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INSIGHTS
GLOBAL MACRO TRENDS
VOLUME 5.1 • JANUARY 2015
Getting Closer to Home
Getting Closer to Home
KKR GLOBAL MACRO & ASSET
ALLOCATION TEAM
HENRY H. MCVEY
Head of Global Macro &
Asset Allocation
+1 (212) 519.1628
henry.mcvey@kkr.com
DAVID R. MCNELLIS
+1 (212) 519.1629
david.mcnellis@kkr.com
FRANCES B. LIM
+61 (2) 8298 5553
frances.lim@kkr.com
REBECCA J. RAMSEY
+1 (212) 519.1631
rebecca.ramsey@kkr.com
JAIME VILLA
+1 (212) 401.0379
jaime.villa@kkr.com
AIDAN T. CORCORAN
+ (353) 151.1045.1
aidan.corcoran@kkr.com
While the general backdrop for risk assets remains favorable,
we are no longer advising folks to “Stay the Course” as we did in
our January 2014 Outlook piece. Rather, given where we are in
the cycle and the magnitude of gains in recent years, we have
begun the inevitable process of “Getting Closer to Home” in terms
of our asset allocation targets. Importantly, though, we think this
transition should be more evolutionary than revolutionary, but
we do advise folks to raise some cash and to tilt the invested
part of the portfolio to become more opportunistic in 2015. In
terms of key themes, we see several compelling “arbitrages” in
the global macro landscape that CIOs and portfolio managers
should pursue this year. First, we believe that China’s slowing
is not an aberration. As such, its role in the global economy
is materially shifting, which means that we expect to see
sizeable restructuring and recapitalization opportunities in
sectors that previously over-earned and/or overstretched their
footprints. Second, many corporations still have inefficient
capital structures, including too much cash and too little debt,
in our view. As such, investors can still benefit from corporate
and/or shareholder actions to lower companies’ cost of capital
and/or improve growth, including buybacks, dividends, capital
expenditures and acquisitions. Third, despite a slew of liquidity
in the system, many companies across both emerging and
developed economies still can’t get proper access to credit.
Hence, we still see a compelling illiquidity premium that is
worth pursuing, particularly in today’s low rate environment.
Fourth, in a world of contango commodity pricing, we continue
to favor private real asset investments with upfront yield, growth
and long-term inflation hedging relative to traditional liquid
commodity notes and swaps. Finally, government deleveraging
in the developed markets is disinflationary, which drives our
thinking about the direction of long-term interest rates as well
as the relative value of risk assets against the risk-free rates.
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© 2015 Kohlberg Kravis Roberts & Co. L.P. All
2
KKR INSIGHTS: GLOBAL MACRO TRENDS
Rights Reserved.
“
The best safety device is a rearview
mirror with a cop in it.
”
DUDLEY MOORE
ENGLISH ACTOR, COMEDIAN, MUSICIAN, AND COMPOSER
Since my team and I arrived at KKR in 2011, our asset allocation
targets have been consistently aggressive relative to the benchmark against which we measure ourselves. In particular, given our
strong view that the global economic recovery would last longer than
the consensus, we have been willing to overweight public equities, “spicy” credit, private real assets, and other illiquid products to
garner excess returns that we viewed as unachievable through many
traditional liquid asset classes, including generic commodity notes
and sovereign debt.
This strategy has served us well (see performance Exhibits 74, 75,
and 76) in recent years, but now we think it is time to start “Getting
Closer to Home” on the asset allocation front, including raising some
cash and getting more opportunistic across the portfolio in 2015. To
be sure, as we discuss in detail below, we are still running with a
pro-risk tilt, but after 67 months of economic expansion, we just do
not think that it is necessary — as Dudley Moore so eloquently stated
— to wait to fully see the policeman in the rearview mirror before we
began to embrace some higher level of safety.
Several influential macro considerations shape our more opportunistic approach. First is cumulative performance this cycle of risk assets. All told, the S&P 500 has now appreciated six consecutive years
in a row, returning a full 204% through December 31, 2014 versus
an historical average of 115% during bull markets (Exhibit 39). During
this period its multiple has expanded a full 40%, now in line with the
historical median of 42% (Exhibit 39).
Outside the U.S., valuations are certainly less demanding; however,
consistent with our Asynchronous Recovery thesis (see Investment
Implications of an Asynchronous Global Recovery), we still expect
some additional bumpiness in 2015 as many parts of Europe, Latin
America, and Asia must endure some important but painful economic
restructuring initiatives, including debt deleveraging, fiscal belt-tightening, and wage compression.
Finally, we think the monetary backdrop is becoming more complicated. On the one hand, the central banks in Europe, Japan, and
China are all likely to be more accommodative during 2015 in order
to stoke growth. On the other hand, the U.S. Federal Reserve is now
in the process of reducing its ultra-accommodative stance (Exhibit 4).
Hence, unlike in past years, central bank policy around the world is
now less in synch, which could create some tension in global capital
markets, currencies in particular, during parts of 2015.
So, against the macro backdrop that we envision for 2015, how
should one position a multi-asset class portfolio? Our highest conviction asset allocation ideas are as follows:
• We further embrace our Asynchronous Global Recovery theme
by lifting our highest conviction idea, Distressed / Special
Situation, to a 15% allocation from nine percent previously. We
now target a full 15% allocation, notably above our benchmark
weighting of zero, to Distressed / Special Situation. Our bottom
line: This sizeable allocation allows us to efficiently invest behind
– not against — the Asynchronous Global Recovery we continue
to forecast. Importantly, beyond the European restructurings/
recapitalizations that we have been highlighting for some time,
two recent trips to Asia confirm to us that we are now seeing
“emerging” opportunities in Asia as the China Growth Miracle
wanes – and companies are forced to restructure, recapitalize,
and resize. Finally, we believe some notable dislocations across
the energy market, the U.S. in particular, are also starting to
emerge for managers of opportunistic capital.
• To pay for this increased overweight position, we have lowered
our growth equity allocation in our Other Alternatives bucket.
To underwrite our increased Distressed / Special Situation allocation, we take five percent from Growth Capital / VC / Other
and reduce this weighting to zero versus a benchmark of five
percent. Importantly, given the carnage we are seeing in areas
like U.S. energy, European banks, and Asian commodity plays, we
are more interested in taking advantage of current dislocations
around the globe, and in so doing, we seek to avoid some of the
hefty valuations we now see in “hot” growth parts of the market,
including the Internet and life sciences (Exhibit 61).
• Our Fixed Income allocation also becomes less “spicy” in
2015, but we increase flexibility in the liquid credit portion
of our portfolio. For the past three years, we have been substantially overweight “spicy credit,” including Mezzanine, Direct
Lending, and Fixed Income Hedge Funds, based on our view that
the economic cycle 1) would be longer than expected in duration;
2) the illiquidity premium represented a massive opportunity
amid lower rates; and 3) the return profile of spicy credit would
approach that of equities but with less risk. In 2015, however,
we are shifting course by beginning to dial back some of our less
liquid, “spicy” credit positions. Specifically, we are moving our
Mezzanine allocation to two percent from five percent versus
a benchmark weighting of zero. Within our liquid book, we are
reducing our hedge fund allocation, but we are increasing our
weighting towards Actively Managed Opportunistic Credit to
seven percent from four percent. Our intent is to allow investment managers to toggle between bank loans, high yield, and
other credit-sensitive products as opportunities/dislocations
present themselves this year. Separately, we have added three
percent to investment grade credit versus a benchmark of five
percent and a previous weighting of zero percent. Our goal is
to add some ballast to the fixed income portion of the portfolio
during what we believe could be a more volatile year for the
asset class. Overall, our total fixed income book remains small
at just 18% of the portfolio versus a benchmark of 30% and is
unchanged from June 2014.
• We are reducing our long-term overweight positions in Public
Equities back to equal weight and are now more opportunistic
at this point in the cycle. Our research suggests less upside for
equities than in past years, and as such, we now want to be a little
more opportunistic in our approach. As we discuss below in more
detail, our base view is that not only is the absolute return in global
equities likely to be lower on a go-forward basis, but we also believe
the Sharpe ratio is likely to decline. From a regional perspective, we
stay overweight Asia and move to underweight in Latin America to
reflect our cautious view on Brazil’s near-term prospects.
• In order to become more opportunistic in equities, we are
raising Cash to start 2015 with — boosting this allocation to
three percent from zero during the entire 2011-2014 period.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
3
• Risks/Hedges: Tactically, we consider buying downside
protection in equities, currency, and rates when volatility
compresses. We think that investors should expect spasms of
risk asset de-ratings in 2015 when either growth and/or forward
inflation expectations periodically drop towards uncomfortable levels. Consistent with this view, we are also increasingly
concerned that the currencies of commodity exporting countries
may cause further dislocations across the global capital markets
in 2015. Our research shows that we are not likely to have a full
1997 unwind, but we are going to continue to endure a sizeable
adjustment period ahead. In terms of implementation, we believe
an investor should use periodic compression of volatility levels
to purchase tactical protection across equity, currency, and fixed
income markets. Details below.
“
We now think it is now time to
start “Getting Closer to Home”
on the asset allocation front,
including raising some cash and
getting more opportunistic in 2015.
“
4
KKR
INSIGHTS: GLOBAL MACRO TRENDS
KKR GMAA
JUNE 2014
TARGET
(%)
• Currency: We believe the USD freight train remains on track.
At the risk of staying in a crowded trade, we remain positive
on the U.S. dollar against most major currencies, including
the euro, Japanese yen and commodity currencies, including
Brazilian real, Russian ruble, and Nigerian naira. Within the EM
currency arena, we favor the Indian rupee, while in terms of EM
“crosses,” we champion MXN over BRL again in 2015.
