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KKR 2018 Outlook: You Can Get What You Need

KKR Outlook for 2018: You Can Get What You Need, January 2018

Macro Basics

  • Many of the drivers of our US model are now becoming much more dependent on financial conditions, including net worth and credit spreads
  • Expect the Goods segment of the US economy to outperform Services in 2018
    • Consistent with our forecast for stronger capex as well as ongoing growth in EM
  • In Europe, central bank policy remains the largest driver of GDP growth; anticipate that the ECB will remain dovish in 2018, given that unemployment rate is still elevated (8.8% in the Eurozone)
  • China remains the most influential driver of global GDP growth; China, coupled with the rest of EM, explains fully 78% of total global growth in 2018
  • Backdrop for equipment capex, inventories, net exports, and government spending all improving in 2018; however, we envision Personal Consumption Expenditures on a slowing trend
  • Estimate the 2018 GDP tailwind from tax reform to 1) be modest and 2) be already largely incorporated into our proprietary leading indicator variables such as equity prices, credit spreads, business confidence, consumer confidence, etc
  • In terms of inflation, we expect headline CPI inflation of 2.2% in 2018 (given that Food and Energy are excluded from Core CPI)
  • Fed hikes three times in 2018 and two more times in 2019; our forecast is meaningfully above current futures market pricing, which embeds just two hikes in 2018 and just a 50% chance of any additional hike in 2019
  • 10-year yields to grind higher and hit 3% this year and 3.25% at our expected cycle peak in 2019
  • Looking for another solid year of GDP growth in the Eurozone, with a base case of 2% growth; importantly, this growth is finally being shared across almost the entire Eurozone area; every Eurozone industrials firms now report hiring intentions at all-time highs
    • While the rate of change is slowing, the ECB is still on track to add about a third of a trillion euros to its balance sheet in 2018
    • Lion’s share of the buying will still occur in the sovereign market, which should be supportive of an ongoing technical bid in 1H18
  • Even with QE remaining a solid tailwind, continue to feel that the price of the German bund is too rich in the context of the robust Eurozone recovery
    • US/European interest rate differential appears too large relative to the inflation differential
    • We do look for a normalization to one percent in 2018, with a significant risk of a more substantial bear market in European rates over time
  • In the UK, Brexit remains the dominant theme; belief is that progress is being made; base case is that UK economy will continue to post positive GDP growth in 2018 and 2019
    • We remain sensitive to downside risks as the UK has a history of long and deep recessions (average duration is a little over four quarters with an average peak to trough fall of 4.4% of GDP)
    • UK is not just vulnerable to Brexit mishaps but also has its own domestic vulnerabilities (non-bank consumer credit increased aggressively and still growing at double-digit rates)
  • Real GDP growth in China to decelerate 30 bps to 6.5%, driven by a cooling housing market, more modest infrastructure spending growth, increased anti-pollution measures, and additional supply side reforms
    • Headwinds partially offset by a resilient consumer as the job market is tight, wages are rising, and consumer confidence remains strong
    • Stronger US growth could lift local export demand in China
    • While we expect growth to cool in China, we do not expect a sharp deceleration, and while inflation will rise, it will remain within the government’s comfort zone
  • 5% real GDP growth for Brazil; this re-acceleration is a big deal; after the 11-quarter long recession, economy is finally gaining traction
    • Underpinned by sharply lower interest rates, declining inflation, higher real wages, and a continued rebound in consumer/business confidence
    • Expect headline IPCA inflation to stay benign, rising to ‘just’ 4.1% in 2018
    • Current political distractions associated with the October 2018 general elections will likely prevent the Temer administration from passing comprehensive social security reform in the near term
  • Public Equities more compelling than Liquid Credit at this point in the cycle
    • Both QE and the demographic yearn for yield have not only driven absolute rates down but they also have materially compressed credit spreads to a point where they make stocks look more attractive on a relative basis
    • Still see several macro tailwinds to bolster S&P earnings growth in 2018, including rising home prices, robust consumer confidence, and strong ISMs
  • In terms of EPS outlook for 2018, forecasting organic earnings growth of 8% for the S&P 500, which is roughly 30% lower than the 11.8% implied
    • Believe we are more optimistic than the sell-side analyst community but in-line with top-down views in key areas such as revenue growth, operating leverage, etc
    • Embedded in the forecast is our belief that net profit margin will peak at a record 11.1% this year
  • While lower tax rate should boost Consumer Discretionary earnings in 2018, we worry that highly competitive and commoditized industries within the sector will struggle to retain the entire benefit of the tax cut beyond 2018
    • Seems likely that a large portion of the profits could be passed on to consumers via lower prices and workers via higher wages as many of these companies lack pricing power and need to compete for both market share and labor
  • Around 50% of total margin expansion since 2009 has come from just the Tech sector; with Tech margins already at 20-year highs and a full 1000 bps higher than overall S&P 500 margins, any deterioration in tech margins would have a disproportionate effect on overall S&P net margins
  • We think S&P can trade around 18-19x P/E multiple; believe that some of the step-up in earnings will be discounted by investors worried about whether the current windfall will be competed away in the form of higher wages, increased operational costs, and intensified pricing schemes
    • Confident that no significant multiple degradation is likely in 2018
  • Think that forward returns are likely to be notably lower than in the past; believe that spreads in Credit are at their tights at a time when risk-free rates are too low, and we believe that equity multiples as well as corporate margins could be approaching their peak in 2018
  • Continue to view oil as likely range-bound in the near term but a bit more constructive over the longer term
    • See potential for prices to head above $60 during the next few years
    • This view helps to support our decision to increase our overweight to Real Assets, including Energy and Energy-Related Infrastructure
  • Oil stocks in developed markets have declined in recent months but remain elevated on an absolute basis; market will be undersupplied by a modest 360Mbbl/d in 2018; it would take until early 2020s to normalize global stockpiles
    • Current futures pricing which embeds prices hovering around $50 could ultimately prove too pessimistic
  • We think WTI oil has bottomed but believe that excess inventories and optimistic positioning still leave the commodity exposed to periodic drawdowns over the medium term; however, on a 3-to-5-year basis, more constructive than the consensus

