By HENRY H. MCVEY Mar 30, 2017

Our most recent macro deep-dive across Europe left us with several high conviction investment conclusions. First, we have boosted our European GDP forecast for 2017 to 1.7% from 1.4%, reflecting the reality that heightened political uncertainty has not yet derailed the region’s surprisingly strong economic recovery. Against this backdrop, we favor consumption stories, especially those linked to experiences. We also believe that European equities, financials in particular, are poised to perform well in 2017. Our work also suggests structurally overweighting innovation in Europe, including the region’s small but growing technology sector. However, there are plenty of thorny issues that must be considered. For example, the current monetary union is creating substantial structural strains not only across economies (e.g., Germany versus Italy) but also within economies (e.g., France). We also believe political concerns about immigration represent secular, not cyclical, headwinds that must be carefully considered. Our bottom line: Europe is likely to experience a notable “catch-up” trade in the near-term, but long-term structural headwinds continue to argue for moderate pacing, embracing complexity, and regional diversification.

“ A man should not strive to eliminate his complexes but to get into accord with them: they are legitimately what directs his conduct in the world. ”

Sigmund Freud

Austrian neurologist and the founder of psychoanalysis

My colleague Aidan Corcoran, who leads KKR’s macroeconomic analysis effort in Europe, and I recently joined many of our European KKR colleagues for a series of meetings with business executives, government officials, and central bank prognosticators across the region. Given the political uncertainty of late, there was certainly plenty to discuss, particularly as KKR remains quite active in assessing potential investment opportunities across private equity, private credit, liquid credit, infrastructure, and real estate in the region.

Our bottom line: We actually left feeling more encouraged about the prospects for risk assets in the near term, though some of our long-term concerns about the “Union” remain intact. See below for full details on our latest views, but our initial Thoughts from the Road are as follows:

1. Despite significant political uncertainty — and almost in spite of itself — European GDP continues to chug along at a steady clip. In fact, we are lifting our 2017 GDP forecast to 1.7% from 1.4% previously, driven by better than expected investment trends. Maybe more important, though, is that our quantitative GDP model is forecasting robust growth in Europe of 2.5% for 2017 (Exhibit 11). This forecast is driven largely by the powerful effects of the European Central Bank’s highly accommodative monetary policy regime, partially offset by stagnant housing market concerns. However, if mortgage lending growth does accelerate, implied growth by our model could be even stronger, though we fully acknowledge an overall political risk discount of 50-75 basis points to our quantitative growth model likely makes sense in the current environment.
A man should not strive to eliminate his complexes but to get into accord with them: they are legitimately what directs his conduct in the world.

