Download Outlook for 2017: Paradigm Shift

INSIGHTS
GLOBAL MACRO TRENDS
VOLUME 7.1 • JANUARY 2017
Outlook for 2017:
Paradigm Shift
TABLE OF CONTENTS
INTRODUCTION INCLUDING TARGET ASSET ALLOCATION������������������������������������������������������������������������
SECTION I: GLOBAL MACRO BASICS ���������������������������������������������������������������������������������������������������������������������������������������������������
2
10
GDP and Inflation������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������� 10
Interest rates������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������15
Equities�������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������� 17
KKR Global Macro & Asset Allocation
Team
Henry H. McVey
Head of Global Macro & Asset Allocation
+1 (212) 519.1628
[email protected]
David R. McNellis
+1 (212) 519.1629
[email protected]
Frances B. Lim
+61 (2) 8298.5553
[email protected]
Oil����������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������19
Expected returns��������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������� 21
SECTION II: SIX HIGH-CONVICTION THEMES/TRENDS�������������������������������������������������������������������������
23
Long-term rates have achieved their lows this cycle, which implies steeper global
yield curves and lower correlation between stocks and bonds ������������������������������������������������������������������������������ 23
Gap between Simplicity and Complexity too wide and likely to reverse ������������������������������������������������ 25
We remain cautious on global trade, favoring more domestic-oriented stories���������������������� 26
U.S. dollar remains in a bull market������������������������������������������������������������������������������������������������������������������������������������������������������������������������������ 29
Private Equity preferred over Public Equity at this point in the cycle �������������������������������������������������������� 30
Rebecca J. Ramsey
+1 (212) 519.1631
[email protected]
More fiscal spending supports overweight Real Assets position����������������������������������������������������������������������������31
Aidan T. Corcoran
+ (353) 151.1045.1
[email protected]
SECTION III: CHALLENGING OUR CONVENTIONAL WISDOM������������������������������������������������������
Brett J. Tucker
+1 (212) 519.1634
[email protected]
U.S. financial services regulation could abate. How will this impact Private Credit? 36
32
Fiscal stimulus a positive for U.S. growth but we are still later cycle ������������������������������������������������������ 32
Emerging markets to have bumpier bottoming process �������������������������������������������������������������������������������������������������������� 35
No near-term interest rate surge, but technical bid for bonds could be waning ������������������ 38
Buying Liquid Credit relative to Equities is no longer as obvious������������������������������������������������������������������������ 39
SECTION IV: RISKS/HEDGING�������������������������������������������������������������������������������������������������������������������������������������������������������������������������������
41
Short an equally-weighted basket of Korean won, Turkish lira, and the one-year
forward on the Chinese yuan (all relative to the USD) ��������������������������������������������������������������������������������������������������������������41
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2
KKR INSIGHTS: GLOBAL MACRO TRENDS
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Buy U.S. credit protection to gain exposure to potential deterioration ������������������������������������������������������41
Short U.S. branded consumer staples equities���������������������������������������������������������������������������������������������������������������������������������������42
SECTION V: CONCLUSION �����������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������
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Outlook for 2017:
Paradigm Shift
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
I can’t change the direction of the
slowdown in global trade, had
wind, but I can adjust my sails to
already begun to capture this sea
always reach my destination
change in macro and geopolitical
trends. At the same time, however,
”
in certain areas our macro
JIMMY DEAN
preferences have evolved of late in
AMERICAN COUNTRY MUSIC SINGER, TELEVISION HOST,
ACTOR, AND BUSINESSMAN
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.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
3
China K/L
U.S.
U.K.
110
Germany
Japan
France
105
Spain
100
Italy
35
China
2001 was the
inflection point
800
30
25
600
20
15
400
Global Internet
Usage
200
US
10
2001
1994
1987
1980
5
2008
115
Global Internet Usage (RHS)
1000
0
Real GDP, SA
(Indexed: Q4 2008 = 100)
U.S. K/L
1973
The Two Countries with Notable Populist Movements of
Late Have Had the Best Growth. However, Dispersion of
Income Has Created Major Issues
Capital (K) / Labor (L) Ratio (Current PPPs, US$ Bn
2005 Prices, 1989 = 100 )
Internet Usage Ratio per 100 People
1966
EXHIBIT 1
Since China Entered the WTO in 2001, DM Labor Has
Been Adversely Affected by Rapid Technological Change
and Heavy Fixed Investment in China
1959
As we look ahead into 2017, we think that we are at a major inflection point across the global capital markets. Specifically, we view
Donald Trump’s ascendency to the Presidency of the United States
of America 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.
EXHIBIT 2
1952
When we titled our January 2016 Outlook piece Adult Swim Only,
our original intent was to signal that it would be a bumpy year, likely
driven by slowing global trade, less supportive monetary policy, volatile currencies, and rising populism. To be sure, we did not predict a
record $13 trillion in negative yielding securities, Brexit, Presidentelect Trump, and most importantly, a Chicago Cubs’ victory in game
seven of the World Series. But here we are.
0
WTO = World Trade Organization. Data as at November 15, 2016. Source:
Eurizon SLJ Capital Limited, http://www.rug.nl/research/ggdc/data/pwt/
pwt-8.1, World Bank.
EXHIBIT 3
Post the Great Financial Crisis, Volatility Spikes Have
Become the Norm
% of Trading Days When VIX was up 50%+, Y/y
95
8.8%
90
4Q08
1Q10
2Q11
3Q12
4Q13
1Q15
2Q16
Data as at 3Q2016. Source: Eurizon SLJ Capital Limited, U.S. Bureau
of Economic Analysis, Deutsche Bundesbank, Institut National de la
Statistique/Economique, Cabinet Office of Japan, UK Office for National
Statistics, Instituto Nacional de Estadística, Istituto Nazionale di
Statistica, Haver Analytics.
Importantly, though, we strongly believe that the seeds of today’s
discontent actually were planted in 2001, driven by China’s outsized
commitment to fixed investment after it joined the WTO as well as
rapid adoption of the Internet (and the subsequent transparency/
disruption it has created). One can see the exponential, simultaneous
increase in both China’s fixed investment relative to its labor ratio
and global Internet adoption in Exhibit 2, both of which materially
accelerated the significant displacement of the traditional DM labor
force. Thereafter, central banks began to overcompensate for this
structural downturn in wage inflation by inflating prices of financial
assets, with the explosive surge in monetary stimulus that occurred
in the aftermath of the Great Financial Crisis only exacerbating this
trend (Exhibit 4).
4
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INSIGHTS: GLOBAL MACRO TRENDS
4.9%
Apr'03-Sep'07
Apr' 09-Current
Equity Market Expansion Cycles
Data as at December 31, 2016. Source: CBOE, Bloomberg, KKR Global
Macro & Asset Allocation analysis.
EXHIBIT 4
Global QE Has Not Been Enough to Stimulate a
Sustained Increase in Growth, and as Such, We See More
Fiscal Stimulus Ahead
Central Bank Balance Sheet as a % of GDP
Fed
100
ECB
BoJ
Dec-16
89
90
80
70
60
50
40
34
24
30
20
10
0
06
07
08
09
10
11
12
13
14
15
16
17
Data as at December 31, 2016. Source: European Central Bank, Bank of
Japan, Federal Reserve.
Inspired by the aforementioned catalysts, we have entered into what
my KKR colleague Ken Mehlman describes as a “political bull market.” From 2008-2015, this “political bull market” took the form of
more regulation, higher taxes, and heightened industry scrutiny. Many
governments also promoted fiscal austerity, multilateral trade and aggressive monetary stimulus. However, last year’s U.K. Brexit vote and
U.S. election of President Donald Trump likely presage a new chapter
in this bull market story. Specifically, many nations are definitely now
viewing trade and foreign investment from a more nationalist perspective, fiscal austerity is being replaced by stimulus via lower taxes
and infrastructure spend, while key industries such as the Energy and
Financial Services sectors are likely to be deregulated.
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 fiscal stimulus will help
to boost U.S. growth, many of
our indicators are still flashing
later cycle.
“
KKR
INSIGHTS: GLOBAL MACRO TRENDS
5
EXHIBIT 5
Global QE Has Promoted a Sustained
Increase in FX Market Volatility
Bond Markets Are Now Beginning to
Experience a Similar Increase…
…and at the End of the Cycle, We Think
That Equities Will Participate Too
U.S. 10Yr Treasury Volatility
(TYVIX)
U.S. Equity Volatility (VIX)
Currency Volatility (CVIX)
13
12
Avg
Since
2012
10
9
+1σ
–1σ
5
–1σ
4
5
12
13
14
15
16
17
3
+1σ
20
6
6
4
Extremely low equity vol
28
24
7
8
7
Recent increase
in bond vol
8
+1σ
11
32
9
Elevated FX vol
12
13
14
Avg
Since
2012
15
16
16
Avg
Since
2012
12
17
8
12
13
–1σ
14
15
16
17
Data as at December 31, 2016. Source: Bloomberg.
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:
6
KKR
INSIGHTS: GLOBAL MACRO TRENDS
• 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:
1. 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 longerterm 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.
2. 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 Actively Managed Opportunistic 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.
3. 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 AssetBased 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.
4. 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.
“
We expect some of the current
volatility in the currency markets
to first bleed into the interest
rate market in 2017 and then
ultimately find its way into the
equity markets, particularly as QE
subsides further in the U.S.
“
KKR
INSIGHTS: GLOBAL MACRO TRENDS
7
5. 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.
6. 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.
7. 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.
8
KKR
INSIGHTS: GLOBAL MACRO TRENDS
8. 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.
“
What is really needed to
boost long-term growth is
an investment-led surge in
productivity, something that we
think is hard for any politician
to manufacture overnight.
“
EXHIBIT 6
KKR GMAA 2017 Target Asset Allocation Update
Asset Class
KKR GMAA
Strategy
January 2017 Benchmark
Target (%)
(%)
KKR GMAA
June 2016
Target (%)
Public Equities
53
53
51
U.S.
21
20
22
Europe
15
15
15
All Asia ex-Japan*
6
7
5
Japan
7
5
5
Latin America
4
6
4
Total Fixed Income
28
30
27
Global Government
6
20
3
Asset-Based Lending/Mezzanine
5
0
3
High Yield
0
5
0
Levered Loans
4
0
6
High Grade
0
5
0
Emerging Market Debt
0
0
0
Actively Managed Opportunistic
Credit
5
0
5
Fixed Income Hedge Funds
0
0
0
Global Direct Lending
8
0
10
Real Assets
6
5
8
Real Estate
3
2
3
Energy / Infrastructure
5
2
5
Gold
-2
1
0
Other Alternatives
10
10
10
Traditional PE
8
5
Distressed / Special Situation
2
Growth Capital / VC / Other
Cash
ture overnight. Also, given that we are shifting towards using more
fiscal initiatives because monetary ones did not provide the uplift to
growth that many were hoping for, we should acknowledge that the
dispersion of potential outcomes in 2017 and beyond is now much
wider, particularly if protectionist tendencies gain momentum and/
or increasingly nationalistic leaders such as Vladimir Putin, Tayyip
Erdogan, Donald Trump, or even Xi Jinping misjudge a situation.
Just consider that if President-elect Trump imposes the 45% tariff
on Chinese imports that he referenced during his campaign for the
White House, it would drag down China’s GDP by 4.8% and Chinese
exports to the USA by 87% in three years, according to Daiwa Capital
Markets in Hong Kong. Given that China is on track to account for
around one-third of global growth this year, any move in the direction
towards increased protectionism must be taken very seriously. Also,
increased fiscal spending will not happen in a vacuum. Indeed, let
us not forget that faster global growth amidst larger deficits usually
means higher rates and less friendly central banks, particularly if
there is any hint of sustained inflation.
EXHIBIT 7
If Border Tax Adjustability Gains Momentum, Then U.S.
Consumers and Businesses Will Pay More for Basics,
Such as iPhones and Related Equipment
China’s Top Ten Goods Exports to the U.S., 2016 YTD
YTD equals Jan-Sep 2016
In
USD
Bn
% of China’s
Total Exports
to the U.S.
1
Telecom & Sound Record Equip
56
16.5%
2
Office Machinery & Automatic Data Processing
47
13.8%
3
Electrical Machinery, Apparatus & Appliances
33
9.7%
4
Apparel & Clothing Accessories
24
7.1%
5
5
Furniture and Parts Thereof
16
4.8%
0
5
6
General Industrial Machinery & Equip
15
4.6%
0
5
0
7
Metals
14
4.3%
3
2
4
8
Footwear
12
3.4%
9
Road Vehicles
10
3.0%
10
Textile Yarn, Fabrics & Articles
8
2.4%
*Please note that as of December 31, 2015 we have recalibrated Asia Public
Equities as All Asia ex-Japan and Japan Public Equities. Strategy benchmark
is our estimate of the typical allocation of a large U.S. pension plan. Data as at
December 31, 2016. Source: KKR Global Macro & Asset Allocation (GMAA).
Looking at the big picture, for the first time in years investors may
now be paying for more potential cyclical upside in terms of GDP
and EPS growth if fiscal stimulus and reflationary forces do – in
fact – grab hold. In particular, President-elect Trump seems poised
to attack two key overhangs, tax complexity and over-regulation, that
appear to have stymied both innovation and productivity in recent
years. That’s the good news, and it is likely to flow through to both
business and consumer confidence in 2017.
The downside, however, is that – almost irrespective of where we
are in the cycle – declining demographics and large debt overhangs,
particularly in China, are more structural in nature. What is really
needed to boost long-term growth is an investment-led surge in productivity, something that we think is hard for any politician to manufac-
YTD data as at September 30, 2016. Source: CEIC, Morgan Stanley.
“
Investors may now be paying for
more potential cyclical upside in
terms of GDP and EPS growth if
fiscal stimulus and reflationary
forces do – in fact – grab hold.
“
KKR
INSIGHTS: GLOBAL MACRO TRENDS
9
EXHIBIT 8
EXHIBIT 9
Bull Markets End With Bangs, Not Whimpers
Average Daily Performance Index of S&P 500
Before and After Market Peaks
2017 Real Global GDP Growth, %
t-1yr Market Peak
4.0
+0.4
3.5
+1.6
US makes
up 10%
2.5
2.0
1.5
Trading Days Relative to Market Peak
+3.4
+0.3
3.0
-500
-400
-300
-200
-100
+0
+100
+200
+300
+400
+500
+600
+700
+800
+900
+1,000
+1,100
1.50
1.45
1.40
1.35
1.30
1.25
1.20
1.15
1.10
1.05
1.00
President-Elect Trump May Boost U.S. Growth, but EM
Countries Are Supposed to Account for More Than ThreeQuarters of Total Global Growth
Other Emerging Markets
make up another 46%
of growth in 2017
+1.1
1.0
China alone makes up 33%
of growth in 2017
0.5
0.0
Data as at November 22, 2016. Source: BofAML U.S. Equity & Quant
Strategy, Bloomberg, S&P.
China
Other
Emerging
Markets
US
Other
World
Data as at October 5, 2016. Source: IMFWEO, Haver Analytics.
So, our bottom line is that there is still potential for good money to be
made in 2017 as bull markets end with bangs, not whimpers (Exhibit
8). However, as we detail below, our top-down framework does not
actually suggest huge theoretical upside to most asset classes at this
point in the cycle, and as such, we have focused more on arbitrages
where we either think investor expectations are offside and/or the
regulatory environment still puts capital at a premium. In particular,
our highest conviction idea remains that the ongoing rotation away
from Simplicity (e.g., equity bond proxies) towards Complexity will
continue, especially if we are right about a cyclical bottoming in commodities after a 50-85% decline across the complex.
Section I: Global Macro Basics
In the following section we update several key top-down metrics,
including targets for GDP growth, rates, earnings, oil, and expected
returns.
GDP and Inflation
Given that we have a global footprint both at KKR and within the
Global Macro & Asset Allocation team, we have the benefit of being
able to provide an integrated view on the global economy. See below
for details by region, but our punch line is that, even though policy
makers are trying to boost growth, structural headwinds are likely to
prevent any notable, sustained reacceleration in global GDP growth
relative to current 2017 consensus expectations.
EXHIBIT 10
Brazil Is the One Country Where We Are Well Below
Consensus Growth Forecasts
2017 Growth & Inflation Base Case Estimates
GMAA Target
Real GDP
Growth
Bloomberg
Consensus Real
GDP Growth
KKR GMAA
Target
Inflation
Bloomberg
Consensus
Inflation
U.S.
2.25%
2.2%
2.2%
2.3%
Euro Area
1.4%
1.4%
1.4%
1.3%
China
6.5%
6.5%
2.3%
2.2%
Brazil
0.0%
0.8%
6.0%
5.1%
GDP = Gross Domestic Product. Bloomberg consensus estimates as
at December 31, 2016. Source: KKR Global Macro & Asset Allocation
analysis of various factors that contribute meaningfully to these
forecasts.
