volume 5.4 • june 2015 midyear outlook: five distinct ... · • fourth, with china’s ongoing...
TRANSCRIPT
VOLUME 5.4 • JUNE 2015
Midyear Outlook: Five Distinct Macro Disconnects
INSIGHTSGLOBAL MACRO TRENDS
2 KKR INSIGHTS: GLOBAL MACRO TRENDS
Midyear Outlook: Five Distinct Macro DisconnectsWhile we certainly appreciate that generating outsized returns has gotten more complicated as the cycle has progressed, we still see five distinct macro “disconnects,” or arbitrages that we view as attractive for long-term patient capital. First, given ongoing financial services de-leveraging, we still view the current illiquidity premium that has emerged in many lending arenas as quite compelling. Second, in an environment where central banks are holding nominal interest rates below nominal GDP, we favor real assets with yield, growth, and inflation hedging. Third, in pursuing rising GDP-per-capita stories in the emerging markets, we encourage folks to look beyond traditional public equities. Fourth, with China’s structural slowing now upon us, we see an increasing number of restructuring opportunities emerging across Asia, Europe, and Latin America. Fifth, in the developed markets we still see some opportunities in the corporate sector as many balance sheets remain under-levered and inefficient. To fund these five distinct macro disconnects, we continue to recommend a substantial underweight to traditional government bonds.
KKR GLOBAL MACRO & ASSET ALLOCATION TEAM
HENRY H. MCVEY Head of Global Macro & Asset Allocation and CIO of KKR’s Balance Sheet +1 (212) 519.1628 [email protected]
DAVID R. MCNELLIS +1 (212) 519.1629 [email protected]
FRANCES B. LIM +61 (2) 8298.5553 [email protected]
REBECCA J. RAMSEY +1 (212) 519.1631 [email protected]
JAIME VILLA +1 (212) 401.0379 [email protected]
AIDAN T. CORCORAN + (353) 151.1045.1 [email protected]
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© 2015 Kohlberg Kravis Roberts & Co. L.P. All Rights Reserved.
“ If it ain’t broke, don’t fix it.
”BERT LANCE
AMERICAN BUSINESSMAN AND FORMER DIRECTOR OF THE OFFICE OF MANAGEMENT AND BUDGET
3KKR INSIGHTS: GLOBAL MACRO TRENDS
In today’s rapidly globalizing capital markets, there appears to be an increasing premium being placed on managers who can react quickly to changing world events, and when necessary, reposition an invest-ment portfolio in a relatively short period of time. Without question, the ability to change one’s mind and move quickly in and out of investments should certainly be heralded as a positive develop-ment across the entire financial services industry. However, through painful trial and error, we have also learned that there is a balance. Sometimes the best thing an investor can do is just sit idle, letting one’s existing bets play out while avoiding the risk of diminishing the true courage of one’s conviction.
In our humble opinion, now is one of those times. Key to our thinking is that the major long-tail macro themes that we presented in Janu-ary 2015 are still playing out nicely, and as such, we do not want to get distracted by any short-term gyrations in the marketplace. In particular, as we show in Exhibit 1, the combination of our mas-sive underweight to government bonds, coupled with our substantial overweight to Distressed/Special Situations and other alternative asset classes, is still delivering strong performance. In addition, some of the more defensive repositioning we adopted in early 2015 relative to the 2012-2014 period has served us well, particularly as it relates to our return per unit of risk taken.
So the bottom line on our current asset allocation framework is that things just don’t seem to be too “broke,” so we are inclined not to try to “fix” them. That said, there is still a lot going on in the global mar-kets these days, and as such, we wanted to use this mid-year update to reinforce some of our most important themes, as well as discuss some changes we are making on the margin. Our key beliefs, which we describe in more detail below, are as follows.
1. We retain our 1700 basis point underweight to Government Bonds. From a strategic perspective, we still believe that the tra-ditional role of government bonds as both an attractive yield ve-hicle and a portfolio “shock absorber” is just not that applicable in today’s low rate, central bank affected environment. Importantly, as we look ahead, we see several catalysts, including higher infla-
tion, lower unemployment, and more robust wage growth by April 2016 to further confirm the merits of our massive underweight. Therefore, we are tweaking up our 2015 year-end yield target for the U.S. 10-year treasury to 2.6% from 2.4%. Our other interest rate forecasts, however, remain unchanged. Details below.
2. Our biggest overweight remains Distressed/Special Situations at 15% versus a benchmark of zero. As the current asynchro-nous recovery unfolds, we continue to see lots of periodic dislo-cations that favor opportunistic capital that can be placed high up in a company’s capital structure, earn a respectable coupon, and potentially also enjoy some equity upside through options and/or warrants. From a regional perspective, China’s slowing now makes Asia the most attractive region for this specific investment opportunity, but we also think that some appealing situations now exist across Europe, the United States, and even Brazil.
3. The one material change that we are making to our asset al-location in 2H15 is that we are raising Direct Lending to six percent from three percent versus a benchmark of zero. We pay for this increase by reducing our High Grade bond exposure to zero from three percent versus a benchmark of five percent. The catalyst for the increase: As we travel around, we continue to hear about more traditional financial intermediaries shrinking their footprints and backing away from non-traditional opportuni-ties. The well-publicized unwind of GE Capital is certainly the highest profile example of late in this ongoing saga, but our inter-national travels lead us to conclude that there are still an increas-ing number of lower profile exits occurring elsewhere around the world. Also, with dealer inventories now down 81%, we continue to see a convergence between the liquid and illiquid markets, particularly during periods of market stress.
4. Across the rest of the portfolio, we continue to believe in over-weighting both yield and growth. This drives our overweight in Real Assets, including Infrastructure, Real Estate, and Energy. It also dovetails with our approach to public equities. In particular, with greater than 65% of European equities trading with dividend
EXHIBIT 1
KKR GMAA Target Asset Allocation Returns, Volatility, and Return/Risk Metrics
RETURNS VOLATILITY RETURN / RISK
GMAA BENCHMARK DIFFERENCE GMAA BENCHMARK DIFFERENCE GMAA BENCHMARK DIFFERENCE
2012 14.8 11.3 3.5 9.3% 8.9% 0.4% 1.6 1.3 0.3
2013 14.6 10.6 4.1 7.4% 6.9% 0.5% 2.0 1.5 0.5
2014 4.2 2.2 1.9 6.7% 6.4% 0.3% 0.6 0.3 0.3
YTD MAY 3.7 2.2 1.5 7.5% 7.2% 0.3% 1.5 0.9 0.6
Weights as per KKR white papers “Where To Allocate, January 2012, “Real Estate Focus on Growth, Yield and Inflation Hedging,” September 2012, “Outlook for 2013: A Changing Playbook,” January 2013, “Asset Allocation in a Low Rate Environment,” September 2013, “Outlook for 2014: Stay the Course,” January 2014, “Midyear Outlook: Four Macro Trends at Work,” June 2014, and “Getting Closer to Home,” January 2015. Private equity returns as of 3Q2014, and using 0% for remaining months. Data as at May 31, 2015. Gross returns. Source: KKR Global Macro & Asset Allocation (GMAA), Bloomberg, Factset, MSCI, Cambridge Associates.
4 KKR INSIGHTS: GLOBAL MACRO TRENDS
yields above their corporate bond yields, we think this region of the world is still highly attractive. To this end, we are using recent stock price weakness to boost our European public equity allocation a percentage point to 16% versus a benchmark weight-ing of 15%. To “pay” for this increase, we further reduce our Latin American exposure to four percent from five percent and a benchmark of six percent.
5. Selectivity in EM means thinking beyond just public equities. While we do think that many EM public equities could be in the process of bottoming, we still favor selectivity. As we discuss below, we still favor India, China and select parts of Mexico in the larger markets during 2015. Our bigger picture conclusion though, is that real estate and fixed income (both public and pri-vate credit) may make more sense than traditional public equities in countries where nominal rates and inflation are high. In our view, this potential investment arbitrage of owning private EM debt over equity in certain instances is still underappreciated by many investors, particularly in markets like India and Brazil.
Importantly, as we look at the big picture, our approach to long-term investable themes still rests on our ability to find macro “discon-nects,” or arbitrages where we think the upside/downside ratio is quite attractive. The good news, is that — though we are certainly later in the cycle — we see five distinct macro disconnects that we still believe in. They are as follows:
• First, as we mentioned above, we continue to take advantage of the illiquidity premium being created by Wall Street’s significant downsizing.
• Second, in today’s low yield environment, we continue to favor real assets that can provide yield, growth and inflation hedging.
• Third, we think that in the emerging markets one has to think more broadly than pure public equities. With high nominal rates but slower growth, corporate credit, particularly higher yielding private credit, can be a more pragmatic investment approach.
• Fourth, with China’s ongoing slowing, we see substantial invest-ment opportunities to help restructure companies as they are forced to reckon with the reality that the China Growth Miracle that defined 2000-2010 is now over.
• Finally, in the developed markets we still see a lot of inefficient balance sheets where the cost of capital is still close to the cost of equity, opening the door for more buybacks, dividends and bolt-on acquisitions.
EXHIBIT 2
KKR GMAA 2015 Target Asset Allocation Update
ASSET CLASS KKR GMAA JUNE 2015 TARGET (%)
STRATEGY BENCH-MARK (%)
KKR GMAA JANUARY 2015 TAR-GET (%)
Public Equities 53 53 53
U.S. 20 20 20
Europe 16 15 15
All Asia 13 12 13
Latin America 4 6 5
Total Fixed Income 18 30 18
Global Government 3 20 3
Mezzanine 2 0 2
High Yield 0 5 0
Bank Loans 0 0 0
High Grade 0 5 3
Emerging Market Debt 0 0 0
Actively Managed Opportunistic Credit
7 0 7
Fixed Income Hedge Funds 0 0 0
Direct Lending 6 0 3
Real Assets 6 5 6
Real Estate 3 2 3
Energy / Infrastructure 5 2 5
Gold -2 1 -2
Other Alternatives 20 10 20
Traditional PE 5 5 5
Distressed / Special Situations
15 0 15
Growth Capital / VC / Other
0 5 0
Cash 3 2 3
Strategy benchmark is the typical allocation of a large U.S. pension plan. Data as at June 25, 2015. Source: KKR Global Macro & Asset Allocation (GMAA).