Sigmund Freud
Austrian neurologist and the founder of psychoanalysis

2. Investors should continue to think about a European macro environment where consumption, particularly around experiences, remains compelling relative to overall trend growth. This viewpoint is consistent with an emphasis on sectors such as travel, health/beauty, and home improvement. By comparison, we remain cautious on global trade, and our research shows increasing examples of China insourcing manufacturing equipment that used to be built by leading European industrial enterprises (Exhibit 10). Our bigger picture conclusion is that globalization flows and production increasingly now appear to be moving towards more of a regional model, with a particular emphasis on Asia, Europe, and the Americas.
3. Europe continues to barrel down the path of a two-tiered economy, which is likely long-term unsustainable, in our view. Specifically, there is a large and growing dichotomy between Germany, with its strong growth, and the rest of Europe, Italy in particular. See below for details, but Italian GDP is now seven percent below its 2008 level in real terms; by comparison, Germany is a full eight percent above its 2008 level in real terms. During the next few quarters we believe that the ECB will allow Germany to run “hot,” leading to a further widening between Europe’s largest and fourth largest economies. Somewhat ironically, the better Germany’s GDP performs, the more German bunds the ECB has to buy, while Italy’s economic underperformance currently leads to less ECB purchases of Italian sovereign debt. We view these types of divergences as unsustainable, underscoring our belief that Europe will need to implement monetary and fiscal policies that better smooth economic growth and equality across the region; otherwise, we fear it will lead to even more dire populist reactions, particularly if immigration issues are not reconciled.
4. We spent some extra time in Paris discussing the political outlook with a variety of players from the various parties. Our base case is that anti-European candidate Marine Le Pen does not advance beyond the second round. While we think that risk assets could play “catch-up” following a Le Pen defeat, the current populist backlash in Europe is not likely to dissipate. At its core, the monetary union that defines the EU makes it hard for countries to both be globally competitive and domestically responsive to stagnant wage growth. Also, the refugee/immigration situation remains contentious, despite Europe’s urgent and long-term strong need to boost labor force growth — and hence GDP — via immigration.
5. Our discussions surrounding the banking sector from this trip lead us to remain constructive on both bank stocks and the assets banks are selling. According to Deloitte, sales by banks of European loans to third parties reached 172.7 billion euros during 2016, up a full 65.6% from 2015. We see more running room, as a steepening yield curve, higher stock prices, and solid GDP growth accelerate the healing of ongoing wounds in the European financial services sector. This outlook is also bullish for our substantial overweight in our asset allocation to both Private Direct Lending and Asset Based/Mezzanine Lending. Overall, our trip reinforces our 2017 outlook view (see Outlook for 2017: Paradigm Shift) that European financials will outperform during the next few quarters, a view we have not held in the past. That said, we do remain cautious on U.K. consumer-facing financial intermediaries. Key to our thinking is that we now see almost indiscriminate lending to consumers, despite deteriorating risk profiles in many instances. In our view, this trend is unsustainable, particularly given our base case for more of a hard than soft Brexit. Details below.
6. We think that the underlying performance of European equities is potentially misunderstood by market participants. See below for full details, but our key conclusions are as follows. First, almost seventy percent of the European underperformance versus the S&P 500 in recent years has been linked to the small size of the European tech sector, not the banking or commodity sectors. Said differently, Europe’s public equity underperformance is more compositional than it is structural. Second, whereas in past years we have argued that stocks with stable earnings looked expensive relative to stocks with cyclical earnings, the outlook today is now more balanced. However, that does not mean that there are no anomalies. See below for details, but our work shows that market capitalization — bigger being cheaper and smaller being expensive — is worthy of investor attention.

We left Europe with several investment conclusions. First, in terms of asset allocation, our view is that continental equities, which are finally experiencing positive earnings revisions for the first time in six years at the aggregate level, are quite a bit cheaper than bonds and real estate on a relative basis. To be sure, all financial assets have benefitted from quantitative easing, but interest rates and cap rates have fallen proportionately faster than the discount rate for stocks in recent years. Also, the embedded operating leverage in equities is higher than in real estate — and actually in most other equity regions — at this point in the cycle (Exhibit 35).

Second, we think that cyclical securities in Europe, financials in particular, will likely continue to rally. From what we can tell, the ECB now better appreciates that negative rates are problematic, and as such, it is steepening the yield curve to resuscitate the much maligned banking sector. Also, we continue to see multiple examples of banks selling assets off their balance sheets to create more flexibility with their capital base. However, we are not suggesting 100% of equity allocations go into cyclical stocks in Europe. In fact, as we mentioned above (and detail below) our work shows that overweighting innovation, the technology sector in particular, across Europe is key to delivering in both absolute and relative performance, especially versus the S&P 500, over a longer period of time.

Finally, private infrastructure will continue to be an attractive investment opportunity in Europe, as public spending in this area is problematic, given high government debt loads and falling marginal productivity. As an example, France has built more roundabouts for its drivers than all of the rest of the EU combined. Not surprisingly, the multiplier effect on these types of projects has declined massively in recent years. As a result of capital misallocation by public entities, we see a large and growing pipeline of sizeable private infrastructure plays — often with footprints that extend beyond the continent to include structures in the Americas and Asia. When coupled with the ability to deliver some operational improvement, we think that the upside potential for some of these stories could be meaningful.

Looking at the big picture, we are sticking with our original call from January that we have entered a Paradigm Shift, which includes four major changes in the global macroeconomic landscape. First, we think that fiscal policies are now likely to become more influential on the margin than monetary policy. This viewpoint is consistent with both central bank tapering as well as governments electing to increase deficits with pro-growth investment strategies in countries such as the United States, United Kingdom, and China.