KKR GMAA 2015 Target Asset Allocation
STRATEGY
BENCHMARK (%)
• Within Real Assets, we believe investors should still avoid
traditional commodity notes and swaps with no yield; we stay
overweight income-producing Real Assets and short Gold. As
in past years, we continue to stay away from liquid commodity swaps/notes again in 2015, particularly given 1) near-record
negative roll features (Exhibit 62); and 2) our view that spot oil
and other commodity prices could display some additional downside volatility in 1H15. We also stay short Gold again this year, as
we see deflation, not inflation, as the bigger near-term risk. By
comparison, we still think that there is a substantial opportunity
to own cash-flowing hard assets that can produce yield, growth,
and long-term inflation hedging. Our favorites include real estate, infrastructure, and pipelines. Given the significant price appreciation in certain gateway cities, however, we have reduced
our Real Estate weighting to three percent from five percent and
a benchmark weighting of two percent.
EXHIBIT 1
KKR GMAA
JANUARY
2015 TARGET (%)
While we think that 2015 could again be another up year for
many stocks, our view is that more volatility lies ahead than in
recent years. So at the moment, we think it finally makes sense
to have a little “dry powder” to add to risk assets in the event of
a downdraft in 2015.
53
53
55
U.S.
20
20
20
EUROPE
15
15
16
ALL ASIA
13
12
13
LATIN AMERICA
5
6
6
18
30
18
GLOBAL GOVERNMENT
3
20
3
MEZZANINE
2
0
5
HIGH YIELD
0
5
0
BANK LOANS
0
0
0
HIGH GRADE
3
5
0
EMERGING MARKET DEBT
0
0
0
ACTIVELY MANAGED
OPPORTUNISTIC CREDIT
7
0
4
FIXED INCOME HEDGE FUNDS
0
0
3
DIRECT LENDING
3
0
3
REAL ASSETS
6
5
8
REAL ESTATE
3
2
5
ENERGY / INFRASTRUCTURE
5
2
5
GOLD
-2
1
-2
20
10
19
TRADITIONAL PE
5
5
5
DISTRESSED / SPECIAL SITUATION
15
0
9
GROWTH CAPITAL / VC / OTHER
0
5
5
3
2
0
ASSET CLASS
PUBLIC EQUITIES
TOTAL FIXED INCOME
OTHER ALTERNATIVES
CASH
Strategy benchmark is the typical allocation of a large U.S. pension
plan. Data as at December 31, 2014. Source: KKR Global Macro & Asset
Allocation (GMAA).
Importantly, our asset allocation framework for 2015 is driven by five
key top-down themes that we think represent macro “mismatches,”
or arbitrages between real and perceived values. They are as follows:
1. First, China’s fixed investment slowing is not an aberration. China’s
environmental headwinds, including pollution, water concerns
and food safety, now represent potentially more contentious
political issues than job creation, in our view. This priority
realignment is a big deal because it means fixed investment and
low-end manufacturing will be de-emphasized. As such, we
believe that investors should expect to see sizeable restructuring
and recapitalization opportunities in sectors that previously overearned and/or overstretched their footprints during the China
2. Second, many corporations still have inefficient capital structures,
including too much cash and too little debt. Hence, we believe that
investors can still benefit from corporate actions to lower their
costs of capital and/or improve growth, including buybacks, dividends, capital expenditures and acquisitions. Without question,
activist managers are clear beneficiaries, but we also think LBOs
and MBOs make sense.
3. Third, despite a surge in the global monetary base, access to credit
remains a major issue, particularly for small- to medium-size
businesses. As such, investors should continue to be able to
garner an attractive illiquidity premium in the private markets.
Interestingly, our research shows the premium actually widens
again in 2014 (Exhibit 27). In the public markets, there too is
opportunity as balance sheet downsizing across Wall Street and
limited dealer inventory should fuel periodic market dislocations
for investors with patient capital.
4. Fourth, in a world of contango commodity pricing, we continue
to favor cash-flowing private real asset investments, including real
estate, infrastructure, and energy, with upfront yield, growth and
long-term inflation hedging relative to traditional liquid commodity notes and swaps. Already, the relative performance between
these two sub-asset class groups has widened substantially in
recent quarters, but we still see more opportunity ahead for even
greater divergence.
5. Finally, government deleveraging in the developed markets is
disinflationary, which drives our thinking about the direction of
long-term interest rates as well as the relative value of risk assets against the risk-free rates. In particular, given our view that
the economic cycle will stretch into 2017, we think that many
public and private equity stories with capital management and
operational improvements still appear attractive.
Importantly, several of the aforementioned themes are continuations
of high conviction ideas that we have developed during the past few
years. Put another way, while we are beginning to turn more conservative in our overall outlook towards risk assets, we still feel very
strongly about the key macro trends we are championing – and more
importantly – their ability to deliver alpha again in 2015.
What has changed, however, is that 1) we are now 12 months later
in the cycle at a time when asset prices are higher and the world’s
most influential central bank is about to shift its stance on monetary
policy (and our models point towards stronger growth by late 2015/
early 2016); 2) China’s structural overbuild in its fixed investment
arena is now under greater pressure than the consensus now appreciates, which has broad-based implications for global industrials,
commodities and currencies. We believe that China is also likely to
influence global inflation rates as it tries to export away some of its
excess capacity.
EXHIBIT 2
The Recovery Remains Asynchronous, with Carnage in
Oil as the Latest Stress Point
Credit Suisse HY Index
Energy & Coal
Excluding Energy & Coal
800
750
12/4/2014
758 bp
700
650
Spread to Worst
Growth Miracle that defined the 2000-2010 period in the global
economy.
9/29/14
536 bp
600
536 bp
550
500
450
482
bp
400
350
300
12/31/2013 3/31/2014 6/30/2014 9/30/2014
Data as at December 4, 2014. Source: Credit Suisse Research.
EXHIBIT 3
China’s Fixed Asset Investment Is in Structural Decline,
Which We Think Is a Major Macro Investment Theme
China: YTD Fixed Asset Investment Y/y (%)
35
Jun-09
33.6
30
25
Nov-14
15.8
20
15
09
10
11
12
13
14
Data as at December 12, 2014. Source: China National Bureau of
Statistics.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
5
EXHIBIT 4
EXHIBIT 5
We Believe Central Bank Differentiation Will Be a Key
Theme in 2015
Change in Central Bank Balance Sheet
Additions 2014-2015
United States:
Structural Fiscal Expansion/(Consolidation), %
0.3
$944bn
$902bn
U.S. Fiscal Drag Is Now Finally Waning
-0.2
-0.3
$520bn
-0.7
-1.0
-1.2
-2.2
Total
SECTION I: Key Trends/Themes for 2015
Less Government Austerity and Lower Commodity Prices May Help
to Drive Global Growth Higher, but We Expect the Recovery to
Remain Asynchronous
Today, as we peer around the corner on tomorrow, we think that less
government “drag” on the global economy could provide a nice tailwind to global growth in 2015. In the United States, for example, less
government austerity is a significant growth driver, as it is expected
to be just a 30 basis point “drag” versus a 1.0% drag in 2014 and a
full 2.1% in 2013 (Exhibit 5). This reduction could go a long way towards reducing the sizeable gap that has existed between the private
sector and overall GDP since as far back as 1Q10 (Exhibit 6).
KKR
INSIGHTS: GLOBAL MACRO TRENDS
180bp less austerity
in '15e vs. '13
-2.1
2013
2014e
2015e
Measured as change in general government underlying primary balance,
adjusted for cycle and one-offs. Data as at December 31, 2014. Source:
OECD Economic Outlook 96 Database.
EXHIBIT 6
Real Private Sector GDP Has Outpaced Overall U.S. GDP
Growth by Approximately 90 Basis Points, On Average,
Since 2010. This Gap Should Narrow in 2015
U.S. Real GDP y/y
U.S. Real Private GDP y/y
4.5%
4.0%
3.5%
Avg.
3.1%
3.0%
2.5%
3Q14
2.9%
2.4%
Avg.
2.2%
2.0%
1.5%
3Q14
1Q14
3Q13
1Q13
3Q12
1Q12
1.0%
3Q11
Of course, there are always macro risks to consider. As we discuss in greater detail in our hedging section, we think that one risk
for 2015 lies in maintaining inflation expectations at proper levels.
Stocks and high yielding credit are really only attractively priced relative to sovereign debt if the earnings come through. Our base case
is that they will, but when inflation expectations crater (as they did
in October 2014), multiples can get de-rated quickly. At the moment,
the U.S. seems to be decoupling from some of the “bad” inflation levels we see in China, Japan and Europe, but history has often shown
that – over time – decoupling tends to be a flawed investment theory,
particularly in an increasingly global economy. Separately, while reserves are higher and external debt lower in many EM countries than
in 1997, many developing countries are increasingly facing both fiscal
and export-related headwinds. Finally, we think that EM consumers
who binged on credit are likely to see some retrenchment in 2015.
For instance, we take a cautious stance on high-priced Brazilian
consumer stories as we expect to see below consensus growth amid
weaker employment trends.
2012
1Q11
Data as at December 31, 2014. Source: European Central Bank, Federal
Reserve Board, Bank of Japan, Macrobond, KKR Global Macro & Asset
Allocation estimates.
6
2011
3Q10
BOJ
160bp per year, on
average over three years
1Q10
ECB
-$478bn
FED
-1.3
-1.4
-1.7
Data as at 3Q14. Source: Bureau of Economic Analysis, Haver Analytics.
European austerity, which has also been a big macro theme in recent
years, is also starting to wane. One can see this in Exhibit 7, which
shows that fiscal drag in 2015 could be essentially zero. Ironically
though, a comparison of the data in Exhibits 5 and 7 also suggests
that Europe, despite being in the press all the time for major budget
tightening initiatives, has actually implemented less fiscal consolidation than the U.S. All told, Europe’s structural budget deficit closed,
on average, by just 100 basis points per year from 2011-2013 versus
160 basis points in the United States.