Of course, as we describe in more detail below, there are certainly risks to our macro world view that bear watching, particularly after nine consecutive quarters of positive performance in the S&P 500 (which is the longest winning streak in 17 years)1. For example, we now feel that corporate mergers and acquisition activity seems a little frenetic, given that almost everything is technically accretive in to-day’s low rate world. Separately, we continue to watch China closely, as the macro data have been much weaker than expectations. At the moment, we think this slowdown is more of a negative for many of China’s trading partners than for China, but this view could prove too optimistic. Finally, at a time when 60%+ of the global economy is in
1 Data as at May 31, 2015. Source: Bloomberg.
5KKR INSIGHTS: GLOBAL MACRO TRENDS
easing mode, the Federal Reserve is embarking on its first tighten-ing campaign since the Great Recession. With valuations now higher, volatility generally low, and the dollar breaking out, the risk of a syn-chronized global capital markets disruption has increased materially.
SECTION I: The Global Economic Outlook Remains Asynchronous
While we are making very few changes to our asset allocation targets this time, we have made and/or are making several notable tweaks to our 2015 economic outlook. Specifically, as we detail in Exhibit 9, we have reduced our U.S. GDP forecast to 2.4% from 2.7% on the heels of a weak start to 2015, including another negative first quarter GDP print again this year. As we show in Exhibit 3, we believe that weather in the Northeast has been an issue, while the ongoing slowdown in investment and hiring related to energy has also made a difference (Exhibit 4).
We see these growth headwinds to the U.S. economy as largely transitory. Our research on the last big supply-driven oil shock in the U.S. during 1986 also led to a temporary – and transitory – slow-down in both jobs and investment like the one we are seeing now in the United States (Exhibits 5-7). However, as the exhibits also show, consumers in 1986 began to appreciate the long-term benefits of lower gas prices by spending more a few quarters — though not im-mediately — after the initial supply shock. Our base is that a similar pick-up will occur during this cycle too by late 2015/early 2016.
EXHIBIT 3
Bad Weather Significantly Impacted Economic Growth On the East Coast During 1H15, Even Against Modest Comparisons
-0.9%
0.0%
0.0%
0.2% 0.4%
2.4%
New England
Mid Atlantic
South Midwest Southwest West
First Data SpendTrend,$Volume Growth By Region (April, Y/Y)
Data as at April 30, 2015. Source: First Data.
EXHIBIT 4
We Estimate That Oil Producing States Accounted for 18% of Total U.S. Job Growth in 2014; However, In 2015 This Trend Has Reversed Sharply
212
150
-62
0
50
100
150
200
250
Non-Oil Producing States
Oil Producing States
Total National
Estimated Base Case Average MonthlyPayroll Growth, ‘000s
Data as at March 31, 2015. Source: Bureau of Labor Statistics, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 5
During the 1986 Bust, There Was an 18-Month Lag Between Oil Trough and GDP Peaking
Dec-874.4%
Jun-86-50.0%
-60%
-40%
-20%
0%
20%
40%
60%-2%
0%
2%
4%
6%
8%
10%
Dec-
84
Jun-
85
Dec-
85
Jun-
86
Dec-
86
Jun-
87
Dec-
87
Jun-
88
Dec-
88
Jun-
89
Dec-
89
Jun-
90
Dec-
90
Jun-
91
Real GDP, Y/Y (LHS) WTI, Y/Y (RHS)
Data as at June 2, 2015. Source: Bloomberg.
“ With valuations now higher,
volatility generally low, and the dollar breaking out, the risk for a
synchronized global capital markets disruption has increased materially.
“
6 KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 6
Importantly, It Took Consumers Time to Start Translating Their Oil Savings Into More Spending Elsewhere…
Dec-864.5%
Jun-86-50.0%
-60%
-40%
-20%
0%
20%
40%
60%-2%
0%
2%
4%
6%
8%
10%
Dec-
84M
ay-8
5Oc
t-85
Mar
-86
Aug-
86Ja
n-87
Jun-
87No
v-87
Apr-
88Se
p-88
Feb-
89Ju
l-89
Dec-
89M
ay-9
0Oc
t-90
Mar
-91
Real Consumption, Y/Y (LHS) WTI, Y/Y (RHS)
Data as at June 2, 2015. Source: Bloomberg.
EXHIBIT 7
…As Energy Investment Fell First, But Was Later More Than Offset by an Acceleration in Consumer Spending
Dec-86-51.1%
Jun-86-50.0%
-60%
-40%
-20%
0%
20%
40%
60%-60%
-40%
-20%
0%
20%
40%
60%
Dec-
84
Jun-
85
Dec-
85
Jun-
86
Dec-
86
Jun-
87
Dec-
87
Jun-
88
Dec-
88
Jun-
89
Dec-
89
Jun-
90
Dec-
90
Jun-
91
Real Upstream Investment, Y/Y (LHS)WTI, Y/Y (RHS)
Data as at June 2, 2015. Source: Bloomberg.
In Europe, our recent trip confirms that things are progressing nicely (see below for more details), and we have actually boosted our European GDP forecast to 1.7% from 1.3% (see Thoughts from the Road: Returning to Normality, April 2015). Somewhat ironically, Europe – which faces structural demographic and labor force rigidity headwinds – is actually one of the few regions with upside potential to current growth expectations in 2015, driven by a weaker currency, lower rates and favorable comparisons.
Separately, we recently lowered our growth rate for Brazil (see Thoughts from the Road: A Perfect Storm, March 2015) to -1.5% from -0.75%. Without question, Brazil is one of the most challenging macro
stories out there right now, as the local economy is being adversely impacted by a trifecta of fiscal tightening, the Petrobras scandal, and dismal hydro power conditions. Against this backdrop, we are using our mid-year update to boost our CPI estimate for 2015 to 8.2% from 7.3%. Recent trips to Sao Paulo confirm to us that the adjustment in admin-istered prices is now more severe than we originally expected, thus we will likely push the headline CPI a full percentage point above our original estimate. Bottom line: We now allocate only four percent of our public equity exposure to Latin America versus five percent previously and a benchmark of six percent. Importantly, within Latin America, we skew our weighting distinctly towards Mexico, which we believe has better fundamentals amid important reform initiatives.
Finally, in China, we are using this opportunity to lower our 2015 GDP forecast to 6.8% from 6.9-7.0%. To date in 2015, the macro data have been even worse than our already conservative outlook. In particular, both fixed investment and export data have been sluggish (see our China section below for more details), but we do acknowl-edge growth in services is helping to cushion the blow. Our bottom line: We have not seen increased monetary stimulus leading to GDP and EPS improvements, and as such, we feel more comfortable with a more subdued outlook for the country.
EXHIBIT 8
Global Growth is Now a Two Horse Race Between the U.S. and China
3.0%
1.0%
0.5%
0.7%
0.7%
China Other EM U.S. Other World
Contribution to 2015e Global GDP Growth(Actual $US Terms)
Data as at January 22, 2015. Source: Haver Analytics.
“ At the moment, we think this
slowdown is more of a negative for many of China’s trading partners
than for China. “
7KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 9
Europe is the Only Region Where We Have Boosted GDP Expectations Since January
2015 GROWTH & INFLATION BASE CASE ESTIMATES
GMAA TARGET REAL GDP GROWTH
BLOOM-BERG CON-SENSUS REAL GDP GROWTH
KKR GMAA TARGET INFLATION
BLOOM-BERG CON-SENSUS INFLATION
U.S. 2.4% 2.5% 0.25% 0.3%
EURO AREA 1.7% 1.5% 0.3% 0.2%
CHINA 6.8% 7.0% 1.8% 1.5%
BRAZIL -1.5% -1.2% 8.2% 8.2%
GDP = Gross Domestic Product. Bloomberg consensus estimates as at June 9, 2015. Source: KKR Global Macro & Asset Allocation analysis of various variable inputs that contribute meaningfully to these forecasts.
Overall, we continue to view this recovery as notably asynchronous, particularly relative to recent cycles. We see two primary issues. On the one hand, a pattern of higher savings and lower wages is now preventing developed market consumers from consistently being the engines of global growth that they were during the past few decades. On the other hand, EM consumers are still nascent in their consump-tion patterns, including low appetite for credit in places like Mexico and a high propensity to save in places like China. As such, EM consumers are not yet ready to assume the role of the world’s most important shoppers in the way that U.S. and European consumers did in the recent past.
EXHIBIT 10
The World’s Biggest Shoppers Still Reside in the U.S. and Europe, Not in the Emerging Markets
0.81.11.11.11.21.31.41.51.51.62.1
3.03.43.9
7.17.4
9.910.3
11.5
SpainRussia
IndiaSub-Saharan Africa
Arab StatesItaly
BrazilMid East & N. Africa
South AsiaFrance
GermanyJapanChina
Latam & CaribbeanBRICs
Euro AreaEast Asia & Pacific
European UnionU.S.
2013: Household Consumption Expenditure(U.S.$ Trillions)
Data as at April 14, 2015. Source: World Bank, Haver Analytics.
EXHIBIT 11
Access to Consumer Credit in Mexico Remains Subdued
5.2
9.9
29.5
44.5
Consumer Credit % GDP
Mortgage % GDP
Corporate Credit % GDP
Credit % GDP
Mexico: Credit as a % GDP in 2014
Data as at December 31, 2014. Source: Instituto Nacional de Estadística Geografía e Informática, Haver Analytics.
EXHIBIT 12
Many of the World’s Biggest Savers Are in the Developing Markets
3.4
5.9
8.7
10.2
12.9
13.0
14.1
15.1
16.7
17.0
27.4
40.7
0 10 20 30 40 50
Japan
United Kingdom
United States
Spain
Euro Area
Ireland
Russia
France
Australia
Germany
India
China
Gross Savings Rate, %
Data as at 2014 except for Japan and Ireland (2013) and China and India (2012). Source: World Bank, Haver Analytics.
