September 2017 will mark our six year anniversary at KKR heading up the Global Macro & Asset Allocation (GMAA) analysis effort. Without question, it has been a wonderful opportunity for the entire GMAA team to engage with the Firm’s deal teams across a variety of assignments, including both entries and exits. All told, during this period KKR has deployed in excess of $36 billion across its Private and Public markets; during the same period KKR has returned in excess of $53 billion to its investors.
Beyond the day-to-day deal work, having more than 200 portfolio companies in 19 cities across 16 countries staffed by local professionals has also created a unique environment for our team to derive macro insights by leveraging the strengths of our integrated business model across asset classes and capital structures.
Not surprisingly — given the tool kit the platform provides us — we have consistently shied away from using a ‘crystal ball’ approach to make bold predictions based on a ‘gut’ feel. Rather, we have concentrated our efforts on building long-term, top-down frameworks, including both fundamental and quantitative ones that identify key investment themes behind which we can form capital (or in some instances avoid forming capital). We have also tried to guide our employees and investors on where we may be in the cycle, leveraging a variety of data sets we have built out during the past two decades of macro analysis and investing.
Today, almost all our work streams suggest that asset prices across most parts of the global capital markets are somewhere between fair value and expensive (Exhibit 1). From a cycle perspective, we believe that we are mid-to-later cycle in some of the more developed markets, including the United States. Consistent with this view, our base case remains that we have some form of an economic pullback in 2019. We also think it is worth noting that we are well below consensus in terms of inflation across most parts of the world, including the United States, Euro Area and Brazil (Exhibit 4).
Against this backdrop, we do feel inspired to narrow our investment focus towards fewer high conviction themes, relying less and less on macro tailwinds such as margin and multiple expansion than in the past. In particular, we are focused on potential macro disconnects, or financial arbitrages, where we can largely quantify where investor expectations appear offsides relative to the upside potential we envision. See below for full details, but our current highest conviction investment themes are as follows:
- De-conglomeratization: Corporate Spin-Offs Are Creating ‘Rightsizing’ Opportunities As corporations around the world look to optimize their global footprints in a world that is increasingly turning domestically focused, we believe that this transition will create a significant opportunity for investors to buy, repair, and improve non-core assets from regional and global multinationals. We also see increased activism in the global public equity markets as a play on our thesis. Importantly, as we describe below, we see this trend towards entities hiving off non-core assets currently extending beyond traditional corporations to now include Infrastructure and Energy Assets.
- Experiences over Things We see a secular shift towards global consumers willing to spend more on experiences than on things these days. Leisure, wellness, and beauty all represent important growth categories, all of which appear to be taking share from traditional ‘things.’ Mobile shopping and online payments are only accelerating this trend, we believe, and our recent travels lead us to believe that this shift is occurring in both developed and developing countries. On the other hand, the work we lay out below shows that true core ‘goods’ inflation has actually been negative on a year-over-year basis for the past 16 consecutive quarters and negative for 50 of the last 69 quarters since 2000. Not surprisingly, we view this deflationary pressure as a secular, not cyclical, issue for corporate profitability in several important parts of the global economy.
- Emerging Markets over Developed Markets As we indicated in our 2017 Outlook Piece (see Outlook for 2017: Paradigm Shift), our five factor model has begun to inflect upwards for EM. The direction of these signals is important, because when they do collectively turn upward, EM outperformance can often last for years. Also, we are now more constructive on EM currencies, which is an important part of the EM total return equation for both equity and debt investors. If we are to be right, then commodity prices must stabilize near current levels. Details below.
- Fixed Income Illiquidity Premium Despite the prospect of deregulation in financial services in the U.S., we still view the illiquidity premium as compelling, particularly in today’s low interest rate environment. Importantly, though, at the moment we think that there is likely more potential upside in Asset-Based Lending than in Direct Lending, which represents a shift in our previous view.
- Continue to Embrace Dislocation While the S&P 500 Volatility Index (VIX) has been low in recent months, ongoing periodic spikes in uncertainty – often linked to geopolitical tensions – have created attractive investment opportunities since 2011. All told, the VIX has jumped 50% or more on a year-over-year basis one out of every 11 days since April 2009. That compares to similar volatility spikes on just one out of every 20 days during the prior 2003-2007 market cycle. In our view, these types of unforeseen ‘shocks’ represent a secular, not a cyclical, pattern. See below for details, but certain Master Limited Partnerships (MLPs), CCC-rated credits, and healthcare companies currently appear interesting to us.
Based on these macroeconomic views, we are making the following changes to our target asset allocation:
- We are reducing our Global Direct Lending allocation to five percent from eight percent at the start of the year and 10% a year ago. We are still structurally bullish on this market (hence, why we retain significant exposure), but we do believe that pricing in the small end of the market has gotten competitive. Also, on the large end of the market, we think that High Yield is becoming — on the margin — more of a competitive option relative to Private Credit. So, we think right now could be a good time to allocate capital to Direct Lending at a more measured pace versus the ‘all in’ call we have been making in recent years.
- …and using the proceeds to increase our allocation to Asset-Based Lending/Mezzanine. Meanwhile, our recent trip to Europe leads us to believe that the private credit opportunity in Asset-Based Lending/Mezzanine is actually growing quite nicely. Bank stock prices are rising, enabling financial institutions to dispose of performing assets that are priced to move. As such, we are increasing our allocation to Asset-Based Lending/Mezzanine to eight percent from five percent.
