KKR Global Perspectives: New Playbook Required

Investing

One must now invest through the lens of fiscal policy accommodation, not monetary policy accommodation

  • At the moment, the US is clearly leading the pack, but many countries, including Italy, Spain, and Mexico, are trying to use fiscal stimulus to help not only stimulate growth but also to thwart the growing socioeconomic divide that has been created in the GFC’s aftermath
  • It could favor assets with greater linkages to the real economy than purely to the financial markets
  • Also means that equity multiples have likely peaked
  • During the past few years sluggish economic growth meant above normal policy accommodation from global central banks, which was a boon for owners of most financial assets, which was a boon for owners of most financial assets, including long duration debt and equity
  • Reinforces our strong desire to lock in low cost liabilities

Nationalist agendas are now aggressively being emphasized over global ones

  • At the moment, we estimate roughly 40% of the US’ total trade deficit is derived from three areas: transportation (Mexico), apparel (China), and technology (China)
  • If one is to focus on the signal and not to the noise, then we believe any attempt to narrow the deficit will have to involve significant changes in these three areas
  • We advocate a heightened scrutiny on capital deployment across these three sectors of the global economy
  • Global trade actually peaked around 2008 after a multi-decade upward run
  • Our view is that President Trump’s trade negotiations may just further accelerate a global growth headwind that has actually been with us for some time, particularly as China insources production of more intermediate goods
  • It could also lead to further volatility in the currency market, as trade-affected countries try to regain competitive advantage through potential devaluations

Remain bullish on the Yearn for Yield, but we are further turning our focus towards hard assets that benefit more from nominal GDP running so hot relative to nominal interest rates

  • Structural bid for yielding assets remain outsized
  • Given our high conviction view that governments are committed to driving higher nominal GDP at a time of low nominal interest rates (which has traditionally been the cure for deflation/disinflation), we want to continue to increase our allocation to yielding assets backed by nominal GDP
  • It has legs in terms of duration, and we believe it warrants a notable overweight position

Similar to the late 1990s, we think that the market is giving investors a wonderful opportunity to buy complexity at a discount

  • For investment managers with operational expertise, there is potentially a lucrative opportunity to buy companies at a discount, reposition or restructure them, and sell them back into the public markets at a significant valuation increase
  • Momentum and Growth are the two most coveted strategies by equity investors over the last three years. At the same time, Value and Dividend are the two least preferred. This arbitrage is an extremely compelling one
  • Similar story is playing out in Credit which supports our heavy overweight to Opportunistic Credit over High Grade Debt

We remain bullish on our ‘Deconglomeratization’ thesis

  • Outsized activism in the public markets is forcing CEOs to refine their global footprints, which has been a boon to private equity investors
  • There are key markets, particularly in Japan, where in our view there are just too many companies with too many subsidiaries
  • A full 25% of the Nikkei 400 has 100 or more subsidiaries, and many have more than 300 divisions below the parent company
  • The catalysts for this acceleration are the rising cost of capital, increasing global competition, and a surge in activist dollars

Experiences over Things 2.0

  • We are increasingly struck by how fast overall consumer behavior patterns are changing
  • There are several structural forces at work, including technology, demographics, and education, that are radically changing how, when, and where consumers are spending their time and money against a backdrop of stagnant real wages in many economies
  • These changes are now occurring at a time when savings rates are falling sharply in large markets like the US

We continue to favor EM over DM, but we acknowledge that our mid-cycle pause thesis is playing out more intensely than we originally envisioned. We continue to advocate more selectivity in the second phase of this secular bull market in EM

  • After beginning to hook upwards in 2016, EM model now indicates that we are actually entering a mid-cycle phase for EM, which is usually associated with solid, albeit more volatile, returns
  • Valuation is no longer as compelling as it once was in EM, but ROE is improving, as margins are expanding in Tech as well as many ‘old economy’ sectors
  • Bottoming in commodities is also important
  • At the moment, we are constructive on both EM public equities and EM dollar-based government debt but less so on EM corporate debt
  • We think that the recent appreciation in the dollar is not the beginning of the second leg of a dollar bull market after the currency’s strong run from 2011-2015
  • In terms of areas of focus within EM, we favor Asia by a wide margin over Africa and/or Turkey, both areas where we see structural imbalances building
  • Also remain notably underweight Latin America, which has served us well so far in 2018
  • Currently most concerned by the sharp decline that we are seeing in the margins within the EM Consumer Discretionary sector

Other Key Points

  • Combination of tax cuts and the recent budget deal could increase the deficit to 5.5% of GDP in 2019
  • Personal consumption growth is moderating relative to recent years but still robust in absolute sense
  • There has been a sharp fall in consumer credit availability in the UK
  • Nominal GDP in China fell 67% from 2011 to 2015
  • Mexican economy remains heavily skewed towards services, including trade
  • Continue to expect the US 10-year yield to push towards the mid-three percent range by the peak of this cycle
  • Financials and Technology still make up close to 50% of the 2018E S&P 500 EPS growth
  • EBITDA growth forecasts have not kept pace with the surge in EPS growth expectations
  • Cyclicals and Resources stock are enjoying the strongest EPS revisions in EM
  • P/E multiples have declined in 8 of the past 8 Fed tightening cycles and are now on track to make 9 of 9
  • We now think S&P 500 can trade in the 17-18x range in 2018 (implies 4-12% total return for full year 2018)
  • Assuming 8% total return for the S&P 500, it will be driven by about 20% EPS growth, plus 2% of dividend income, offset by 12% of multiple contraction
  • With real 10-year yields in the 0-0.6% range, today’s forward PE of 17x is actually in line with its long-term median of 16.9x
  • On a seasonally adjusted basis, the YTD rate of oil draws suggests OECD inventories could normalize to pre-2014 levels in 14 months
  • While spot oil prices have been recovering for over a year, long-dated prices have only started increasing recently
  • Declines in conventional oil supply are now substantially offsetting surging US shale production
  • Performance in the energy sector has been abysmal; we now believe there are significant, near-term value-creation opportunities
  • 5-year annualized risk-adjusted returns in the US are approaching peak levels; 10-year cumulative equity returns are now beginning to look more full too
  • MLPs are one of the few assets with above average yields
  • With public REITs now badly lagging the S&P 500, we think an interesting investment opportunity is being created
  • After 9 years of a bull market, 40% of Russell 2000 companies still have EV/EBITDA of less than 10x
  • US upstream now seems to be in consolidation mode
  • World needs to invest an average of $3.7 trillion in infrastructure assets every year through 2035 in order to keep pace with projected GDP growth
  • Indian millennials spend more than 36% of their incremental income on entertainment and travel
  • Global populism is now close to highs not seen since right before the Second World War
  • Investment Grade market has also grown rapidly with BBB now nearly 48% of investment grade
  • Spreads are now extraordinarily tight in the BBB market on both an absolute and relative basis
  • Credit conditions are now back to levels not seen since just before the GFC
  • Unlike the investment grade market, the composition of the high yield has been improving
  • Stock and bond volatilities are now on par – this relationship does not make sense to us

KKR Global Macro Trends: New Playbook Required, June 2018

Image Source: KKR Global Macro & Asset Allocation

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