Second, we see increased deregulation across many developed market industries, including banking and energy. Third, given slowing global trade and increased protectionist rhetoric, we think that more capital is likely to flow into domestic economies; in the past, by comparison, foreign direct investment tended to flow undeterred towards low-cost production facilities. Finally, we expect QE-driven volatility to extend beyond the global currency markets to include the interest rate markets in 2017/2018.

Against this backdrop, we envision more modest overall returns for investors at this point in the cycle, and accordingly, we have positioned our target portfolio this way (Exhibit 8). Specifically, we are substantially overweight Private Credit, which we believe can deliver high single-digit unlevered returns. Importantly, this trip reinforced the opportunity set in Europe, including both direct private lending to corporates as well as asset disposals from Europe’s banking sector. By comparison, we are generally underweight sovereign debt, investment grade bonds, and liquid high yield. Meanwhile, we hold an overweight in Real Assets, including Infrastructure, Energy, and Real Estate. Within Real Assets, our preference remains for investments that have both yield and growth. Finally, we believe that both Public and Private Equities should outperform Liquid Credit, though we recently boosted our Private Equity exposure to overweight. This viewpoint is consistent with our research, which shows Private Equity often outperforms many asset classes, Public Equities in particular, in the later stages of a bull market.

Section II: Details

In the following section we provide a detailed analysis of key themes from our trip.

Both Our Fundamental and Quantitative Inputs in Europe Suggest Faster GDP Growth As we mentioned earlier, we have boosted our 2017 GDP forecast for Europe to 1.7% from 1.4%. We still look for solid consumption, but my colleague Aidan Corcoran now feels more comfortable forecasting stronger investment. Beyond the more optimistic tone we encountered during almost all of our meetings, we also can’t ignore our GDP model, which has served us well in recent years. As one can see in Exhibit 9, our model continues to point towards stronger than expected growth. A key driver in the model remains the significant positive impact from the ECB’s heavy-handed dose of monetary stimulus. The importance of the ECB’s balance sheet certainly makes sense to us, as it now holds assets totaling 34% of the region’s GDP, compared to 24% for the United States’ Federal Reserve.

Maybe more important, though, is that one of the major drags on the model, namely, our “stagnant housing market” inputs, appears to be turning. One can see in Exhibit 13 that prices have rebounded nicely in recent quarters; however, we would be even more encouraged if credit availability towards housing improved more robustly (Exhibit 14).

To be clear, our model was also optimistic in 2016, and while it prevented us from getting overly bearish at a time when European GDP actually beat U.S. GDP for growth, we also did not achieve the upside that the model was forecasting either (it predicted growth of around 2.25% in 2016). As such, we attribute the “miss” between predicted and actual economic results to be largely linked to political risks. Said differently, if we were asked to guess at the political “tax” on growth last year, our work would suggest it would have been around a 75-90 basis point drag.

So, what’s our bottom line? Barring a Marine Le Pen victory (which is not our base case), European growth may actually surprise on the upside again relative to expectations in 2017, particularly if mortgage lending accelerates. A potential growth offset to consider, however, is that we do expect accelerated tapering by the ECB in the coming months. If we are right, then 2018 could be bumpy if the ECB is forced to respond more quickly than the investment community currently thinks.

Within the economy, we again look for consumption to outpace trade (at least the global part of it), but we now believe that investment could be stronger than we originally forecasted in January. Also, after years of acting as a material drag on growth, government spending is now a tailwind. All told, we think that government contribution to growth has gone from an incredible 150 basis point drag on GDP at its most difficult point in 2012 to a 20 basis point tailwind in 2017. Moreover if President Trump does encourage more defense spending as part of his NATO agenda, then there could be even further upside to our updated estimate.

Economic Divergences Within Europe Are Growing Wider—Too Wide? While there is certainly a lot of near-term handwringing regarding the prospects around the French election or assessing the impact of Brexit, much of the longer-term anxiety was actually focused in another area. Specifically, many of the business leaders and macro folks with whom we spoke are growing increasingly concerned about the divergence between Germany and Italy.

Just consider the current economic dichotomy unfolding. On the one hand, Germany growth has surged of late, posting an impressive 1.9% real GDP growth in 2016. The strong backdrop drove a record budget surplus of €23.7bn in 2016, fueled by higher tax revenues and low debt costs. In fact, the 2016 budget surplus, which was the third consecutive positive one, actually reached its highest level since reunification in 1990. In terms of employment trends, the story is equally compelling. German unemployment is at a post reunification low of 5.9%, with the participation rate simultaneously at a post reunification high of 68%, with further upside on both metrics in the near term.

