately just 100 basis points of spread widening to break even if held for one year. Finally, in our opinion, this hedge would perform if there was a flare-up in parts of the market which drove risk aversion over the last 18 months, namely China, European banks and global oil markets.
Energy Credit Has Snapped Back Sharply in Recent Months
Given Our Sizeable Overweight to Credit, We Think Buying Some Form of Protection May Make Sense
In Europe, we believe staying short the GBP and/or EUR may be the cleanest way to handle any potential further issues related to the intensifying political discord. Our base case is that the United Kingdom enters a recession in 2017 against a backdrop of higher inflation and a sizeable current account deficit. Importantly, despite these headwinds, we still expect the Bank of England to lower rates by fall 2016, which does not bode well for the currency, in our view.
Euro-skepticism Has Increased of Late, Particularly in Italy
Section IV: Conclusion
While we believe that we are in the mid-to-late innings of the current economic expansion, we still see significant opportunity, particularly in the credit markets. Flexible capital mandates across all of Credit have emerged as some of our favorite investment ideas in today’s current environment of low rates and uneven global growth. Not surprisingly, we also favor Real Assets that can deliver yield and growth, and our research, as we have shown in this report, suggests Private Equity is likely to outperform Public Equity at this point in the cycle.
Are we being too cautious? We do not think so; some selectivity seems required after 84 months of economic expansion amidst rising geopolitical tensions. Maybe more, though, is our view that the investment community now better understands that lower rates and more stimulus suggest slowing nominal growth and low returns now lie ahead, Also, as we have seen with recent events in the United Kingdom, political tensions are now an influence that is likely to gain in stature in the coming quarters.
However, if we are wrong and risk assets do climb materially higher from here, we believe that it could be because there is another surge of global liquidity, China growth recovers significantly, and the U.S. dollar depreciates meaningfully. In our humble opinion, a weak dollar solves a lot of the world’s problems: sluggish growth in China, disinflationary trends, low commodity prices, and lack of EPS growth in the United States. At the moment, we do think that the U.S. dollar “pauses” from appreciating significantly in 2H16. However, we do not see a significant depreciation either, given the Fed appears to be the only developed market central bank capable of raising rates. Separately, there is also risk that this cycle lasts longer than we are forecasting (i.e., it lasts longer than 2018). Predicting a turn in the cycle is certainly more art than science, but we believe we see enough late cycle indicators, including peaking margins, to feel that we are being prudent to forecast some form of a slowdown by 2018.
On the other end of the spectrum, our modest forecast for equity and debt capital markets returns could be worse than expected if China can’t hold its currency stable against the dollar. In our view, an unsettled China macro backdrop would be destabilizing across both global equity and credit markets. Also, as we mentioned earlier, geopolitical risks in Europe, the United States, and even China seem to be trending higher, not lower, in recent months.
We Believe a Mild Recession Could Occur by 2018
Despite Stronger Balance Sheets and Wages, Consumers Still Face Significant Headwinds From Healthcare and Rental Costs
Looking ahead, we feel comfortable about our decision to move more idiosyncratic in terms of ideas. Consistent with this view, we do not think that now is the time to make huge sector and style bets; rather, we would focus on where quality assets with complexity are trading at a discount to their intrinsic value. Also, we note that Growth is well-bid but Value in many instances appears to lack a catalyst unless China re-accelerates, which is not our base view. As such, we stick to our base case that we remain in “Adult Swim Only” mode, with a particular focus on Private Credit, yielding Real Assets, and select parts of Private Equity.
We Are Beginning to Wonder How Long the ECB Can Prevent Political Discourse From Affecting Bond Markets
1 Data as at May 31, 2016. Source: Bloomberg.
2 Data as at March 31, 2016. Source: Goldman Sachs Research.
3 Data as at May 31, 2016. Source: Bloomberg.
4 Data as at March 31, 2016. Source: Bloomberg.
7 The S&P 500 bottomed at a trailing P/E of 12.1 on March 9, 2009 and has risen to a trailing P/E of 18.3 as at June 6, 2016. Source: S&P, Thomson Financial, Factset.
8 Data as at May 31, 2016. Source: Bureau of Economic Analysis, Haver Analytics.
9 Data as at April 30, 2016. Source: Bureau of Economic Analysis, Haver Analytics.
10 Data as at March 13, 2016. Learning to Live with Less Liquidity, Morgan Stanley Research.
11 Ten Banks include Barclays, Bank of America, Citigroup, Credit Suisse, Deutsche Bank, GS, HSBC, JPM, MS and UBS. Data as at March 27, 2016. Source: FT, Corlytics.
12 Data as at December 31, 2015. Source: China Bureau of National Statistics, Haver Analytics.