- Within Liquid Credit, we still favor Opportunistic Credit and Levered Loans. See below for details, but we retain our four hundred basis point, non-benchmark position in Bank Loans, including certain spicy parts of the CCC-credit market. We also retain our 500 basis point position in Opportunistic Credit, which has served us well, particularly during periods of notable dislocation. By comparison, the implied default rate for High Yield is now less than one percent, which inspires us to underweight the asset class. Investment Grade Debt, we believe, also looks richly priced to us, and as such, we hold a five percent underweight versus the benchmark (zero versus a five benchmark allocation).
- We continue with a notable underweight to government bonds; within government bonds, we now favor EM exposure to DM exposure. Since our arrival at KKR in 2011, our base call has been that risk assets would generally outperform risk-free assets. We based this view on 1) the relative spread of risk assets using earnings yields in equities and credit spreads in fixed income versus the risk-free rate; and 2) our belief that the economic expansion cycle would be longer than normal. Today, we are running with a 14% underweight to government bonds; however, this underweight is down from the 17% underweight we had employed for the five years prior to entering 2017. Key to our thinking is that inflation remains stubbornly low, while the ongoing demographic bid for yield is likely stronger than the consensus still thinks, in our view. In terms of preferences within government bonds these days, we would have at least half of our six percent weighting in paper from Indonesia, India, and Mexico, all of which have large domestic economies, offer attractive yields, and benefit from attractive local currency ‘carry’ at current levels (Exhibit 65). By comparison, we would be notably underweight, or even short, German bunds at current levels. Details below.
- We are shifting around our Public Equity allocations, including reducing our U.S. exposure to below benchmark for the first time. Specifically, we are reducing our U.S. Public Equity exposure to 19% from 21%, compared to a benchmark of 20%. Though 45% of the Russell 2000 stocks with enterprise values of $500 million to five billion are still trading below 10x EBITDA (Exhibit 43), overall indexes in the U.S., including parts of the Nasdaq, appear somewhat overheated. With the reduction in the United States, we are boosting Europe by one percent to 16% versus our current benchmark weight of 15%, and we are adding a percent to All Asia Ex-Japan to show our confidence in domestic demand stories where reforms are taking shape, India and Indonesia in particular (see our recent note Indonesia: Harnessing Its Potential dated June 2017). We retain our underweight in Latin America, which — at four percent — is two percentage points below the benchmark target. We think that corruption remains a problem in Brazil, therefore we would rather own debt than equity in Mexico at current levels.
- Our overweight to Private Equity relative to Public Equities and Growth Investing remains unchanged. We continue to target a three hundred basis point overweight to Private Equity relative to our equal-weight in Public Equities and our five hundred basis point underweight to Growth Investing. As one can see in Exhibit 42, what we found is that low return environments for Public Equities have actually historically been decent environments for traditional Private Equity. From what we can tell, it seems single-digit return environments for Public Equities tend to be markets where fundamentals are good enough to support deleveraging and operational improvements, but not so good that it is difficult for Private Equity to keep pace with public alternatives. Also, we believe that buyout opportunities tend to increase as the forward-looking total return in public equities decreases. Within Private Equity, we are most bullish on our de-conglomeratization theme, which we describe in more detail below. On the other hand, we maintain our five percent underweight to Growth Investing (i.e., zero versus a benchmark of five percent), driven by our belief that near-term valuations appear largely full.
- We also continue to run with a notable overweight to Energy Assets/Infrastructure in 2017, a direct play on our long-term investment thesis to buy Yield and Growth. Specifically, we hold a five percent allocation to these asset classes, compared to our benchmark of two percent. In recent months we have seen significant selling of properties from publicly traded energy companies looking to reposition their portfolios by selling non-core producing assets as well as performing mid-stream properties. Indeed, transaction volumes in this area of the ‘Oil Patch’ have increased from $20 billion in 2015 to $60 billion in 2016, and year-to-date through April 2017, volume was running at $45 billion. Meanwhile, within Infrastructure we are seeing lots of good cash flowing assets for sale. In many instances investors are getting 500-600 basis points of premium over sovereign debt returns, which is substantial in today’s low rate environment. Interestingly, similar to what we are seeing with Energy Assets, we are seeing lots of conglomerates selling off interesting infrastructure properties in sectors like towers and energy infrastructure.
- Currency: U.S. dollar bull market is now in later stages. As we describe below, the dollar has appreciated meaningfully since we joined KKR in 2011, and we now see it as somewhat extended on a real effective exchange rate basis. Moreover, given we remain in a low rate environment, we think that the value of EM currencies is again rising, particularly those countries with large domestic economies and improving macroeconomic fundamentals. We prefer carry currencies in Indonesia and India, and we even believe that the Chinese yuan may stabilize for now.
- Cash: We reduce Cash to one percent from three percent. We use these proceeds to cover our two percent short position in Gold, which we have shorted periodically during the past few years. However, given heightened geopolitical tensions, we think that this two percent asset class ‘swap’ probably makes good sense.
To be sure, there are risks that warrant investor attention at this point in the cycle… Continue Reading