On the other hand, the Italian economy appears stuck. Overall unemployment is 12%, youth unemployment is 27%, and investment has fallen by 25% since 2008. As we mentioned earlier, in real terms, Italy’s growth has underperformed even Japan, which has actually delivered growth three percentage points above its 2008 level of GDP (see Exhibit 17).

Against this backdrop, it is not surprising that populism has taken a firm hold in Italy, particularly as the reform momentum ushered in by Prime Minister Matteo Renzi has stalled. Further austerity measures will have a tough time passing parliament, likely leading to ongoing skirmishes with Brussels, we believe.

Our bigger picture conclusion from this growing economic divergence, which we were increasingly asked about during our time in Europe, is that a macro divergence on this scale makes for a difficult backdrop against which to run a “Union” for at least two reasons. The first is monetary policy. Indeed, while the Italian economy continues to sputter, German inflation is starting to break out, notably in real estate, where record low mortgage rates are driving rapid appreciation (Exhibit 18). In the near term, our conversations with policy makers lead us to believe the ECB will continue to overweight the struggling periphery in their calculus, and in doing so, it will let German inflation heat up further. However, longer-term, this type of differential is becoming too substantial to ignore, and we may ultimately end up in a situation where the ECB needs to react with less policy stimulus, which could be quite damaging for an Italian economy that is already struggling to grow. It could also lead to a stronger euro, which would further dent Italian exports.

One area to consider within monetary policy is the ECB’s bond-buying program. At the moment, the ECB buys 50% more German bunds for every sovereign security it buys in Italy. In our humble opinion, some reallocation away from German bunds to Italy and its other weak peripheral peers must be considered. Otherwise, the ECB faces a situation where it is giving outsized stimulus to the countries that don’t need it at the same time it is providing less stimulus to the ones that do need it.

The other issue to consider is political. Specifically, we want to underscore that lack of flexibility around the exchange rate not only prevents Italy from being competitive with Germany but also from properly redistributing wealth and employment opportunities within Italy. Importantly, though, Italy is not alone; this tension across countries and perhaps more significantly, within countries is true in Spain, Netherlands, Greece, etc. As such, we think the potential for further populist discord during the next few years remains a notable concern, particularly if tougher immigration regulations are not implemented. Just consider, for example, that the increase in Africa’s population is on track to reach 1.3 billion by 2050, or 2.5x the current population of the EU.

Our bottom line: If we are right about the growing number of cross-currents that have emerged within the European Union, then country risk premiums throughout many parts of the region may be too low. Indeed, despite the heavy debt loads we show in Exhibit 21, country risk premiums appear quite low in both absolute and relative terms.

France: the Road Ahead Given the upcoming election in France, Aidan and I spent a fair amount of the time drilling down on current trends in the country. While almost every French politician has a radically different approach to how he or she would deal with what ails the country, one major recurring issue remains the size of its government. Indeed, as we show in Exhibit 20, government expenditures as a percentage of GDP are north of 56%, essentially dwarfing more dynamic economies like Ireland and Spain. In bad times, this economic structure does make it less vulnerable to sharp economic fall-offs, which is why France actually outperformed the Eurozone on peak-to-trough GDP during 2008-2009, with a 4.6% fall in real terms, vs. 6.7% for the Eurozone overall. On the other hand, there is little operating leverage in the model, which helps explain why debt-to-GDP continues to increase even as GDP growth has improved.

To our surprise, however, we actually left Paris — despite all the political uncertainty — feeling better, not worse, about the economic backdrop for several reasons. First, fiscal austerity has eased, which has reversed the harsh compression in public spending. Second, lower rates are helping the French consumer, which has served to offset some of the overhang associated with terrorism and an uncertain political environment.

While none of these reforms (e.g., Tax Credit for Competitiveness and Employment, the Responsibility and Solidarity Pact, and the Hiring Subsidy) in isolation is a game changer, collectively they represent a meaningful support to employment. Third, the outgoing government has pushed through a series of labor reforms aimed at reducing the taxes companies pay on their workers. At the same time, 2017 is likely to see higher wages for civil servants following the end of the wage freeze in 2016, and we look for this to bleed over into private sector wages too.