European Outlook My colleague Aidan Corcoran is looking for a midcycle slowdown in Eurozone GDP growth, downshifting to 1.4% in
2017, compared to 1.6% in 2016. Importantly, we are looking for
some notable softness around the middle of 2017, with GDP growth
touching one percent year-over-year around summer time. There are
four key influences that shape our 2017 outlook. The first is that the
return of energy inflation (i.e., crude oil prices are up 111% in EUR
terms since their low on January 20, 20161) will eat into household spending power, which is already struggling to grow. In fact,
the year-on-year increase in Eurozone compensation per employee
has averaged just 1.2% over the past six quarters in nominal EUR
terms. This fall-off in buying power represents a critical weakness
1 Data as at December 31, 2016. Source: Bloomberg.
10
KKR
INSIGHTS: GLOBAL MACRO TRENDS
in a world where global trade is challenged, making the domestic
consumer trends all the more important.
EXHIBIT 11
We Look For Trade to Make a Negative Growth
Contribution vs. Trend in Mid-2017, While Investment
May Provide a Drag Throughout the Full Year
GMAA Eurozone Real GDP
High Frequency Model and Breakdown
Trend
Consumption
Investment
Government
Trade
EZ Real GDP
Actual
2.5%
Predicted
2.0%
Fiscal Turning
Positive, as
Reaction to
Populist Threat
1.5%
1.0%
Trend = 1.3%
0.5%
0.0%
-0.5%
Trade & Investment Drag
01/15
03/15
05/15
07/15
09/15
11/15
01/16
03/16
05/16
07/16
09/16
11/16
01/17
03/17
05/17
07/17
09/17
11/17
-1.0%
Data as at December 31, 2016. Source: Eurostat, European Commission,
Statistical Office of the European Communities, ZEW Financial Market
Survey, Haver Analytics.
EXHIBIT 12
We Look for Eurozone Inflation to be at a Five-Year High
of 1.4% in 2017, Driven by Services and a Reversal of
Energy Deflation
GMAA Target Eurozone 2017 Inflation Breakdown, PPT, Y/y
1.6
0.3
1.4
1.2
0.3
1.0
0.8
Finally, while game-changing fiscal initiatives in Europe appear
unlikely, we do think governments will loosen the reins a little in response to the growing populist threat. Defense spending in particular
is likely to benefit. However, the limited fiscal stimulus we expect
will not be enough to counteract populism, which we think remains a
major investment theme in the coming years.
United States Outlook In terms of the U.S., my colleague Dave McNellis has changed our cycle call following Donald J. Trump’s surprise
victory. Specifically, we have pushed back our recession forecast
to 2019 from 2018. Key to our thinking is that – in the near term
– President-elect Trump is likely to both cut taxes and increase
investment, the potential benefits of which one can see in Exhibit 13.
As a result, we have boosted both our growth and inflation forecasts
during the 2017 and 2018 periods. One can see these changes in
Exhibit 16.
0.1
0.7
0.6
0.2
Services
Third, while we look for trade to be a positive driver in 1Q17 — thanks
in part to a dovish European Central Bank keeping the euro under
pressure — we do expect some payback around mid-2017 as base
effects kick in and the euro year-over-year change could turn less
supportive.
1.4
0.4
0.0
Second, we think heightened political uncertainty will continue to
take its toll on investment, which we think is key to restimulating
productivity in 2017 and beyond (Exhibit 11). One needs to look no
further than France. Indeed, even if France does avoid the extreme
right candidate, Marine Le Pen, and elects the current favorite,
Francois Fillon, as president, it could still be messy. Fillon’s ascendancy will still likely usher in a period of austerity and labor reform in
France, both initiatives that could spark protests and disruption. The
European companies we have spoken to are understandably nervous
ahead of the French elections — not to mention Brexit, elections in
Germany and the Netherlands — and we believe that this nervousness could impact fixed investment next year.
Food, Nonenergy
Alcohol & Industrial
Tobacco
Goods
Energy
Inflation
Data as at December 31, 2016. Source: Bloomberg, KKR Global Macro &
Asset Allocation analysis.
“
We expect more opportunity
for private infrastructure
projects in the next threeto seven-years; the reality
is that governments can’t
afford to pay for much of the
infrastructure that is now so
desperately needed.
“
KKR
INSIGHTS: GLOBAL MACRO TRENDS
11
EXHIBIT 13
EXHIBIT 14
U.S. Fiscal Stimulus Will Likely Be a Tailwind to Growth
in 2018, Which Was Not in Our Original Call
U.S. Real GDP Y/y Leading Indicator
GDP
Contribution
Individual income taxes similar to
G.W. Bush-era regime²
0.40%
0.4
0.14%
Five percent reduction in effective corporate tax rate³
0.15%
0.3
0.05%
Additional $50 billion per year of
infrastructure spending4
0.25%
1.4
0.36%
$10 billion increase in Federal
‘discretionary’ spending5
0.05%
6%
Actual
Model Predicted
4%
Dec-17e
2.5%
2%
Sep-16a
1.5%
0%
-2%
Leading indicator now
points to modest uplift to
mid-2% growth versus
recent mid-1% range
R-squared = 74%
-4%
Grand Total
1.5
0.08%
0.6%
e = KKR Global Macro & Asset Allocation (GMAA) estimate as of
November 14, 2017. (1) Fiscal multipliers as per Moody’s Analytics
estimates as of 1Q12. (2) KKR GMAA estimate of fiscal headwind from
the roll-off of G.W. Bush-era tax rates at the time of the 2013 ‘Fiscal
Cliff‘ was -0.40% of GDP. (3) KKR GMAA estimate assumes a 10%pt
reduction in the 35% headline rate, which equates to a 5%pt reduction
in the 26% headline rate, as per BEA data. (4) As per Trump transition
website, which refers to an infrastructure investment target of $550bn.
We assume this is implemented over ~10 years. (5) As per GS analysis
(“Economic Implications of the Trump Agenda”), which assumes $40bn
reversal of defense ‘sequester’, offset by $30bn reduction to other
discretionary spending.
-6%
00
02
04
06
08
10
12
14
16
a = Actual, e = Estimated. Our GDP leading indicator is a combination
of eight macro inputs that in combination we think have significant
explanatory power regarding the U.S. growth outlook. Data as at
December 31, 2016. Source: Bureau of Economic Analysis, Haver
Analytics, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 15
…Supported by Lower Oil, Rising Home Sales, Recovering
Household Wealth and Improving Credit Conditions
Elements of 4Q17e GDP Leading Indicator
0.3%
0.2%
0.1%
0.2%
2.6%
2.5%
-0.8%
Interestingly, our statistical GDP indicator is actually pointing to
2017e growth of potentially 2.5% (Exhibit 14), so our fundamental
forecast of 2.25% does incorporate a modest haircut to our quant indicator. We make this haircut due to some cross currents we see that
are not fully captured by the model, including the post-election jump
in economic policy uncertainty as well as the tightening of financial
conditions represented by the recent dollar rally.
12
KKR
INSIGHTS: GLOBAL MACRO TRENDS
-0.1%
Restrained
Credit
Conditions
Other Factors
Rising Home
Sales
Recovering
Household
Wealth
Lower Oil Px
Improved from -1.8%
headwind as of June 2016
Baseline
In terms of specifics, we are raising our 2017 U.S. GDP forecast to
2.25%, which is a 25 basis point upgrade from 2.0% previously, and
slightly above the current consensus of 2.2%. Key factors influencing
our thinking include a) the improvement in U.S. credit conditions in
recent months, both in terms of liquid market spreads and in terms of
banks’ willingness to lend; b) the recent improvement in U.S. investment and trade growth – which has been evident both in the 3Q16
GDP report and in recent PMI survey data; and c) the fact that oil in
the current ~$50 dollar range appears to be in something of a sweet
spot that is high enough to alleviate some of the financial stress on
producers, but low enough to promote a mild continued “oil dividend”
in consumer spending.
Forecast
Fiscal
Impulse
Note:
Multiplier¹
Graying
Workforce
2018e Incremental Fiscal Stimulus
Element
Our U.S. GDP Leading Indicator Points to a Moderate
Growth Recovery in 2017…
e = Estimated. Our GDP leading indicator is a combination of eight
macro inputs that in combination we think have significant explanatory
power regarding the U.S. growth outlook. Data as at December 31, 2016.
Source: Bureau of Economic Analysis, Haver Analytics, KKR Global
Macro & Asset Allocation analysis.
While our base case forecasts have improved, we want to emphasize
that the range of potential economic outcomes has widened considerably as a result of Mr. Trump’s election. We have incorporated this
into our forecast in Exhibit 16 by raising the magnitude of potential
growth under a bull case in which meaningful government stimulus
and fewer regulatory hurdles unleash a virtuous cycle of confidence
and investment. We have also, however, increased the severity of a
EXHIBIT 16
We Are Extending Our Cycle Base Case by One Year and Raising Our Inflation Outlook for 2018-19e. Importantly,
However, the Spread of Potential Outcomes Has Widened
U.S. GDP Growth Forecast
Base Case
Bull Case
U.S. Inflation Forecast
Bear Case
New
Prior
New
Prior
New
Prior
2015a
2.60%
2.38%
2.60%
2.38%
2.60%
2.38%
2016e
1.60%
1.50%
1.75%
2.40%
1.50%
2017e
2.25%
2.00%
2.75%
2.50%
2018e
2.00%
0.00%
3.00%
2019e
0.00%
2.00%
2020e
2.00%
2021e
2.00%
Base Case
Bull Case
Bear Case
New
Prior
New
Prior
New
Prior
2015a
0.10%
0.10%
0.10%
0.10%
0.10%
0.10%
1.00%
2016e
1.50%
1.50%
1.60%
2.25%
1.25%
1.00%
0.50%
0.40%
2017e
2.25%
2.25%
3.00%
3.00%
1.50%
1.50%
2.40%
-1.50%
-0.90%
2018e
2.50%
2.00%
3.00%
2.50%
1.25%
1.25%
2.50%
2.20%
1.50%
1.75%
2019e
2.00%
1.75%
2.50%
2.50%
1.00%
1.00%
2.00%
2.25%
2.00%
1.50%
1.75%
2020e
2.00%
2.00%
2.50%
2.50%
1.75%
1.75%
2.00%
2.00%
2.00%
1.50%
1.75%
2021e
2.00%
2.00%
2.50%
2.50%
1.75%
1.75%
e = KKR Global Macro & Asset Allocation estimates. Data as at December 31, 2016. Source: Bureau of Economic Analysis, Bureau of Labor Statistics, KKR
Global Macro & Asset Allocation analysis.
Labor Market Deterioration
Y/y % Chg. (RHS)
Unemployment Rate (LHS)
13%
12%
11%
10%
9%
8%
7%
Sep-16
Dec-15
5%
Mar-15
6%
Jun-14
Brazilian Outlook We are forecasting flat or zero percent real GDP
growth for Brazil in 2017, compared to a contraction of 3.3% in 2016
and a consensus forecast of 0.8% for 2017. Make no mistake, Brazil
is recovering from one of its worst recessions ever, but we continue
to see a “U-shaped” recovery. In our view, Brazil will finally exit its
three-to four-year recession sometime in the second half of 2017, but
Unemployment Continues to Increase in Brazil at the
Same Time Wages Are Contracting
Sep-13
Moreover, in nominal terms, near-term growth appears to have
bottomed, which is a big deal for business operators that have been
operating in a negative PPI and a low CPI environment for quite some
time. Specifically, we now think that inflation will rise to 2.3% in
2017 from an average of 2.0% in 2016. In terms of what would give
inflation a boost in 2017, we believe the reduction of excess capacity,
strong property prices — hence rent inflation, and a weaker currency
will cause inflation to rise. On the other hand, we think the 2016
rally in commodity prices, coal and steel in particular, was induced
by domestic supply side measures that are now being rolled back.
As commodity prices fall in response to the increased supply, it will
likely have a deflationary impact on commodity-related sectors.
EXHIBIT 17
Dec-12
Chinese Outlook For China, my colleague Frances Lim is forecasting
real GDP growth of 6.5%, which is 20 basis points below her revised
6.7% 2016 target and in line with the Bloomberg consensus of 6.5%
for 2017. Implicit in our forecast is that China’s housing and auto sectors will slow as 2016’s highly stimulative policy measures now mean
tougher comparisons and heavier oversight. While growth of “just”
6.5% GDP for 2017 could set off alarm bells with some investors,
the 20 basis point reduction in real growth that we are forecasting is
actually in line with the 20-40 basis points decline over the past two
years.
growth for the full year will struggle to be positive and be back-end
loaded at best. With universal expectations for positive GDP growth,
we feel the first half might disappoint the optimists, especially as China pulls back its stimulus, as discussed above. To note, this Brazilian
recession has already lasted 10 quarters, leading to a steep decline of
10.3% in per capita GDP during this period. As such, we think the potential for a V-shaped recovery is quite low. Consistent with this view
(and despite a recent surge in business and consumer confidence),
unemployment continues to increase while wages contract, which is
deteriorating the wage mass and keeping consumption trends sharply
negative. One can see this in Exhibits 17 and 18, respectively.
Mar-12
potential recession under our bear case, in which the administration
significantly ratchets up trade tensions, but delivers little net fiscal
stimulus.
4%
3%
3%
2%
2%
1%
1%
0%
-1%
-1%
-2%
Data as at October 31, 2016. Source: Banco Central do Brasil, Ministerio
do Trabalho e Emprego, Haver Analytics.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
13
EXHIBIT 18
EXHIBIT 19
These Trends Are Shrinking the Wage Mass and Keeping
Consumption Trends Sharply Negative
Brazil: Real Wage Mass Growth, Y/y %
IPCA National CPI, Y/y, %
Real Earnings Growth
Employment Growth
Real Wage Mass Growth
BCB Reference Scenario (assumes no rate cuts)
Market Consensus (w/ rate cuts)
GMAA Estimate
12%
8%
Dec-17e
6.0%
6%
Meanwhile, on the inflation front, we note that the IPCA-15 CPI index
has now dropped over 300 basis points in the last nine months, and
it could potentially fall to the top end of the central bank’s inflation
target (6.5%) within a few months, which has not happened since
2014. Without question, the recent decline in inflation trends has
been encouraging; however, as we look ahead, we only see a path for
inflation to fall to just 6.0% in 2017, versus a consensus of 5.1%. One
can see this in Exhibit 19. If we are right, then it means that expectations for large cuts to the Selic rate in 2017 may disappoint investors.
Indeed, we think that the median estimate for 2017, which embeds an
additional 325 basis points of cuts to 10.5% by year-end 2017e, is too
aggressive. We also do not yet see concrete evidence that President
Michel Temer’s new administration is serious about pushing for more
significant fiscal contraction, with recent events showing signs of
backsliding on budget reform goals. If we are right, then we think that
both bond and equity investors could be disappointed.
Mar-17
Mar-16
Mar-15
Mar-14
Mar-13
Mar-12
2%
Mar-11
Data as at October 31, 2016. Source: Banco Central do Brasil, Ministerio
do Trabalho e Emprego, Haver Analytics.
4%
Mar-10
Sep-16
Sep-15
Sep-14
Sep-13
Sep-12
Sep-11
Sep-10
Sep-09
Sep-08
Sep-07
Sep-05
Jun-16
-8.6%
Sep-06
Sep-16
8.5%
10%
Mar-18
Oct-16
-5.1%
Sep-04
15.0%
12.5%
10.0%
7.5%
5.0%
2.5%
0.0%
-2.5%
-5.0%
-7.5%
-10.0%
-12.5%
We Believe Inflation in Brazil Will Fall, but Not as Much
as the Market Believes, Due to Currency Weakness,
Higher Taxes and Wages
Blue line equals actual CPI. Data as at September 30, 2016. Source:
Instituto Brasileiro de Geografia e Estatística, Haver Analytics.
EXHIBIT 20
The Weaker BRL from 2015 Helped to Kick Start a
Recovery in Manufacturing and Exports, Which Has
Helped to Close the Current Account Deficit
Brazil Industrial Production, Y/y%
Industrial Production
Mining
Manufacturing
25%
20%
15%
10%
Oct-16
-5.0%
5%
0%
-5%
-10%
-15%
14
KKR
INSIGHTS: GLOBAL MACRO TRENDS
Jan-16
Jan-15
Jan-14
Jan-13
Jan-12
Jan-11
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
-25%
Jan-05
“
We continue to advocate solid
exposure across risk assets, with a
particular focus on idiosyncratic
opportunities that benefit from
either dislocations and/or existing
regulatory arbitrages.
“
-20%
Data as at October 31, 2016. Source: Instituto Brasileiro de Geografia e
Estatística, Haver Analytics.
The Brazilian real was among the best performing currencies in
2016, up 21% on a spot basis and up 33% on a total return basis.