Consistent with this reality, we note that real global GDP growth has been just 2.4% since 2010, compared to 3.2% for the 1970-2002 period and 3.3% for the 2002-2008 period. One can see this in Exhibit 13. Of all the components of GDP, the trade-related ones have seen the most pronounced slowdowns. Further exacerbating the overall global growth slowdown issue is that – in an effort to reduce outsized debt loads – household and government spending have shrunk sharply in recent years, particularly relative to the 2008-2013 period (Exhibit 13).
8 KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 13
Both Import and Export Activity Have Contracted Meaningfully in Recent Years. Meanwhile, Austere Conditions Have Dented Both Household and Government Spending
3.2 3.3
2.4
3.3
3.0
2.42.7
2.5
1.2
2.9
4.9
3.3
5.6
7.3
4.4
5.3
7.5
4.3
70-02 02-08 10-13
GDP Households GovernmentInvestment Exports Imports
Global Real GDP Growth (%)
Data as at April 15, 2015. Source: World Bank, Haver Analytics.
EXHIBIT 14
Given the Lack of Additional Global Demand, Currency Weakness Has Become a Tool for Increasing Competitiveness
-50.5
-49.9
-46.6
-40.9
-36.0
-35.8
-28.9
-26.8
-25.7
-24.1
-21.3
-11.3
-7.0
4.5
RUB
BRL
ZAR
TRY
JPY
NOK
AUD
SEK
MXN
EUR
CAD
CHF
GBP
CNY
Past Four Years Change in USD Spot Price (%)
Data as of June 5, 2015. Source: Bloomberg.
EXHIBIT 15
The Big Headwind: Global Trade Is No Longer the Growth Engine It Once Was
198617%
200832%
2014e31%
15%
17%
19%
21%
23%
25%
27%
29%
31%
33%
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
2013
Global Exports as a % of Global GDP
Data as at January 22, 2015. Source: Haver Analytics.
EXHIBIT 16
DM Belt-Tightening Has Become a Headwind to Trade-Driven EM Growth
1988
200918%
19%
20%
21%
22%
23%
24%
25%10%
15%
20%
25%
30%
35%
40%
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
EM Exports, % of GDP (Left Axis)DM Gross Savings, % of GDP (Right Axis, Inverted)
Data as at January 22, 2015. Source: Haver Analytics.
Not surprisingly, central banks around the world have resorted to unconventional monetary policies in an attempt to try to improve the situation. In many instances the “easy fix” has been to deliver currency weakness to stimulate exports and a little inflation, rather than embark-ing on the structural reform and investment that we think is required to fix the “hangover” that resulted from the excess spending and credit growth that occurred prior to the Great Recession. In the near term, we acknowledge that such aggressive central bank intervention can deliver a weaker currency, and as such, produce a better export environment for certain countries — but in local currency terms (Exhibit 17).
9KKR INSIGHTS: GLOBAL MACRO TRENDS
However, for the entire global economy there is scant evidence that – after trillions of dollars of unconventional monetary policy – we have made enough structural changes to re-stimulate and sustain long-term demand trends. Indeed, as Exhibit 13 shows, household consumption is actually running 60 basis points below what it was during the last cycle, while government spending is running at just about half the level of the prior cycle.
Bottom line: We remain confident that the current economic recovery can last until 2017 or so, but there is mounting evidence that some of the growth we are seeing is currency-driven, central-bank manufac-tured growth – not the structural growth that is often associated with long-term, healthy, sustainable economic recoveries. Therefore, we are becoming increasingly worried that global politicians and central bankers need to do more to re-stimulate global trade by putting forth policies that stoke long-term demand improvements in both the developed and developing economies. If we are right, then higher volatility and lower returns are now in store for the investment com-munity.
SECTION II: Key Themes/Investment Opportunities
In the following section, we provide an update on some of the key themes and macro trends that heavily influence our thinking around our high conviction asset allocation recommendations.
Higher Inflation, Some Wage Growth and Lower Unemployment Are Coming, Making Us Feel Better About Our Significant Under-weight to Government Bonds
While we do not see structurally higher inflation, our forward-looking research does suggest that near-term inflation is poised to inflect upward by early 2016 – potentially more than the market now thinks. One can see this in Exhibit 18, which shows that U.S. headline infla-tion will move from -0.13% in April 2015 to 2.43%, or a change of 256 basis points by March 2016. Bond investors should also be aware that, unless the participation rate jumps meaningfully, we see unemployment moving towards 4.7% by March 2016, which is below the Fed’s long-term objective of 5.1% (Exhibit 19).
“ In many instances, an ‘easy fix’
has been to deliver currency weakness to stimulate exports
and a little inflation, rather than embarking on the structural reform
and investment that we think is necessary to fix the ‘hangover’
from the Great Recession. “
EXHIBIT 17
Export Growth in Local Currencies Has Rebounded Somewhat, But Actual Growth Remains Quite Tepid in U.S. Dollar Terms
MONTHLY EXPORT OF GOODS YEAR-OVER-YEAR (%)
IN LOCAL CURRENCY IN USD
APR-15 MAR-15 FEB-15 JAN-15 DEC-14 NOV-14 APR-15 MAR-15 FEB-15 JAN-15 DEC-14 NOV-14
VIETNAM 4.5 10.5 0.9 18.5 12.1 11.6 2.1 8.7 -0.3 17.0 10.6 10.3
PHILIPPINES -4.6 1.3 -4.4 -0.7 -1.9 23.5 -4.1 2.1 -3.0 0.0 -3.2 19.7
THAILAND -0.5 -4.1 -6.8 -2.3 5.7 2.9 -1.7 -4.4 -6.1 -3.5 1.9 -1.0
KOREA -4.3 -0.7 -0.6 1.0 7.7 0.6 -8.0 -4.5 -3.3 -1.0 3.1 -2.7
SINGAPORE -9.3 0.7 -16.1 -1.6 -0.7 -3.1 -15.6 -7.4 -21.6 -6.4 -5.0 -6.7
JAPAN 8.0 8.5 2.5 17.0 12.8 4.9 -7.4 -7.8 -11.9 2.6 -2.2 -9.7
MALAYSIA -8.8 2.3 -9.7 -0.6 2.7 2.1 -18.3 -8.8 -17.0 -8.4 -4.0 -2.4
INDONESIA 3.7 2.8 -10.0 -4.3 -10.5 -9.4 -8.5 -10.3 -16.8 -8.5 -13.8 -14.6
CHINA -6.2 -14.6 48.8 -3.2 9.9 4.9 -6.4 -15.0 48.2 -3.3 9.7 4.7
INDIA -10.5 -19.2 -14.2 -9.3 -0.1 7.3 -14.0 -21.1 -13.9 -9.5 -1.4 8.9
Data as at April 30, 2015. Source: Respective national statistical agencies, Haver Analytics.
10 KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 18
Our Analysis Suggests That Just the Stabilization in Energy Prices Will Cause a 2.6% Swing in Headline U.S. CPI by 1Q16
Apr-15-0.13%
Mar-162.43%
-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%
Dec-
14
Apr-
15
Aug-
15
Dec-
15
Apr-
16
Aug-
16
Dec-
16
Headline U.S. CPI Y/Y by Component
Food Energy Core Headline CPI
Data as of March 31, 2015. Source: Bureau of Labor Statistics, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 19
If the Participation Rate Does Not Increase Soon, the U.S. Unemployment Rate Could Fall Below the Fed’s Long-Term Objective by 1Q16
Jun-994.3%
Jun-045.4%
Mar-074.4%
Mar-155.5%
Mar-164.7%Dec-16
4.1%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
U.S. Unemployment Rate
Data as at March 31, 2015. Source: Bureau of Labor Statistics, KKR Global Macro & Asset Allocation analysis.
The third and final piece of the rate puzzle centers squarely on wage growth, a trend we are now monitoring closely. Importantly, accord-ing to some work done by my colleague Jaime Villa (Exhibits 20 and 21), wage growth should start to pick up right around spring 2016 – the same time that our research suggests cyclical inflation peaks and unemployment may go below the Fed’s long-term target.
EXHIBIT 20
Our Analysis Suggests That Average Hourly Earnings Lag the BLS’ Employment Cost Index by 7 Months…
May-152.2
Apr-152.6
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Mar
-07
Oct-
07
May
-08
Dec-
08
Jul-0
9
Feb-
10
Sep-
10
Apr-
11
Nov-
11
Jun-
12
Jan-
13
Aug-
13
Mar
-14
Oct-
14
May
-15
U.S. Average Hourly Earnings vs. the EmploymentCost Index (ECI)
Average Hourly EarningsBLS Employment Cost Index
Data as at May 8, 2015. Source: Bureau of Labor Statistics, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 21
…So, If We Are Right, Wage Growth Should Accelerate in the Back of 2015
Apr-152.2
Nov-152.6
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Mar
-07
Oct-
07
May
-08
Dec-
08
Jul-0
9
Feb-
10
Sep-
10
Apr-
11
Nov-
11
Jun-
12
Jan-
13
Aug-
13
Mar
-14
Oct-
14
May
-15
Average Hourly Earnings Modeled on theEmployment Cost Index (ECI)
Data as at April 30, 2015. Source: Bloomberg, KKR Global Macro & Asset Allocation analysis.
Importantly, the reflation theme that we are describing is not limited to just the United States. Rather, as we show in Exhibit 22, the market is anticipating that the entire G8 country complex should start to see some improvement in its inflation outlook by spring of 2016. Consistent with this view, we have the Fed first boosting rates in September of 2015, with a moderate increase schedule thereafter. While we are certainly not as optimistic as the Fed on the path of
11KKR INSIGHTS: GLOBAL MACRO TRENDS
interest rate increases, we are more confident than the market that rate increases are indeed coming. One can see this interplay of what we view as variant expectations in Exhibit 23.
