KKR Today Released the 2017 Global Macro Outlook by Henry McVey
We view Donald Trump’s ascendancy to the Presidency of the U.S. as confirmation of a political and economic paradigm shift that started with Brexit but is likely to continue for the foreseeable future, including elections across Europe in 2017. Consistent with this view, we believe that there are four major potentially secular changes that all investment professionals must consider:
Fiscal stimulus over monetary
Domestic agendas over global ones
Deregulation over reregulation
And a broadening of outsized volatility from the currency markets to include global interest rate markets.
The good news is that many of our highest conviction investment themes for 2016, including the ongoing slowdown in global trade, had already begun to capture this sea change in macro and geopolitical trends. At the same time, however, in certain areas our macro preferences have evolved of late in response to the “new” reality that we now live in. As such, we have used this outlook piece to challenge conventional investment wisdom, and in some instances, “adjust our sails.”
In terms of asset allocation preferences for 2017, we are still probably most excited by what we see in Private Credit on a risk-adjusted basis. We also believe that Real Assets, particularly those with yield and growth, can prosper in the macro backdrop that we envision. Meanwhile, we are now balanced in our outlook on Equities versus Credit, but in both asset classes, we continue to suggest selling Simplicity and buying Complexity.
Overall, though, we do not lose sight of the fact that we are undergoing a paradigm shift, and often these types of regime changes do not always transition smoothly. As a result, we maintain our long-held approach of seeking to monetize aggressively the periodic dislocations that inevitably occur in a world of increasing geopolitical uncertainty and macro instability.
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This populism is also the result of longer term structural changes to the corporate and job environment: 15 years of secular stagnation where corporate profits, not necessarily wages, were championed; multiple industrial revolutions that disrupted key industries and transformed millions of workers from secure employment in one area to more tenuous project work across multiple careers; the Internet empowering critics of any and all institutions; demographic changes replacing an aging Baby Boom population with a very different workforce of Millennials. The underlying populist impulse that empowered this “political bull market” is unlikely to abate, we believe, and as such, it means that industries and companies remain subject to public distrust and political pressure.
Somewhat ironically, both the U.S. and the U.K. – the two countries now leading the charge on political change in the developed markets – have actually delivered decent GDP growth relative to their peers in recent years (Exhibit 1). However, in absolute terms, it has been subpar compared to history and it has been wildly lopsided in terms of income dispersion. Not surprisingly, working citizens around the globe, particularly in the developed markets, are now tired of paying for a financial crisis that they feel they did not create and of the effects of extreme monetary policy (i.e., it is harder to increase savings with low/negative rates); they want less fiscal austerity and less traditional political rhetoric. They also want growth in real incomes and benefits for their families, including education, healthcare, and retirement savings.
All these influences have coalesced to create what we believe is a paradigm shift across the global capital markets. Accordingly, investors will need to – as the opening quote suggests – “adjust our sails.” In particular, we strongly believe that investors should now expect to operate in a global macro environment where four important trends are either reversing or shifting materially relative to the past. They are as follows:
- Fiscal policies are now favored over monetary ones to stimulate growth
- Deregulation over reregulation
- Domestic agendas take precedence over global ones
- Heightened volatility spills over from the currency markets to the interest rate markets
Consistent with this view, we think that the macroeconomic backdrop will likely be shifting from a disinflationary, slower growth environment towards a reflationary-directed one with less onerous near-term banking regulation and fiscal targets. Importantly, our paradigm shift “call” is not just a U.S.-centric lens from which to view the world; rather, it is a global one. We note that the Producer Price Index (PPI) in China – which will account for one-third of total global growth in 2017 – has turned positive after 54 months of being negative. Moreover, our recent visit to China in December leads us to believe that the government may actually be running a fiscal deficit north of 10%, well above the reported “federal” figure of three percent.
In our view, this shift towards more reflationary policies by many growth-starved countries around the world is still largely an aspirational one, offset in many instances by slowing trade, poor demographics, weak productivity, and heavy debt burdens. As such, we think that the cross-currents of near-term reflationary stimulus juxtaposed against the aforementioned structural macro headwinds likely mean more volatility lies ahead for investors again in 2017. In particular, we expect to see elevated and sustained volatility extend beyond the currency markets to include – among other things – global interest rates markets in 2017.