Given persistently high inflation and slow growth, we anticipate a
gradual weakening of the BRL back towards 4.00 versus its year-end
level of 3.27. At current levels, the real is no longer cheap compared to its long-term average real effective exchange rate (REER).
In addition, given the recent deterioration in industrial production
and employment, we feel the currency needs to reverse the 2016
gains so the export sector can remain competitive and stabilize the
economy. To be sure, this depreciation will help to boost exports, but
it will ultimately limit the amount of monetary easing from the Central
Bank, which will likely continue to hurt both credit creation and
private consumption. This strength in the U.S. dollar / weakness in
the Brazilian real is further evidence for why we do not think inflation
will ultimately drop to where the current consensus is forecasting.
Our Interest Rate Forecast Suggests Rates Back Up to 2.75% in
2017 and a Cycle Peak of 3.25%; However, There Is No Change to
Our 2017 Fed Call for Two Hikes
EXHIBIT 22
We Have Raised Our 2017 U.S. 10-Year Yield Target
by 50 Basis Points vs. Pre-Election Levels, and We Now
Expect Peak-Cycle Rates of 3.25% in 2018
GMAA U.S.10Yr Yield Target
Prior (Pre-U.S. Elections)
3.25%
2.75%
2.25%
As we mentioned earlier, we recently boosted our 2017 forecast for
U.S. 10-year rates to 2.75% from 2.25%, but we maintain our forecast that the Federal Reserve lifts short-term rates “just” two times
in 2017 versus the Fed’s current forecast of three times. Here’s our
thinking on both:
Fed Funds Forecast: We have not changed our base forecast that the
Fed implements two 25 basis point rate hikes in 2017, which takes
the mid-point Fed Funds target rate to 1.125% by year-end. A key
factor that makes us confident that the Fed will be in motion in 2017
is that unemployment is nearing or at the government’s estimate of
NAIRU, or the natural rate of unemployment. The proximity of the
unemployment rate to NAIRU is important because, as we show,
in Exhibit 24, the rate of core inflation has risen fully in four of the
past five times that unemployment dipped below NAIRU by a median
increase of 25 basis points. Consistent with this view, we are also
seeing solid wage growth, with December 2016’s average hourly
earnings climbing a full 2.9% year-over-year, the highest level in
seven years.
EXHIBIT 21
Our Fed Funds Forecast Continues to Tread the Middle
Ground Between the FOMC and the Market
2.3%
Current Expected Fed Funds Rates
FOMC
2.1%
GMAA
1.875%
1.9%
1.7%
+75bp
1.5%
1.125%
1.3%
1.1%
0.9%
0.7%
0.5%
Futures Mkt
+50bp
0.625%
YE'16
YE'17
YE'18
Data as at December 13, 2016. Source: KKR Global Macro & Asset
Allocation analysis.
New
N/A
YE'17
YE'18 (Cycle Peak)
Data as at December 13, 2016. Source: KKR Global Macro & Asset
Allocation analysis
As we detail in Exhibit 21, our overall Fed forecast continues to tread
a middle ground between the Fed and market expectations, with our
base case for 2017 close to the current market consensus but below
the three hikes outlined in the Fed’s December “dots plot.” Our thinking is that, while we do expect the U.S. economy and unemployment
rate both to improve in 2017, we also believe there will be significant
market volatility and economic uncertainty over fiscal policy as well
as continued upward pressure on the U.S. dollar. Ultimately, we
believe these influences restrain Fed hikes to just 50 basis points.
Our outlook for 2018, however, is more hawkish relative to our 2017
assumptions. Specifically, we assume three Fed hikes in 2018, driven
by our expectations that 1) the bulk of U.S. fiscal stimulus will hit in
2018; 2) even tighter labor markets in the U.S. drive stronger wage
growth in 2018 compared to 2017.
“
A stronger dollar could also likely
coincide with higher rates, which
may pressure yields not only in
the U.S. but also in Europe and
Japan. We do not see the dollar’s
move getting extreme in our
base case, but there are multiple
scenarios where it could move
beyond its fair value in 2017.
“
KKR
INSIGHTS: GLOBAL MACRO TRENDS
15
EXHIBIT 23
Unemployment Seems Poised to Dip Below Its Natural
Rate (“NAIRU”)…
U.S. Unemployment Rate
% Above/(Below) Natural Rate of Unemployment
5
4
3
2
1Q97
1
4Q63
0
3Q16
-1
1Q78
2Q05
3Q87
Turning towards real 10-year rates, we think they could rise to about
50 basis points, which would be around the high end of the range in
recent years. This level would also represent a meaningful increase
versus the trend in 2016, when real rates dipped below zero at times.
That said, while we do think rates are headed higher, we continue to
temper our U.S. forecast to reflect the significant global pressures
on bond yields, particularly from Europe and Japan. In particular,
as we illustrate in Exhibit 26, the spread between U.S. and German
rates is extremely elevated relative to the differential in inflation rates
between the two countries, which is comparatively modest at less
than one percent. Said differently, if there is something that does not
make sense in the global bond markets in 2017, it will likely emanate
out of Europe, or even Japan.
EXHIBIT 25
1Q16
1Q12
1Q08
1Q04
1Q96
1Q00
1Q88
1Q92
1Q84
1Q76
1Q80
1Q72
1Q68
1Q64
-3
1Q60
-2
25). However, we just don’t see a massive upward adjustment in
overall inflation, particularly if the dollar continues to appreciate in
2017.
Data as at November 15, 2016. Source: Bureau of Labor Statistics,
Congressional Budget Office, KKR Global Macro & Asset Allocation
analysis.
The Inflation Indicators We Are Watching Suggest That
Inflation Break-evens Could Continue Rising Towards
About 2.25% From 1.97% as of 12/31/16
130
ECRI U.S. Fut. Inflation Gauge (L)
U.S. 10Yr Break-evens (R)
EXHIBIT 24
120
…Historically, This Has Been Accompanied by
Accelerating Core Inflation
3Q87
4Q63
1.0%
1.75%
2Q05
1Q97
90
0.00%
+8Q
+7Q
+6Q
+5Q
+4Q
+3Q
+2Q
+1Q
Baseline
0.50%
Data as at December 31, 2016. Source: ECRI, Bloomberg, KKR Global
Macro & Asset Allocation analysis.
Core CPI is currently running around 2.15%
Y/y, so a 25 basis point acceleration would
push it to approximately 2.4% Y/y by 4Q17
INSIGHTS: GLOBAL MACRO TRENDS
1.00%
0.25%
70
U.S. 10-Year Yield Forecast: Our U.S. 10-year yield forecast of 2.75%
incorporates our views on both inflation break-evens and on TIPS
real rates. Looking at inflation break-evens, we think they may be
headed towards 2.25% from 1.97% as of year-end 2016 and what we
believe was a cycle low of 1.20% in February of 2016. Our forecast
appears consistent with what we are seeing from forward-looking
inflation indicators such as the ECRI Future Inflation Gauge (Exhibit
KKR
1.25%
0.75%
Data as at November 15, 2016. Source: Bureau of Labor Statistics,
Congressional Budget Office, KKR Global Macro & Asset Allocation
analysis.
16
1.97%
Dec-16
80
0.0%
-1.0%
1.50%
100
Median
+4Q
0.25%
0.5%
2.00%
110
Jun-97
Oct-98
Feb-00
Jun-01
Oct-02
Feb-04
Jun-05
Oct-06
Feb-08
Jun-09
Oct-10
Feb-12
Jun-13
Oct-14
Feb-16
Jun-17
1Q78
Median
2.50%
2.25%
Change in Rate of Core CPI Inflation Rate From Quarter
Before Unemployment Fell Below NAIRU
-0.5%
3.00%
2.75%
“
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.
“
EXHIBIT 26
Our Year-End 2017 U.S. 10-Year Yield Target Moves to
2.75% from 2.25% Previously. This Level Would Be at the
High End of What We Think Is a Reasonable Spread to
European Rates
Spread Between U.S. and Germany 10Yr Yield
Spread Between U.S. and Germany 10-Year Yield and CPI
+/- One StDev
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
-0.5%
-1.0%
-1.5%
Median
Memo: 2017e
Beyond the margin expansion market-to-market that we are making,
we think that there are four “extraordinary” items that also need to
be considered in concert with more traditional earnings forecasting
techniques for 2017. They are as follows:
Very high bond yield
spread relative to
only moderate
inflation differential
< 0%
0% to +0.5% to +1.0% to +1.5% to
+0.5% +1.0% +1.5% +2.0%
Given this potential disconnect, we have elected to forecast “baseline” 2017 EPS growth of 6.5% (including both Energy and non-Energy sectors), essentially in line with revenues. In our opinion, 6.5%
nominal revenue growth represents a healthy growth rate that one
might see in an environment of improving nominal GDP; however, it
assumes that the margin improvement we are seeing in beaten-down
sectors is largely offset by some of the more mature trends we are
seeing in consumer, healthcare, and technology at this point in the
cycle.
> 2%
Spread Between U.S. and Germany CPI
Historical analysis based on annual data from 1983-2015. Data as at
November 15, 2016. Source: Bloomberg, KKR Global Macro & Asset
Allocation analysis.
Earning and Target Multiple Analysis Suggests Modest Upside to
Equities
After three years of flat to negative earnings growth, we finally look
for S&P 500 earnings per share to reaccelerate in 2017 to $132.00
from $118.70, which represents about 11.2% growth. That’s good
news, and it is consistent with our decision to maintain our overweight to U.S. Equities again in 2017. The potentially bad news
is that the consensus forecast of $133.40, which implies a 12.3%
growth rate, may need to be marked down further, in our view. Our
more conservative viewpoint on 2017 earnings growth comes from
our more cautious outlook in two areas relative to the consensus:
1) we are of the mindset that significant margin expansion seems
unlikely at this point; and 2) the high degree of embedded operating
leverage also seems too optimistic, in our view. The consensus forecast for revenue growth (ex-Energy) of 4.2% is expected to springboard into plus 9.1% earnings growth. That’s a huge bet 90 months
into an economic cycle. Were this sizeable improvement to actually
occur, it would be the exact opposite of what the S&P 500 experienced in 2016 (negative operating leverage), and it would also be
above the actual margin expansion achieved in 2013, 2014 and 2015.
• U.S. Dollar: The DXY is currently up 5.1% versus its 2016 average,
if it holds these levels. We estimate that for every one percent
move in the DXY, S&P 500 earnings are reduced by 0.40%. As
a result, we expect a pass through of at least negative $2.85, or
two percent, to 2017 earnings, with upside risk towards being
more of a deterrent to S&P 500 EPS.
• Taxation: Based on our work, we think that a 10% cut in the
statutory tax rate, from 35% down to 25%, would equate to a
roughly six percent drop in the “effective” tax rate (from 28% to
22%). Key to our thinking is that roughly 60% of S&P earnings
are taxed at statutory rates, while the implied offshore rate for the
other 40% is a more modest 17.5%. So, each one percent drop in
the effective rate increases S&P 500 earnings by $1.50/share or
1.3%, leading us to forecast that a 10% cut in statutory tax rates
(six percent effective) would increase S&P 500 earnings by a
sizeable $9.00/share or 7.6%. We then cut this number by 50%
for 2017 to align with our assumption that Trump’s program is
implemented on July 1, 2017.
• U.S. Financials Earnings: Financials earnings are estimated to
grow 11.9% Y/y in 2017, compared to 0.6% growth in 2016. Given
higher absolute rates, steeper yield curves, and the potential for
less regulation, we think that the consensus forecast could still be
too low. As such, we have added 500 basis points of incremental growth to the consensus forecast, which boosts the sector’s
earnings by $1.20 to $25.10, compared to consensus forecast of
$23.90 in 2017.
• Buybacks: Share count has decreased by an average of one
percent over the past five years, after netting buybacks and
issuance. In 2017, we expect share buybacks to boost EPS an
additional 2.3% over notional earnings. Our forecast assumes we
get a slightly higher rate of buybacks than recent years, given the
potential cash flow boost from repatriation and lower taxes, as
well as the lower regulatory burden on select financials, such as
regional banks. This rate of EPS accretion from buybacks would
be more similar to what we saw in the 2005-2007 period.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
17
Putting all the aforementioned factors together, we see a path for a
base-line 2017 EPS growth of 6.5% “organic” that increases to 11.2%
after adjusting for “extraordinary” items. One can see this in Exhibits
27 and 28, respectively.
EXHIBIT 29
44% of 2017’s Growth Is Coming from Two Lower
Multiple Sectors: Financials and Energy
Consensus S&P 500 2017 EPS Estimate (U.S.$/share)
$1.20
1.0%
Adj. for buybacks
$2.70
2.3%
$132.00
11.2%
Pro-forma GMAA 2017E EPS
Data as at December 8, 2016. Source: KKR Global Macro & Asset
Allocation analysis.
EXHIBIT 28
We Look for 2017 EPS to Reach $132 in 2017 After
Factoring in All the Various Considerations
2017 S&P 500 Earnings Per Share Estimate (U.S.$/share)
+$133.4
+$126.5
+$4.5
+$1.2
+$2.7
+$132.0
–$2.9
–$6.9
Consen- Assuming GMAA
Trump
Higher Buybacks Stronger
sus 2017
No
2017
Tax Cuts Financial
U.S.
Margin Baseline
Contrib'n
Dollar
Growth
EPS
GMAA
2017e
EPS
Data as at December 8, 2016. Source: Bloomberg, KKR Global Macro &
Asset Allocation analysis.
18
KKR
INSIGHTS: GLOBAL MACRO TRENDS
2017e
Adj. for higher financial contribution
Utilities
-2.4%
Telecom
$(2.85)
Adj. for stronger US dollar
Real Estate
3.8%
110
Materials
$4.50
Adj. for Trump tax cuts
44% of incremental growth
coming from two sectors
Industrials
6.5%
133.4
0.4 0.3 0.2 0.1
2.5
Health Care
$126.46
0.9 0.9
118.7
115
6.5%
GMAA 2017E baseline EPS
3.9
1.6 1.0
Cons Discret
120
6.5%
‘17 earnings growth
2.9
125
$118.74
‘17 revenue growth
130
Energy
Current consensus 2016E EPS
Y/y %
Info Tech
U.S.$ /
share
2016e
S&P 500 EPS Scenarios
135
Financials
Our Earnings Outlook Is Contingent on a Likely Change
in Policies…
Cons Staples
EXHIBIT 27
Data as at December 8, 2016. Source: Morgan Stanley.
In terms of valuation, we think that the S&P 500 can trade around
a 17-18x P/E multiple, down seven percent to the midpoint of 17.5x
from a level of 18.8x at year-end 2016. If we are right, then our
framework implies a range of approximately 2200 to 2400 for the
S&P 500 (Exhibits 30 and 31).
There are three important inputs that drive our thinking around
multiples. First, we think the contribution to earnings in 2017 from
lower multiple sectors is now much more significant than in the past.
One can see this in Exhibit 29. All told, 44% of total earnings growth
in 2017 comes from Energy and Financials. Second, we think that
higher rates and more uncertainty surrounding policy will stifle any
additional multiple expansion this cycle. From what we can tell, it
currently feels like we are being more conservative than the consensus about the proper discount rate that we should now use for
valuing long duration assets, equities in particular. Third, one-time
tax cuts are generally not multiple enhancing events, particularly if it
leads to tighter monetary conditions and/or a stronger dollar.
“
We now think that the
intensifying regulatory changes
in financial services, particularly
in the U.S., could abate under a
Trump administration.
“
EXHIBIT 30
We Think the S&P 500 Can Trade Around a 17-18x P/E
Multiple…
S&P Price Index at Various P/E and EPS Levels
EPS
16.0
16.5
17.0
17.5
18.0
18.5
19.0
123
1,968
2,030
2,091
2,153
2,214
2,276
2,337
125
2,000
2,063
2,125
2,188
2,250
2,313
2,375
127
2,032
2,096
2,159
2,223
2,286
2,350
2,413
129
2,064
2,129
2,193
2,258
2,322
2,387
2,451
131
2,096
2,162
2,227
2,293
2,358
2,424
2,489
133
2,128
2,195
2,261
2,328
2,394
2,461
2,527
135
2,160
2,228
2,295
2,363
2,430
2,498
2,565
137
2,192
2,261
2,329
2,398
2,466
2,535
2,603
139
2,224
2,294
2,363
2,433
2,502
2,572
2,641
141
2,256
2,327
2,397
2,468
2,538
2,609
2,679
Data as at December 8, 2016. Source: KKR Global Macro & Asset
Allocation analysis.
If we are right on our earnings and valuation forecasts, then the S&P
500 could provide a total return of around four-to seven-percent,
with two percent of that return coming from the dividend. In our
view, this return would be competitive with credit instruments such
as High Yield and Levered Loans, but is still likely to lag Private
Equity and Private Credit at this point in the cycle. It is also subject
to downside risk if the new administration does not advance its tax
reduction agenda by mid-2017 or trade tensions flare up at any point
during the year.