That said, we do think the headline austerity numbers in Europe
may actually understate the actual impact. Key to our thinking is that
Europe’s numbers mask the fact that the region’s fiscal contraction
took place amidst 1) notable regional fragmentation and 2) without
as much offsetting monetary stimulus for the hardest hit countries.
As such, some work done by my colleague David McNellis concludes
that every percentage point of fiscal consolidation has equated to a
full 1.4% GDP drag in Europe of late (Exhibit 8), which is far above
the 0.50-0.75% GDP drag we might expect from the same austerity
impulse in the U.S. (Exhibit 5)
EXHIBIT 7
Fiscal Headwinds in Europe Are Now Slowing …
Euro Area:
Structural Fiscal Expansion/(Consolidation), %
0.0
0.0
-0.2
-0.2
-0.4
-0.6
-0.7
-0.8
-1.0
-1.0
100bp per year,
on average over
three years
-1.2
-1.4
-1.3
2012
2011
70bp less austerity
in '15e vs. '13
2013
2014e
2015e
Measured as change in general government underlying primary balance,
adjusted for cycle and one-offs. Data as at December 31, 2014. Source:
OECD Economic Outlook 96 Database, Haver Analytics.
EXHIBIT 8
…Which Is Critical, as Austerity Has Taken a Big
Economic Bite Out of Growth in Recent Years in the
Eurozone
('09-'14e)
Annualized Real GDP Growth
3%
y = -1.4x + 1.6%
R2 = 82.4%
Germany
2%
1%
France
0%
Italy
-1%
Ireland
Spain
Portugal
One percentage
point of fiscal
contraction has
equated to 1.4%
slower GDP growth
In Japan, there is also good news on the austerity front these days.
What’s changed is that Prime Minister Shinzo Abe has successfully pushed to have the second leg of the consumption tax increase
shelved. To review, after increasing the consumption tax to eight
percent from five percent in April 2014, Abe recently shelved the
proposed follow-on tax scheduled for October 2015, which was
intended to increase the consumption tax to ten percent from eight
percent. While the impact of the consumption tax would have been
minimal in 2015 as it was scheduled for 4Q15, GDP growth in calendar year 2016 may now reach 1.8% versus 1.0% if the tax regime had
been implemented1.
Separately, the other big consideration for the global economy’s
growth trajectory is the potential benefit from lower commodity prices. If we use Brent oil as a proxy, it has declined a sizeable 50% over
the past few months to $57.33/barrel (bbl) from a high of $115.06/
bbl in June 2014. Beyond adding what we estimate to be over $1.7
trillion of annualized savings for energy consumers worldwide (Exhibit 12), we think the fall in the price of Brent crude also provides an
important tailwind to central bank policy in many of the world’s major
economies. Already, with oil prices now acting as a less of a drag on
one of the world’s most dependent commodity importers, Japan has
allowed its currency to rise to a high of 120 yen per U.S. dollar from
101 in July 2014.2
Meanwhile, in China — with inflation falling all the way to 1.4% in
November 2014 from 6.5% in July 2011 — President Xi Jinping and
Premier of the State Council Li Keqiang recently worked with the
country’s central bank to cut rates for the first time since July 20123.
In our view, this rate cut is a direct response to slower growth in the
real economy and the increasing threat of deflation, and as such, we
now expect additional easing measures after the Lunar New Year in
February 2015.
Lower commodities – among other developments – are also shaping
monetary policy in Europe, in our view. European Central Bank President Mario Draghi recently commented that he was not only going to
increase the ECB’s balance sheet by one trillion euros but also that,
beyond asset backed and covered bond purchases, “other unconventional measures might entail the purchase of a variety of assets, one
of which is government bonds.” This statement, in our view, is a big
deal, and as Exhibit 12 suggests, a lower-priced commodity environment now gives him a lot more flexibility to pursue a broader range
of non-conventional measures to counter the downward pressure we
now see on forward-looking inflation expectations.
-2%
-3%
-4%
-5%
Greece
0%
2%
4%
Structural Deficit Reduction, % GDP Per Year
('09-'14e)
e = IMF estimates. Data as at October 7, 2014. Source: KKR Global Macro
& Asset Allocation analysis of IMF data.
1 Data as at December 1, 2014. Source: Morgan Stanley Equity Research, Four
Punches Knock Out Deflation.
2 Data as at December 31, 2014. Source: Bloomberg.
3 Data as at December 9, 2014. Source: China National Bureau of Statistics,
Haver Analytics.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
7
EXHIBIT 9
EXHIBIT 11
The ECB Target for Inflation Is Two Percent. Only
Services Is Currently Even Close to Reaching That Level
Our Base Case Is for 3.1% GDP Growth in 2015, Helped
by Lower Commodity Prices and Less Fiscal Drag
Eurozone Inflation in Aggregate and by Sector, y/y %
1.5%
1.1%
1.0%
4%
0.5%
0.3%
5%
3%
0.0%
-0.1%
2%
1%
-2.0%
0%
-2.5%
-1%
-2%
2018e
2017e
2015e
2016e
2014e
2013
Data as at November 30, 2014. Source: ECB, Haver Analytics.
Data as at December 31, 2014. Source: KKR Global Macro & Asset
Allocation analysis.
EXHIBIT 10
As Such, Inflation Expectations Are Now Falling to
Dangerously Low Levels
EXHIBIT 12
Eurozone Inflation y/y
Market Expected 3yr Fwd
Actual y/y
Memo: ECB Target
4.0%
3.5%
3.0%
Jan-13
2.0%
2.5%
2.0%
Nov-14
0.8%
1.5%
1.0%
0.5%
0.3%
0.0%
-0.5%
-1.0%
2.8%
2.9%
2.0%
3.3%
-3%
2010
Food,
Services
Alcohol and
Tobacco
2009
Energy
2007
Nonenergy
Industrial
Goods
2008
Inflation
2004-2014
2014-2018e (Base)
2014-2018e (Bear)
2014-2018e (Bull)
2004
-2.7%
-3.0%
Memo: CAGR
2006
-1.5%
2012
-1.0%
2011
-0.5%
2005
0.5%
KKR GMAA Global Real GDP Growth Estimate, y/y%
04 05
06
07
08
09
10
11
12
13
14
Market expected inflation is as per Eurozone inflation swaps. Data as at
November 30, 2014. Source: Eurostat, Bloomberg.
So, our bottom line is that the collective benefit of both less government drag and lower commodity prices on global growth could be
one of the more important macro stories in 2015. Consistent with
this view, we are now comfortable forecasting that global growth will
reach 3.1% in 2015 versus 2.7% in 2014 and 2.5% in 2013. One can
see this in Exhibit 11, which also shows that the global economy finally
starts to turn down around 2017 in our base case.
Lower Oil Could Be an Important Tailwind to Both
Growth and Central Bank Policies Across Many of the
World’s Major Economies
CRUDE OIL
PRICE US$/
BBL
GLOBAL OIL
BILL (US$
TRILLIONS)
SAVINGS VS OIL
AT $110 (US$
TRILLIONS)
SAVINGS %
GLOBAL GDP
110
3.7
0.0
0.0%
100
3.3
0.3
0.4%
90
3.0
0.7
0.9%
80
2.7
1.0
1.3%
70
2.3
1.3
1.8%
60
2.0
1.7
2.2%
50
1.7
2.0
2.7%
40
1.3
2.3
3.1%
Note: Using $110 as the reference point, 2013 global oil consumption rate
of 91 million barrels per day, 2013 Global GDP of $75 trillion. Data as
at December 31, 2013. Source: BP Statistical Review, IMF, KKR Global
Macro & Asset Allocation analysis.
That said, our bigger picture view for 2015 is that we still expect
ongoing bouts of significant volatility during this Asynchronous
Recovery for several reasons. First, while a recent rate cut by China
could help, it does not overshadow the structural issues the country
faces as it shrinks its outsized fixed investment outlays.4 Also, given
that China and its emerging market brethren are expected to account
for nearly 74% of global growth (Exhibit 14), we worry that these
estimates place too much responsibility on the emerging consumer
4 Data as at November 30, 2014. Source: China National Bureau of Statistics,
Haver Analytics.
8
KKR
INSIGHTS: GLOBAL MACRO TRENDS
to drive growth up without some hiccups along the way. Let us not
forget that U.S. and European shoppers still out-consume the BRIC
countries by nearly a 3.5:1 ratio5.
Second, we think the recovery will remain asynchronous because the
global economy still lacks the type of overall demand that we have
seen in prior recoveries. We believe real wage growth across the
developed markets remains a major issue. As such, it is impossible for
every country to narrow its deficits through more competitive exports
when the lion’s share of countries we visit are now more focused
on producing goods, not consuming them. Third, governments in the
developed markets still need to deleverage, which historically has led
to increased volatility in the global capital markets. Finally, we think
many emerging market economies must deal with the overhang from
too much money supply and credit growth in recent years. As a proxy,
we note that today China’s M2 money supply growth is now running in
the low double digits, versus a peak of around 30% in 20096. Without
question, this slowdown in China’s M2 is affecting the growth trajectory of global fixed investment, commodity-related inputs in particular.
EXHIBIT 13
We Remain Committed to Our View That This Recovery
Remains Asynchronous, Including Lower Than Expected
Inflation
2015 GROWTH & INFLATION BASE CASE ESTIMATES
KKR GMAA
TARGET
REAL GDP
GROWTH
BLOOMBERG
CONSENSUS
REAL GDP
GROWTH
KKR GMAA
TARGET
INFLATION
BLOOMBERG CONSENSUS
INFLATION
U.S.