During our visit we spent extra time drilling down with advisors linked to nominees Emmanuel Macron and Francois Fillon. Macron’s fresh approach has certainly captured the attention of many Parisians, but we do wonder whether he has enough support in the Assemblée to be effective if he does indeed win. Meanwhile, Fillon’s campaign team clearly thought through how to make France a more dynamic economy. Our worry, however, is that the desire to immediately implement a two percent increase in the VAT tax could dent growth a time when France is finally coming out of the doldrums.

Given the Trump and Brexit election outcomes, no one seems to be taking the Marine Le Pen effort lightly. We agree, though our view is that she will not win in the second round. Key to our thinking is that this election represents her third one; said differently, she is more of a known quantity relative to when then nominee Donald J. Trump surprised voters during his campaign. As such, we think it will be hard for her to bridge the gap from her current seven million support base to the 17 million votes that are needed to win, unless she is competing against a Socialist candidate (not our base case).

Our bigger picture take-away from a series of political meetings is that the French agenda feels more like a heavily amplified version of what we see unfolding in many of the countries that we visit these days, including more control of borders (i.e., immigration), increased competitiveness (i.e., lower taxes), income equality (i.e., redistribution of wealth), and nuclear power (i.e., nationalism). Said differently, given the significance of the aforementioned discussion points now on the table, populist agendas are likely to dominate economic agendas for the foreseeable future, in our view.

Public Equities in Europe Appear Attractive As we mentioned above, we think that European equities could enjoy a surprising catch-up rally in 2017, particularly after the French elections. In particular, we think that cyclical stocks, including financials, appear poised to outperform. In terms of financials, we are encouraged by these three trends: 1) a shift in ECB policy that encourages a steeper yield curve, despite negative short rates; 2) higher inflationary patterns are leading to an acceleration in nominal GDP; 3) some increase in risk taking, including M&A, debt trading, and certain securitizations. Also, as we show in Exhibits 26 and 27, both valuations appear attractive and earnings appear to be accelerating.

We also remain excited about the repositioning of balance sheets that we are seeing across the European banking sector. As activity has heated up in recent quarters, the bid/ask between buyers and sellers has narrowed. This improvement in pricing transparency has — not surprisingly — increased balance sheet repositions and asset disposals, trends we expect to continue. Also, unlike in 2011/2012, today investors do have confidence in the ECB to do whatever it takes, which has helped narrow spreads in credits related to both residential and commercial mortgages.

In terms of our overall outlook for public equities, our work shows that large capitalization stocks appear more attractive than mid- to small-cap stocks. Key to our thinking is that the earnings potential of large capitalization stocks appears to have significant upside; one can see this in Exhibit 30. By comparison, small- to mid-cap stocks in Europe appear to be over-earning on both an absolute and relative basis.

From a “style” perspective, our message is now more balanced, which represents an important change. To review, in the past two years, value stocks appeared extremely cheap relative to defensive/growth stocks. One can see the magnitude of the imbalance that was achieved in terms of relative outperformance in Exhibit 32. However, with the reflation trade gaining momentum since 2H16, many expensive growth stocks have faltered, while value stocks have rallied sharply. Importantly, we link this shift in style preference to the improving dynamics of the macro paradigm shift that we outlined earlier — a trend that we expect to continue in the coming quarters.

The other noteworthy conclusion within Public Equities is for investors to be structurally overweight technology stocks. Importantly, the entire technology sector in Europe is only four percent of the index, compared to 21% in the U.S., despite both sectors essentially delivering the same performance during the 2012-2016 period. As a result, Europe’s small weighting in the technology sector literally accounted for 70% of the 26 percentage point performance differential of the S&P 500 relative to Europe, a reality that we think is largely ignored by bearish European investors who have not spent the time analyzing the drivers of relative underperformance across the Eurozone.

Our bottom line: We think that European equities are likely to perform well in 2017. Earnings are finally accelerating after a seven-year recession, valuations are reasonable, and sentiment remains subdued. In the near term, we favor cyclicals over defensive and growth stocks. Longer term, however, our research suggests that investors who favor Europe either need to significantly overweight publicly traded technology stocks (or at least innovation) and/or look for alternative exposure through either private equity or growth-oriented capital if they are to maintain competitive performance with other more diversified benchmarks like the S&P 500.