Oil Outlook: We Are Still Using $60-$75 as our 2016 Base Case
As most folks know, OPEC recently delivered on the production target
cut it first announced back in late September. Importantly, this OPEC
action should help to finally force global oil production into a net deficit relative to demand. The global production surplus has come down
significantly in recent quarters, but as Exhibit 32 illustrates, it had
been difficult to see the market moving into a material deficit as long
as OPEC continued to increase production. As we have emphasized
since our 2016 Outlook note a year ago, oil bear markets tend to bottom out coincident with production moving into deficit (Exhibit 33).
EXHIBIT 32
The OPEC Cut Could Send Global Oil Production Into
Deficit Relative to Demand in 1Q17 for the First Time
Since the Beginning of 2014
Global Oil Production Surplus/(Deficit),
% of Global Demand
EXHIBIT 31
Expected Path, Given OPEC Cut
…Which Implies a Low to High Single Digit Return,
Including Dividends
Memo: Expected Path if OPEC Had Not Acted
2.0%
S&P Total Return at Various P/E and EPS Y/y Levels
1.5%
16.0
16.5
17.0
17.5
18.0
18.5
19.0
3.6%
-10.8%
-8.0%
-5.3%
-2.6%
0.1%
2.8%
5.5%
5.3%
-9.3%
-6.6%
-3.8%
-1.1%
1.7%
4.4%
7.2%
7.0%
-7.9%
-5.1%
-2.3%
0.5%
3.3%
6.1%
8.9%
8.7%
-6.5%
-3.7%
-0.8%
2.0%
4.9%
7.7%
10.6%
10.4%
-5.1%
-2.2%
0.7%
3.6%
6.5%
9.3%
12.2%
12.0%
-3.7%
-0.8%
2.2%
5.1%
8.0%
11.0%
13.9%
13.7%
-2.3%
0.7%
3.7%
6.7%
9.6%
12.6%
15.6%
15.4%
-0.9%
2.2%
5.2%
8.2%
11.2%
14.2%
17.3%
17.1%
0.5%
3.6%
6.7%
9.7%
12.8%
15.9%
19.0%
18.8%
2.0%
5.1%
8.2%
11.3%
14.4%
17.5%
20.6%
0.5%
Sep-16
0.3%
Dec-17e
1.0%
0.0%
-0.5%
Dec-17e
-0.7%
-1.0%
-1.5%
Dec-12
Apr-13
Aug-13
Dec-13
Apr-14
Aug-14
Dec-14
Apr-15
Aug-15
Dec-15
Apr-16
Aug-16
Dec-16
Apr-17
Aug-17
Dec-17
EPS y/y
Jun-15
1.6%
1.0%
Data as at November 30, 2016. Source: IEA, Bloomberg, KKR Global
Macro & Asset Allocation analysis.
Data as at December 8, 2016. Source: KKR Global Macro & Asset
Allocation analysis.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
19
EXHIBIT 33
EXHIBIT 34
Historically, Oil Bear Markets Have Almost Always Ended
When Production Finally Moved Into Deficit Relative to
Demand
Global Inventories Are Still Massively Glutted. They
Could Take Three Years to Normalize, Even Once
Production Moves Into Deficit
Global Oil Inventories (EOP, Mil.Bbl)
Global Production Surplus/(Deficit)
3Q86
3%
4Q98
2%
1Q09
1Q16
0.9%
1%
1Q16
3Q16
0.3%
Oct-16
6,061
6,000
Typical
Level, Pre4Q14
5,000
5,500
0%
-1%
5,000
Inventories are above trend by ~1.1bn barrels. If global production
runs in deficit by ~1%, we estimate inventories will take
approximately three years to normalize
0
1
2
3
4
5
4,000
Data as at November 30, 2016. Source: IEA, Bloomberg, KKR Global
Macro & Asset Allocation analysis.
As we look ahead, we do think OPEC’s actions will help place a floor
under oil prices, but we are also cognizant that global oil inventories
remain profoundly glutted, which means markets will likely need time
to fully normalize. Looking at the details, Exhibit 34 illustrates that inventories are above-trend by approximately 1.15 billion barrels, which
equates to a 23% surplus relative to the pre-4Q14 norm. If global
production runs into deficit by ~ one percent (as Exhibit 32 suggests
could be the trajectory), we estimate inventories would take fully
three years to normalize. Put another way, we think it could still be a
matter of years until oil prices move up to levels that would incentivize significant shale re-investment.
Data as at November 30, 2016. Source: IEA, Bloomberg, KKR Global
Macro & Asset Allocation analysis.
EXHIBIT 35
Over Time, Oil and the USD Tend to Be Quite Negatively
Correlated
Correlation Between WTI and Trade-Weighted USD
(Rolling Three-Month Correl of 5-Day Performance)
0.00
Dec-16
-0.11
-0.10
-0.20
Avg. Thru
Oct-16
-0.41
-0.30
-0.40
20
KKR
INSIGHTS: GLOBAL MACRO TRENDS
-0.60
Nov-15
-0.80
Sep-15
-0.70
Jul-15
“
Many of our models suggest
more limited upside to asset class
returns than in the recent past.
Accordingly, we continue to favor
a strategy that takes advantage
of idiosyncratic opportunities,
particularly those that enjoy better
pricing during periods of market
dislocations as well as those that
harness complexity to their benefit.
“
-0.50
Nov-16
-1
Sep-16
-2
# Quarters (Before)/After WTI Trough
Jul-16
-3
May-16
-4
Jan-11
May-11
Sep-11
Jan-12
May-12
Sep-12
Jan-13
May-13
Sep-13
Jan-14
May-14
Sep-14
Jan-15
May-15
Sep-15
Jan-16
May-16
Sep-16
4,500
Mar-16
-3%
Jan-16
-2%
-4%
Typical Level, Pre-4Q14
6,500
Data as at December 31, 2016. Source: Bloomberg, KKR Global Macro &
Asset Allocation analysis.
The bottom line from our perspective is that OPEC’s recent actions
look moderately supportive for near-term oil dynamics, but we still
think the upside to prices could be constrained by significant producer hedging and rig count increases when prices move into the $50+
range (as we already saw over the summer of 2016). Continued U.S.
dollar appreciation could also hamper near-term oil upside, given the
traditionally negative correlation of these assets (Exhibit 35). Longerterm, we are maintaining our base case long-term oil price target
range of $60-75, which had always envisioned that OPEC would
eventually resume modulating production (Exhibit 36).
EXHIBIT 36
EXHIBIT 37
We Believe Oil Can Hit $60-75 Within Five Years
2021e
Brent
Target
Range
Base Case
Bear Case
Bull Case
$60-75
$40-50
$80-100
‘1621e Oil
Demand
Growth
1.0%
Rationale
Approx.
Probability
Returns for Financial Assets (Treasuries, Private Equity,
MSCI ACWI and High Yield) Have Been Falling Since
1995
Trailing 5 Year Average Returns by Main Asset Class, %
The market clears at USD 60-75/
bbl in the long-term as supplydemand balances through moderate LT demand growth and continued shale oil supply growth.
Assumes OPEC maintains market
share above 40%, but eventually
resumes modulating production
to keep prices in check
0.2%
Driven by weak demand, prices
fall to the lower end of the shale
marginal cost curve, which itself
is pressured by cost deflation
1.5%
Demand is sufficient to allow
OPEC to resume defending price
rather than market share, which
sends oil back to the pre-4Q14
pricing regime
25
50%
Treasury Returns
Global PE Return
ACWI Return
HY Return
20
15
10
30%
5
0
1990
1995
2000
2005
2010
2015
20%
Data as at November 30, 2016. Source: IEA, Bloomberg, KKR Global
Macro & Asset Allocation analysis.
Our Long-Term Expected Returns Are More Modest Than in Recent
Years
Data as at December 31, 2015. Source: Bloomberg.
EXHIBIT 38
We See Returns for the Industry Headed Lower Across
Most Asset Classes
CAGR Past 5 Years: 2010-2015, %
CAGR Next 5 Years: 2015-2020, %
While we believe that our macro themes can help deliver differentiated relative performance, we must also acknowledge that at this
point in the cycle we have entered an environment of lower absolute
returns for many asset classes. This outlook makes sense to us,
given that we are now starting with higher equity valuations and
lower bond yields versus history.
However, this insight is not necessarily “new” news to most folks. Indeed, as one can see in Exhibits 37 and 38, respectively, returns have
been actually trending down since 2000 in absolute terms, largely
consistent with a 41% decline in nominal GDP (and interest rates)
over the same period. Our work suggests that declining labor force
growth and productivity, both of which still remain challenged, have
negatively impacted global GDP’s recent growth trajectory.
12.6
12.2
11.1
10.2
4.5
4.6
4.4
6.4
2.3
1.3
U.S. 10-Year S&P 500
Treasury
Bond
Private
Equity
Hedge
Funds
Real Estate
(unlevered)
Data as at December 31, 2016. Source: Bloomberg, Cambridge
Associates, NCREIF, HFRI Fund Weighted Composite Index (HFRIFWI
Index), KKR Global Macro & Asset Allocation.
“
We also believe that Real Assets,
particularly those with yield and
growth, can prosper in the macro
backdrop that we envision.
“
KKR
INSIGHTS: GLOBAL MACRO TRENDS
21
EXHIBIT 40
EXHIBIT 39
Post-Crisis Returns of 60/40 Stock and Bond Portfolios
Have Been Quite Strong; We Look for More Modest
Gains in the Future
25%
20%
+1 St. Dev
15%
80%
HFs outperform
Equities and show
their downside
protection
Financial
60%
40%
Crisis
Tech bubble
bursts
20%
Average
10%
We expect
some mean
reversion
-1 St. Dev
0%
56
61
66
71
76
81
86
91
96
01
06
11
16
Data as at November 30, 2016. Source: Goldman Sachs Research.
HFs Underperform
0%
5%
-5%
Three-Year Rolling Return Difference
Between the HFRI HF Index and the S&P 500
HFs Outperform
Long Term Five-Year Trailing Returns
of Traditional 60/40 Portfolio
Hedge Funds Typically Outperform During Periods of
Stress
-20%
-40%
-60%
Dot-Com era, Equities
outperform HFs
HFs lag equity markets as
S&P 500 on a seven-year bull run
92 94 96 98 00 02 04 06 08 10 12 14 16
Data as at November 30, 2016. Source: Bloomberg.
In terms of where we are headed on the return front, we note the following. First, as we show in Exhibit 38, we assume that the S&P 500
returns 4.5% annually over the next five years, down from 12.6%
in the prior five years. Multiple contraction and margin contraction
are the major drivers of the downward pressure we are forecasting.
Meanwhile, in terms of bonds, we forecast a 10-year Treasury return
of 1.3%, comprised of a gross 2.4% yield from the current yield or
coupon minus 1.1% linked to the bond price decline from the 10-year
yield rising to 3.0% by 2021.
Within hedge funds we anticipate some rebound in overall performance. All told, the percentage of underlying managers with positive
alpha, which had historically been 55%, had fallen to a low of just
40% in 20162. However, we expect the trend towards deregulation as
well as the trend towards fiscal spending over monetary stimulus to
favor some of the value securities currently owned by the hedge fund
community. In addition, our research shows that hedge funds tend to
do better when volatility picks up.
Given these aforementioned trends, we now look for hedge fund
alpha to reach about 155 basis points per year, above the historical
norm of 80 basis points, but notably above performance in recent
years3. Meanwhile, given our modest overall view for nominal returns, we only expect the beta component to return 280 basis points.
So, when we pull it all together (i.e., beta of 280 basis points plus
155 basis points of alpha) we expect hedge funds to return roughly
4.4%, on an annualized basis over the next five years.
EXHIBIT 41
Hedge Funds Often Outperform in Rising Rates
Environments
Date
# of
Chg in
UST
Performance
Annualized
Performance
Start
End
Days
10Yr
(bps)
HFRI
FoF
US
Agg
HFRI
FoF
US
Agg
Sep-93
Nov-94
426
260
4%
-4%
4%
-3%
Dec-95
Jun-96
182
120
8%
-1%
17%
-2%
Sep-98
Jan-00
488
185
30%
-1%
22%
-1%
Jun-03
May-06
1066
178
28%
6%
9%
2%
Dec-08
Apr-10
485
143
14%
9%
10%
7%
Oct-10
Feb-11
120
104
3%
-1%
10%
-4%
Jul-12
Dec-13
518
137
12%
-2%
8%
-1%
Jul-16
Dec-16
153
103
1%
-4%
2%
-9%
Average
154
13%
0%
10%
-1%
Median
140
10%
-1%
9%
-2%
Data as at December 21, 2016. Source: Bloomberg, Haver Analytics.
2 Data as at July 31, 2016. Source: KKR Global Macro & Asset Allocation
analysis.
3 Ibid.2.
22
KKR
INSIGHTS: GLOBAL MACRO TRENDS
The other question we often get is why did Private Equity not maintain its historic 400-500 basis point spread above Public Equities
this cycle, and as such, are we comfortable forecasting that spread
will return during the next five-year cycle? Our answer is yes. Key
to our thinking is that Private Equity returns do not deliver as big a
spread during the early-to-middle stages of a bull market, which is
generally what happened this cycle too. We also note that, while high
frequency funds have arbitraged most of the inefficiencies in the
liquid markets, private markets are – by definition – less efficient.
There are also more opportunities to use time arbitrage to one’s
advantage, particularly in a world where investment styles and techniques seem to come in and out of favor more quickly. Finally, there
is often better alignment of management, shareholders, and the board
towards the ultimate goal of value creation.
EXHIBIT 42
Eight Years of Positive Consecutive Performance for the
S&P 500 Is Highly Unusual
# of Consecutive Years of
Positive Returns
Start
End
Cumulative
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%
8
2009
2016
194%
20%
8
1921
1928
435%
23%
8
1982
1989
291%
19%
9
1991
1999
450%
21%
Avg. CAGR
19%
Data as at December 31, 2016. Source: Factset.
during a period of better economic growth. Said differently, as we
shift from monetary to fiscal stimulus, the backdrop for multi-asset
class investors could actually be less favorable than in the past.
Section II: Six High-Conviction Themes/Trends
In the following section we describe in detail where we feel most
confident about six macro themes:
#1: We think that long-term rates have achieved their lows this
cycle, which implies steeper global yield curves and lower correlation between stocks and bonds. Consistent with President-elect
Trump’s pro-growth agenda, we believe that the long end of the interest rate curve is structurally bottoming in the United States. Outside of the U.S., there are also two important changes that also need
to be considered as one thinks about the direction and steepness of
global interest rates in the coming quarters. First, our recent trip to
China in December confirmed that the country’s PPI has bottomed
after 54 months of deflation. This upward trajectory in the world’s
largest manufacturing economy is a big deal, as it underscores our
belief that reflation is occurring not only in the U.S. but also in Asia.
As one can see in Exhibit 43, the Chinese government is actually supporting growth with fiscal spending that is potentially the largest we
have seen on record in both absolute and relative terms. Specifically,
according to the investment bank Goldman Sachs, total “augmented”
spending, which includes both official and non-official spending, is
now running north of 10%, compared to less than four percent before
the Great Financial Crisis.
EXHIBIT 43
China Is Now Running a Deficit of Between 11-13%
of Its GDP Because of Heavy Central and Regional
Government Spending
China Fiscal Deficits as a % of GDP, 3mma
Off-budget deficit
Official fiscal deficit
Augmented fiscal deficit
4
0
Finally, within Real Estate we forecast unlevered returns of six-to
seven-percent. As we only expect a modest increase in interest
rates, we believe the increase in cap rates should also be modest,
which means that rates should remain supportive for real estate.
Historically, when cap rates do not increase by more than 75 basis
points over a three year period, then the three-year real estate returns are north of six percent as the growth in net operating income
is sufficient to offset the modest increase in cap rates. So, given
today’s starting point of a 5.4% cap rate, we think that our forecast
appears reasonable.
-4
-8
-12
-16
05
06
07
08
09
10
11
12
13
14
15
16
Data as at August 31, 2016. Source: CEIC, Wind, Goldman Sachs Global
Investment Research.
Looking at the big picture, our key message is that both institutional
and individual investors are going to have to work much harder to
achieve their return objectives. For our nickel, many pension funds
need to lower their return assumptions by 100-300 basis points to
adjust to the environment that we are forecasting. Somewhat ironically, though, this backdrop of lower returns could actually occur
KKR
INSIGHTS: GLOBAL MACRO TRENDS
23
EXHIBIT 44
EXHIBIT 46
Yield Curves Are Finally Steeping Again
Change in 10-2 Yr Yield Curve:
November 11, 2016 vs. 2016 Full-Year Low, Basis Points
China: Headline PPI Y/y (L)
120
98
00
02
04
06
08
10
12
14
16
4%
Data as at December 31, 2016. Source: Bloomberg.
Italy
U.K.