3.2%
3.0%
0.7%
1.5%
EURO AREA
1.3%
1.1%
0.4%
0.6%
CHINA
6.9-7.0%
7.0%
1.8%
2.0%
BRAZIL
0.25%
0.85%
6.5%
6.4%
GDP = Gross Domestic Product. Bloomberg consensus estimates as
at December 31, 2014. Source: KKR Global Macro & Asset Allocation
analysis of various variable inputs that contribute meaningfully to these
forecasts.
“
Unlike in past years, central bank
policy around the world is now
less in synch, which could create
some tension in global capital
markets, currencies in particular,
during parts of 2015.
“
5 Data as at July 1, 2014. Source: World Bank, Haver Analytics.
6 Ibid.3.
EXHIBIT 14
Consensus Forecast Now Relies on Strong EM Growth to
Carry Global Growth. We Are More Cautious
2015 Real Global GDP Growth (%)
4.5
+0.5
4.0
+0.5
3.5
U.S. makes
up 13%
+1.6
3.0
2.5
Other Emerging
Markets make up
another 43% of
growth in 2015
2.0
1.5
+3.8
+1.2
1.0
China alone makes up 31%
of growth in 2015
0.5
0.0
China
Other
Emerging
Markets
U.S.
Other
World
Data as at October 8, 2014. Source: IMF, Haver Analytics.
Ongoing Commodity Pressures Amid Declining Currencies Could
Create a Major Change in the Outlook for Both Commodity Producer and Consumer Nations
While the recent decline in oil is noteworthy, we think it is more
reflective of three bigger macro trends that we see playing out in
the global commodity arena. First, after a decade of China literally
consuming almost all the incremental commodity supply (Exhibit
15), we think that its insatiable appetite is now waning. True, recent
initiatives by the People’s Bank of China to lower interest rates could
provide a short-term boost, but we do not think it will be enough to
offset fixed investment overcapacity amid a period of slowing growth
and falling inflation. Ultimately, China needs more credit extension in
the consumer sector, not the corporate sector (which caters more to
exports and fixed investments). However, as it stands now, consumer mortgages have higher capital charges (they can’t be securitized),
have less of a government-implicit guarantee, and are being impaired
by lack of deposit growth in the channel.
Second, technological improvements, particularly in the area of oil
production, are contributing to record supplies of oil and natural
gas. In 2014, for example, we estimate global crude oil supply grew
by almost 1.5 million barrels per day (Mb/d), which is far higher
than the roughly 1.0 Mb/d of run-rate demand growth we expect in
coming years7. As has been well documented in the press, the trend
towards robust production is most apparent in the United States, but
over time we also expect additional transfer of skills and technology
to certain international destinations, including Mexico. Moreover,
beyond ongoing technological advances, our research shows that
Iran and Libya are still currently producing far below their historical
rates and normalization could add to global supply over the longer
term. However, unless there is an agreement on the Iranian nuclear
7 Data as at December 31, 2014. Source: IEA, KKR Global Macro & Asset
Allocation estimates.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
9
program that reduces sanctions that currently keeps about a million
barrels per day of Iranian crude off the market, we do not expect
significant additions in 2015.
Third, given that many commodities are quoted in U.S. dollars, recent appreciation in the greenback has put further downward pressure on prices – a trend history suggests will continue (see Currency section for more details). Key to our thinking is that, as their
currencies depreciate versus the dollar, local producers in countries
like Russia, Brazil and South Africa are encouraged to still produce
as it may be profitable in local terms, even if it is not in U.S. dollar
terms. In many instances, commodity producers in EM countries can
be affiliated with the government, often serving as a major source of
fiscal revenue.
The examples can be striking: While crude oil fell about 50% in USD
terms in June-December 2014, it was down only 9% in Russian
ruble terms over the same period. Similarly, gold was down 10%
in USD terms, but fell only three percent in South African rand. In
Brazil, in coffee, Arabica futures were up 50% in USD terms in 2014,
but up fully 69% in Brazilian real .8
So our bottom line is that we think that the current unwind of the
commodity boom that defined much of the 2000-2010 period will
continue. Importantly, amid this decline we do not think it is unreasonable for commodities to trade through their marginal cost
curves. To be sure, we think that there will be opportunities amid the
carnage, but a purge is coming as access to the recently outsized
flow of credit wanes, suggesting that a much smaller universe of
low-cost and lowly leveraged companies in sectors like copper and
unconventional oil and gas garner outsized profits, not the entire
sector as the consensus had – until recently – come to believe. Over
time, this purge should be bullish. According to the investment bank
Morgan Stanley, looking at when oil dropped 20% or more since
1982, 85% of the time the average one-year forward return was
34.9% (Exhibit 38).
EXHIBIT 15
China Consumes More Than 40% of Global Commodities
in Eight of Fifteen Categories Below
CHINA % WORLD CONSUMPTION
1990
1995
2000
2010
2013
CEMENT
18.6%
31.5%
35.7%
56.2%
58.5%
PORK
34.9%
48.0%
46.9%
49.9%
51.3%
3.7%
5.1%
37.2%
50.5%
COAL
23.7%
30.6%
30.7%
48.2%
50.3%
STEEL
10.8%
12.7%
15.1%
44.6%
49.8%
NICKEL
ALUMINUM
9.3%
13.4%
39.8%
47.2%
COPPER
7.4%
12.4%
38.3%
46.7%
4.9%
10.2%
44.0%
41.9%
COTTON
LEAD
23.3%
22.0%
25.0%
40.2%
31.8%
RICE
36.9%
36.1%
33.8%
31.1%
30.7%
POULTRY
8.8%
19.5%
17.4%
16.1%
15.9%
BEEF & VEAL
2.7%
8.4%
9.6%
9.9%
12.2%
OIL
3.5%
4.9%
6.2%
10.4%
11.8%
NAT GAS
0.8%
0.8%
1.0%
3.4%
4.8%
NUCLEAR ENERGY
0.0%
0.6%
0.6%
2.7%
4.4%
Data as at December 31, 2013. Source: USDA, USGS, World Steel
Association, China National Bureau of Statistics, EIA, IEA, BP Statistical
Review, World Bureau of Metal Statistics, Bloomberg, Haver Analytics.
EXHIBIT 16
History Suggests Oil Should Be Bottoming, While Real
Metals Could Fall Further
DATES (PEAK TO TROUGH)
LENGTH IN
YEARS
% CHANGE IN
PRICE
REAL METAL COMMODITIES
“
China’s environmental headwinds,
including pollution, water
concerns and food safety, now
represent potentially more
contentious political issues than
job creation, in our view.
“
APR 1974 -JUL 1975
1.2
-47%
MAR 1979 – MAY 1986
7.0
-65%
APR 1989 – SEP 1993
4.3
-49%
JUL 1995 – DEC 2001
6.3
-53%
APR 2008 – DEC 2008
0.7
-60%
AVERAGE
3.9
-55%
FEB 2011 - CURRENT
3.8
-29%
DEC 1979 – JUL 1986
6.5
-84%
OCT 1996 – DEC 1998
2.1
-62%
SEP 2000 – NOV 2001
1.1
-50%
JUL 2006 – JAN 2007
0.5
-33%
JUN 2008 – FEB 2009
0.7
-70%
AVERAGE
2.2
-60%
JUN 2014 - CURRENT
0.5
-50%
REAL CRUDE OIL
Data as at December 31, 2014. Source: Thomson Reuters, Credit Suisse
Research.
8 Data as at December 31, 2014. Source: Bloomberg, Haver Analytics.
10
KKR
INSIGHTS: GLOBAL MACRO TRENDS
Against this backdrop, we think that the commodity-dependent
countries like India and Japan stand to benefit mightily. Importantly,
India is starting to enjoy not only lower inflation but also a smaller
current account deficit (compliments of lower prices of imported oil
and higher interest rates), which is important for its currency. Japan
too should benefit from lower oil prices, given that it is a major oil
importer. Already, the country’s central bank has elected to run with
a significantly cheaper currency because oil prices become less of a
deterrent to consumer spending at $50-$70 a barrel than they do at
$95-$105 a barrel.
We believe both the U.S. and Europe should see stronger consumer
activity in 2H15 if commodity prices, oil in particular, remain subdued.
All told, our research shows that each 10% drop in oil initially adds
around 0.2% to U.S. GDP growth. At the consumer level, we note
that, according to the Bureau of Labor Statistics, gasoline/motor oil
usage represents about $2,600 of total household income of around
$64,0009. So the recent 40% drop in gasoline prices, coupled with
the 50% drop in oil, provides at least $1,000 of incremental shopping
power per household10. Importantly, though, our work shows about
a 12-month lag (i.e., lower oil prices are not a coincident indicator);
moreover, given the importance of energy activity in fueling U.S.
GDP growth during the 2010-2014 period, we do think that there will
be important offsets to the standard notion that lower oil prices are
universally good for growth throughout the United States.
EXHIBIT 17
Our Model Suggests a Notable Tailwind from Oil Price
Declines, but Cautions That the Benefit Might Not Be Felt
Fully for Several Quarters
Oil Px, Approximate Contribution to
U.S. GDP Growth, According to Our Statistical Model
1.0%
0.5%
3Q16
0.8%
3Q10
0.9%
0.0%
2Q15
0.0%
-0.5%
-1.0%
4Q12
-0.8%
3Q09
-1.2%
4Q03
4Q04
4Q05
4Q06
4Q07
4Q08
4Q09
4Q10
4Q11
4Q12
4Q13
4Q14
4Q15
4Q16
4Q17
-1.5%
3Q17
0.0%
Note: Our statistical leading indicator uses seven variables to predict U.S.
GDP growth twelve months in the future with a backtested r-squared of
74%. The 12-month moving average of Brent oil prices is a key input to
the model. Specifically, the model assumes that a 10% fall in 12-month
moving average oil prices leads to a ~20 basis points uplift to GDP
growth four quarters later. Data as at December 19, 2014. Source: Haver
Analytics, KKR Global Macro & Asset Allocation analysis.