While we did not explicitly forecast either Brexit or a Trump presidency, we do take some comfort in our investment process, as many of our highest conviction investment themes in the second half of 2016 had already begun to capture this sea change in macro and geopolitical sentiment. See Section II for full details, but we now actually have higher conviction about the following six macro themes that we have been espousing for some time:
- We still strongly believe that long-term rates achieved their lows immediately after Brexit, suggesting that stocks and bonds may not be as positively correlated in the future
- The gap between Simplicity and Complexity is too wide and will likely reverse in the coming quarters
- We remain cautious on global trade, favoring instead more domestic-oriented stories, particularly in EM
- The U.S. dollar remains in a bull market, in our view
- We think Private Equity outperforms Public Equity at this point in the cycle
- Our long-standing view to buy Yield and Growth in the Real Asset space dovetails quite nicely with the environment we envision
That said, not all the recent news has been totally in sync with the way we have been thinking about the world. Indeed, we would be remiss in this outlook if we did not also spend time on areas where our original investment thesis may need to be revisited at some point in 2017 – or at least tweaked to better accommodate the new world reality that we now live in. See Section III for full details, but we acknowledge the following areas where our macro outlook has evolved of late:
- The U.S. economic cycle may now last longer than we thought during our 2016 mid-year update
- Emerging markets may have a bumpier bottoming process than in our original base case
- Reregulation of financial intermediaries will likely wane, and as such, certain opportunities in Private Credit may now be more measured
- We do not see interest rates surging too high in the near-term, but the existing technical bid for bonds could be waning by 2018
- Our desire to favor Liquid Credit over Public Equities seems less compelling than in the past; we now think that the returns profiles will be more similar and have positioned our 2017 portfolio accordingly
In terms of our asset allocation framework, we are maintaining several long-held asset class preferences but shifting other ones to accommodate to the new world order in which we must now invest. What has not changed, however, is our desire to again seek to aggressively monetize the inevitable periodic dislocations that occur in a world of heightened political uncertainty and macro instability. See the full paper for details of how we are translating our macro views into specific asset allocation suggestions, but our key action-items for 2017 are as follows:
- Given the large move in interest rates of late, we are taking some profits from our target asset allocation and actually tactically trimming our macro team’s massive 17% underweight to longer-duration government bonds to “just” a 14% underweight. We now allocate six percent to government bonds, compared to a benchmark of 20%, but an increase from three percent previously. Our target for the 10-year Treasury at year-end 2017 is now 2.75%, up from 2.25% previously, but long-term rates have already moved 120 basis points since their low of 1.36% on July 8, 2016. As such, they are now actually not that far from what we view as near-term fair value. We also believe that current real 10-year rates of around 50-70 basis points are at the top end of their near-term range, and they could actually decline in the first half of 2017. If we are wrong and global bond yields do surge higher in the near-term, then German bunds, not U.S. Treasuries, appear most at risk, especially on a local currency basis, in our opinion. Importantly, though, please do not confuse our cyclical conservatism on the level of bond yields with our longer-term outlook that 10-year rates bottomed after Britain’s decision to exit the European Union. Consistent with this view, we believe that we recently entered an important regime change, with many governments now targeting reflation via fiscal impulses versus simply more monetary stimulus. In our view, this shift in focus is a big deal because it means that stocks and bonds may no longer be as positively correlated in the future.
