KKR Releases “Europe: Complexity Rules” by Henry H. McVey

KKR, a leading global investment firm, today announced the release of Europe: Complexity Rules, a new macro Insights piece by Henry H. McVey, KKR’s Head of Global Macro and Asset Allocation:

Our most recent macro deep-dive across Europe left us with several high conviction investment conclusions.

First, we have boosted our European GDP forecast for 2017 to 1.7% from 1.4%, reflecting the reality that heightened political uncertainty has not yet derailed the region’s surprisingly strong economic recovery. Against this backdrop, we favor consumption stories, especially those linked to experiences.

We also believe that European equities, financials in particular, are poised to perform well in 2017. Our work also suggests structurally overweighting innovation in Europe, including the region’s small but growing technology sector.

However, there are plenty of thorny issues that must be considered. For example, the current monetary union is creating substantial structural strains not only across economies (e.g., Germany versus Italy) but also within economies (e.g., France).

We also believe political concerns about immigration represent secular, not cyclical, headwinds that must be carefully considered. Our bottom line: Europe is likely to experience a notable “catch-up” trade in the near-term, but long-term structural headwinds continue to argue for moderate pacing, embracing complexity, and regional diversification.

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

1. Despite significant political uncertainty — and almost in spite of itself — European GDP continues to chug along at a steady clip. In fact, we are lifting our 2017 GDP forecast to 1.7% from 1.4% previously, driven by better than expected investment trends. Maybe more important, though, is that our quantitative GDP model is forecasting robust growth in Europe of 2.5% for 2017 (Exhibit 11). This forecast is driven largely by the powerful effects of the European Central Bank’s highly accommodative monetary policy regime, partially offset by stagnant housing market concerns. However, if mortgage lending growth does accelerate, implied growth by our model could be even stronger, though we fully acknowledge an overall political risk discount of 50-75 basis points to our quantitative growth model likely makes sense in the current environment.
2. Investors should continue to think about a European macro environment where consumption, particularly around experiences, remains compelling relative to overall trend growth. This viewpoint is consistent with an emphasis on sectors such as travel, health/beauty, and home improvement. By comparison, we remain cautious on global trade, and our research shows increasing examples of China insourcing manufacturing equipment that used to be built by leading European industrial enterprises (Exhibit 10). Our bigger picture conclusion is that globalization flows and production increasingly now appear to be moving towards more of a regional model, with a particular emphasis on Asia, Europe, and the Americas.
3. Europe continues to barrel down the path of a two-tiered economy, which is likely long-term unsustainable, in our view. Specifically, there is a large and growing dichotomy between Germany, with its strong growth, and the rest of Europe, Italy in particular. See below for details, but Italian GDP is now seven percent below its 2008 level in real terms; by comparison, Germany is a full eight percent above its 2008 level in real terms. During the next few quarters we believe that the ECB will allow Germany to run “hot,” leading to a further widening between Europe’s largest and fourth largest economies. Somewhat ironically, the better Germany’s GDP performs, the more German bunds the ECB has to buy, while Italy’s economic underperformance currently leads to less ECB purchases of Italian sovereign debt. We view these types of divergences as unsustainable, underscoring our belief that Europe will need to implement monetary and fiscal policies that better smooth economic growth and equality across the region; otherwise, we fear it will lead to even more dire populist reactions, particularly if immigration issues are not reconciled.
4. We spent some extra time in Paris discussing the political outlook with a variety of players from the various parties. Our base case is that anti-European candidate Marine Le Pen does not advance beyond the second round. While we think that risk assets could play “catch-up” following a Le Pen defeat, the current populist backlash in Europe is not likely to dissipate. At its core, the monetary union that defines the EU makes it hard for countries to both be globally competitive and domestically responsive to stagnant wage growth. Also, the refugee/immigration situation remains contentious, despite Europe’s urgent and long-term strong need to boost labor force growth — and hence GDP — via immigration.
5. Our discussions surrounding the banking sector from this trip lead us to remain constructive on both bank stocks and the assets banks are selling. According to Deloitte, sales by banks of European loans to third parties reached 172.7 billion euros during 2016, up a full 65.6% from 2015. We see more running room, as a steepening yield curve, higher stock prices, and solid GDP growth accelerate the healing of ongoing wounds in the European financial services sector. This outlook is also bullish for our substantial overweight in our asset allocation to both Private Direct Lending and Asset Based/Mezzanine Lending. Overall, our trip reinforces our 2017 outlook view (see Outlook for 2017: Paradigm Shift) that European financials will outperform during the next few quarters, a view we have not held in the past. That said, we do remain cautious on U.K. consumer-facing financial intermediaries. Key to our thinking is that we now see almost indiscriminate lending to consumers, despite deteriorating risk profiles in many instances. In our view, this trend is unsustainable, particularly given our base case for more of a hard than soft Brexit. Details below.
6. We think that the underlying performance of European equities is potentially misunderstood by market participants. See below for full details, but our key conclusions are as follows. First, almost seventy percent of the European underperformance versus the S&P 500 in recent years has been linked to the small size of the European tech sector, not the banking or commodity sectors. Said differently, Europe’s public equity underperformance is more compositional than it is structural. Second, whereas in past years we have argued that stocks with stable earnings looked expensive relative to stocks with cyclical earnings, the outlook today is now more balanced. However, that does not mean that there are no anomalies. See below for details, but our work shows that market capitalization — bigger being cheaper and smaller being expensive — is worthy of investor attention.

We left Europe with several investment conclusions:

First, in terms of asset allocation, our view is that continental equities, which are finally experiencing positive earnings revisions for the first time in six years at the aggregate level, are quite a bit cheaper than bonds and real estate on a relative basis.

To be sure, all financial assets have benefitted from quantitative easing, but interest rates and cap rates have fallen proportionately faster than the discount rate for stocks in recent years. Also, the embedded operating leverage in equities is higher than in real estate — and actually in most other equity regions To complete reading click HERE