9 Data as at December 31, 2013. Source: Bureau of Labor Statistics.
10 Data as at December 31, 2014. Source: KKR Global Macro & Asset Allocation
estimates.
EXHIBIT 18
We Think the Fall In Oil Prices Will Provide a 1.6% Boost
to U.S. Consumers, Which Is Only Partially Offset by the
Hit to Domestic Oil Producers
BARRELS
/ DAY
ANNUAL VALUE
($BN)
IMPLIED GAIN/
(LOSS)
(000)
@
$100/
BBL
@
$60/
BBL
$BN
% GDP
U.S. CRUDE
CONSUMERS
19,010
694
416
278
1.6%
U.S. CRUDE
PRODUCERS
8,595
314
188
-125
-0.7%
U.S. NET CRUDE
POSITION
10,415
380
228
152
0.9%
-20
-0.1%
MEMO: POTENTIAL
ADDITIONAL HIT
TO UPSTREAM
INVESTMENT (1)
ESTIMATED TOTAL
NET BENEFIT TO
U.S. ECONOMY
0.8%
¹We estimate U.S. upstream investment may need to fall by roughly
$40bn, half of which we assume is funded by credit, and therefore
not captured by the $125bn cash hit to producers shown above. Data
as at December 19, 2014. Source: Energy Intelligence, U.S. Bureau
of Economic Analysis, Haver Analytics, KKR Global Macro & Asset
Allocation analysis.
On the other hand, we expect that the fiscal situations in Russia,
Nigeria, Chile, South Africa, and Brazil will remain under pressure as
the “hangover” effect from lower commodity prices ripples through
the economic outlook for these commodity export-dependent economies. This viewpoint is significant because we think it also means
that their currencies and certain related credits could remain under
pressure. Already, many of the aforementioned commodity plays have
seen their currencies fall substantially since the beginning of 2014.
However, given that many of these countries are now experiencing
declines in both export volume and price, we still see bumpier roads
ahead as fiscal balances are harder to achieve amid increasing social
unrest and rising inflation. At the moment, we are most cautious on
the economies of Russia and Brazil.
If there is good news, in the near term we think that the overall
markets can withstand the tension being created between beneficiaries of and losers from lower prices in the commodity arena. As
such, we expect to hear a lot in the investment community about a
“decoupling” of commodity beneficiaries from commodity-inflicted
countries.
However, we should not underestimate the impact of shifting $1.7
trillion of value from producing nations to consumer nations in a
relatively short period of time (Exhibit 12). Our work, which we detail
below, shows neither a global recession nor a capital markets crisis
is likely, particularly given higher reserves and lower debt levels.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
11
However, we think that the ongoing tension that is already being created in the global capital markets from this massive shift of economic
value from commodity producing nations towards consumer-oriented, import-dependent nations is not likely to abate, and as such, it
could be one of the biggest macro stories in 2015.
EXHIBIT 20
…But Some Countries Are Still Challenged vis-à-vis Import
Cover
Reserves in Months Import Cover
1997
EXHIBIT 19
10.5
Brazil
In Aggregate, External Debt to GDP Levels Are 25%
Lower Than in 1997…
3.0
Russia
7.7
Colombia
Emerging Markets: External Debt as a % of GDP
Korea
45
1.7
Nigeria
1999
40.0
3.3
Malaysia
5.0
Indonesia
35
Turkey
1997
33.8
30
3.1
Mexico
2013
25.7
Argentina
98
01
04 07
10
13
Data as at December 31, 2013. Source: IMF, Haver Analytics
7.1
6.7
7.0
16.2
5.8
8.8
18.4
3.3
2.1
3.1
Vietnam
80 83 86 89 92 95
7.3
4.7
Egypt
20
9.6
5.9
2.5
South Africa
14.7
6.1
Venezuela
25
18.8
8.5
8.0
8.2
8.8
8.1
India
40
15
Current
Data as at November 30, 2014 or latest available. Source: Above
referenced respective central banks, World Bank, Haver Analytics.
EXHIBIT 21
Overall, Though, Reserves Are More Than Sufficient to
Cover Short-term External Debt Needs…
Reserves / Short Term External Debt
“
Our base view is that not only
is the absolute return in global
equities likely to be lower on a
go-forward basis, but we also
believe the Sharpe ratio is likely
to decline.
“
1997
Nigeria
1.3
Brazil
1.5
1.7
Colombia
Indonesia
0.5
Vietnam
0.8
Mexico
1.0
Argentina
Malaysia
Turkey
Venezuela
India
Egypt
11.5
2.1
Russia
0.7
Current
5.1
4.4
2.5
2.6
2.7
2.1
1.5
2.7
1.5
1.5
2.1
1.1
3.6
5.5
4.6
6.8
Data as at November 30, 2014 or latest available. Source: Above
referenced respective central banks, World Bank, Haver Analytics.
12
KKR
INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 22
EXHIBIT 23
…And Most Countries Have Less External Debt Today
Than in 1997
Lots of Liquidity Has Not Impacted the Money
Multiplier…
Money Multiplier (M2/Monetary Base)
Reserves / Gross External Debt
1997
0.2
Mexico
0.1
0.1
Egypt
0.2
0.2
Venezuela
0.2
Japan
We again expect the Euro area money
multiplier to decline as the repayment
of the T-LTRO caused the spike
7
6
Falling
multiplier
5
4
3
0.7
0.4
0.5
0.2
0.1
8
0.5
0.3
Argentina
Nigeria
0.7
0.4
0.3
0.4
Turkey
Malaysia
0.7
0.4
0.1
Euro Area
10
9
0.6
0.3
Colombia
Indonesia
1.1
0.3
India
Vietnam
U.S.
0.3
Brazil
Russia
Current
0.3
Data as at November 30, 2014 or latest available. Source: Above
referenced respective central banks, World Bank, Haver Analytics.
2
07
08
09
10
11
12
13
14
15
16
Data as at November 30 2014. Source: ECB, BOJ, Federal Reserve
Board, Haver Analytics.
EXHIBIT 24
…Even During Periods of Great Balance Sheet Expansion
Central Bank Balance Sheet % GDP
Financial Services “Plumbing” Still Not Working, in Our View,
Despite Surging Global Monetary Base
Though it has been 75 months since Lehman Brothers filed for bankruptcy, our work shows that the traditional financial services industry
is still not functioning properly. Supporting our view is that, as one
can see in Exhibit 23, the money multiplier remains somewhat “broken.” This realization is particularly noteworthy, given the size of the
increases in central bank balance sheets in recent years (Exhibit 24).
To be sure, the illiquidity premium that we identified three years ago
has begun to erode in some areas of the market (and hence, why
we have reduced some of our overweight positioning). However,
in a world of extremely low government bond yields, we think that
the benefit of 300-400 basis points of illiquidity premium that one
can obtain through the direct, non-bank lending market is extremely
compelling versus a seven percent hurdle rate for many pensions
and – depending on the country – a 50 basis points to 2.5% 10-year
“risk-free rate” in today’s market environment. Also, given the lack
of liquidity in the traditional credit markets these days, we are of the
mindset that there is an ongoing blurring between the over-the-counter and the negotiated private markets, particularly during periods of
stress in the system.
100
90
Fed
ECB
BoJ
80
70
60
50
40
30
20
10
0
06 07 08 09
10
11
12
13
14
15
16
Data as at November 30, 2014. Source: ECB, BOJ, BOE, Federal Reserve
Board, Haver Analytics.
What’s driving this opportunity set? In addition to a deflated money
multiplier, the traditional banking industry is also suffering from its
inability to facilitate customer flow the way it did in the past. Indeed,
as Exhibit 26 shows, dealer inventories have shrunk to a puny $59
billion in November 2014 from a sizeable $285 billion in October
2007. Not surprisingly, this decline coincides with a dramatic fall-off
in leverage within the broker-dealer and universal bank community,
which has collapsed by more than 40% since 2008 (Exhibit 25).
Moreover, because of heightened regulation, traditional financial
intermediaries are unable to participate in many of the higher margin,
KKR
INSIGHTS: GLOBAL MACRO TRENDS
13
non-traditional lending opportunities at a time when many small- to
medium-size businesses need access to credit. Finally, there are
just more needy industries that are either impaired and/or require
customized lending solutions. As such, we expect skilled managers
to be able to increasingly earn near distressed-like returns, but in
performing situations.
EXHIBIT 27
A Yield Comparison of Originated vs. Traded Leveraged
Loans Suggests the Illiquidity Premium Is Still Significant
Weighted Average Yield of Originated Senior Term Debt
EXHIBIT 25
Leverage for Broker-Dealers Has Collapsed, Creating a
Significant Opportunity for Non-Traditional Lenders
19
16
-42% in aggregate, but
varying between -27% and
-66% on a company level
15
14
11
3Q14
10.6
08
09
10
11
12
13
14
9.6%
8.3%
7.8%
5.8%
5.8%
6.0%
5.1%
8.2%
4.8%
2.0%
12
07
9.7%
4.0%
0.0%
13
06
12.0% 11.4%
10.8%
11.3%
10.7%
6.0%
17
05
11.2%
8.0%
3Q08
18.2
18
12.0%
10.0%
Wall Street Assets / Equity Ratio
10
12-Month Average Yield of Traded Loans
14.0%
2007 2008 2009
2010
2011
2012
2013
2014
YTD
Weighted average yields of senior term debt and yield of traded loans.
Senior term debt data as at September 30, 2014; traded loans data as at
November 30, 2014. Source: S&P LSTA, public company filings of Ares
Capital Corporation.
Aggregate of GS, MS, BAC, C, and JPM balance sheets. Data as at 3Q14
Source: Factset.