EXHIBIT 22
We Think the Global Deflation Scare Is Behind Us…
Jun-141.84
Dec-141.21
Apr-151.62
-
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
Dec-
08
Jun-
09
Dec-
09
Jun-
10
Dec-
10
Jun-
11
Dec-
11
Jun-
12
Dec-
12
Jun-
13
Dec-
13
Jun-
14
Dec-
14
G8* 5 Year Breakeven Inflation(GDP Weighted)
*Countries included: Australia, Germany, France, Italy, Spain, UK, U.S., and Japan. Data as at April 30, 2015. Source: Bloomberg, KKR Global Macro & Asset Allocation.
EXHIBIT 23
…Which We Think Gives the Fed the Go Ahead Signal to Begin Hiking Sometime in the Second Half of 2015
Dec-17,2.88%
2.50%
1.86%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
Dec-
15
Jun-
16
Dec-
16
Jun-
17
Dec-
17
Jun-
18
Dec-
18
Jun-
19
Dec-
19
FOMC ForecastGMAA ForecastMarket
Fed Funds Expected Rates
Data as at June 17, 2015. Source: Federal Reserve, Bloomberg, KKR Global Macro & Asset Allocation.
Against this backdrop of steadily evolving inflation expectations, we feel comfortable with our three percent allocation to Government Bonds versus a benchmark allocation of 20%. Importantly, though, our call is not that long-term bond yields are going to get unhinged. Rather, as we show in Exhibit 25, we now see a more modest move in U.S. 10-year Treasury yields towards 2.6% in 2015, up slightly from our prior target of 2.4%. Key to our absolute view on the level of U.S. rates this year is our relative call versus European rates. What do we mean? Well, we are still of the mindset that the U.S. Treasury rate will remain anchored by the German bund at this point in the economic cycle. History is on our side as we note that the Treasury yields have generally not traded more than about 150-200 basis points above the German bund since 1989. One can see this in Exhibit 24, which assumes a year-end bund yield of 1.0%, consistent with the current forwards curve.
Importantly, with the recent introduction of quantitative easing (QE) in Europe, we feel confident that Mario Draghi will keep 10-year German yields low by fully following through on his commitment to buy 60 billion euros per month of bonds through at least Septem-ber 2016. To be sure, we do not think that yields will collapse back towards the historically low levels that we saw after the program was announced earlier in the year, but we do remain confident that keeping yields around current levels is critical to ensuring that the ECB’s program inspires the confidence required for sustained higher asset prices and increased corporate confidence.
“ Wage growth should start to pick up right around spring 2016 – the same time that cyclical inflation
peaks and unemployment may go below the Fed’s long-term target.
“
12 KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 24
With the U.S.-German Spread Near a Historic High, We Think It Will Prevent U.S. Treasury Yields From Sky-Rocketing
Apr-892.16 May-99
1.51Sep-05
1.18
Dec-15e1.60
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
89 91 93 95 97 99 01 03 05 07 09 11 13 15
U.S. - Germany 10yr Rate Spread (%)
e = KKR Global Macro & Asset Allocation estimates. Data as at June 9, 2015. Source: Bloomberg, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 25
We Now See 10-Year Yields Moving a Little Higher Than We Expected Over the Course of 2015
2.6%
3.0%
2.4%
3.0%
2015 2017
U.S. 10 Yr. Treasuries, %
KKR GMAA June Forecast KKR GMAA March Forecast
Data as at June 9, 2015. Source: KKR Global Macro & Asset Allocation analysis.
Looking at the big picture, we want to underscore that Europe’s cen-tral bank-driven thirst for sovereign debt purchases is not an isolated event. Indeed, as shown in Exhibits 26 and 27, Japan too will likely again be a major buyer of sovereign debt in 2015. All told, according to the investment bank Morgan Stanley, total G4 supply is on track to fully shrink by 20% in 2015.
EXHIBIT 26
Quantitative Easing, Particularly in Europe and Japan, Remains Robust
0
200
400
600
800
1000
1200
1400
2011 2012 2013 2014 2015E
G4 Central Bank Sovereign Purchases
US ($ bn) Japan ($ bn) UK ($ bn) Euro ($ bn)
1,031
486
1,062
807
1,175
Data as at March 2015. Source: Bank of Japan, Federal Reserve, ECB, Bank of England, Bloomberg, Morgan Stanley Research.
EXHIBIT 27
G4 Supply Is on Track to Shrink – Through a Combination of QE and Smaller Deficits – by 20% in 2015
-1000
-500
0
500
1000
1500
2000
2011 2012 2013 2014 2015E
G4 Net Issuance Less Central Bank Purchases
US ($ bn) Japan ($ bn) UK ($ bn) Euro ($ bn)
-55
1,415
854
1,599
714
Data as at March 2015. Source: Bank of Japan, Federal Reserve, ECB, Bank of England, Bloomberg, Morgan Stanley Research.
That said, we think that the efficacy of global QE is starting to wane with interest rates at such low levels. Moreover, with a little more eco-nomic growth and some inflation coming back into the system, our bot-tom line is that folks should massively underweight sovereign bonds and redeploy the capital elsewhere across their asset allocation frameworks.
Driven by Upside to Growth Estimates, We Remain Constructive on European Assets in 2015
Given that Europe is the only region where we have both boosted our growth prospects and added to our public equity allocation this year, we thought it might make sense to review what in our view is finally
13KKR INSIGHTS: GLOBAL MACRO TRENDS
going right, particularly for a region that has experienced two reces-sions in the last five years.
What’s changed, we believe, is the following:
1. First, after years of fiscal austerity, Europe’s fiscal drag has fallen to around zero from 70 basis points in 20132. This pullback can-not be understated, as the negative multiplier effect on GDP had ballooned to 1.5x versus a historical average of around 0.5x.
2. Second, the euro is now down 11% on a trade-weighted basis (and fully 20% versus the USD) since peaking in March 2014.
3. Third, lower oil prices are proving to be somewhat of a boon to both GDP growth and private consumption. All told, my col-league Aidan Corcoran believes that each ten percent decline in oil prices adds 20 basis points to GDP after about 12-24 months (Exhibit 28). So with oil now down 35% from the June 2014 peak in euro terms, this tailwind is quite meaningful.
4. Finally, with ECB President Mario Draghi now buying 60 billion euros of sovereign bonds per month, financial conditions at least in the mainstream parts of the economy are extremely compelling relative to history3.
Though we have raised our 2015 GDP forecasts to 1.7% from 1.3%, there is still a good chance that we might need to boost our forecast even further by year-end. To get a feel for this upside risk, we up-dated our quantitative GDP growth model (Exhibit 29). As the charts indicate, a purely quantitative assessment of a lower euro, a posi-tive oil shock, and lower rates all suggest something north of 2.0% growth. Moreover, the model is still suggesting that weak housing activity/pricing will hurt growth, but recent data suggest housing is turning more positive in almost all of the countries we have visited across the Eurozone during the past 6-12 months.
2 Data as at December 31, 2014. Source: OECD Economic Outlook 96 Database.
3 Data as at March 18, 2015. Source: Bloomberg.
EXHIBIT 28
The Impact of Changes in Oil Price and Euro Weakening on Eurozone GDP Are Significant, Even Before One Includes the Benefit of QE
MACRO TAILWIND
CATALYST PER
DECLINEBOOST TO
GDPY/Y
CHANGE
TOTAL ES-TIMATED IMPACT
EURO
10% ON A TRADE-
WEIGHTED BASIS
50 BPS -11% 55 BPS
OIL 10%
20 BPS AFTER 12-24
MONTHS
-50% 100 BPS
TOTAL 155 BPS
Data as at March 25, 2015. Source: Bloomberg, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 29
Our Quantitative Model Suggests Our 1.7% Fundamental GDP Forecast Is Too Conservative
Dec-14a0.9%
Dec-15e2.4%
-6%
-4%
-2%
0%
2%
4%
6%
02 03 04 05 06 07 08 09 10 11 12 13 14 15
Actual Model Predicted
Eurozone Real GDP Y/Y - Leading Indicator
R-squared = 86%
Data as at March 2015. Source: Bloomberg, KKR Global Macro & Asset Allocation analysis.
So, our bottom line is Europe still represents an attractive invest-ment backdrop. GDP is moving from essentially flat to nearly two percent at a time when we think every 100 basis point increase in GDP translates into a 10-12% EPS growth. As such, we think that European corporate earnings could materially surprise on the upside in 2015. Initial indications are favorable, as the 1Q15 earnings season had the best earnings at the top line for five years, according to the investment bank UBS. As such, if Europe experiences any mean reversion of earnings relative to the U.S., the performance “catch-up” trade that we have been outlining to investors could still be quite substantial.
“ We are still of the mindset that
the U.S. Treasury rate will remain anchored by the German bund at this point in the economic cycle.
“
14 KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 30
Eurozone: Earnings Momentum Has Finally Turned Positive After 48 Months in a Row of Downgrades
0
50
100
150
200
250
300
-50
-40
-30
-20
-10
0
10
20
Jun-05 Jun-07 Jun-09 Jun-11 Jun-13
1-month Earnings Momentum (LHS)MSCI Eurozone (RHS)
Data as at May 20, 2015. Source: UBS European Equity Strategy, Thomson Datastream.
EXHIBIT 31
Trailing 12 Month EPS in the U.S. Is 27% Above 2007 Levels While Europe Is 19% Below
50
150
250
350
450
550
650
Dec
87
Dec
89
Dec
91
Dec
93
Dec
95
Dec
97
Dec
99
Dec
01
Dec
03
Dec
05
Dec
07
Dec
09
Dec
11
Dec
13
U.S. and Europe Trailing 12 MonthEPS In Local Currency
U.S. (USD) Europe (EUR)
2000Peak
2007/2008Peak
A 46%Gap
Data as at May 20, 2015. Source: UBS European Equity Strategy, Thomson Datastream.