Section III: Conclusion

Our most recent macro deep-dive across Europe left us with mixed emotions. On the one hand, we are likely more optimistic than the consensus on GDP growth in the near term. As we have indicated, our GDP model suggests even stronger growth than our recently revised GDP estimates, driven primarily by the huge tailwind that significant quantitative easing has provided. With moderate inflation and an accommodative central bank, we think that both credit and equities should continue to perform across Europe in 2017. In terms of high conviction ideas, we believe that banks are improving their balance sheets in Europe, which should help corporate lending; meanwhile, it finally appears that consumer credit growth rates on the Continent will achieve respectable levels, which is supportive of our consumption/experiences thesis.

On the other hand, our discussions also raised some perplexing questions where there does not appear to be an “easy” answer. On the political front, we have transitioned from a discussion about the “Left” versus the “Right” towards one about “Open” versus “Closed” economies. Importantly, these discussions are often being led by new political entrants, many of whom who are stronger on ideology than implementation. In France, for example, candidates from traditional parties are set to cede the presidency to an outsider for the first time since the founding of the Fifth Republic in 1958. Regardless of who takes control, immigration is a secular, not a cyclical, issue in Europe, we believe given surging population growth across both the Middle East and Africa.

Equally as important, we think that the monetary union is creating substantial structural strains not only across economies (e.g., Germany versus Italy) but also within economies (e.g., France). Without the Authorities paying some serious attention to this issue in the near term, we think that it could increasingly undermine members’ desire to withstand the bureaucracy of this size and complexity. In particular, if the Eurozone does not rebalance its economy more during the current period of economic optimism, the downside risk during the next economic downturn could be more unsettling than the 2011 period, we believe.

Finally, if we are right that we are shifting from a monetary stimulus to fiscal one, Europe could be more challenged than some of its global peers. Its sovereign debt loads remain outsized, which means it will be harder to accelerate nominal GDP above nominal interest rates. This dilemma will be rather problematic if the ECB normalizes rates by the end of 2018, which is in line with our base view.

With these macro thoughts in mind, our overall asset allocation advice is largely unchanged. Specifically, we believe that there are a few key areas where investors should consider leaning in aggressively. For example, we would focus more on large capitalization opportunities than small- to mid-capitalization ones in the public equity markets. We also believe that asset-based lending in the private credit markets remains an outsized opportunity, particularly if banks continue to shed assets at a healthy clip. Within private equity, we would focus on carve-outs, consumer substitution plays, and experiences over things.

On the other hand, we would avoid consumer credit-related “plays” in the United Kingdom (given our conviction surrounding a hard Brexit), and we would now caution selectivity in European small- to mid- cap equities. In our view, both earnings and valuation in this subset of the equity market appear somewhere between full and overvalued in many instances.

Overall, though, we continue to favor moderate pacing across many asset classes in Europe. In our view, rates are artificially low for the growth rates we are forecasting, and we believe that more significant tapering is likely in 2018 and beyond. Moreover, given that there is no quick fix to the currency or immigration issues cited above, we think that a balanced approach to both deployment and asset allocation makes sense at this point in the region’s macroeconomic and geopolitical cycles.

Important Information

References to “we”, “us,” and “our” refer to Mr. McVey and/or KKR’s Global Macro and Asset Allocation team, as context requires, and not of KKR. The views expressed reflect the current views of Mr. McVey as of the date hereof and neither Mr. McVey nor KKR undertakes to advise you of any changes in the views expressed herein. Opinions or statements regarding financial market trends are based on current market conditions and are subject to change without notice. References to a target portfolio and allocations of such a portfolio refer to a hypothetical allocation of assets and not an actual portfolio. The views expressed herein and discussion of any target portfolio or allocations may not be reflected in the strategies and products that KKR offers or invests, including strategies and products to which Mr. McVey provides investment advice to or on behalf of KKR. It should not be assumed that Mr. McVey has made or will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client or proprietary accounts. Further, Mr. McVey may make investment recommendations and KKR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this document.

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