EXHIBIT 28
EXHIBIT 26
Lower Inventories in the Broker Dealer Community Have
Massively Dented Liquidity
Primary Dealer Positions: Corp Securities, U.S. $ Billions
300
Oct-07
285
250
0.9%
7%
2.4%
0.5%
4%
8.0%
3%
2%
4.1%
1%
100
0%
50
59
01 02 03 04 05 06 07 08 09 10 11 12 13 14
Data as at November 30, 2014. Source: Federal Reserve Bank of New
York, Haver Analytics.
14
8%
5%
150
0
9%
6%
A decline of
nearly 80%
200
Over 240 Basis Points of Illiquidity Premium on Offer in
European Middle Market Loans Today
KKR
INSIGHTS: GLOBAL MACRO TRENDS
European
Credit Risk
Syndicated
Premium for
Leveraged Loan Middle Market
New Issue
Loans
Spreads (B+/B)
(Note 2)
(Average senior
leverage: 5.0x)
(Note 1)
Illiquidity
Premium
(Note 3)
Underwriting
Fees
(Note 4)
All-in Spread
plus fees for
European
Middle Market
Loans
(Average senior
leverage: 4.7x)
(Note 5)
Data as at November 30, 2014. Source: KKR Credit. See endnote 1 for
important disclosures1.
Importantly, we see this opportunity set as a global one. In Europe,
for example, banks appear to be backing away from smaller companies and credits that are non-traditional or complex. Separately, in
many parts of Asia we see a growing number of non-bank lending
opportunities, including India and Indonesia. To be sure, these types
of investments require more due diligence and a higher risk premium,
but our conclusion is that the global disconnect between the growing
demand for non-traditional capital by small- to medium-size businesses as well as the inability of traditional financial intermediaries
to meet this need – despite a sea of central bank-induced liquidity –
remains one of the great anomalies in the global capital markets.
Styles to Pursue Within Public Equities: We Retain a Barbell Approach
We approach global equities with two dramatically different strategies in 2015. On the one hand, in the developed markets we retain our
bias for relatively inexpensive stocks with excess cash flow that is
being redeployed in the form of dividends, buybacks and/or acquisitions. Without question, we still favor our Brave New World names
(see our earlier note Brave New World: The Yearning For Yield Across
Asset Classes for further details), which places an additional emphasis
on rising dividends and improving returns on equity. Importantly, we
are not alone in this view, as the recent surge in activist investors
validates our view that many companies in the United States are
operating with cost of capital that is equal to their cost of equity and
significantly in excess of cost of debt, which is usually sub-optimal
outside of the hyper-growth part of the market. Consistent with this
view, we also expect global M&A activity to exceed 2014’s level of
$2.9 trillion.11
EXHIBIT 29
We Remain Constructive On Stocks With Yield and
Growth
Indexed Returns for Various Dividend Yield Buckets
Index 1990 = 1
35
0-1%
30
1-2%
25
2-3%
20
3-4%
4-5%
15
>5%
10
5
0
1990
1994
1998
2002
2006
Data as at December 31, 2014. Source: S&P, Factset.
11 Data as at December 31, 2014. Source: Bloomberg.
2010
2014
EXHIBIT 30
A Record Number of European Companies Now Have
Dividend Yields Above Corporate Bond Yields
70%
65%
% of companies with Dividend Yield >
Corp Bond Yield
60%
Average
55%
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
99 00 01 02 03 04 05 06 07 08 09 10 11
12 13 14
Data as at October 21, 2014. Source: Datastream, Goldman Sachs Global
Investment Research Adventures in Wonderland.
We see similar opportunities to buy attractively priced high dividend yield, cash flowing companies outside of the United States. In
Europe, for example, nearly 65% of the companies now trade with a
dividend yield that is above their corporate bond yield. Importantly,
as Exhibit 29 shows, positioning appears quite clean as many investors exited the region in the fall of 2014 after the IMF cited concerns
about Europe’s growth profile.
On the other hand, in the emerging markets we are willing to pay up
for high quality consumption stories that are linked to improving GDP
per capita dynamics versus just GDP growth. Our favorites for 2015
again include both India and Mexico. In India, we are more bullish
than the consensus expectations for lower inflation, which we think
is constructive for trading multiples. We also believe that earnings
growth could be stronger than many folks think as improving confidence encourages both consumers and businesses to spend more.
In Mexico we think that the negative shock of last year’s tax increases has abated. Meanwhile, Mexico’s export economy is accelerating
at a time when even the naysayers of President Enrique Pena Nieto’s
reforms acknowledge that this multi-year transition is still ahead of
schedule in many areas12. To be sure, lower oil prices will hurt government spending in the near term, and we are closely watching the
Pena-Nieto administration’s response to recent rule of law and corruption allegations. Nonetheless, our overall view is that both Mexico’s capital markets and its currency represent good long-term value
at current levels. Within Mexico we are most favorable on real estate;
in particular, we think that commercial real estate is underpriced at
a time when many multinationals are increasingly considering calling
Mexico City, not Sao Paulo, their home base in Latin America.
12 Data as at November 26, 2014. Source: Itaú BBA.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
15
EXHIBIT 31
SECTION II: Asset Class Review
Reforms May Have Hindered the Performance of Mexican
Large Cap Names versus Their Mid Cap Peers, a Trend
We Expect to Continue…
Mexico Midcaps (IMC30) vs. Mexico Large Caps (MEXBOL)
December 31, 2013 = 100
120
IMC30
MEXBOL
115
108.2
110
105
100
101.0
95
90
Dec-14
Nov-14
Oct-14
Sep-14
Aug-14
Jul-14
Jun-14
May-14
Apr-14
Mar-14
Feb-14
Dec-13
Jan-14
85
EXHIBIT 32
…While In India, Reforms Seem to Have Bolstered
Performance, Particularly in Relation to Other Large
Emerging Markets
India Nifty Index vs. MSCI EEM
December 31, 2013 = 100
India NIFTY
MSCI EEM
131.4
135
There is no harm in repeating a good thing. Plato
When we did our 2014 mid-year outlook update (see Midyear Outlook:
Four Big Macro Trends at Work), we spent a significant amount of time
discussing why we believe that in today’s uneven growth environment investors should consider allocating more capital to special
situations-type investments. In the past, many of the most attractive
opportunities were related to corporate restructurings and deleveraging stories in the developed markets.
However, based on recent trips to India, Indonesia and China, we see
that many banks in the region are now carrying too much bad corporate credit and, as a result, there is a growing role for private lenders
and restructuring professionals to step in and provide value-added
capital to struggling corporations across a variety of sectors in the
emerging markets. Importantly, we see this opportunity as secular,
not cyclical, as credit creation in the emerging markets in recent
years has been outsized.
In many instances these deals are large and complicated, requiring
not only expertise in financial engineering but also in operational
capability. This insight is important, we believe, because many
investment managers in emerging markets are currently set up to
do public investing and/or private equity, but not the restructurings,
recaps, and deleveragings that we think are needed. As a result, we
think many firms, particularly in the alternatives space, will be forced
to overhaul their models. In particular, we think the ability to move up
and down the capital structure and provide corporate partners with
value-added financial and operational expertise will go from being a
luxury offering to becoming a prerequisite for success in the new era
of emerging market investing we now envision.
Data as at December 31, 2014. Source: Bloomberg.
145
Distressed/Special Situation: Our Largest Wager for 2015
125
EXHIBIT 33
Credit as a % of GDP Has Ballooned in Many EM
Countries
Domestic Credit to Private Sector % GDP
115
2000
2007
2013
160
105
95
Data as at December 31, 2014. Source: Bloomberg.
Dec-14
Nov-14
Oct-14
Sep-14
Aug-14
Jul-14
Jun-14
May-14
Apr-14
Mar-14
Feb-14
Dec-13
85
Jan-14
94.0
120
80
40
0
India
Turkey
Brazil
Vietnam
China
Thailand
Data as at December 31, 2013. Source: World Bank, Haver Analytics.
16
KKR
INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 34
EXHIBIT 35
EM Credit Has Mushroomed Since the Great Recession
EMERGING MARKETS DOMESTIC BANK LOANS AS A % OF GDP
2008
AUGUST
2014
If OPEC Will Not Cede Market Share, Our Work Suggests
That Rig Count May Need to Fall Considerably…
Y/Y Production Growth (000 bpd)
CHANGE PER
ANNUM (%)
U.S. Oil Rig Count (4Q Lead)
1,400
1,577
1,600
EMERGING MARKETS
70.7
94.1
4.0
EM ASIA
97.6
123.9
4.4
CHINA
99.6
139.1
6.7
800
INDIA
49.8
55.6
1.2
600
INDONESIA
23.7
32.2
1.4
SINGAPORE
93.8
128.4
5.7
THAILAND
90.2
122.1
5.5
-200
200
HONG KONG
192.8
323.9
20.7
-400
0
LATIN AMERICA
30.0
47.6
3.0
-600
-200
BRAZIL
43.3
71.2
4.9
MEXICO
17.0
21.7
0.8
ARGENTINA
9.9
12.5
0.4
EMEA EM
48.1
44.2
-0.7
RUSSIA
36.8
50.9
2.4
SOUTH AFRICA
76.8
69.4
-1.3
TURKEY
30.7
68.4
6.2
1,200
1,000
1,103
1,200
1,000
800
400
600
200
400
1Q04
4Q04
3Q05
2Q06
1Q07
4Q07
3Q08
2Q09
1Q10
4Q10
3Q11
2Q12
1Q13
4Q13
3Q14
2Q15
1Q16
4Q16
0
Data as at December 19, 2014. Source: Energy Intelligence, Baker
Hughes, U.S. Bureau of Economic Analysis, Haver Analytics, KKR Global
Macro & Asset Allocation analysis.