- Relative to January 2016, Liquid Credit no longer appears like a bargain. Just consider that our measure of the market-implied default rate for High Yield has dipped all the way to 0.9%, down sharply from 7.8% last January and now on par with levels not seen since 2006/2007. Subordination risk across High Yield is also a concern. Meanwhile, spreads within the High Grade segment of the market appear rich in both absolute and relative terms. As such, a high conviction call for us remains our overweight position in Opportunistic Credit. To fund this five percent, non-benchmark position in Private Credit, we now hold sizeable underweights in our pure-play High Grade and pure-play High Yield allocations. While we have a more guarded stance towards Liquid Credit in 2017, our current targets do not mean that there will not be periods of significant upside opportunity across Credit in 2017. In fact, as Exhibit 3 shows, volatility shocks, which typically lead to periodic dislocations in the credit markets, have become the norm this cycle, a trend we expect to continue. Consistent with this top-down view, we want to allocate capital to products and styles in 2017 that can harness these dislocations to their benefit. In our view, our allocation to Opportunistic Credit, which toggles amongst loans, high yield, and structured products to find the best opportunity at the time does just this, particularly relative to traditional Investment Grade and High Yield debt allocations. Separately, we also are trimming our Levered Loan allocation to four percent from six percent, though we are still ahead of the benchmark weighting of zero. Said differently, while we are less enamored with overall Credit today, we still think Levered Loans represent a good spot to earn a solid coupon and still be prepared for potentially higher rates down the road.
- We prefer global performing Private Credit, which remains one of our most outsized non-benchmark overweight allocations. Similar to last year, we are still finding a lot of opportunity in the performing side of the Private Credit Markets across the U.S., Europe, and even Asia. In fact, performing Private Credit, particularly at the large end of the market, remains our highest conviction risk adjusted return idea again in 2017. All told, we maintain a robust 13% allocation to the asset class versus a benchmark of zero, though we are making some product tweaks within this segment of the market. Specifically, in 2017 we are dropping our Global Direct Lending allocation to 800 basis points from 1000 basis points last year. With the proceeds, we top up our Asset-Based Lending/Mezzanine exposure, boosting this allocation to 500 basis points from 300 basis points in 2016. See below for details, but we like the return profiles on the increasing number of opportunities that we are seeing in this segment of the market. Also, given that so much of the activity is currently being sourced out of Europe, we believe that it will be less susceptible to deregulation headline risk in 2017. Overall, though, as we detail below in Section III, we are going to watch this area of the market throughout 2017 to ensure that a shifting regulatory landscape does not squeeze the healthy illiquidity premium we still see in both the Direct Lending and Asset-Based Lending markets.
- Within our Other Alternatives bucket, we are reducing Distressed/Special Situation to two percent from five percent, and we are using the proceeds to add to our global Private Equity allocation. Given the excessive amount of Quantitative Easing now flowing through the system, the traditional distressed cycle – which usually occurs when nominal credit growth is running above nominal GDP growth for too long – has not unfolded properly this cycle. As such, we have lowered our Distressed/Special Situation allocation to two percent, down from five percent in 2016. Meanwhile, we have moved to an overweight position in Private Equity, increasing our Private Equity bet by 300 basis points in 2017 to 800 basis points versus a benchmark of 500 basis points. As we detail below in Section II, Private Equity generally tends to notably outperform Public Equities in a more modest return environment, which is what we are forecasting. Also, we believe Private Equity likely affords us a better opportunity to execute on our Buy Complexity, Sell Simplicity thesis, versus buying a broad index. Within global PE, we are most encouraged by what we see in Japan (Exhibit 68). Finally, we believe that global PE will outperform Distressed/Special Situation at this point in the cycle, or until at least global QE initiatives slow further.
- As part of our decision to neutralize our outsized Credit over Equity call from 2016, we have moved to equal-weight from underweight in our Public Equity allocation bucket. Within Public Equities, however, our biggest overweight relative to benchmark in 2017 is now Japan; previously, it had been the United States. In terms of specifics, we now hold a seven percentage point position in Japan, compared to a benchmark and prior weighting of five percent. We reduce our U.S. weighting to 21%, compared to 22% previously and a benchmark of 20%. See Section I for details, but we forecast 11% earnings growth for the S&P 500, largely offset by a seven percent multiple contraction in essentially our base case scenario. Separately, we remain underweight non-Japan Asia, given our conservative view on Chinese public equities, and we are underweight Latin America. In Latin America, President-elect Trump’s policies could be troublesome for Mexico’s heavy dependence on exports. Also, we think China will slow its torrid pace of stimulus, which likely dents commodity earnings in places like Brazil. This viewpoint on Chinese policy will also weigh on certain European commodity stocks, which represent about 14% of the Eurostoxx 600 Index in total, but we do think that financials could perform admirably in Europe on a cyclical basis. As such, we remain equal-weight Europe.