Beyond equities, we also expect European liquid credit, private credit and especially real estate to all perform strongly into the end of 2015. That’s the good news. The bad news is that we do increasingly wonder whether the near-term bullish macro tailwinds are actually too favorable to usher in some of the more structural changes that Europe needs to offset poor demographics and labor rigidity, particu-larly in countries like France and Italy. Together those two coun-tries account for 37% of Eurozone GDP and while recent economic indicators have perked up, they will need to do much more structural
reform if they are to keep up with some of their more economically flexible peers, including Germany, Ireland and Spain 4.
There are two other risks that we also think warrant investor attention. First, though we do not see Greece exiting the Union, we do think that this country’s saga will continue to periodically elevate the region’s risk premium during the next 12-24 months. Second, Russian aggres-sion remains an ongoing threat, and so we expect occasional flare-ups to dent the prices of risk assets.
Recent China Data Makes Us Feel Confident About Our Large Over-weight to Distressed/Special Situations
At the risk of sounding like a broken record, we continue to view China’s slowdown in fixed investment as a secular, not a cyclical, event. To review, there are two major influences driving our outlook for fixed investment. First, the export data we track continues to show that China’s low-end manufacturing is being ceded to other countries. This headwind clearly affects capital expenditures, logis-tics, infrastructure, and investment. To this end, we note that exports in China declined 2.8% year-over-year in the month of May. Second, in our opinion, China’s real estate market feels overbuilt and over-leveraged at a time when low inflation is driving an asset allocation shift away from hard assets like housing towards the country’s stock market.
EXHIBIT 32
China Continues to Rebalance Away From Lower Value-Added Exports
Feb-0641.0
Jan-1043.8
May-1552.5Jun-02
55.6Jan-10
49.1
May-1536.6
363840424446485052545658
02 03 04 05 06 07 08 09 10 11 12 13 14 15
China % Total Exports, 12mma
Ordinary Trade (Higher Value Add)Reexports (Lower Value Add)
Data as at May 31, 2015. Source: China Customs, Haver Analytics.
4 Data as at December 31, 2014. Source: ECB, Haver Analytics.
15KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 33
This Transition Has Been Damaging to “Old China,” Particularly Manufacturing and Commodity-Related Exports
CHINA: U.S.$ EXPORT GROWTH Y/Y (%)
WGT 2010 2014 APR-15
Crude Materials ex Fuel 1% 42.2 8.7 -15.2
Misc Mfg: Clothing etc. 27% 26.0 7.0 -13.4
Fuels & Related Materials 1% 30.8 0.8 -10.8
Food & Live Animals 3% 26.2 5.7 -8.2
TOTAL EXPORTS 0% 31.3 6.0 -6.5
Chemicals & Related 6% 41.0 12.5 -6.1
Steel, Pulp, Leather, Rubber etc. 17% 34.8 11.0 -5.7
Machinery, Transport Eqp 46% 32.2 3.0 -2.9
Animals, Oils, Fats & Waxes 0% 11.9 6.7 8.0
Beverage &Tobacco 0% 14.3 10.5 25.6
Data as at April 30, 2015. Source: China Customs, Haver Analytics.
Moreover, as we look ahead, we think that the government is sincere in its pledge to make fixed investment a smaller percentage of GDP. As such, we expect fixed investment to grow in the mid-to-high single digits versus a nominal GDP of 8.5-10%. If we are right, then there is likely more downside to commodity-related inputs and activ-ity surrounding China’s growth in this area.
Against this backdrop, we retain our bullish stance that a growing number of companies across several geographies will need to refi-nance and restructure their balance sheets. Importantly, during the great China Growth Miracle that defined the 2000-2010 period, many CEOs took the additional step of over-leveraging their companies using U.S.-dollar denominated debt. As such, we are already seeing interesting opportunities in more mature markets like Australia as well as in emerging countries like Brazil and Indonesia to refinance companies that clearly underestimated the rate of overall global growth as well as the strength of the U.S. dollar relative to their local currencies.
EXHIBIT 34
There Has Been a Broad-Based Deceleration in Chinese Investment Growth
CHINA: YTD URBAN FIXED ASSET INVESTMENT GROWTH Y/Y (%)
WGT 2010 2014 APR-15
Mining 3% 19.3 -0.5 -7.8
Catering 1% 27.4 3.9 -4.9
Banking 0% 36.2 8.8 0.3
Construction 1% 23.8 19.1 1.8
Real Estate 25% 33.7 11.0 7.1
Sports, Recreation 1% 22.6 17.9 8.9
Manufacturing 33% 26.7 13.3 9.9
Public Mgt 1% 16.8 12.6 11.0
TOTAL FAI 100% 24.4 15.0 12.0
Other Svcs 0% 49.8 11.1 13.4
Water, Environment 9% 25.0 23.1 19.4
Wholesale, Retail Trade 3% 17.2 23.4 20.1
Education 1% 15.1 21.7 20.1
Power, Gas & Water 5% 7.8 16.1 20.3
Transport, Storage, Post 9% 19.5 18.8 21.3
Scientific, Technical Svcs 1% 20.9 33.5 23.1
Leasing, Commcl Svcs 2% 31.9 34.6 25.0
Health Care, Soc Welfare 1% 16.5 25.1 26.4
Agriculture 3% 17.6 26.6 26.6
Tech, Software, Svcs 1% -4.9 30.2 35.4
Data as at April 30, 2015. Source: China National Bureau of Statistics, Haver Analytics.
“ In an environment where central
banks are holding nominal interest rates below nominal GDP,
we favor real assets with yield, growth, and inflation hedging.
“
16 KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 35
China’s Fixed Asset Investment Is in Structural Decline, Which We Think Is a Major Macro Investment Theme
Jun-0933.6
May-1511.4
10
15
20
25
30
35
09 10 11 12 13 14 15
YTD China Fixed Asset Investment Y/Y, %
Actual YTD 11.4% vs. expected 11.9%. Implied monthly FAI in May was 9.9% Y/Y
Data as at May 31, 2015. Source: China National Bureau of Statistics.
This backdrop is certainly helping performance as it relates to our sizeable 15% overweight to Distressed/Special Situations. To be sure, we believe that this opportunity set will take years, not months or quarters, to play out. However, the die has been cast as China now needs nearly eleven units of debt to generate one unit of GDP, nearly triple what it was a few years ago5. In our view, this ratio is unsustainable and is now in the process of reversing, with significant implications for the banks and corporations that have benefitted from China’s increased leverage in recent years.
5 Data as at December 31, 2014. Source: People’s Bank of China, China Bureau of National Statistics, Haver Analytics.
Yield and Growth Investments: Our Brave New World Thesis Re-mains Resilient
One of our longest-held macro themes, which we term “Brave New World,” is that there has been a major demographic shift in investor preference – one that would drive individuals and institutions toward investments that could deliver both yield and growth. We introduced our Brave New World thesis circa 2004, and chose that name be-cause we thought investors at the time would have had to be “brave” in order to shun sporty, high-flying telecom and technology stocks – all in favor of stable growers and payers.
Fast forward to today’s environment of very low yields and a re-newed emphasis on return of capital, and now we find ourselves asking a totally different question: has this yield-and-growth story played out fully? Our answer is still an unequivocal “no.” At the risk of overstaying our welcome, we think it is worth considering that demographic forces remain extremely supportive of the yearn for yield, particularly as real yields have turned negative in many parts of the world.
EXHIBIT 36
Retirees Have a Strong Appetite for Dividend Yield
1.5
2.8
Under 65 Over 65
Estimated Dividend Yield of Equity Portfolios,By Age of Head of U.S. Household, 2007 (%)
Data as at December 6, 2011. Dividend yield calculated using dividend income as reported by the IRS Statistics of Income Division and equity holdings as reported by the Federal Reserve Survey of Consumer Finances. Our estimate includes an assumption that roughly half of privately held businesses pay some form of dividend. Source: IRS, Federal Reserve, KKR Global Macro and Asset Allocation estimates.
“ With China’s structural slowing
now upon us, we see an increasing number of restructuring
opportunities emerging across Asia, Europe, and Latin America.
“
17KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 37
We See Demand for Yield and Growth Continuing as More Boomers Retire
201018.4
203025.3
205026.6
208029.2
10
12
14
16
18
20
22
24
26
28
30
1960 1980 2000 2020 2040 2060 2080
U.S.: Percent of Population Age 60+ (%)
Retiring babyboomers
Data as at May 30, 2011. Source: United Nations World Population Prospects.
In addition to the United States, we remain particularly focused on the dividend and growth opportunity in Europe. As Exhibit 38 indicates, more than 65% of European equities now sport a dividend yield that is higher than their corporate bond yield. In our view, this percentage is too high, and we expect some normalization in the coming quarters, particularly if we are right about positive earnings momentum in Europe.
Beyond public equities, we think that our focus on yield and growth is also playing out nicely in the Real Assets space. Indeed, in a world where many central banks are using QE to try to get nominal interest rates below nominal GDP, we think investors should own more cash-flowing, inflation-oriented hard assets, including infrastructure, real estate and parts of the energy food chain.
To be sure, we do not see a scenario where inflation runs away in the near term. Rather, in today’s low rate world, the idea of getting a size-able upfront and recurring coupon from cash flowing hard assets with inflation protection features makes a lot of sense to us. Also, over-weighting Real Assets in one’s asset allocation should give some option-ality on current monetary policies not being so benign over time. Indeed, as Exhibit 39 shows, during past cycles when nominal interest rates were held below nominal GDP for long periods of time, an investor was usually rewarded for buying some form of inflation hedging optionality.
EXHIBIT 38
A Record Number of European Companies Now Have Dividend Yields Above Corporate Bond Yields
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
% of companies with Dividend Yield > Corp Bond Yield
Average
Data as at October 21, 2014. Source: Datastream, Goldman Sachs Global Investment Research Adventures in Wonderland.