EXHIBIT 36
… As Will Overall Upstream Investment
Y/Y Production Growth (000 bpd)
U.S. Upstream Energy Investment (SAAR $Bn, 4Q Lead)
1,500
1,400
1,200
1,000
R2 = 65%
146
Relationship suggests that for
production growth to drop to 750k
bpd, investment needs to fall ~25%
to $110bn vs. $146bn current
1,103
120
100
600
400
80
200
60
0
-200
40
1Q15
1Q16
1Q14
1Q13
1Q12
1Q11
1Q10
1Q09
1Q08
1Q07
1Q06
-400
-600
160
140
800
1Q05
We also think that the recent carnage in energy will ultimately prove
to be an interesting investment opportunity. According to work done
by my colleague David McNellis, both rig counts and investment could
fall notably over the next 12 months. One can see his research in
Exhibits 35 and 36. Without question, calling the bottom in commodities is hard, but as Exhibit 37 shows, there is certainly a lot of stress
now in the system, which we think could create some opportunities
to support low cost producers with differentiated strategies as well
as help to repair the finances of companies that were too optimistic about both prices and drilling activity. Importantly, derivative
structures, including selling puts that harness the market’s outsized
volatility in the energy sector, appear compelling. All told, volatility in
the sector is now upwards of 60%, nearly triple where it was in the
spring of 2014 (Exhibit 37).
1,400
Relationship suggests that for
production growth to drop to 750k
bpd, rig count needs to fall ~40%
to ~950 rigs vs. 1,577 current
1Q04
Data as at August 31, 2014. Source: JPMorgan Research, IMF.
R2 = 82%
20
Data as at December 19, 2014. Source: Energy Intelligence, Baker
Hughes, U.S. Bureau of Economic Analysis, Haver Analytics, KKR Global
Macro & Asset Allocation analysis.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
17
EXHIBIT 37
EXHIBIT 39
E&P and Oil Service Volatility Is Up 200% Since June
2014; Our Intent Is to Harness It
DATE OF
TROUGH
DATE
OF
PEAK
DURATION
TROUGH
TO PEAK
(MONTHS)
% CHANGE
TROUGH TO
PEAK
P/E
MULTIPLE
APR-42
MAY-46
49
157.1%
177%
JUN-49
DEC-52
42
96.2%
87%
SEP-53
AUG-56
35
119.0%
51%
DEC-57
JUL-59
19
53.8%
45%
OCT-60
DEC-61
14
38.9%
39%
JUN-62
JAN-66
43
79.8%
2%
SEP-66
NOV-68
25
48.0%
35%
JUN-70
JAN-73
31
73.5%
32%
OCT-74
DEC-76
26
72.5%
57%
MAR-78
NOV-80
32
61.7%
21%
AUG-82
AUG-87
60
228.8%
166%
DEC-87
JUL-90
31
64.8%
18%
OCT-90
MAR-00
112
417.0%
113%
OCT-02
OCT-07
60
101.5%
-1%
41.3
115.0%
42%
68
204.0%
40%
Implied Volatility, %
80
Market Vectors Oil Service
60
SPDR S&P Oil & Gas Exploration
and Production
40
20
Nov-14
Oct-14
Sep-14
Aug-14
Jul-14
Jun-14
May-14
Apr-14
Mar-14
Feb-14
Dec-13
Jan-14
0
Data as at December 15, 2014. Source: Bloomberg.
EXHIBIT 38
Looking at History, There Seems to Be Opportunity When
Oil Declines 20% or More
TIME
PERIOD
U.S. $ PRICE
/ BARREL
DECLINE, YOY
# OF
OCCURRENCES
AVERAGE 1 YR
FORWARD
RETURN
MEDIAN 1
YR FORWARD
RETURN
HIT
RATIO ON
POSITIVE
RETURN
1982 TO
CURRENT
-20% OR
MORE
60
+34.9%
28.3%
85%
Data as at December 12, 2014. Source: Morgan Stanley.
Public Equities: Less Aggressive Posture to Start the Year
As we indicated earlier, we have begun to lower our Public Equities allocation for the first time since joining KKR in 2011. We are
not bearish per se, as we expect S&P 500 earnings to grow a solid
6.0% in 2015. Overall though, we need to recognize that this bull
market has been an over-achiever from almost any vantage point,
recent dollar gains are now likely to more than offset the benefits of
corporate buyback activity, and the tailwind from multiple expansion
is now finally abating, in our view. All told, as Exhibit 39 shows, the
total return on the S&P 500 is now already 204% this cycle versus
a historical norm of 115%. Moreover, as Exhibit 40 shows, even amid
some of the great bull markets, the propensity for the market to go up
consistently every single year is not that high this late in the cycle.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
AVERAGE
MAR-09
WTI SPOT OIL PRICE, % CHANGE OF U.S.$ PRICE / BARREL AND
SUBSEQUENT 1 YEAR FORWARD RETURN
18
Performance This Cycle Is Well Above Historical Norms
DEC-14
Performance on a monthly basis, peak to trough. PE Multiple as of
nearest month end. Data as at December 31, 2014. Source: Standard &
Poor’s, Omega Advisors.
“
There is certainly a lot of stress
now in the system, which
we think could create some
opportunities to support low cost
producers with differentiated
strategies as well as help to
repair the finances of companies
that were too optimistic about
both prices and drilling activity.
“
EXHIBIT 40
EXHIBIT 41
2014 Will Be the Sixth Consecutive Year of Cumulative
Positive Return in the S&P 500
The Low Volatility Rally Tends to End as the Fed Starts Its
Tightening Cycle…
S&P 500 Performance Around First Fed Hike
CONSECUTIVE YEARS OF POSITIVE RETURNS
# YEARS
START
END
CUMULATIVE
RETURN
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%
-10
5
2003
2007
83%
13%
-15
6
1947
1952
148%
16%
6
2009
2014
159%
17%
8
1921
1928
435%
23%
8
1982
1989
291%
19%
9
1991
1999
450%
21%
AVG. CAGR
19%
CAGR
Cumulative total return on an annual basis. Data as at December 31,
2014. Source: http://www.econ.yale.edu/~shiller/, Bloomberg.
As one can see in Exhibit 42, price-to-earnings ratios tend to contract
around decisions by the Federal Reserve to become less accommodative. This outcome makes sense to us as the transition from a P/E
led market to an earnings-driven one means that volatility typically
increases. We certainly expect this fact pattern to hold true in 2015,
though we do expect less multiple compression this tightening cycle
for two reasons. First, commodity prices are falling, which lowers the
risk premium on owning stock in many equity markets, particularly
developed ones. Second, as we describe below in detail in the fixed
income section, we think that low inflation will encourage the Federal
Reserve to keep its tightening campaign quite mild by historical standards. In particular, we expect the Fed to hike only 275 basis points
this cycle versus 319, on average, during prior cycles (see Exhibit 55
for details).
Higher vol, range bound
market
10
5
0
Low vol
rally
-5
-20
-24 -20 -16 -12
-8
-4
0
First Hike
4
8
12
16
20
24
Months from First Fed Hike
Includes first Fed hikes of Nov-54, Jul-58, Jul-61, Oct-67, Feb-71,
Feb-72, Feb-74, Nov-76, Jul-80, Apr-83, Nov-86, Jan-94, May-99, and
May-04. Source: http://www.econ.yale.edu/~shiller/, Bloomberg, S&P,
Thomson Financial, Federal Reserve, Haver Analytics.
EXHIBIT 42
…Because Multiples Often Contract, Volatility Tends to
Rise When the Fed Begins to Raise Rates
Average S&P 500 Characteristics Between
Start of and End of Fed Hiking Cycles
Unannualized
Annualized
28.2
13.8
8.6
2.8
-13.4
-9.3
P/E Change (%)
EPS Change (%)
Price Change (%)
Data as at October 31, 2014. Source: http://www.econ.yale.edu/~shiller/,
Bloomberg, S&P, Thomson Financial, Federal Reserve, Haver Analytics.
So as we look ahead, we think that the S&P 500 can deliver around
$126 in earnings in 2015, which would represent around 6.0% in
earnings growth, versus $118.50 in 2014. We also think that the
multiple on the S&P 500 can trade at 17.1 times in 2015, down from
17.5 in 2014. If we are right about a slight multiple contraction in
2015 against a backdrop of modest earnings growth, then our outlook
KKR
INSIGHTS: GLOBAL MACRO TRENDS
19
for 2015 would suggest a target for the U.S. market index of around
2,155 (Exhibit 45). Including a dividend yield of just under 2.0%, we
therefore expect the S&P 500 to return of 6-7% in 2015.
EXHIBIT 44
…However, Real GDP Growth of 2-3% Implies a Higher
P/E Multiple Than in the Past
EXHIBIT 43
In Current Environment, Falling Yields Look Like a
Valuation Headwind…
20x
Median Trailing P/E for Various Real 10 Yr
Yield Environments (1948-Current)
Trailing Price-to-Earnings Ratio
19
17
15
13.8 14.0
13
11.2
14.5
Median
15.5
12x
16.0
11.4
12.3
13.0
10x
8x
8.1
<0
0-1
1-2
2-3
3-4
4-5
>5
5-Year US Real GDP Annualized Growth Rate %
7
5
16.9
14.3
14x
10.8
11
9
17.8
16x
16.0
15.8
2013 to 2017 Real GDP
CAGR 2-3%
18x
17.6 17.7
We are here
Median S&P 500 Normalized Price-to-Earnings
for Various Growth Environments
Normalized Price-to-Earnings valuation ratio = Price divided by average
of past 5 years EPS. Study from 1900 to 3Q14. Source: BEA, Historical
Statistics of the United States, Factset, S&P, Bloomberg, stock market
data used in “Irrational Exuberance” by Robert J. Shiller.
<-2% -1-2% -1-0% 0-1% 1-2% 2-3% 3-4% 4-5% 5-6% >6%
Real 10 Year Treasury Yield %
Data as at October 31, 2014. Source: Thomson Financial, S&P, Federal
Reserve Board, Factset.