0
Philippines
-8%
8%
France
-4%
Spain
12%
69
86
17
12
20
Australia
0%
64
77 77
34
40
Canada
16%
U.S.
60
Indonesia
20%
54 57
47 48 49 50
China
80
Germany
4%
24%
Korea
8%
100
Japan
28%
12%
109
Mexico
China: Nominal GDP Y/y (R)
Brazil
PPI Is an Important Driver of Nominal GDP Growth in
China
Data as at November 30, 2016. Source: China National Bureau of
Statistics, Haver Analytics.
Second, central banks in both Japan and Europe are now signaling
that they want to steepen the yield curve by putting pressure on the
long-end of the curve versus the previous ideology of focusing more
heavily on negative short-end rates. This change, which we think is
a major turning point in monetary policy, underscores our long held
belief that corporations and individuals would view negative rates as
a catalyst to actually save more, not spend more as the “Authorities”
had originally hoped.
EXHIBIT 45
Rates Have Increased Sharply; We See More Limited
Upside in the Near-Term
Change in 10Yr Yields:
November 11, 2016 vs. 2016 Full-Year Low, Basis Points
161 165
95 97
40
33 36 40
50
58
109
If we are right about this shift in fixed income, then asset allocators
must take note of what we believe is a fundamental regime change
relative to where we have been. Specifically, we think that stocks
and bonds will move away from being so positively correlated, which
could adversely affect the performance of many “hot” long duration, multi-asset class investment vehicles, including risk parity.
Consistent with this view, we still suggest a substantial underweight
position in government bonds (six percent versus a benchmark of
20%; see Exhibit 6 for details), particularly those of longer duration.
We also believe that global financial stocks, which have been chronic
underperformers in recent years, could continue to stage a significant multi-year rally.
EXHIBIT 47
The Increase in Yields Post the U.S. Election Has Been
Quite Different Than During the Taper Tantrum
Taper Tantrum vs. President-elect Trump Impact on Yields
Nominal U.S. 10Yr Yields
120
Real Rates
Inflation Expectations
180
72 74 77
140
90
Data as at December 31, 2016. Source: Bloomberg.
-40
Taper Tantrum
Trump Surprise
Data as at November 10, 2016. Source: Bloomberg.
24
KKR
INSIGHTS: GLOBAL MACRO TRENDS
45
Mexico
Philippines
Indonesia
U.S.
Italy
Australia
Canada
U.K.
Korea
France
Spain
China
Germany
Brazil
Japan
45
EXHIBIT 48
EXHIBIT 49
After a QE-driven Surge in Correlations, We Now
Expect Some Moderation in the Relationship Between
Stocks and Bonds
Rolling 1Yr Correlation of Weekly Returns:
S&P 500 vs. BarCap U.S. Long Treasury Index
30
11/7/2016
-0.23
-0.40
20
15
Stocks and bonds
became increasingly
correlated during the
era of aggressive QE...
-0.30
25
10
5
...a trend which
may now be rolling
over following the
U.S. elections
-0.50
-0.60
-0.70
0
-5
-10
-15
-0.80
Jan-17
Jul-16
Jan-16
Jul-15
Jan-15
Jul-14
Jan-14
Jul-13
Jan-13
Jul-12
Jan-12
Jul-11
Jan-11
-0.90
Data as at December 31, 2016. Source: Bloomberg.
#2: We think that the gap between Simplicity and Complexity is
still too wide and will likely reverse in the coming quarters. From
our vantage point, it appeared that – prior to the U.S. election –
investors were fully convinced that we were going to remain in a
slow growth, low inflation environment. As a result, markets became
increasingly bifurcated between companies with earnings visibility
and those without it. Indeed, it felt very similar to what we saw during the 1999/2000 period, when too much money was chasing “hot”
technology and telecommunications stocks at the expense of valueoriented cyclical exposures.
In recent weeks markets clearly have begun to correct these excesses, but we think there remains a healthy valuation arbitrage between
complexity and simplicity that still needs to narrow. On the one hand,
a lot of companies that have missed or have lumpy earnings still
seem to be trading well below their intrinsic values. As a result, we
think that – with some value-added restructuring, market repositioning, and/or “tuck-in” acquisitions – there is still a significant opportunity today to dramatically boost the value that public shareholders
will pay for a company across a variety of sectors.
On the other hand, it also feels to us that investors have overpaid
for earnings visibility and/or yield in many instances. As a result, we
still believe opportunities exist across the corporate and real asset
sectors to carve out and monetize distinct earnings streams that are
trading at what we believe are premium valuations relative to their
long-term intrinsic value.
75
80
85
90
95
00
05
10
15
Data as at November 30, 2016. Source: MSCI, IBES, Morgan Stanley
Research.
EXHIBIT 50
U.S. Value Is Now Just Outperforming Growth for the
First Time in Over Two Years, Helped by Strength in
Banks and Insurance
S&P 500 Value Relative to S&P 500 Growth
0.88
0.86
0.84
0.82
0.80
0.78
0.76
0.74
0.72
Oct-13
Dec-13
Feb-14
Apr-14
Jun-14
Aug-14
Oct-14
Dec-14
Feb-15
Apr-15
Jun-15
Aug-15
Oct-15
Dec-15
Feb-16
Apr-16
Jun-16
Aug-16
Oct-16
Dec-16
-0.20
MSCI Europe Defensives % Premium / Discount to
MSCI Europe
35
0.00
-0.10
Defensive Stocks in Europe Still Look Quite Expensive in
a Reflationary Environment
Data as at December 31, 2016. Source: Bloomberg.
Consistent with this view, we are bullish “value” stocks and domestically focused names, particularly in the United States (Exhibit 50).
Europe too still appears to be a fertile environment for differentiated
security selection and given the wide disparity in valuations, we
expect European value-oriented securities to outperform too. 2017
could also be a good year for credit selection, though the gap between simplicity and complexity seems less attractive in Credit than
Equities after the most recent bout of spread tightening. Finally, we
think that Private Equity should be able to unearth some interesting
opportunities. Right now we see the deconglomeratization in places
like Japan and Europe as potentially the most interesting way to harness this theme.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
25
#3: We remain cautious on global trade, favoring more domesticoriented stories. While many investors are focused on Presidentelect Trump’s agenda, we actually believe that China has emerged as
ground zero for this important shift in global trade priorities. Beyond
the country’s ongoing shift from fixed investment towards consumption, there are two other traded-related macro headwinds to consider:
• An increasing amount of China’s fixed investment is being
diverted towards projects like renewables, subways, and sewers, all of which have a less robust multiplier effect than general
construction.
• The government is increasingly pushing a variety of industries to
drive more insourcing, which ultimately means less demand for
intermediate goods from China’s trading partners.
Given these two changes, we were not surprised to uncover that
imports of machinery and equipment, which used to account for
nearly half of China’s total imports as recently as 2002, have fallen
to approximately 35% of total imports by 2016. As we show in Exhibit
52, China’s growing in-house industrial proficiency has clearly come
at the expense of major industrial equipment providers located in
Japan, Korea, Taiwan, Germany, and Sweden, many of which have
traditionally relied on strong Chinese demand to boost their own
exports.
EXHIBIT 51
The Growth of China’s Own Industrial Expertise Has
Come at the Expense of the Major Industrial Equipment
Providers
China Imports of Machinery and Equipment From
Major Supplier Countries
China: LTM Trade as a % of GDP
LTM Exports % GDP
40
Feb-07
35.6
36
32
28
35%
30%
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
EU
Japan Thailand S. Korea Taiwan
U.S.
Data as at October 31, 2016. Source: Big Macro 08: The What, Why and
So-What of Globalization - III. Asset Implications, UBS.
China Continues to Gain Export Share Despite the Weak
Global Trade Market, While Importing Less
China Import and Export Share of Global Trade, %
LTM Imports % GDP
Global trade is a smaller
part of China's economy
Sep-06
29.2
24
20
16
China: LTM Current Account Balance, U.S.$B (L)
China Exports as a % of Global Exports, 12mma (R)
China Imports as a % of Global Imports, 12mma (R)
600
Nov-16
19.1
Nov-16
14.3
03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
“
We remain constructive on large
domestic-oriented EM stories that
are less reliant on global trade.
“
INSIGHTS: GLOBAL MACRO TRENDS
12
400
10
300
8
200
6
100
4
0
2
-100
KKR
14
500
Data as at November 30, 2016. Source: China Customs, Haver Analytics.
26
January 2001-2006 5Yr CAGR
August 2011-16 5Yr CAGR
40%
EXHIBIT 53
Trade Is Becoming a Smaller Part of China’s Economy
12
EXHIBIT 52
90 92 94 96 98 00 02 04 06 08 10 12 14 16
Data as at August 31, 2016. Source: IMF, Haver Analytics.
0
EXHIBIT 54
EXHIBIT 55
China Is Insourcing More of the Products It Consumes,
Autos in Particular
Global Trade Has Actually Declined in Recent Years
Global Merchandise Exports as a % of Global GDP
China: LTM Auto Sales, % of Total
Chinese Brand (L)
Japanese Brand (R)
German Brand (R)
American Brand (R)
Sep-08
26
28
24
China supplying its
own market
Jan-14
Mar-14
May-14
Jul-14
Sep-14
Nov-14
Jan-15
Mar-15
May-15
Jul-15
Sep-15
Nov-15
Jan-16
Mar-16
May-16
Jul-16
Sep-16
Nov-16
44%
43%
42%
41%
40%
39%
38%
37%
36%
35%
21%
20%
19%
18%
17%
16%
15%
14%
13%
12%
Data as at November 30, 2016. Source: China Association of Automobile
Manufacturers, Haver Analytics.
In our view, this shift in China’s approach towards manufacturing
more of its own equipment as well as its desire to move up the global
food chain in high-end exports is secular, not cyclical. If we are right,
then we think that there are two important, long-term investment implications. First, global trade as a percentage of GDP should remain
more muted than in the past. Already, we note that global exports as
a percentage of GDP actually peaked in 2008 at 26% and now total
around 21%, a percentage we expect to fall into the high teens during
the next five years. Against this backdrop, we remain cautious on
shipping as well as many parts of the global logistics supply chain.
We also think that insourcing could dent traffic both in Latin America
and Asia, particularly if President-elect Trump and President Xi Jinping execute on their vision to improve the opportunity set for their
countries’ domestic labor forces.
20
Aug-16
21
16
12
80
85
90
95
00
05
10
15
Data as at August 31, 2016. Source: IMF, Haver Analytics, KKR Global
Macro & Asset Allocation.
EXHIBIT 56
World FDI Relative to GDP Peaked Right Before the Great
Financial Crisis and Has Yet to Rebound Meaningfully
World FDI/GDP, %
6
2007
5.3
5
4
3
2015
2.8
2
1
0
70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15
Data as at December 31, 2015. Source: UNCTAD, Haver Analytics.
“
In nominal terms, near-term
growth appears to have bottomed
in China, which is a big deal for
business operators that have been
operating in a negative PPI and
a low CPI environment for quite
some time.
“
KKR
INSIGHTS: GLOBAL MACRO TRENDS
27
EXHIBIT 59
EXHIBIT 57
There Have Been Many Factors Driving the Slowdown in
Global Trade
Trade Elasticity to Industrial Production Has Been Falling
Across Both DM and EM Economies in Recent Years
Trade Elasticity to Industrial Production
2011-2015 Contribution to Slowdown in Trade
1991-1999
2000-2007
2014-2015
2.16
2.08
China,
23.5%
1.74
1.27
0.80
Import
Adjusted
Demand
(IAD),
58.8%
Trade
Liberalization,
6.9%
Global Value
Chains,
10.9%
Developed Markets
Data as at December 31, 2016. Source: UBS EM Cross Asset Strategy No
trigger for a blow up, no ideas for growth – managing a ship adrift, OECD
input-output tables, Haver Analytics, Fraser Institute.
Globalization Has Ebbed and Flowed Over Time. We
Now Think We Are in a Period of Slowing Growth
Data as at December 31, 2015. Source CPB World Monitor, Haver
Analytics, UBS.
EXHIBIT 60
Country
Global Trade Volumes and Real GDP Growth, %
GDP Growth
World Exports to GDP (rhs)
10
2nd Wave of
Globalization
9
8
7
3rd Wave of
Globalization
6
1st Wave of
Globalization De4 Early stages of
Globalization
industrial
3 revolution
1.2
150%
59%
29
Indonesia
0.2
0.5
167%
57%
U.S.
8.8
12.3
40%
68%
26
Slowdown
14
11
1
5
1913-1950
1973-1988
2008-Present
2
Data as at December 31, 2016. Source: UBS EM Cross Asset Strategy
No trigger for a blow up, no ideas for growth – managing a ship adrift,
Maddison, IMF, WTO, World Bank, Haver Analytics.
Second, we think that the global flows are likely to be less dynamic
than in the past. Already, foreign direct investment (FDI) as a
percentage of GDP has been flat to down since the Great Recession. In many instances, developed market multinationals have lost
confidence in the ability to earn excess returns in difficult markets
like Brazil and China. Also, there is growing risk to being global, particularly if material expressions of the populism politics and political
dissatisfaction continue to bubble up.
28
KKR
Data as at December 31, 2015. Source: World Bank, IMF, Haver Analytics.
17
8
1830-1870
2015
Consumption
as a % of
GDP, 2015
0.5
2
0
2005
% Change
from 2005
to 2015
India
20
5
Household Consumption
in U.S.$ Trillions
32
23
Oil Shocks and
High Inflation
Emerging Markets
In Addition to the U.S., We Believe Investors Will Seek
Out Large EM Consumption Stories in the Coming Years
EXHIBIT 58
Exports Growth
1.10
INSIGHTS: GLOBAL MACRO TRENDS
“
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.
“
EXHIBIT 61
EXHIBIT 62
Services, Which Often Require Less Tradable Goods,
Are Becoming More Influential in Driving Rising
Consumption Growth
After a Brief “Pause,” the U.S. Dollar Appears to Be
Starting the Second Leg of Its Bull Market
U.S. Trade Weighted Major Dollar:
Trough to Peak: Indexed: Trough=100
Source of Consumption Growth, % of Growth
Population Growth
Per Capita Consumption Growth
Sep 1980 (54m)
Apr 1995 (82m)
Aug 2011 (64m to-date)
160
45%
47%
Mar-85
154.5
150
58%
75%
140
130
55%
1970-85
53%
1985-2000
42%
2000-15
25%
2015-30
Data as at October 27, 2016. Source: McKinsey, Elderly In the Developed
World: Investment Themes for Aging Societies.
Dec-16
139.4
Aug-98
127.8
Feb-02
139.7
Oct-99
120
USD "Pause"
110
100
0
10
20
30
40
50
60
70
80
Data as at December 31, 2016. Source: Bloomberg, Haver Analytics.
In terms of allocation opportunities in a slowing global trade environment, we would focus on economies where domestic consumption as
a percentage of GDP is large and growing. Not surprisingly, we favor
our overweight position to the United States, particularly domesticfocused names that can benefit from lower taxes and higher consumer confidence. Outside of the U.S., we think Indonesia and India
will likely be two beneficiaries. Consumption as a percentage of GDP
is high in both economies, the demographics are favorable, and we
continue to see ongoing improvements in GDP per capita. One can
see this in Exhibit 60.
By comparison, we remain wary of increasing exposures to global
transportation plays, certain trade finance receivables, and traditional
beneficiaries of China’s fixed investment build-out. Our bigger picture
thought is rising tensions surrounding trade balances could expand
well beyond U.S.-Mexico and U.S.-China to include intermediate
goods producers such as Vietnam and Korea. If we are right, we
must all be vigilant not to invest blindly in companies and/or industries that could garner political attention on key issues such as labor
laws, outsourcing, and/or environmental damages.
EXHIBIT 63
History Suggests That Foreign Earnings Repatriation
Tends to Be USD Bullish
Foreign Earnings Repatriation and USD Impact
U.S. Dollar Index (DXY), % Chg. Y/y (Right)
Foreign Earnings Retained Abroad, Y/y Change $Bn
(Left, Inverted)
-200
12.8%
-150
-100
-50
0
50
100
-7.0%
150
#4: The U.S. dollar remains in a bull market. Higher rates, more
stimulus, and more lending all suggest that the dollar is set to rise
again in 2017. As we mentioned earlier, embedded in our outlook is
our view that the Federal Reserve boosts rates by two times in 2017
and three more in 2018. We also like the USD as a hedge against
border tax deductibility gaining any momentum in Washington, D.C.
Were the U.S. to impose an import tax penalty and an export tax benefit of equal amounts, then our research shows that the dollar would
normalize the market by moving higher to offset any tax initiative.
Finally, our research also suggests that repatriation of foreign profit
acts as a notable stimulus. Indeed, in 2005, the U.S. dollar actually
appreciated a full 13% after President Bush approved a one-time
repatriation.