EXHIBIT 39
Central Banks Around the World Are Running with Aggressive Monetary Policy
1978-5.6%
19825.7%
2005-4.2%
20091.0%
2014-3.8%
2019e-1.8%
-6%
-4%
-2%
0%
2%
4%
6%
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
2011
2014
2017
e
U.S. Fed Funds Rate, % Points Above/(Below)U.S.Nominal GDP Growth
3yr Moving Avg.
Rest
rict
ive
Pol
icy
Rate
sLo
ose
Pol
icy
Rate
s
e = KKR Global Macro & Asset Allocation estimates. Our estimates assume the Fed starts tightening in September 2015 and that Fed Funds peak this cycle at 2.5%. We expect average nominal GDP growth of 3.9% over the forecast period. Data as at June 22, 2015. Source: KKR Global Macro & Asset Allocation analysis.
18 KKR INSIGHTS: GLOBAL MACRO TRENDS
Illiquidity Premium Still Compelling; Increasing Our Direct Lending Allocation to Six Percent from Three Percent
Given that the illiquidity premium has been a big theme of the KKR Global Macro & Asset Allocation team since our arrival, we are not going to spend a lot of time describing its evolution (interested par-ties can read our earlier pieces, Financial Services: The Road Ahead, Outlook for 2013: A Changing Playbook and Asset Allocation in a Low Rate Environment for further details).
However, we do want to underscore that the global macro backdrop as well as the regulatory environment continues to suggest that the outlook remains robust. We quantify this in Exhibit 40, which shows that the il-liquidity premium has actually widened again in 2015. To be sure, many folks will point to General Electric’s exiting of its financial services busi-nesses as clear evidence that capital is being withdrawn from key areas of the market. We agree, but it is the less well-publicized downsizing and wind-downs that we now see in increasing numbers across Europe, Asia and even Latin America that fully round out the picture.
EXHIBIT 40
The Illiquidity Premium Remains Substantial
11.212.0
11.410.8
9.7 9.6
7.88.2
8.78.3
11.310.7
5.8 5.8 6.05.1 4.9 5.0
2007 2008 2009 2010 2011 2012 2013 2014 Q1 2015
Weighted Average Yield of Originated Senior Term Debt
12-Month Average Yield of Traded Loans
Weighted average yields of senior term debt. Data as at March 31, 2015. Source: S&P LSTA, Public Company Filings of Ares Capital Corporation.
EXHIBIT 41
Lower Inventories in the Broker Dealer Community Have Massively Dented Liquidity
Oct-07285
May-1555
0
50
100
150
200
250
300
01 02 03 04 05 06 07 08 09 10 11 12 13 14
Primary Dealer Positions: Corp Securities
US $mil
A declineof 81%
Data as at May 31, 2015. Source: Federal Reserve Bank of New York, Haver Analytics.
Beyond the compelling opportunity set that we see in the illiquid-ity premium, the other big call we are making in Fixed Income is to remain flexible. As such, we continue to like our hefty allocation to Opportunistic Credit, which allows managers to shift dynamically among high yield, bank loans and structured credit. At the moment, we prefer rate-sensitive loans over fixed coupon bonds. However, if we are right that growth and inflation bounce back from depressed levels by early 2016, we expect to be able to rotate back more into High Yield.
We also may consider revisiting our underweight in Mezzanine credit. With bank regulation on leverage now sinking in across Wall Street, we are starting to see more mezzanine-like opportunities than in the past. To be sure, this trend is still in its infancy (particularly given that high yield and Business Development Companies (BDCs) are still cannibalizing parts of the traditional market in today’s low rate world), but we do notice that both sponsors and corporates are looking for new and creative ways to add almost equity-like capital to a deal structure under the new Fed guidelines. In addition, we see more mezzanine-like vehicles now being used to finance hard assets, including transportation equipment such as rail cars and ships, as Wall Street backs away from more complex originations.
Finally, as we have mentioned at the outset, we have reduced our three percent weighting in High Grade debt to zero. From our van-tage point, investment grade spreads are not particularly attractive and absolute prices appear quite full in an asset class that has longer duration than high yield but offers little compensation in the form of yield for this risk. We do acknowledge that traditionally spreads have compressed in a stronger growth environment, but our view is that this cycle may be different. Key to our thinking is that high grade debt, like sovereign debt, has been one of the key beneficiaries of the
“ Given ongoing financial services de-leveraging, we still view the current illiquidity premium that has emerged in many lending
arenas as quite attractive. “
19KKR INSIGHTS: GLOBAL MACRO TRENDS
recent central bank quantitative easing in the United States, a trend that is now finally poised to reverse course.
Emerging Markets: Think Beyond Just Pure Play Public Equities
Given that EM public equities have been one of the worst-performing asset classes for the five years ending 2014, we have recently been spending a lot of our time rethinking our more cautious case. As we detailed in a recent report (Emerging Market Equities: The Case for Selectivity Remains), our research prevents us from making an “all in” call. However, with margins and multiples having contracted sharply in recent years, we do think now is the time to start legging into certain positions.
So, what looks interesting to us at the moment? For starters, we retain a bias within EM for Asia over Latin America. To date in 2015, on a total return basis, EM Asia has already outperformed EM Latin America by over five percent (12.6% versus 7.2%) in local terms6. Since 2009, the gap between the two regions has been massive, with EM Asia returning nearly 152% versus 84% for EM Latin America in local terms7. Importantly, within Asia, we still favor cyclicals in India and laggard, lower beta and restructuring names in China.
In addition, we continue to advocate for interesting one-off EM public equity situations in other markets. For example, after the precipitous fall in oil prices, Nigerian banks now look interesting at less than half of book value in certain instances, while certain real estate plays in Mexico, particularly those with development skills (versus just being
6 Data as at April 30, 2015. Source: MSCI, Bloomberg.
7 Ibid.2.
serial acquirers), appear attractive. Finally, with the recent pullback in India, we would be adding to positions.
Overall though, our bigger picture message is that harnessing the at-tractive component of rising GDP-per-capita in the emerging markets is more complicated than it seems. It requires that an investor work hard to truly identify the right themes – and equally the appropriate vehicles – to deliver on key macro tailwinds. In too many instances investors fail to appreciate how levered a country or regional index is to one company, sector, and/or local trend. As a result, the risk premium associated with the investment, particularly in the public equity space, can be vastly understated, which has – more often than not – led to disappointing investment results.
We also believe that investors in EM should consider some non-tradi-tional EM structures, including distressed, Asian PE, real estate, and parts of EM private credit. Our experience has taught us that these vehicles may be more elegant ways to take advantage of the oppor-tunity set that we now see across EM, particularly as China slows. Importantly, in the case of credit and real estate, high nominal rates in many EM countries often allow investors to earn ongoing coupons that dwarf what is available in the public equity markets – and still be higher up in the capital structure. Using the Indian market as a proxy, one can see the potential disparity of returns in Exhibit 42. Overall, our strong conviction about using more targeted vehicles as well as non-traditional approaches is not new for us. Indeed, it has served us well during our tenure as a global asset allocator during a highly unusual time across the global capital markets, and as such, we con-tinue to find it attractive, particularly for institutional accounts with a heavy international focus.
EXHIBIT 42
The Earnings Yield on Public Equities in India Appears Meager Relative to What Certain Debt Instruments Can Deliver
Nifty Sensex GovernmentSecurities
High GradeCorporate
Bonds
Working CapitalLoans
InfrastructureLoans
Term Loans High YieldCorporate
Term Loans
StructuredHolding
CompanyLoans'
Real EstateFinancing
SpecialSituations
Yields Across the Indian Public and Credit Markets, %
6.4%
13-14%12-14%11-12%
8.5-9.5%
6.5%8.0%
15-18%16-20%
18-22%
20-25%
Public Equities Bond Market Bank Market Non-bankMarket
RealEstate
Distressed/Special
Situations
Note: The above reflects the current market views, opinions and expectations of KKR based on its historic experience. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment or any KKR fund, vehicle or account, which may differ materially, and are not to be relied upon as such. There can be no assurance that investors in any KKR fund, vehicle or account will receive a return of capital. Data as at May 12, 2015. Source: KKR India internal analysis, Bloomberg.
20 KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 43
Unlike in the U.S. Where Equities Offer a Substantial Yield Premium to Government Bonds, Indian Equities “Yield” Much Less Than the Local Risk-Free Rate
5.7%
2.2%
6.4%
8.0%
S&P 500 Earnings
Yield
U.S. 10yr Gov't Yield
Nifty Earnings
Yield
India 10yr Gov't Yield
United States India
Equity Earnings Yields vs. Government Bond Yields
Data as at May 12, 2015. Source: Bloomberg, S&P, KKR Global Macro & Asset Allocation analysis.
SECTION III: Risks
Risk comes from not knowing what you are doing. Warren Buffet
72 months into an economic cycle, now is not the time, as Warren Buffet so succinctly puts it, to “not know what you are doing.” In our humble view, now is the time – as we described in our 2015 Outlook piece Getting Closer to Home – to start peeling back some of the more speculative positions in one’s portfolio. Key to our thinking is that the economic cycle in the U.S, which we consider the most dynamic in the global economy, is now somewhere between its middle and later stages.
Moreover, while we think that the Federal Reserve will be quite mea-sured in its tightening cycle, higher short-term rates often foreshad-ow the end of a cycle. One can see this in Exhibit 45. Importantly, while the historical data in this exhibit suggest that the average bull market has peaked 30 months after the Fed began tightening, we actually think it could be sooner this cycle. Why? At the risk of being labeled as a Master of the Obvious, we note that the Fed is starting its tightening campaign much later this cycle than in the past. We also note that, if we exclude long cycles that defined the Great Mod-eration during the 1980s, 1990s and 2000s, the average market peak is closer to 16 months after the first Fed hike.