Key Themes

  • Emerging Markets rules of the road suggest we are already entering a ‘mid-cycle’ phase of recovery
    • Domestic consumption stories are accelerating in many areas of EM; meanwhile, smaller deficits and higher real rates give us additional confidence that the EM tailwind can withstand macro shocks, including a tactical rebound in the dollar, along the way
    • India, Indonesia, Vietnam, and parts of China appear compelling; by comparison, more cautious on much of Africa as well as capital dependent countries like Turkey
  • Changing preferences in direct lending
    • Capital inflows into the space have intensified, traditional global wholesale banks are now taking more risks, and credit spreads are very tight; M&A activity has not been as active as we would like
    • We view Asset-Based Finance as an elegant play on our desire to lock in low-cost liabilities in today’s QE-driven market, allowing investors to earn above average spreads
  • Buy complexity, sell simplicity; active management performance to rebound
    • Private equity typically outperforms public equities in lower return environments
    • After 9 full years of a bull market, 41% of Russell 2000 companies still have EV/EBITDAs of less than 10x
    • Performance in Energy Sector has been abysmal but now believe there are significant, near-term value-creation opportunities in the Energy Sector
    • There are very few asset classes offering above average yields; MLPs are currently one of them
  • Deconglomeratization: Corporate shedding assets creating opportunities across energy, infrastructure, and private equity
    • This idea is a big one, it is global, and it has duration
    • Companies across all sectors now face higher level of scrutiny by the activist community
    • At the moment, Japan has emerged as one of the most compelling examples on our thesis about corporations shedding non-core assets
  • Experiences over things
    • Disposable income available for traditional ‘things’ is waning at a time of significant change in consumer spending
    • Key influences such as increased healthcare spending, heightened rental costs, and rising telecom budgets are leaving less and less discretionary income for traditional items, particularly mainstream retail
  • Central bank normalization
    • Tier 1 capital ratio requirements have risen dramatically at a time of shrinking net interest margin; expect some reversal ahead in both areas
    • G4 sovereign issuance less central bank purchases shows that net issuance is now actually negative; this trend will change notably in 2H18

Risks/Hedging

  • Increasing dependence on technology and financial earnings
    • Financials and Tech make up slightly more than 50% of 2018 S&P 500 EPS growth; they make up nearly 57% of 2018 EM EPS growth
  • A very optimistic implied default rate amidst record tight pricing seems inconsistent with the late-cycle increase in corporate leverage we are now seeing
    • In 2016, implied default rate hit 8.3%; today, we are at just 0.6%
    • High yield spreads appear mispriced relative to those of bank loans at this point in the cycle
    • Investment grade leverage risk is quietly testing record levels again (particularly in Energy, Healthcare, and TMT)
  • Stock/bond correlations reverse amidst stronger growth and central bank normalization, pressuring levered portfolios
    • Stock and bond volatilities are now on par; this seems unsustainable
    • Stock bond correlations have actually been positive since the tech bubble peak in 2000, but this is not the norm over a longer time period
  • Complacency is beginning to set in; buying volatility/hedges may makes sense (finally)
    • Synchronized improvements in economic surprises have helped to foster a benign environment for global capital markets
    • Believe that term premium has fallen to unsustainably low levels
    • Dispersion of EPS has also dropped to levels that is too low
  • Social and reputational issues will remain tail risks in 2018
    • It is not just about reputation issues; it can impact a company’s bottom line, result in termination of top talent, and otherwise impair brand; there is no easy hedge

Image Source: KKR Global Macro & Asset Allocation analysis

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