- We maintain our overweight to Real Assets with yield and growth, but we are short Gold in 2017. In the paradigm shift environment we are espousing, we believe Yield and Growth investments, particularly those that can compound their cash flows, could outperform. At the moment, we think that opportunistic real estate, midstream assets, certain MLPs and “last mile” infrastructure projects all make sense. Importantly, our research also shows that Real Assets tend to outperform in a modestly increasing inflation expectations environment. On the other hand, we believe that rising global rates could dent the effectiveness of Gold, and similar to our view in 2014 and 2015, we are again short Gold for 2017. Separately, while we are not outright short metallurgical coal, we do believe that prices have appreciated too far too fast, and as such, could experience a notable correction at some point in 2017.
- Within Currencies, we believe that the USD will remain well bid, particularly against the Chinese renminbi, the Turkish lira, and the Korean won. Beyond potentially bigger deficits, our research shows that repatriation of overseas capital is U.S. dollar bullish. In 2005, for example, the dollar actually surged a full 13% on the heels of rate increases and repatriation incentives. Sound familiar? There is also the potential that more detailed discussions surrounding border tax adjustability lead to a spike in the USD during 2017. Regardless, our bigger picture conclusion is that we think that the current volatility in the currency market is too outsized relative to other parts of the global capital markets. In the near term we believe volatility will likely shift from currencies to the rate markets in 2017 and then ultimately towards credit and equities over time. We also believe that further U.S. dollar increases may potentially be more financially restrictive than the consensus now thinks; hence, we are using only two rate hikes in 2017, compared to a consensus forecast of three.
- We are slightly overweight Cash to start 2017. We enter 2017 with a three percent Cash position compared to the benchmark of two percent. Similar to last year, we expect more volatility along the way. As such, we think continuing to build a little extra dry powder makes sense, particularly given our heavy weighting towards alternatives.
As we detail below, we see mid-to-high single digit returns for most liquid asset classes if our thesis unfolds as planned, though we are more optimistic that – almost irrespective of the environment – the ongoing rotation away from simplicity towards attractively priced complex assets could add another 300-500 basis points of alpha in 2017. Within the illiquid markets, we see more upside in terms of absolute returns, but we do think that we need greater sustained volatility to put meaningful amounts of capital to work in 2017.
Of course, no one has a crystal ball, and there are always important risks against which one should consider hedging. There is certainly a lot for investors to digest these days when one considers that five of the eight Fed governors could change over the next 12-18 months (including the Chair), five of the seven members of China’s Standing Committee could be replaced by next fall, there are multiple elections in Europe, we’re still sorting through the political and cultural implications of Brexit and we still don’t have a lot of clarity around how the U.S. is going to pay for the proposed large tax cuts and infrastructure proposals.
See Section IV below for details on how we are thinking about hedges, but our latest visit to Beijing definitely left us feeling that China’s currency could continue to sell off more than expected, particularly given higher U.S. rates amidst excessive credit creation relative to nominal GDP in China. Importantly, these pressures could occur when traditional trade practices are challenged on a global basis. Separately, global bond yields could back up further than we currently expect based just on technical repositioning. This risk is worth watching, we believe, as too many investors still appear too long duration at this point in the cycle, in our view. Finally, we are concerned about credit deterioration in certain fixed income markets, including the auto loan market in the U.S.
By Henry McVey, Head of Global Macro and Asset Allocation
Prior to joining KKR in 2011, Mr. McVey was a managing director, lead portfolio manager and head of global macro and asset allocation at Morgan Stanley Investment Management.
Mr. McVey was also a member of the asset allocation committee, and the top ranked asset management and brokerage analyst by Institutional Investor for four consecutive years before becoming the firm’s strategist.
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