200
-14.7%
2003
2004
2005
-8.2%
-8.3%
2006
2007
Data as December 31, 2016. Source: Federal Reserve Board, Haver
Analytics, KKR Global Macro & Asset Allocation analysis.
Our bigger picture view on the global currency markets is that we
see increasing currency volatility, which – as of now – is being
largely ignored by the equity and credit markets. Indeed, as we show
in Exhibits 64 and 65, the UK and Japan are well below the 10-year
average in terms of the ratio of equity volatility to FX volatility. From
what we can tell, all the volatility linked to QE appears – to date – to
be manifesting itself in the global currency markets, not the global
equity markets. We see two important conclusions on which to
focus. First, we think that current Sharpe ratios for most institutional
KKR
INSIGHTS: GLOBAL MACRO TRENDS
29
investors are unsustainably low. Second, we think that the current
situation is untenable. Specifically, we expect some of the current
volatility in the currency markets to first bleed into the interest rate
market in 2017 and then ultimately find its way into the equity markets, particularly as QE subsides further in the U.S.
EXHIBIT 64
All the Volatility from QE Appears to Be in the Currency
Markets, Not the Global Equity Markets…
Great Britain Currency vs. Equity Volatility
ments for 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 PE 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.
EXHIBIT 66
Private Equity Typically Outperforms in Lower Return
Environments
FTSE Volatility / GBP Volatility Ratio
U.S. Private Equity Average Relative Returns in
Various Market Environments, %
10Yr Average
4.5
4.0
10.2
3.5
11.6
7.1
3.0
2.5
2.0
1.5
1.0
0.5
Jan-16
Jan-15
Jan-14
Jan-13
Jan-12
Jan-11
Jan-10
Jan-09
Jan-08
Jan-07
Data as at December 31, 2016. Source: Bloomberg.
EXHIBIT 65
Japan Currency vs. Equity Volatility
Nikkei Volatility / JPY Volatility Ratio
10Yr Average
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
Jul-10
Jan-11
Jul-11
Jan-12
Jul-12
Jan-13
Jul-13
Jan-14
Jul-14
Jan-15
Jul-15
Jan-16
Jul-16
0.5
-
Data as at December 31, 2016. Source: Bloomberg.
#5: Private Equity over Public Equity at this point in the cycle. We
are now overweight Private Equity relative to Public Equity. As one
can see in Exhibit 66, what we found is that low return environments
for Public Equities have actually historically been decent environ-
30
KKR
-7.5
> 20%
10-20%
U.S. Private Equity returns as per Cambridge Associates. Data based
on annual returns from 1989-2015. Source: Cambridge Associates,
Bloomberg, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 67
…and We Expect This Trend to Reverse, Particularly as QE
Subsides Further in the U.S.
5.0
0-10%
S&P 500 Total Return
INSIGHTS: GLOBAL MACRO TRENDS
The Outperformance of Private Equity Relative to Public
Equity Generally Grows as Equity Markets Soften
Quarterly Amount Private Equity Outperforms
Public Equity in PPTs
Jan-06
-
< 0%
15 y = -0.6157x + 2.1148
R = 0.90644
10
Private Equity
Outperforms
Public Equity
5
0
Public Equity
Outperforms
-5
Negative
Returns
-10
-20 -15 -10
-5
Positive
Returns
0
5
10
15
20
Average Quarterly MSCI ACWI Gross USD Returns (%)
The Cambridge Associates Global Private Equity index is an end-to-end
calculation based on data compiled from 2,346 global (U.S. & ex U.S.)
private equity funds (buyout, growth equity, private equity energy and
mezzanine funds), including fully liquidated partnerships, formed between
1986 and 2016. All returns are net of fees, expenses, and carried interest.
Historic quarterly returns are updated in each year-end report to adjust
for changes in the index sample. Data as at 2Q2016. Source: Cambridge
Associates, Bloomberg, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 68
EXHIBIT 69
Valuations Appear Quite Attractive in Japan,
Particularly If We are Right on the Operational
Turnaround Opportunity
Spread Between Cap Rate and 10Yr Treasury Yield,
Basis Points
Japan EV-to-EBITDA
14
600
13
Jul-12, 529
550
12
500 425
+1>
11
10
+1>
Jul-16
465
450
400
Avg
350
9
Avg, 378
300
8
Aug-13
378
-1>
250
-1>
7
Nov-16
361
200
150
6
5
To Date, Cap Rates Have Only Adjusted Back to Average
Levels vs. the Risk-Free Rate…
100
01
03
05
07
09
11
13
15
Data as at December 31, 2016. Source: Factset Aggregates.
01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
Data as at November 30, 2016. Source: Bloomberg.
EXHIBIT 70
“
We are constructive on what we are
seeing in Japan because it is a direct play on our Complexity thesis.
“
Average 3 Annualized Returns of NCRIEF Index Grouped
by Cumulative 3 Year Change in Cap Rates
13.5%
11.5%
8.7%
6.5%
Sample
Median
8.6%
+75 to +150
flat to +75
-75 to flat
-3.0%
-150 to -75
#6: More fiscal stimulus supports our overweight Real Assets with
Yield and Growth. As we indicated at the outset of this 2017 Outlook
piece, we are overweight Real Assets, Real Estate and Energy/Infrastructure in particular. If we are right that we get a little more inflation
in 2017, then the value of these areas should increase in importance to
the investment community. Implicit in what we are saying, however, that
long-term interest rates, as measured by the 10-year Treasury, do not
sell off materially (Exhibits 69 and 70). Also, consistent with the rhetoric
that we have heard from both U.S. and British leaders, we expect more
opportunity for private infrastructure projects in the next three- to
seven-years. The reality is that governments can’t afford to pay for
much of the infrastructure that is now so desperately needed.
…However, Were Cap Rates to Compress Much
Further, Then It Could Ultimately Be an Issue for Real
Estate Returns
> - 150
At the moment, we are most constructive on what we are seeing in
Japan, because it is a direct play on our Complexity thesis. While
Abenomics is not necessarily boosting GDP, it is having a material impact on parts of the corporate sector. In particular, there is
now a tremendous opportunity for Private Equity firms to acquire
and grow non-core subsidiaries from some of the largest and most
complex Japanese conglomerates. In Europe, dislocation and political
change are forcing corporate executives to rethink their footprints,
a trend we view constructively. Meanwhile, in the U.S. we are more
measured in our outlook, focusing more on operational improvement
stories versus traditional growth opportunities.
3-Year Change in Green Street Cap Rate Index
Data as at December 31, 2015. Source: Green Street, Bloomberg.
Within the energy complex, we think that midstream assets could
perform well in 2017. We also think that Real Estate Credit will continue to emerge as an interesting alternative to some of the capital
that has flowed into both the non-performing loan market and the
private market in recent years. The opportunity to provide financing
to “last mile” infrastructure projects could also provide potential to
earn above average rates of return.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
31
EXHIBIT 71
Section III: Challenging Our Conventional Wisdom
MLPs Look Attractive Compared to Many Other YieldOriented Sectors…
Indexed Price Performance (Dec'13 = 100)
Food, Bev, Tobacco
Telecom
27%
30%
26%
10%
-36%
Dec-13
Feb-14
Apr-14
Jun-14
Aug-14
Oct-14
Dec-14
Feb-15
Apr-15
Jun-15
Aug-15
Oct-15
Dec-15
Feb-16
Apr-16
Jun-16
Aug-16
Oct-16
Dec-16
50%
40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
Real Estate
Utilities
Alerian MLP Index
Data as at December 14, 2016. Source: Bloomberg.
EXHIBIT 72
…With the Yield Being Higher Than Other High-Yielding
Plays
Indicated Dividend Yield, December '16, %
Alerian MLP Index vs. High-Yielding S&P 1500 Sectors
7.4
4.5
4.1
In the following section we detail where recent macro events are
inspiring us to potentially rethink our approach to certain key macro
trends and/or portfolio positioning.
#1: While fiscal stimulus will help to boost U.S. growth, many
of our indicators are still flashing later cycle. Calling turns in any
economic cycle is hard, but – with President-elect Trump’s stimulus
slated to benefit U.S. GDP in 2018 – we believe that it is prudent to
change the outlook for the duration and trajectory of the economic
cycle in the U.S. (Exhibit 16). So, we have done that by extending the
cycle until 2019 from 2018. As we also mentioned above, we think
that President-elect Trump’s stimulus could add 60 basis points or
so to economic growth in 2018, with a stronger impact from spending than tax cuts in the near term.
Consistent with these increases, we think that the new administration
could further boost both corporate and consumer confidence in the
near term, while we think that the potentially negative impact from a
more protectionist bent could take longer to play out. Whatever happens in the near term, there are several reasons not to believe that
President-elect Trump can extend the cycle indefinitely. First, we see
little evidence that tax cuts actually prolong the cycle. In fact, my colleague David McNellis recently completed a study that showed fiscal
stimulus is rarely a cycle extender. One can see this in Exhibit 73.
Second, several of our U.S. indicators, including household balance
sheets as a percentage of GDP, the gap between services and manufacturing jobs, and absolute level of corporate margins, all would
suggest that there are important, cyclical mean-reverting forces
worth considering. As we show in Exhibits 74 and 75, many of these
relationships are now at levels consistent with a historical peak in
markets and/or economic activity.
3.5
2.8
Alerian MLP Telecom
Index
Real Estate
Utilities
Food, Bev,
Tobacco
Data as at December 7, 2016. Source: Bloomberg.
For public investors, we would just note that we believe MLPs still
look attractive to us, particularly if our previously mentioned forecasts for oil and interest rates are accurate. As we mentioned earlier,
we do not see interest rates surprising too much to the upside in
2017, which should make the large yield in the MLP sector appear
appealing to many investors. Probably more important, though, is that
MLPs look quite attractive, in our opinion, relative to the “Simple”
assets such as slow-growing utilities, which one can see in Exhibits
71 and 72.
32
KKR
INSIGHTS: GLOBAL MACRO TRENDS
“
We are undergoing a political
and economic paradigm shift
that started with Brexit but
is likely to continue for the
foreseeable future. Often these
types of regime changes do not
always transition smoothly.
“
EXHIBIT 73
History Shows That Fiscal Stimulus Is Rarely a Significant Cycle-Extender
Tax Cut
Signature Measure
Qtr.
Signed
Start of Next
20%+ Bear
Market
Start of Next
Recession
# of Qtrs. Until
Next Bear Mkt.
# of Qtrs. Until
Next Recession
Revenue Act of 1964
(“Kennedy Tax Cut”)
Individual income tax rates were cut across the
board by approximately 20%. (e.g., top marginal
rate to 70% from 91%.)
1Q64
1Q66
1Q70
8
24
Economic Recovery
Tax Act of 1981
(“First Reagan Tax Cut”)
Across-the-board cut in individual tax rates over
three years. (Top marginal rate fell to 50% from
70% and bottom rate fell to 11% from 14%.)
3Q81
3Q81
4Q81
0
1
Tax Reform Act of 1986
(“Second Reagan Tax
Cut”)
The top tax rate for individuals was lowered from
50% to 28% while the bottom rate was raised
from 11% to 15%.
4Q86
3Q87
4Q90
3
16
Economic Growth and Tax
Relief Reconciliation
Act of 2001
(“Bush Tax Cut”)
Across-the-board cut in individual tax rates over
five years, which was eventually accelerated to
two years. (Top marginal rate fell to 35% from
39.6% and bottom rate fell to 10% from 15%.)
2Q01
2Q01
2Q01
0
0
Data as at December 31, 2016. Source: Bloomberg, Haver Analytics, KKR Global Macro & Asset Allocation analysis.
Third, expansions just do not last forever. As Exhibit 76 shows, we
are already 90 months into the current one, and our new base case
is that we do not have a recession until 2019, which implies a recovery of 114 months. To put this in context, only the 1991-2001 recovery
will be longer than what we are predicting in our base.
EXHIBIT 75
We Think That the Gap Between Services and Goods
Jobs Has Gotten Too Wide
US: LTM Services and Goods Payrolls
EXHIBIT 74
Goods
U.S. Household Net Worth Is Again at Record Levels; We
View This as Somewhat of a Contra-Indicator for Returns
480%
460%
440%
1Q00
441%
1Q07
472%
4000
3000
Mar-06
2211
2000
U.S. Household Balance Sheet as a % of GDP:
Total Net Worth
500%
Services
Feb-95
3000
1997
1000
3Q16
483%
420%
0
-1000
-2000
380%
Dec-16
23
May-07
-274
-3000
-4000
400%
Oct-99
99
Aug-85
-89
80 83 86 89 92 95 98 01 04 07 10
13
16
Data as at December 31, 2016. Source: Bureau of Labor Statistics, Haver
Analytics.
360%
340%
300%
1Q70
2Q72
3Q74
4Q76
1Q79
2Q81
3Q83
4Q85
1Q88
2Q90
3Q92
4Q94
1Q97
2Q99
3Q01
4Q03
1Q06
2Q08
3Q10
4Q12
1Q15
320%
Data as at September 30, 2016. Source: Federal Reserve, Haver
Analytics.
Finally, there are still a lot of unknowns that could dent global
growth. For example, border tax deductibility, which focuses on
where items are bought, not produced, could actually impair growth
in the near term, slow investment, and/or spike the U.S. dollar. Separately, removal of interest deductibility for businesses is being floated
as an offset to lower corporate tax rates. In our humble opinion,
market participants have not really spent much time digesting these
potentially significant changes, and as such, the risk of a downside
economic surprise over the next 24 months should not be dismissed.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
33
EXHIBIT 76
EXHIBIT 77
We Are a Solid 90 Months Into the Current Economic
Expansion …
…And Wages Are on the Upswing, Which Usually Does
Not Bode Well for Margins
Duration of U.S. Economic Expansions (Months)
73
92
12
39
45
37
56%
10%
80
55%
9%
54%
8%
Performance on a monthly basis, peak to trough. Data as at December 31,
2016. Source: Bloomberg.
2014
2011
52%
2008
6%
2005
Median = 37
53%
2002
33
7%
1999
44
1996
21
50
11%
1993
12
19
57%
1990
21
27
22
12%
106
1987
24
13%
U.S. Corporate Profits, % of GDP (Left Axis)
U.S. Employee Compensation, % of GDP (Right Axis)
58%
120
58
36
10
90
1984
June 2009 Current (Dec 2016)
November 2001 - December 2007
March 1991 - March 2001
November 1982 - July 1990
July 1980 - July 1981
March 1975 - January 1980
November 1970 - November 1973
February 1961 - December 1969
April 1958 - April 1960
May 1954 - August 1957
October 1949 - July 1953
October 1945 - November 1948
June 1938 - February 1945
March 1933 - May 1937
November 1927 - August 1929
July 1924 - October 1926
July 1921 - May 1923
March 1919 - January 1920
December 1914 - August 1918
January 1912 - January 1913
June 1908 - January 1910
August 1904 - May 1907
December 1900 - September 1902
U.S. Corporate Profits and Employee Compensation as
a % of GDP, 1984-2015
Data as at February 26, 2016. Source: U.S. Bureau of Economic
Analysis, Haver Analytics, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 78
To Date, U.S. Markets Have Endured a Highly Unusual Rate Cycle, Enjoying Significant Multiple Expansion
First Hike
Last Hike
# of Months
LTM P/E
Start
LTM P/E
End
LTM P/E %
Chg
LTM P/E %
Annz’d
SPX % Chg
SPX %
Annz’d
1
Nov-54
Oct-57
35
12.6
11.9
-5.0%
-1.7%
19.9%
6.4%
2
Jul-58
Nov-59
16
16.2
17.1
5.7%
4.3%
23.5%
17.2%
3
Jul-61
Nov-66
64
22.0
14.5
-33.9%
-7.5%
20.5%
3.6%
4
Oct-67
Aug-69
22
17.7
16.3
-8.0%
-4.5%
1.7%
0.9%
5
Feb-71
Aug-71
6
18.5
18.1
-2.1%
-4.2%
2.4%
4.8%
6
Feb-72
Aug-73
18
18.2
13.8
-24.2%
-16.8%
-2.2%
-1.5%
7
Feb-74
May-74
3
11.6
10.1
-12.9%
-42.3%
-9.3%
-32.3%
8
Nov-76
Mar-80
40
10.4
6.7
-36.2%
-12.6%
0.0%
0.0%
9
Jul-80
May-81
10
8.2
9.0
9.4%
11.4%
9.0%
10.9%
10
Apr-83
Aug-84
16
13.0
10.0
-23.4%
-18.1%
1.4%
1.0%
11
Nov-86
May-89
30
15.3
12.6
-17.6%
-7.5%
30.3%
11.2%
12
Jan-94
Feb-95
13
17.7
14.9
-15.9%
-14.8%
1.2%
1.1%
13
May-99
May-00
12
28.1
25.8
-8.3%
-8.3%
9.1%
9.1%
14
May-04
Jun-06
25
18.4
15.5
-15.7%
-7.9%
13.3%
6.2%
Average
22
16.3
14.0
-13.4%
-9.3%
8.6%
2.8%
Median
17
16.9
14.2
-14.3%
-7.7%
5.7%
4.2%
Tapering
Jan-14
Dec-16
35
16.1
19.1
18.9%
6.1%
26.7%
8.4%
First Hike
Dec-15
Dec-16
12
17.4
19.1
9.8%
9.8%
10.5%
10.5%
Data as at December 31, 2016. Source: Robert Shiller data, Bloomberg, S&P, Thomson Financial, Federal Reserve, Haver Analytics.