EXHIBIT 44
We Are 72 Months Into the Current Economic Expansion
2133
1912
441022
2721
5080
3745
3924
10636
5812
92120
7372
December 1900 -September 1902August 1904 -May 1907
June 1908 -January 1910January 1912 -January 1913
December 1914 -August 1918March 1919 -January 1920
July 1921 -May 1923July 1924 -October 1926
November 1927 -August 1929March 1933 -May 1937
June 1938 -February 1945October 1945 -November 1948
October 1949 -July 1953May 1954 -August 1957April 1958 -April 1960
February 1961 -December 1969November 1970 -November 1973
March 1975 -January 1980July 1980 -July 1981
November 1982 -July 1990March 1991 -March 2001
November 2001 -December 2007June 2009 Current (June 2015)
Duration of U.S. Economic Expansions (Months)
Median = 37
Data as at June 1, 2015. Source: National Bureau of Economic Research, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 45
We Believe There Is Considerable Time Left in the U.S. Equity Bull Market
DATE OF TROUGH
DATE OF PEAK
FIRST FED HIKE
MONTHS FROM FIRST FED FUNDS HIKE TO
EQUITY MARKET PEAK
SEP-53 AUG-56 DEC-54 21
DEC-57 JUL-59 AUG-58 11
OCT-60 DEC-61 FEB-61 10
JUN-70 JAN-73 MAR-71 22
OCT-74 DEC-76 JUN-75 18
AUG-82 AUG-87 JUN-83 52
OCT-90 MAR-00 FEB-94 73
OCT-02 OCT-07 JUN-04 40
AVERAGE 30
Data as at April 17, 2015. Note: first Fed rate hike defined as first hike following recession. Source: Federal Reserve, Omega Advisors.
21KKR INSIGHTS: GLOBAL MACRO TRENDS
Another risk we are watching closely is whether China’s stimulus actually leads to positive earnings momentum. If it does not, then the various Chinese stock markets appear to be way ahead of themselves in terms of valuation. In particular, ChiNext, the Chinese Growth and Technology Index, which is already trading at a 116.9 P/E multiple and a 13.5 price-to-book ratio, looks quite vulnerable. One can see the magnitude of the moves throughout Chinese equities in Exhibits 46 and 47. Interestingly, China has started easing programs, including some QE-like initiatives, before it has actually cleaned up its bank-ing system. By comparison, in many other regions of the world (the U.S. in particular after Great Recession), the banks issued equity and cleaned themselves up first before the QE liquidity spigot came on.
EXHIBIT 46
Many Chinese Stocks Have Enjoyed Substantial Upward Revaluations…
22.9
12.4
69.2
116.9
0
20
40
60
80
100
120
96 98 00 02 04 06 08 10 12 14
Trailing P/E Ratio
Shanghai A-Shares MSCI ChinaShenzhen A-Shares ChiNext
Data as at May 31, 2015. Source: Bloomberg.
EXHIBIT 47
…Particularly Growth and Technology Stocks
2.71.7
6.1
13.5
0
2
4
6
8
10
12
14
96 98 00 02 04 06 08 10 12 14
Price-to-Book Ratio
Shanghai A-Shares MSCI China
Shenzhen A-Shares ChiNext
Data as at May 31, 2015. Source: Bloomberg.
EXHIBIT 48
Brokerage Account Openings in China Have Surged, Adding Further Support to the Bull Run in Chinese Equities
29-May-154,428
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
5,000
05 06 07 08 09 10 11 12 13 14 15
China Stock Market: New A-share AccountsEach Week ('000s)
Data as at May 29, 2015. Source: China Securities Depository and Clearing Corporations, Bloomberg.
“ We think investors would be
wise to appreciate that demographic forces remain
extremely supportive of the yearn for yield, particularly as real
yields have turned negative in many parts of the world.
“
22 KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 49
Chinese A-share Margin Debt Now Stands at RMB1.7trn, Or 3.2% of Market Cap and a Full 8.6% of Free Float
3.3%
A-shrFF. cap8.3%
5.1%
2.9%
1%
0.5%
2.6% 2.4%
0%
2%
4%
6%
8%
10%
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
China A-share (total cap)China A-share (free float cap)TaiwanJapanU.S. (NYSE)
Margin Debt Balance as % of Market Cap
Data as at April 13, 2015. Source: Deutsche Bank Research, Wind.
Importantly, though, growing speculation in equity markets is not limited to just China. As Exhibit 50 shows, corporate profitability has gone missing in the Russell 2000, despite performance that remains quite stellar. Maybe it is indeed different this time, but history has shown that strong equity performance without some eventual earn-ings growth usually ends in tears, not smiles.
EXHIBIT 50
Loss Makers Are Now a Major Driver of Performance in the Russell 2000
-10
0
10
20
30
40
50
60
70
1985
1988
1989
1991
1992
1993
1995
1996
1997
1999
2003
2004
2005
2006
2009
2010
2012
2013
2014
Russell 2000 Contibution to Return by Loss-makingCompanies in Up Years, %
Data as at March 2015. Source: Furey Research.
EXHIBIT 51
M&A as a Percentage of GDP Suggests We Are Now Approaching Peak Levels
10.9%10.0%
0%
2%
4%
6%
8%
10%
12%
14%
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15E
U.S. M&A Transactions as a % GDP
1Q15 U.S. M&A transactionswere $454.2.B. Annualized,that would put U.S. at $1,816.8for 2015 or 10.0% of GDP
Data as at March 31, 2015. Source: Bloomberg, IMFWEO Haver Analytics.
Finally, investors should be respectful that we are entering a period of transitioning monetary policy. On the one hand, the Bank of Japan and the European Central Bank are ramping up their purchases. All told, including emerging market activity, we estimate that 60%+ of global GDP is now in monetary easing mode. On the other hand, the Federal Reserve is slowing its purchase activity of longer duration bonds as well as raising rates at the short end of the curve by year-end, we believe.
“ Moreover, while we think that
the Federal Reserve will be quite measured in its tightening cycle,
higher short-term rates often foreshadow the end of a cycle.
“
23KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 52
We Think That the Dollar Could Have Another Compelling Year as the Bull Market Still Has Room to Run
154.5
Aug-11
Oct-99
139.7
May-15129.6
100
110
120
130
140
150
160
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80
U.S. Trade Weighted Major Dollar:Trough to Peak: Indexed: Trough=100
Sep 1980 (54m)Apr 1995 (82m)Aug 2011 (45m to-date)
Data as at May 31, 2015. Source: Bloomberg.
EXHIBIT 53
Central Bank Differentiation Will Also Be a Key Theme in 2015
-$470
$230
$478
$238
$550
$750
$0
$1,300
ECB BoJ Fed Total
2014 2015
Change in Central Bank Balance Sheet US$B
Figures show the change in balance sheet size in USD. The fall in ECB balance sheet in 2014 partly reflects the devaluation of the euro. Data as at June 19, 2015. Source: Bloomberg, IMFWEO, Haver Analytics.
Against this backdrop, we view the dollar as an important hedge. We also view Cash, which we now hold at three percent in the portfolio this year versus a zero balance in the 2012-2014 period, as more of a strategic asset to not only dampen volatility but also to be called on in the event of a market pullback. As Exhibit 54 shows, economic expansions have only lasted longer than six years on three occasions. Hence, we think the idea of having a little extra dry powder makes sense at this point in the cycle.
EXHIBIT 54
If the S&P 500 Delivers Another Positive Year in 2015, It Would Be Highly Unusual Relative to History
# OF CONSEC-UTIVE YEARS OF POSITIVE
RETURNS START END
CUMU-LATIVE RETURN CAGR
3 1904 1906 67% 19%
3 1954 1956 111% 28%
3 1963 1965 60% 17%
3 1970 1972 40% 12%
4 1942 1945 143% 25%
4 1958 1961 102% 19%
5 2003 2007 83% 13%
6 1947 1952 148% 16%
6 2009 2014 159% 17%
8 1921 1928 435% 23%
8 1982 1989 291% 19%
9 1991 1999 450% 21%
AVG. CAGR 19%
Performance on a monthly basis, peak to trough. Data as at December 31, 2014. Source: Factset.
“ Key to our thinking is that the major long-tail macro themes that we presented in January
2015 are still playing out nicely, and as such, we do not want to get distracted by any short-term
gyrations in the marketplace. “
24 KKR INSIGHTS: GLOBAL MACRO TRENDS
In terms of buying outside downside protection, we continue to look for smart ways to hedge our pro-cyclical allocation. However, the VIX is now oscillating between 12% and 17%, and S&P 500 “skew” (or premium of downside puts over the at-the-money level) remains very elevated. Therefore, our research leads us to believe that put spreads versus outright puts are the more attractive vehicles in the current environment. We would also note that short dated hedges appear more attractive, as the term structure (or time premium) to the volatil-ity curve is steeply upward sloping—making hedges longer than a few months largely uneconomical.
An additional hedge we believe is worth considering in case some-thing “goes bump in the night” is buying puts and/or put spreads on a biotechnology index. Although we acknowledge that shorting bull markets rarely works, we do see the biotech index now hitting all-time highs, while corresponding measures of implied volatility remain quite low. Indeed, as one can see in Exhibit 55, the price-to-book ratio of Nasdaq Biotechnology index is now at nearly 8 times, having more than doubled in under five years. Interestingly, though, as Exhibit 56 shows, the implied volatility of this index remains well anchored in the 25% to 30% range. These two fact patterns seem somewhat disconnected, and in our view, therein lies the hedging op-portunity, given lofty valuations and ebullient sentiment.
EXHIBIT 55
The Nasdaq Biotechnology Index Has More Than Doubled in Less Than Five Years…
3.9
5.2
7.9
4.3
5.2
9.9
Dec-10 Dec-12 Jun-15
Nasdaq Biotechnology Index - Valuation Expansion
Price to Book EV to Sales
Data as at June 4, 2015. Source: Bloomberg.
EXHIBIT 56
…But Volatility Remains Well Anchored in the 25%-30% Range
15
20
25
30
35
40
150
200
250
300
350
400
May-13
Aug-13
Nov-13
Feb-1
4
May-14
Aug-14
Nov-14
Feb-1
5
May-15
IBB - iShares Nasdaq Biotechnology ETF
Price (LHS) Implied volatility (RHS)
Data as at June 4, 2015. Source: Bloomberg.
