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KKR 2017 Mid-Year Update: Five Areas of Focus

KKR Mid-Year Update: Five Areas of Focus, July 13, 2017

Henry H. McVey, Head of Global Macro & Asset Allocation, CIO of KKR Balance Sheet

  • Today, almost all our work streams suggest that asset prices across most parts of the global capital markets are somewhere between fair value and expensive
  • From a cycle perspective, believe that we are mid-to-later cycle in some of the more developed markets including the US
  • Base case remains that we have some form of an economic pullback in 2019
  • We are well below consensus in terms of inflation across most parts of the world, including US, Euro Area, and Brazil
  • We feel inspired to narrow our investment focus towards fewer high conviction themes, relying less on macro tailwinds such as margin and multiple expansion. In particular, focused on potential macro disconnects, or financial arbitrages, where we can largely quantify where investor expectations appear offsides relative to the upside potential we envision

De-conglomeratization: Corporate spin-offs are creating ‘rightsizing’ opportunities

  • Believe this transition will create a significant opportunity for investors to buy, repair and improve non-core assets from regional and global multinationals
  • Also see increased activism in the global public equity markets as a play on our thesis; see this trend towards entities hiving off non-core assets currently extending beyond traditional corporations to now include Infrastructure and Energy Assets

Experiences over things

  • Secular shift towards global consumers willing to spend more on experiences than on things
  • Leisure, wellness, and beauty all represent important growth categories – mobile shopping and online payments are only accelerating this trend
  • True core ‘goods’ inflation has actually been negative on a year-over-year basis for the past 16 consecutive quarters and negative for 50 of the last 69 quarters since 2000: view this deflationary pressure as a secular, not cyclical, issue for corporate profitability

Emerging markets over developed markets

  • Our model has begun to inflect upwards for EM; when they do collectively turn upward, EM outperformance can often last for years
  • Now more constructive on EM currencies – if we are right, commodity prices must stabilize near current levels

Fixed income illiquidity premium

  • View the illiquidity premium as compelling, particularly in today’s low interest rate environment
  • Think there is more potential upside in Asset-based lending than in Direct lending

Continue to embrace dislocation

  • While VIX has been low in recent months, ongoing periodic spikes in uncertainty – often linked to geopolitical tensions – have created attractive investment opportunities since 2011
  • Unforeseen shocks represent a secular, not cyclical, pattern – MLPs, CCC-rated credits, and healthcare companies currently appear interesting to us

Making the following changes to our target asset allocation

  • Reducing our Global Direct Lending allocation to 5% from 8% at the start of the year and 10% a year ago: still structurally bullish on this market but do not believe that pricing in the small end of the market has gotten competitive; on the large end of the market, think High Yield is becoming more competitive option relative to Private Credit
  • Using the proceeds to increase our allocation to Asset-based Lending/Mezzanine: believe private credit opportunity in Asset-based lending/Mezzanine is growing quite nicely; bank stock prices are rising, enabling financial institutions to dispose of performing assets that are priced to move
  • Within Liquid Credit, still favor Opportunistic Credit and Levered Loans: retain our 400 bps, non-benchmark position in bank loans, including certain spicy parts of the CCC-credit market; also retain our 500 bps position in Opportunistic Credit; by comparison, implied default rate for High Yield is now less than 1%, which inspires us to underweight the asset class; IG debt also looks richly priced
  • Continue with a notable underweight to government bonds; within government bonds, now favor EM exposure to DM exposure: key to our thinking is that inflation remains stubbornly low, while the ongoing demographic bid for yield is likely stronger than the consensus still thinks; in terms of preference, weighting in paper from Indonesia, India, and Mexico, all of which have large domestic economies, offer attractive yields, and benefit from attractive local currency ‘carry’ at current levels
  • Shifting our Public Equity allocations, including reducing our US exposure to below benchmark for the first time: though 45% of Russell 2000 stocks with enterprise values of $500 million to five billion are still trading below 10x EBITDA, overall indexes in the US appear somewhat overheated; with the reduction in US, boosting Europe by 1% to 16% and adding 1% to All Asia Ex-Japan to show our confidence in domestic demand stories where reforms are taking shape; retain our underweight in Latin America – think that corruption remains a problem in Brazil
  • Overweight to Private Equity relative to Public Equities and Growth Investing remains unchanged: low return environments for public equities have actually historically been decent environments for traditional Private Equity; believe that buyout opportunities tend to increase as the forward-looking total return in public equities decreases; within Private Equity, bullish on our de-conglomeratization theme
  • Continue to run with a notable overweight to Energy Assets/Infrastructure in 2017, a direct play on our long-term investment thesis to buy Yield and Growth: in recent months, have seen significant selling of properties from publicly traded energy companies looking to reposition their portfolios by selling non-core producing assets as well as performing midstream properties; within good cash flowing midstream assets, investors are getting 500-600 bps of premium over sovereign debt returns; seeing lots of conglomerates selling off interesting infrastructure properties in sectors like towers and energy infrastructure
  • Currency – US dollar bull market is now in later stages: dollar has appreciated meaningfully since 2011 and now see it as somewhat extended on a real effective exchange rate basis; think that value of EM currencies is again rising
  • Cash – Reduce cash to 1% from 3%: use these proceeds to cover our 2% short position in Gold which we have periodically shorted during the past few years; given heightened geopolitical tensions, think that this 2% asset class ‘swap’ probably makes good sense
Image Source: KKR Mid-Year Update: Five Areas of Focus, Bloomberg
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