34
KKR
INSIGHTS: GLOBAL MACRO TRENDS
Our bottom line: Now is not the time to aggressively risk up one’s
portfolio. Rather, we continue to advocate solid exposure across risk
assets, with a particular focus on idiosyncratic opportunities that
benefit from either dislocations and/or existing regulatory arbitrages.
We also like margin improvement opportunities and/or industry
consolidation plays. We believe Value should outperform Growth in
Public Equities, while we think that Levered Loans should perform
notably better than High Grade Credit and some of the overbought
commodity-linked parts of High Yield.
#2: We think that Emerging Markets will now have a bumpier bottoming process. Higher real rates, smaller deficits, less institutional
sponsorship, and more stable currencies all lead us to believe that
Emerging Markets as an asset class are bottoming after 75 months
of underperformance. This viewpoint is consistent with what we laid
out in our October 2016 Insights Asia: Pivot Required.
However, what’s new since the publication of the note is that we
now expect an even stronger dollar — compliments of repatriation,
more fiscal stimulus, and a potentially more hawkish Fed. We also
expect heightened investor concerns surrounding global trade under
a Trump presidency. Without question, both a stronger dollar and a
more protectionist bent would hurt low-end manufacturers, many of
whom are domiciled within emerging markets.
No doubt, these are important influences to consider, but our EM
dashboard, which we show in Exhibit 79, continues to suggest that
many of these concerns are now largely “in the price.” Indeed, of
the five indicators that we track as part of our dashboard, all five are
now either neutral or positive.
Moreover, there are two important changes in the macro landscape
that suggest – even if a bottom takes longer to form – a 2013 taper
tantrum-like event is highly unlikely. First, the overall health of EM
countries is in much better shape today, particularly relative to the
famed “taper tantrum.” One can see in Exhibits 80 and 81, respectively, that real rates are higher and deficits are now much lower today
than in 2013.
Second, given that Trump may focus more on a domestic agenda,
China is likely to use the U.S.’ decision to abandon the Transatlantic Trade Partnership (TPP) to increase its presence in the region,
including greater trade connectivity through the China led Regional
Comprehensive Economic Partnership (RCEP). This “pivot” by China
could actually increase near-term activity in many parts of EM, particularly across Asia.
EXHIBIT 79
Emerging Markets Are Getting Progressively More Interesting, but Selectivity Is Still Required
“Rule of the Road”
May’15
Jan’16
Current Signal
Comment
1
Buy When ROE Is
Stable or Rising
↔
↔
↔
Slowing nominal GDP growth has been a headwind to operating leverage and
asset turns; however, this could be turning in 2017
2
Valuation: It’s Not Different This Time
↔


Relative valuation has finally moved into the “strike zone” where EM has historically troughed relative to DM
3
EM FX Follows EM
Equities


↔
Many EM currencies are down 20-40%+ versus the dollar, but we think FX likely
remains a headwind for USD or other hard currency denominated investors
4
Commodities Correlation in EM is High
↔
↔
↔
The GSCI index has stabilized at low levels, but we do not anticipate material
upside until oil inventories start a convincing decline. OPEC action may help, but
will not decisively rebalance the market near-term
5
Momentum Matters in
EM Equities



EM relative momentum vs. DM turned positive on a year-over-year basis in September for the first time since early 2011. Historically, changes in EM momentum
have been sustained over multi-year cycles
Overall
Early-stage recovery is starting to unfold
EM valuation and momentum have turned supportive. The recovery could
prove bumpy at times until fundamentals such as the ROE, FX, and commodity
backdrop offer more definitive support, but on net, the outlook has improved
For full details of our framework, please see Emerging Market Equities: The Case for Selectivity Remains, dated May 14, 2015. Latest data as at December 31,
2016. Source: KKR Global Macro & Asset Allocation analysis.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
35
EXHIBIT 80
EXHIBIT 82
Unlike in 2013, Real Yields Are Now Higher in EM…
Change in Real Yields Current vs. April 2013 (Taper
Tantrum), ppt
Apr-13 (Taper Tantrum)
Dec-16 (Current)
Change Dec-16 vs Apr-13 (ppt)
Relative Total Return, MSCI EM/DM
(Feb'89 = 0%)
350%
Higher Real
Rates in EM
4
300%
3
250%
2
200%
1
150%
0
100%
50%
Lower Real
Rates in DM
-1
Japan
Korea
China
Euro Area
U.S.
New Zealand
Malaysia
Thailand
Australia
Brazil
Philippines
Singapore
India
Mexico
Indonesia
0%
-2
Data as at December 31, 2016. Source: Bloomberg.
EXHIBIT 81
…While Current Account Positions Are Stronger
Change in Current Account as a % of GDP 3Q16 vs
2Q13, ppt
2Q13 (Taper Tantrum)
3Q16 (Current)
Change 3Q16 vs 2Q13 (ppt)
14
Most EM's have a
stronger current
account position
10
8
6
4
2
0
-2
Thailand
India
Singapore
Japan
Indonesia
Brazil
China
New Zealand
Australia
Malaysia
Korea
Mexico
Philippines
-4
-6
Data as at September 30, 2016. Source: IMFWEO, Haver Analytics.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
81
months
Sep-94
288%
108
months
Sep-10
305%
75
months
84
months
Dec-16
121%
Sep-01
17%
87 89 91 93 95 97 99 01 03 05 07 09 11 13 15
Latest data as at December 31, 2016. Source: MSCI, Bloomberg, KKR
Global Macro & Asset Allocation analysis.
Our bottom line: We still think that EM is in the process of bottoming,
but it will likely be bumpier than in the past. As a result, an investor likely now needs to be more tactical than previously because
a sustained V-shape recovery in EM is highly unlikely. Key to our
thinking is that not only is the multiplier on China’s fixed investment
now shrinking but also the overall part of the economy that is directly
linked to fixed investment is also contracting. Also, global trade is
still slowing, and any further discord between the United States and
China will certainly not help revive this area of the global economy.
Given this backdrop, near term we remain focused on three areas
within EM. First, we remain constructive on large domestic-oriented
EM stories that are less reliant on global trade. Over the longer-term,
we favor India and Indonesia. Second, through both Public and Private Equities, we see significant opportunity to align with companies
that are using acquisitions and/or joint ventures to grow their businesses outside of their core markets. Key industries on which we are
focused include travel, healthcare, and technology. Third, our conversations with banking and private sector executives in China and India
both confirm our view that more and more global conglomerates will
likely be divesting non-core businesses, which we view as an emerging opportunity for global PE players, particularly across Asia.
12
36
EM Equities Have Moved in Long and Relatively Stable
Cycles Relative to DM
#3: We now think that the intensifying regulatory changes in financial services, particularly in the U.S., could abate under a Trump
administration. Will this be a negative for Private Credit? Since we
joined KKR in 2011, our travels across Europe, the U.S., and parts
of Asia led us to consistently witness a trend towards traditional
financial services companies becoming more “utility-like” in approach. While we think that there were several influences, the move
towards low-to-negative rates by central banks as well as the desire
by governments for significantly heightened regulation were probably
the most important.
U.S. Broker Dealer Inventory
$300bn
Oct-2007
285
$250bn
$200bn
A decline of
87%
$150bn
$100bn
$50bn
2016
2015
2013
2014
2011
2012
2010
2009
2007
2008
2006
2005
2003
$0bn
Nov-2016
38.3
2004
Here is what we don’t think will change, however. First, we do not
believe that aggressive leverage is coming back into the system. At
the peak, universal banks and investment banks were levered 30:1;
our base view is that leverage remains modest in the 10-12x range.
Second, we think that regulators will still encourage complexity to
trade off market towards private credit solutions with more diversification benefits. Third, we think that the trend towards sponsors just
wanting certainty of capital will favor customized solutions where
private credit players can speak for the entire deal. Finally, we expect
little change in the asset-based lending market, as the lion’s share of
that current deal origination is now occurring in Europe.
After an 87% Decline, We Now Expect Some Modest
Improvement in Liquidity
2001
So, where do we go from here? Our base case is that there will be
some important alterations to the competitive landscape. Specifically,
we now look for an SEC that fines individuals more regularly than
companies. This statement is not to be taken lightly, as banks paid
out nearly 15% of their equity just in reporting fines since the Great
Financial Crisis (Exhibit 83). Second, we think that the Fed-appointed
banking supervisor is likely to be more markets friendly. Coupled
with an SEC that we think will be more concerned about liquidity, we
believe that there will be looser interpretations of the Volker rule on a
go-forward basis. Third, we expect the limit for Systemically Important Financial Institution (SIFI) to get lifted from $50 billion in assets
towards $250 billion in assets.
EXHIBIT 84
2002
Apparently, we were not alone, as President-elect Donald Trump
now thinks that reregulation has dramatically altered the flow of
credit, and he wants change. Maybe more important, though, is that
many of his supporters, including some that who are following him to
Washington, want to repeal Dodd-Frank.
Data as at November 30, 2016. Source: Federal Reserve Bank of New
York.
EXHIBIT 85
The Illiquidity Premium Has Remained Fairly Constant
Across a Variety of Environments…
Weighted Average Yield of Originated Senior Term Debt
12-Month Average Yield of Traded Loans
EXHIBIT 83
Seven Years of Fines Have Taken a Heavy Toll on the Top
10 Global Banks, Wiping Out the Equivalent of 14% of
Equity Capital; We Think This Could Soon Change
12.0% 11.4%
10.8%
11.3%
11.2%
10.7%
9.7% 9.6%
8.3%
7.8% 8.2%
10 Banks Total Equity Capital
Loss Due to
Fines and
Penalties
14%
5.8% 5.8% 6.0%
5.1%
8.5% 8.7% 8.5%
4.9%
5.5%
2007 2008 2009 2010 2011 2012 2013 2014 2015
8.8%
5.9% 6.1% 6.2%
Q1
Q2
Q3
2016 2016 2016
Data as at September 30, 2016. Source: Bloomberg, Ares company
filings, KKR Credit analysis.
Ten Banks include Barclays, Bank of America, Citigroup, Credit Suisse,
Deutsche Bank, Goldman Sachs, HSBC, JPMorgan Chase, Morgan
Stanley and UBS. Data as at March 27, 2016. Source: FT, Corlytics.
“
Despite the threat of future
regulatory changes, the illiquidity
premium still feels appealing.
“
KKR
INSIGHTS: GLOBAL MACRO TRENDS
37
EXHIBIT 86
EXHIBIT 87
…and a Variety of Private Credit Markets
Weighted Average Yield of Originated Senior Subordinated Term Debt
12-Month Average Yield of U.S. Traded High Yield
13.2%
14.9%
13.7% 13.6%
13.3% 13.5%
8.5%
G4 Total Net Issuance in U.S.$B Equivalents
14.5%
11.9%
8.6%
8.1%
11.6%
7.5%
11.7%
11.2%
6.5%
12.1%
7.3%
7.9% 8.2% 8.0%
6.2%
Q1 Q2 Q3
2016 2016 2016
Data as at September 30, 2016. Source: Bloomberg, Ares company
filings, KKR Credit analysis.
In terms of allocation opportunities, we remain quite constructive
on the larger deals in Private Credit. Ironically, having more capital
in this part of the market allows a select number of firms to dictate
pricing, particularly during periods of market dislocations. On the
other hand, we are increasingly concerned that the small end of the
private credit market is becoming saturated by too many players
chasing too few deals with too little differentiation.
Separately, we are increasingly constructive on Asset-Based Private
Lending, particularly in Europe (which is likely to be much less
impacted by any bank regulatory changes under consideration). Also,
it is probably worth noting that, in a world where the German bund
yields less than one percent, we think that the opportunity to earn
low double digit returns with some collateral against the loan remains
quite attractive, in our view.
#4: We do not see interest rates surging too high in the near-term,
but the existing technical bid could be waning by 2018. Given the
trend towards increased fiscal spending and domestic priorities over
monetary tools and global linkages, we have boosted our 2017 10year interest rate outlook. Implicit in our increase is both an uptick
in real rates and inflation. However, we do not envision a 1994type market where bond yields become unglued amidst faster than
expected Fed rate increases. For starters, we do not see significant
wage inflation nor do we believe that the Fed needs to play “catch
up” on inflation expectations. In addition, as we outline in Exhibit 87
we think that the technical bid for sovereign debt remains particularly
strong through 2017. Indeed, whereas the G4 was increasing net
available bonds by over $1.1 trillion in 2011, current estimates – according to the investment bank Morgan Stanley – are for net issuance
to be negative $426 billion in 2017. That’s good news for the longend of the curve.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
Net
Issuance
12.3%
11.9%
2007 2008 2009 2010 2011 2012 2013 2014 2015
38
Net G4 Sovereign Issuance Less Central Bank Purchases
Shows that Net Issuance Is Now Actually Negative.
However, It Does Appear to Be Changing in 2018
Y/y %
Chg.
Central
Bank
Purchases
Net
Issuance
Less QE
Y/y %
Chg.
1300
Y/y %
Chg.
2011
2446
1146
2012
2064
-16%
1508
16%
557
-51%
2013
1890
-8%
1063
-29%
826
48%
2014
1482
-22%
809
-24%
674
-18%
2015
1044
-30%
1091
35%
-48
-107%
2016e
963
-8%
1488
36%
-524
1002%
2017e
996
3%
1422
-4%
-426
-19%
2018e
1317
32%
713
-50%
604
-242%
Total
$12,201
$9,753
$2,810
Data as at December 5, 2016. QE = Quantitative easing. Source: National
Treasuries, Morgan Stanley Research.
EXHIBIT 88
We Expect the Spread Between German Bunds Relative to
U.S. Treasuries to Narrow Again in 2017
Spread Between U.S. 10-Year Treasury and Euro Area
10-Year Benchmark Yields (bps)
300
Dec-16
224
+2σ
200
+1σ
100
0
-100
1970-2016
Average
-1σ
-200
-2σ
-300
-400
70
75
80
85
90
95
00
05
10
15
Data as at December 31, 2016. Source: European Central Bank, Federal
Reserve Board, Bloomberg, Haver Analytics.
The potentially bad news – and an area of the market we are watching closely – is that net issuance is expected to increase to positive
$604 billion in 2018 after net shrinkage in supply in both 2015 and
2016. This shift could be a big deal because many investors have
become accustomed to a robust technical bid, which has kept yields
lower than expected in recent years.
So, as we look ahead, our base view is that long rates remain controlled in 2017. Hence, our decision to cover 300 basis points of our
significant underweight to Government Bonds in our target asset
allocation. However, if President-elect Trump’s fiscal plan is greater
than expected and/or global central bank QE, particularly in Europe,
is not enough to help offset the increase in issuance that we forecast
for 2018, we may need to bump up our target yields for interest rates
in 2H17 and beyond.
#5: Buying Liquid Credit relative to Equities is no longer as obvious. When we rolled out our 2016 outlook piece, we argued strongly
that Credit was much more attractively priced than Public Equities.
As we show in Exhibit 89, the implied default rate for High Yield was
7.8% in January 2016, essentially approaching levels in line with
prior recessions. Today, by comparison, our model shows an implied
default rate of 0.9%, which feels fairly skinny to us.
EXHIBIT 89
Last Year, the Implied Default Rate Was 7.8% (5.3% exEnergy and 13.6% for Energy). Today, We Are at 0.9%
Implied High Yield Default Rate, %
15
13
Sep-02
11.1
11
Jan-16
7.8%
9
7
5
3
1
Dec-16
0.9%
-1
-3
90
93
96
99
02
05
08
11
14
Data as at December 31, 2016. Source: Bloomberg, Morgan Stanley.
“
We maintain our long-held
approach of seeking to aggressively
monetize the periodic dislocations
that inevitably occur in a world of
increasing geopolitical uncertainty
and macro instability.
“
EXHIBIT 90
High Yield Spreads Tightened Significantly During 2016
and Are Now Well Below Average
U.S. High Yield Spread, Basis Points
1200
1000
Jan-16
847
800
Avg. 601
600
400
200
0
Dec-16
409
May-07
259
90
93
96
99
02
05
08
11
14
Data as at December 31, 2016. Source: Bloomberg, Morgan Stanley.
The other point to consider is that spreads relative to the risk free
rate were one standard deviation above normal last year when we
suggested Credit appeared mispriced. As Exhibit 90 shows, that
spread has now dropped back down well below its historical average
and is now actually not that far from the levels reached in May 2007.