SECTION IV: Conclusion
As the cycle progresses, finding the “obvious” macro and asset al-location themes gets more complicated. Valuations are up, liquidity is abundant, and overall supply, particularly corporate equities and sovereign debt, is actually shrinking in many instances. As such, we are certainly cognizant that generating outsized returns has gotten more complicated.
However, we still see five distinct macro “disconnects,” or arbitrages that we view as compelling investment opportunities for long-term patient capital. First, given that we still think that the cycle can extend into 2017 as well as the current low level of absolute rates, we have increased confidence that it still makes sense to pursue investment vehicles that harness the illiquidity premium. To this end, whether it is in the emerging markets or developed markets, we continue to see examples of traditional financial intermediaries that are downsizing their footprints and their appetites for complex transactions.
“ Our bigger picture message
is that harnessing the attractive component of
rising GDP-per-capita in the emerging markets is more complicated than it seems.
“
25KKR INSIGHTS: GLOBAL MACRO TRENDS
Second, in a world where central banks around the world are pinning nominal interest rates below nominal GDP, we think cash-flow pro-ducing real assets that provide yield, growth and some low cost infla-tion protection appear attractive. At the moment, we prefer mature oil wells, parts of infrastructure, and non-core real estate.
Third, we encourage folks to approach emerging markets with a more selective eye. To be sure, public equities may be the easiest way to
pursue the broad-based rising GDP-per-capita thesis that investors champion. However, a public equity allocation might not be the most productive. Rather, we are championing alternative ways to access the emerging markets, including private credit, real estate, private equity and distressed.
Fourth, with China’s ongoing slowing, we see substantial investment opportunities to help restructure companies as they are forced to
EXHIBIT 57
Our Target Portfolio Is Up 3.7% YTD Through May 31, 2015
53
0
0
-6
42 1 2
0
12
4
02 2
-1-2
3
-2
4
31 1
-2
31 1 2 2
-1
2
-3
0 1
-2-1
4
-1
3
0
0%
5%
10%
15%
20%
25%
30%
35%
40%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
Jan-
12
Mar
-12
May
-12
Jul-1
2
Sep-
12
Nov-
12
Jan-
13
Mar
-13
May
-13
Jul-1
3
Sep-
13
Nov-
13
Jan-
14
Mar
-14
May
-14
Jul-1
4
Sep-
14
Nov-
14
Jan-
15
Mar
-15
May
-15
Cum
ulat
ive
Retu
rns
(%)
Mon
thly
Ret
urns
(%
)Monthly Returns GMAA Portfolio
KKR GMAA Global Asset Allocation January 2012 to May 2015 (%)
Weights as per KKR white papers “Where To Allocate,” January 2012, “Real Estate Focus on Growth, Yield and Inflation Hedging,” September 2012, “Outlook for 2013: A Changing Playbook,” January 2013, “Asset Allocation in a Low Rate Environment,” September 2013, “Outlook for 2014: Stay the Course,” January 2014, “Midyear Outlook: Four Macro Trends at Work,” June 2014, and “Getting Closer to Home,” January 2015. Private equity returns as of 3Q2014, and using 0% for remaining months. Data as at May 31, 2015. Gross returns. Source: KKR Global Macro & Asset Allocation, Bloomberg, Factset, MSCI, Cambridge Associates.
EXHIBIT 58
…For an 150 Basis Points of Outperformance Versus the Benchmark So Far in 2015
433632
9 11
65
94
11
-1
24
1
26
96
7357
19 197
16
-29
16
454542
0-10
111
4956
15
4028
1221
-29
2
72
33
0
42
325
0
200
400
600
800
1000
1200
-40
-20
0
20
40
60
80
100
120
Jan-
12
Mar
-12
May
-12
Jul-1
2
Sep-
12
Nov-
12
Jan-
13
Mar
-13
May
-13
Jul-1
3
Sep-
13
Nov-
13
Jan-
14
Mar
-14
May
-14
Jul-1
4
Sep-
14
Nov-
14
Jan-
15
Mar
-15
May
-15
Perf
orm
ance
vs
Benc
hmar
k (b
ps)
Outp
erfo
rman
ce in
Bas
is P
oint
s
KKR GMAA Global Asset Allocation Performance Relative to Benchmark January 2012 to May 2015 (bp)
GMAA vs Benchmark Cumulative Outperformance (bp)
Weights as per KKR white papers “Where To Allocate,” January 2012, “Real Estate Focus on Growth, Yield and Inflation Hedging,” September 2012, “Outlook for 2013: A Changing Playbook,” January 2013, “Asset Allocation in a Low Rate Environment,” September 2013, “Outlook for 2014: Stay the Course,” January 2014, “Midyear Outlook: Four Macro Trends at Work,” June 2014, and “Getting Closer to Home,” January 2015. Private equity returns as of 3Q2014, and using 0% for remaining months. Data as at May 31, 2015. Gross returns. Source: KKR Global Macro & Asset Allocation, Bloomberg, Factset, MSCI, Cambridge Associates.
26 KKR INSIGHTS: GLOBAL MACRO TRENDS
reckon with the reality that the China Growth Miracle that defined 2000-2010 is now over. Without question, this trend is bullish for non-traditional providers of capital who can provide solutions to complex originations, including direct lending, debt-to-equity swaps, and recapitalizations.
Finally, the public equity markets are still littered with companies whose inefficient balance sheets make their cost of capital equivalent to their cost of equity. These sub-optimal capital structures mean that there are opportunities for investors to still own companies that can generate substantial value for shareholders via dividends, buy-backs, and acquisitions (Exhibit 60).
EXHIBIT 60
Despite Being Later in the Cycle, Inefficient Balance Sheets Are Still Rewarding Acquirers For Doing Deals
0.6%0.2% 0.1%
-1.1%
-0.1%
0.3%
0.7%
1.3%
2.6%2.9%
05 06 07 08 09 10 11 12 13 14
2005-2014 Acquirers Average One Day StockPerformance Relative to the S&P 500
Data as December 18, 2014. Universe: All M&A deals with target region United States, value greater than U.S.$1B. Source: Bloomberg.
EXHIBIT 61
Several Macro Indicators Support our Decision to Get “Closer to Home” in 2015
Percentage of Unprof-itable IPOs
U.S. Weekly Average
Initial Jobless Claims, ‘000’s
M&A as a % of GDP in the U.S.
S&P Margins
Relative to Average
VIX Average
2000 76% 300 10.8% 107% 23.3
2007 65% 321 13.3% 122% 17.5
2015 78% 287 10.0% 183%* 15.2
2015 is YTD data as at June 18, 2015. Source: Bureau of Labor Statistics, JP Morgan, Morgan Stanley Research, Third Time’s The Charm for Investors? IPO Market Bubbling to New Highs, at economyandmarkets.com, Bloomberg, Haver Analytics and Factset.
Ultimately, while we are quite bullish on our five top-down macro themes, we want to reiterate that we have generally turned more defensive relative to the 2012-2014 period. We are not bearish per se, but we do want to be respectful of the current cycle’s duration – and the potential excesses that come with long-tailed, liquidity driven, economic expansions. Reinforcing our view is that, as we show in Exhibit 59, there is certainly some quantifiable benefit to knowing when to lean in and out during each and every cycle. So, with in mind, we remain comfortable with the same advice – and the title for that matter – that we laid out in January, that – even with the confidence that we have in our five distinct macro disconnects, 2015 should mark the beginning phase of getting one’s portfolio “Closer to Home.”
EXHIBIT 59
It’s Also Important to Be Able to Take Advantage of Public Markets as Sellers Are Often Too Rational and Less Willing to Transact When the Market Is Washed Out
40
20
22 4794
130
233
434
111
1379
111 98164 149
- 12%
11%
50%
35%28%
-23%-16%
-8%
49%36%
57% 75%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Total U.S. Leveraged Buyout Volume ($Bn) S&P 500 3yr Fwd Total Return
Data as at March 31, 2015. Source: Bureau of Labor Statistics, Haver Analytics.
27KKR INSIGHTS: GLOBAL MACRO TRENDS
Important Information
The views expressed in this publication are the personal views of Henry McVey of Kohlberg Kravis Roberts & Co. L.P. (together with its affiliates, “KKR”) and do not nec-essarily reflect the views of KKR itself or any investment professional at KKR. This document is not research and should not be treated as research. This document does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not repre-sent a formal or official view of KKR. This document is not intended to, and does not, relate specifically to any investment strategy or product that KKR offers. It is be-ing provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own views on the topic discussed herein.
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. The views expressed herein may not be reflected in the strategies and products that KKR offers, including strategies and products to which Mr. McVey provides investment advice on behalf of KKR. It should not be assumed that Mr. McVey has made or will make invest-ment 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 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.
This publication has been prepared solely for informa-tional purposes. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this docu-ment has been developed internally and/or obtained from sources believed to be reliable; however, neither KKR nor Mr. McVey guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.
There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future per-formance of any particular investment which may differ materially, and should not be relied upon as such. Target allocations contained herein are subject to change. There is no assurance that the target allocations will be achieved, and actual allocations may be significantly different than that shown here. This publication should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.
The information in this publication may contain projec-tions or other forward‐looking statements regarding future events, targets, forecasts or expectations regard-ing the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be signifi-
cantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subse-quent market events or for other reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested. The indices do not include any expenses, fees or charges and are unmanaged and should not be considered investments.
The investment strategy and themes discussed herein may be unsuitable for investors depending on their spe-cific investment objectives and financial situation. Please note that changes in the rate of exchange of a currency may affect the value, price or income of an investment adversely.
Neither KKR nor Mr. McVey assumes any duty to, nor undertakes to update forward looking statements. No representation or warranty, express or implied, is made or given by or on behalf of KKR, Mr. McVey or any other person as to the accuracy and completeness or fairness of the information contained in this publication and no responsibility or liability is accepted for any such information. By accepting this document, the recipient acknowledges its understanding and acceptance of the foregoing statement.
The MSCI sourced information in this document is the exclusive property of MSCI Inc. (MSCI). MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.
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