As we look ahead, we think that High Yield could provide a total
return of 5.5% to 6.0% in 2017, which assumes some modest sell-off
within the high quality segment of the market. Implicit in our forecast
is that the default rate for High Yield does not move well beyond
2.5%, which is consistent with our longer-cycle thesis. Similar to last
year, we do expect ongoing periods of volatility in 2017, but we think
that the overall magnitude of dispersion trades will be much less
robust than in 2016. Overall, though, this asset class – higher quality
names in particular – now feels pretty rich to us, particularly when
one considers that almost a third of the entire index trades 150 basis
points tight of the 6.7% yield to worst for the BAML High Yield Index.
As such, if we are wrong and defaults do tick up faster than expected, then this asset class could be particularly vulnerable.
In terms of Levered Loans, we see better risk adjusted opportunities.
We look for a total return of around 5.5% in 2017, though we believe
that loans are better positioned for higher rates, sit higher up in the
capital structure, and appear to have more credit picking opportunities at the moment. As such, we expect less volatility than in the High
Yield market. Meanwhile, with Investment Grade yields sporting a
spread of just 175 basis points, we look for just a 2.5-3% total return
next year, with risk to the downside (see our Risks/Hedging section
for further details).
KKR
INSIGHTS: GLOBAL MACRO TRENDS
39
EXHIBIT 91
High Yield and Levered Loans Look Too Tight Relative to
Other Risky Credits
Comparable Spread Products, Basis Points
CLO A
CLO BBB
CMBX 8 BBB-
CMBX 8 BB
High Yield
Leveraged Loan
240
400
504
260
315
425
500
573
877
635
1,013
1,057
476 479
658
460 460
531
favored sectors. We also think parts of Healthcare look quite compelling for long-term investors.
Meanwhile, in Credit we expect Levered Loans to outperform High
Grade Credit and other longer duration fixed income instruments.
Maybe more important, though, given our view that volatility is likely
to remain high in 2017, is that we expect Opportunistic Credit to
again deliver outsized results. From our vantage point, we think that
there is still enough dispersion for thoughtful credit managers to
provide returns well in excess of their benchmark in 2017 by digging
through the “rubble” in High Yield and Levered Loans. One can see
the magnitude of the existing dispersion in Exhibit 93. Parts of the
CMBX market also look interesting to us (Exhibit 91).
EXHIBIT 93
There Still Seems to Be Value in the Spicier Part of the
Credit Market…
Discount/Premium as % Above/Below Long-term Median,
U.S. Bonds and Loans
Bonds
Loans
Cheap relative to
long-term median
Data as at December 12, 2016. Source: Morgan Stanley Research.
78.5%
EXHIBIT 92
41.8%
Levered Loans Now Look Rich Relative to the Risk-Free
Rate
Relative Total Return U.S. Leveraged Loan vs.
U.S. Treasury
U.S. Leveraged Loan / U.S. Treasury
Trend
+1stdev
+2stdev
Expensive relative to
long-term median
-9.3%
BB-BBB
3.7%
-11.3%
B-BB
CCC-B
B-BB
CCC-B
High yield median over past 20 years. Leveraged loan median over
past 15 years. Data as at November 29, 2016. Source: JPM 2017 Credit
Outlook.
1.1
1.0
0.9
0.8
0.7
0.5
'97
'98
'99
00
'01
02
03
04
05
06
'07
08
09
'10
'11
'12
'13
'14
'15
'16
'17
0.6
Data as at December 2016. Note: US leveraged loan = SPBDAL Index;
U.S. Treasury = G0Q0 Index. Source: BofA Merrill Lynch Global
Research, Bloomberg.
Given these aforementioned return assumptions, our base case is
that Credit will not be the asset class it was in 2016, and as such, a
more balanced approach to Equities and Credit is now likely warranted. Within these two assets classes, however, we do expect some
notable differentiation. Specifically, within Equities, we expect Value
stocks to handily outperform, with Financials and Energy as our most
40
KKR
INSIGHTS: GLOBAL MACRO TRENDS
“
We are growing increasingly
concerned that – at some point
– credit deterioration in any
sector, auto-related markets in
particular, could turn out to be
worse than the consensus is
now expecting.
“
…But Overall, Loans Look More Attractive Than High
Yield
Spread: High Yield - Leveraged Loans, Basis Points
400
350
Mar-09, 330
300
250
200
Oct-11, 178
+1σ, 158
150
Avg, 82
100
50
0
-50
Dec-09, 13
-1σ, 6
-100
2009 2010
2011
Dec-12,
2
2012
2013
2014
2015
2016
2017
Data as at December 17, 2016. Source: JPMorgan High Yield Bond Index
YTW US (CSYWUS), JPMorgan Leveraged Loan Index Loans Yield to
Maturity (JLYMLLI), Bloomberg.
Section IV: Risks/Hedging
Similar to prior years, we have taken time to identify several potential
risks that we are watching as well as to provide potential hedging to
protect against these risks if they do come to fruition. They are as
follows:
Short an equally-weighted basket of Korean won, Turkish lira, and
the one-year forward on the Chinese yuan (all relative to the USD):
As we have highlighted multiple times in this year’s outlook piece,
owning more dollars seems like potentially the most efficient way
to solve for many of the tail risks that could adversely affect today’s
jubilant market conditions. Without question, our latest visit to Beijing
in December 2016 left us feeling even more strongly 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. At the moment, the one-year forward in the
offshore CNH market is priced for 3.5% to 4.0% depreciation versus
the U.S. dollar in 2017. However, we expect a move of two to three
times that level, given the current pace of capital flight and the recent
rates at which the country has burned through reserves trying to
maintain an orderly depreciation.
We also think that mounting pressure on the Chinese renminbi could
promote further weakening of EM currencies that are exposed to
global trade (e.g., Korean won) and/or global capital flows to EM
(e.g., Turkish lira). The Turkish lira is one of the few “high carry”
shorts that we think can still depreciate further than forwards (which
are pricing in more than a seven percent decline for 2017). All told,
the average depreciation versus the U.S. dollar has been 15% for the
last three years, and we now view the political and economic envi-
ronment as being in no better shape than previous years. Meanwhile
in Korea, exposure to a weakening won is positive carry, given interest rate differentials with the U.S. Given our view of an extremely
competitive Asian export environment, we see the Korean won heading lower in 2017.
Buy credit protection at current levels as a low-carry way to gain
exposure to a potential default cycle in the U.S., driven by excess
lending in U.S. Investment Grade Credit, particularly auto-related.
As we discussed earlier, we have abandoned our Credit over Equity
call, which was one of our key messages in 2016. Risk-free rates are
now on the rise, while the entry point in terms of spread per unit of
leverage is now considerably less attractive than it was last January.
As such, we are growing increasingly concerned that – at some point
– credit deterioration in many sectors, auto-related markets in particular, could turn out to be worse than the consensus is now expecting. According to the Federal Reserve Bank of New York, subprime
auto originations are running at just under $50 billion per quarter on
a trailing 12-month basis, which is approaching the record pace of
subprime auto-lending we saw during the 2005-2006 period. Importantly, this robust growth in subprime originations is happening at a
time when delinquencies in auto loans are increasing and used car
prices (which proxy for recovery values) are decreasing.
There are several ways to hedge this risk, but we like investment
grade CDX as a hedging vehicle at current levels. Investment grade
CDX is trading at just 68 basis points (Exhibit 95), approaching the
level of all time tights in Investment Grade Credit last seen during the
spring of 2014. We view buying protection at this level as a lowcarry way to get exposure to a potential credit cycle driven by the
excess lending in subprime auto over the last four years. In fact, U.S.
Investment Grade Credit has exposure to the U.S. auto OEMs, credit
card issuers and banks, all which should experience direct stress if
subprime auto causes a repricing of credit in 2017.
EXHIBIT 95
We Want to Gain Exposure to a Potential Credit Cycle,
Including the Excess Lending in Subprime Auto During
the Last Four Years
Investment Grade 5-Year CDX Index
160
5Yr Avg.
+/- 1 SD
140
120
100
80
60
Dec-16
68
40
20
Nov-11
Mar-12
Jul-12
Nov-12
Mar-13
Jul-13
Nov-13
Mar-14
Jul-14
Nov-14
Mar-15
Jul-15
Nov-15
Mar-16
Jul-16
Nov-16
EXHIBIT 94
Data as at December 31, 2016. Source: Bloomberg.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
41
Potential play on a basket of U.S. branded consumer staples equities. We believe an elegant way to take advantage of our “sell simplicity” theme is to capitalize on the downside potential of a basket of
four large cap branded consumer stocks which has seen substantial
inflows from a combination of yield seeking and “min vol” ETF investors. All told, these four names trade with an average P/E valuation
of 22.8x and average EV to EBITDA of 14.2x – both measures being
more than one standard deviation rich to long-term levels. Moreover,
the average dividend yield across the four names is 2.6%, which is
well below our 2017 - 2019 forecast for the U.S. 10-year Treasury. If
we are right and these stocks do correct more meaningfully in 2017,
we believe that the downside could be significant. One can see in Exhibit 96 how far these stocks are currently trading above trend, even
after the most recent mini-correction.
EXHIBIT 96
Branded Consumer Products Are an Elegant Way to Take
Advantage of Our Sell Simplicity Theme
Branded Equal-weight Consumer Basket P/E Ratio
P/E
LT avg.
+/- 1 SD
26
20
18
16
14
Dec-16
May-16
Oct-15
Mar-15
Jan-14
Aug-14
Jun-13
Apr-12
Nov-12
Feb-11
Sep-11
Jul-10
Dec-09
Oct-08
May-09
12
Data as at December 28, 2016. Source: Bloomberg.
“
At its core, global growth is still
being bogged down by poor
demographics, heavy debt loads,
and excess capacity, none of
which can be quickly overcome
by lower corporate taxes and
deregulation of industry.
“
42
As we look ahead towards 2017’s investment opportunities, we are
most excited by what we see in Private Credit. Despite the threat of
future regulatory changes, the illiquidity premium still feels appealing, a feature we do not expect to shift in the near to medium term.
Moreover, in a world awash in liquidity, Private Credit is one of the
few markets in which we transact where demand still seems to be
handily outstripping supply, particularly at the high end of the market.
Also, if we are right that volatility extends beyond the currency market to the interest rate market the way we think it will in 2017, then
there should be ample opportunity to lean in when the cost of capital
has increased for financial sponsors, corporations, and project-based
financiers.
We also believe that Real Assets, particularly those with yield and
growth, can prosper in the macro backdrop that we envision. Savers
still need yield, and the uptick in inflation that we are forecasting
should allow Real Assets to regain some pricing power. Separately,
we are now balanced in our outlook of 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. In particular, it appears that we are
adding stimulus to the U.S. economy exactly when its labor markets
have tightened. Also, while we have been pointing out globalization’s
shortcomings for years, we are not sure that swinging wildly in the
opposite direction is the cure for what ails global growth.
24
22
10
Section V: Conclusion
KKR
INSIGHTS: GLOBAL MACRO TRENDS
Finally, there are a lot of policy initiatives, particularly in the United
States, where we have limited visibility on how they will play out. Interest deductibility and border tax adjustments are two potential “hot
spots” on which to stay focused. Meanwhile, 2016 policy stimulus in
China was likely much more potent than the consensus now appreciates, and as such, we will need to study closely how President
Xi Jinping deals with slowing economic trends heading into a highly
important political landscape in October 2017 (i.e., five of the seven
members of China’s Standing Committee could be replaced).
We also do not want to ignore some of the structural issues. At its
core, global growth is still being bogged down by poor demographics,
heavy debt loads, and excess capacity, none of which can be quickly
overcome by lower corporate taxes and deregulation of industry. Said
differently, a lot of cyclical stimulus would be required to overcome
some of the headwinds that have defined the secular stagnation that
the global economy has witnessed in recent years.
EXHIBIT 97
EXHIBIT 99
Geopolitical Tensions Are Causing Many to Question Key
Issues Like Immigration
Annual Asylum Seekers Received by EU 28 +
Norway, Switzerland
1,400
Productivity Has Been Falling Around the Globe…
Productivity: 10-Year CAGR, %
U.S.
10%
1,200
Euro Area
Japan
China
8%
1,000
800
1998:
Start of
Kosovo War
1989:
Fall of
Berlin Wall
600
6%
2011:
Start of Syrian
Conflict
4%
2013
2015
2011
2007
2009
2005
2001
2003
1997
1999
1995
1991
0
1993
0%
1987
200
1989
2%
1985
400
70
75
80
85
90
95
00
05
10
15
Note: Real GDP growth equals labor force growth times productivity
growth. Data as at April 12, 2016. Source: IMF, UN, Haver Analytics.
Data as at June 22, 2016. Source: Pew Research Center Analysis of
Eurostat Data.
EXHIBIT 100
EXHIBIT 98
Population Growth Is Concentrated in Frontier Markets,
While Many Developed Markets Are Now Expected to
Shrink
…and Has Actually Been Negative in the United States
This Cycle
Productivity Growth Comparison, %
2005-2010 CAGR
2010-2015 CAGR
Working Age Population CAGR: 2030 vs. 2015, %
10.9%
2.9%
10.3%
Positive labor force growth
1.7%
1.0%
1.2% 1.2%
0.5%
0.5% 0.4%
0.3% 0.6%
0.9%
0.1%
-0.3%
-0.6%
Japan
-1.1%
U.S.
China
Nigeria
Saudi Arabia
India
Mexico
Note: Real GDP growth equals labor force growth times productivity
growth. Data as at April 12, 2016. Source: IMF, UN, Haver Analytics.
Indonesia
Brazil
U.S.
China
Europe
Japan
Russia
Germany
-0.7%
-0.8%
-0.9%
Negative labor force growth
Euro Area
CAGR = Compound annual growth rate. *Universe = Top 50 global
economies by GDP in U.S.$, plus other economies relevant to KKR
including Vietnam, Ethiopia, and Serbia. Data as at July 30, 2015.
Source: World Bank, KKR Global Macro & Asset Allocation analysis.
If we are wrong and 2017 turns out to be a down year across the
global capital markets, then we believe that it will be linked to continued slow productivity amidst a surging U.S. dollar. Specifically,
under our bear case, we think that an overly robust dollar becomes
financially restrictive both domestically and abroad. A stronger dollar could also likely coincide with higher rates, which may pressure
yields not only in the U.S. but also in Europe and Japan. As we have
indicated in our outlook, we do not see the dollar’s move getting
extreme in our base case, but there are multiple scenarios where it
could move beyond its fair value in 2017.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
43
In sum, we still see significant opportunity for our target portfolio
to outperform during what we believe will be a structural paradigm
shift across the global capital markets in 2017, including more fiscal
spending, a greater focus on domestic priorities, increasing deregulation agendas, and heightened interest rate volatility. Tail risks
have clearly increased, even under our base case. Said differently,
investment-led productivity has to take hold quickly for the aforementioned policies to be effective, and if it does not, then volatility is
likely to surge.
Also, as we outlined earlier, many of our models suggest more limited upside to asset class returns than in the recent past. Accordingly,
we continue to favor a strategy that takes advantage of idiosyncratic
opportunities, particularly those that enjoy better pricing during periods of market dislocations as well as those that harness complexity
to their benefit. On the other hand, we continue to shun simplicity
and/or areas of the market where we believe recent inflows have
been too exuberant, particularly around visibility of earning streams.
“
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.
“
44
KKR
INSIGHTS: GLOBAL MACRO TRENDS
KKR
INSIGHTS: GLOBAL MACRO TRENDS
45
46
KKR
INSIGHTS: GLOBAL MACRO TRENDS
Important Information
The views expressed reflect the current views of Mr.
McVey as of the date hereof and neither Mr. McVey nor
KKR undertakes to advise you of any changes in the
views expressed herein. Opinions or statements regarding financial market trends are based on current market
conditions and are subject to change without notice.
References to a target portfolio and allocations of such
a portfolio refer to a hypothetical allocation of assets
and not an actual portfolio. The views expressed herein
and discussion of any target portfolio or allocations may
not be reflected in the strategies and products that KKR
offers or invests, including strategies and products to
which Mr. McVey provides investment advice to or on
behalf of KKR. It should not be assumed that Mr. McVey
has made or will make investment recommendations in
the future that are consistent with the views expressed
herein, or use any or all of the techniques or methods
of analysis described herein in managing client or proprietary accounts. Further, Mr. McVey may make investment recommendations and KKR and its affiliates may
have positions (long or short) or engage in securities
transactions that are not consistent with the information
and views expressed in this document.
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 necessarily 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 represent 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.
This publication has been prepared solely for informational 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 document 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 performance 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 projections or other forward‐looking statements regarding
future events, targets, forecasts or expectations regarding 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 significantly 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 subsequent 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 specific 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.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
47
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