EXHIBIT 45
Amid Some Volatility, We See More Modest Gains for the S&P 500 in 2015
S&P 500 PRICE TARGET FOR DIFFERENT EARNINGS
AND VALUATION LEVELS
S&P 500
2014E
2015E
S&P 500 P/E MULTIPLE
KKR
S&P 500
S&P 500 P/E MULTIPLE
EPS
16.0
16.5
17.0
17.5
18.0
18.5
EPS Y/Y
16.0
16.5
17.0
17.5
18.0
18.5
118
1888
1947
2006
2065
2124
2183
-0.4%
-6.3%
-3.4%
-0.6%
2.3%
5.2%
8.0%
119
1904
1964
2023
2083
2142
2202
0.4%
-5.5%
-2.6%
0.3%
3.1%
6.0%
8.9%
120
1920
1980
2040
2100
2160
2220
1.3%
-4.7%
-1.8%
1.1%
4.0%
6.9%
9.8%
121
1936
1997
2057
2118
2178
2239
2.1%
-4.0%
-1.0%
1.9%
4.8%
7.8%
10.7%
122
1952
2013
2074
2135
2196
2257
3.0%
-3.2%
-0.2%
2.7%
5.7%
8.7%
11.6%
123
1968
2030
2091
2153
2214
2276
3.8%
-2.4%
0.6%
3.6%
6.5%
9.5%
12.5%
124
1984
2046
2108
2170
2232
2294
4.6%
-1.6%
1.4%
4.4%
7.4%
10.4%
13.4%
125
2000
2063
2125
2188
2250
2313
5.5%
-0.9%
2.2%
5.2%
8.2%
11.3%
14.3%
126
2016
2079
2142
2205
2268
2331
6.3%
-0.1%
3.0%
6.0%
9.1%
12.2%
15.2%
127
2032
2096
2159
2223
2286
2350
7.2%
0.7%
3.8%
6.9%
9.9%
13.0%
16.1%
128
2048
2112
2176
2240
2304
2368
8.0%
1.5%
4.6%
7.7%
10.8%
13.9%
17.0%
129
2064
2129
2193
2258
2322
2387
8.9%
2.2%
5.4%
8.5%
11.6%
14.8%
17.9%
130
2080
2145
2210
2275
2340
2405
9.7%
3.0%
6.2%
9.3%
12.5%
15.7%
18.8%
Data as at December 31, 2014 Source: Factset.
20
S&P 500 IMPLIED TOTAL RETURN FOR 2015
INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 46
larly fixed investment and exports. Moreover, our work shows that
Petrobras, one of the Bovespa’s largest constituents, will continue to
face regulatory and financial challenges in 2015. In Europe, we are
targeting equities with bond-like features. In a world in which we
think that the European Central Bank does move towards traditional
quantitative easing, shares of capital return stories are likely to be
significantly re-rated.
Acquirers Are Still Being Rewarded for Acquisitions
Acquirers Average One Day Stock
Performance Relative to the S&P 500
2.6%
2.9%
1.3%
0.7%
0.6%
0.3%
0.2% 0.1%
-0.1%
05
06
07
-1.1%
08
09
10
11
12
13
14
Data as December 18, 2014. Universe: All M&A deals with target region
United States, value greater than US$1B. Source: Bloomberg, KKR Global
Macro & Asset Allocation analysis.
Dividends and Stock Buybacks Remain Strong, Growing
at a 22% CAGR from 2009-2014E
S&P 500 Dividends & Gross Share Buybacks $B
Dividends
1000
900
700
600
340
247
07
08
100
196
206
09
10
240
11
U.S.
Germany
8
7
Dec-15e
Dec-14 2.60
2.17
4
2
399
1
0
138
247
9
10-Year Government Yield
3
476
299
300
0
German Yields Are Likely to Remain at Historic Lows…
5
544
409
400
200
EXHIBIT 48
6
Buybacks
CAGR of 22%
Since 2009
589
500
While fixed income is never easy to predict, we do feel some relief
as we think about 2015. Why? Because we think the direction of
global rates has become more of a relative call – not an absolute one.
Specifically, our message for how the long-term rates trade remains
unchanged: follow the German bund and then decide how much you
think Treasuries can trade above that. At the moment, the yield on
the Bund is approximately 54 basis points. As Exhibit 49 shows, the
US 10-year has not traded more than 200 basis points above the
Bund in over 25 years, and as such, we are willing to wager that
rates stay bound within this range in 2015. Specifically, we see the
U.S. 10-year yield rising only modestly to 2.6%.
10
EXHIBIT 47
800
Fixed Income: Less “Spicy” but More Opportunistic
281
12
312
13
351
14e
Data as at December 18, 2014. Source: Standard and Poor’s, KKR Global
Macro & Asset Allocation analysis.
Outside of the United States, we are overweight Asia, underweight
Latin America and equal weight Europe. In Asia, we see equity
markets in India, Japan and China all doing well. Key to our thinking is that, as a region, we believe Asia benefits mightily from lower
oil prices. By comparison, we retain our negative stance towards
Brazil, Latin America’s largest market. As our below consensus GDP
forecast indicates, we are quite concerned about growth, particu-
0.54
0.70
89 91 93 95 97 99 01 03 05 07 09 11 13 15
Data as at December 31, 2014. Source: Bloomberg.
“
Our goal is to add some ballast
to fixed income portion of the
portfolio during what we believe
could be a more volatile year for
the asset class.
“
KKR
INSIGHTS: GLOBAL MACRO TRENDS
21
EXHIBIT 49
EXHIBIT 50
…And With the U.S.-German Spread Near a Historic
High, We Think It Will Constrain the Near-Term Upside
to U.S. Treasury Yields.
KKR GMAA
FUNDAMENTAL
KKR GMAA
QUANT “FAIR
VALUE”
MARKET
KKR GMAA
VS. MARKET
(BASIS PTS.)
10YR YIELD, 2015
2.60%
3.00%
2.43%
17
10YR YIELD, 2017
3.25%
3.25%
2.68%
57
10YR REAL, 2015
0.70%
1.00%
0.50%
20
10YR REAL, 2017
1.25%
1.25%
0.71%
54
5YR YIELD, 2015
2.20%
2.60%
2.15%
5
5YR YIELD, 2017
3.00%
3.00%
2.67%
33
5YR REAL, 2015
0.40%
0.50%
0.37%
3
5YR REAL, 2017
1.00%
1.00%
0.63%
37
U.S. - Germany 10yr Rate Spread (%)
2.2
1.7
Interest Rates: We Forecast a Slow Crawl to Higher Levels
Apr-89
2.16
1.2
May-99
1.51
Sep-05
1.18
Dec-14
1.63
Dec-15e
1.90
0.7
0.2
-0.3
-0.8
-1.3
-1.8
89 91 93 95 97 99 01 03 05 07 09 11 13 15
e = KKR GMAA estimates. Data as at December 31, 2014. Source:
Bloomberg, KKR Global Macro & Asset Allocation.
At the moment, our forecast envisions German yields of 70 basis points next year, based off forwards market pricing that looks
reasonable to us given the disinflationary forces at work in Europe.
Importantly, our “fundamental” 2.6% forecast for the U.S. 10-year
next year, which incorporates the relative value impact of ultra-low
German rates, is well below the 3.0% rate forecast of our “quantitative” modeling, which is based purely on the present value of our
future short-term rate expectations. One can see the difference
between our “fundamental” and “quantitative” forecasts in Exhibit 50.
Looking further ahead, our modeling suggests a U.S. 10-year yield that
could reach a fair value of 3.25% by 2017, which coincides with what
we believe will be the approximate peak for this cycle. Importantly,
though, in the near term, we do not see a lot of wiggle room in longerterm rates. Consistent with this view, our rates forecasts imply only
slight upside to current market pricing this year (on the order of 10-20
basis points), whereas we are 30-50 basis points higher than the consensus on three-year forward implied expectations for interest rates.
“
Despite a surge in the global
monetary base, access to
credit remains a major issue,
particularly for small- to
medium-size businesses.
“
22
KKR
INSIGHTS: GLOBAL MACRO TRENDS
KKR GMAA “fundamental” forecast for 2015 assumes that U.S. 10yr
yield is capped at 2.6%, which is 190 basis points above the one-year
forward German 10yr yield of 0.7%. Quantitative fair values are based
on our estimates of the present value of future short term rates. Data as
of December 31, 2014. Source: Bloomberg, KKR Global Macro & Asset
Allocation analysis.
Implicit in our forecasts is that inflation stays low not only in Europe but also in the United States. Otherwise, we think the relative
comparisons versus Europe would become irrelevant and our Fed
outlook would likely need to accelerate too. But from where we stand
today, U.S. inflation seems set for an exceedingly moderate reading
of just 0.7% or so in 2015. Exhibit 51 details our expectations. On the
one hand, we forecast core CPI to remain at 1.75%. Moreover, we
expect food inflation to continue to run around a relatively elevated
3.0% rate, spurred by continued tight conditions in animal protein
markets (Exhibit 51). On the other hand, we expect energy deflation
of fully 12% or so, which envisions that OPEC continues its policy of
not supporting oil markets, holding oil range-bound around $50-70
per barrel. Beyond 2015, we see oil stabilizing and eventually moving
back towards $80-100 per barrel, as EM countries eventually achieve
higher economic growth and producers reduce previously anticipated
growth expectations. As such, we ultimately see the longer term
outlook of inflation reverting back towards two percent (Exhibit 64),
but investors should make no mistake that inflation is going to be
extraordinarily low in 2015.
EXHIBIT 51
EXHIBIT 53
Implicit in Our Rates Forecast Is That Inflation Stays Low
in 2015
KKR GMAA 2015e U.S. Inflation Forecast
U.S. Average Hourly Earnings Rise as Unemployment
Decreases. We See This as a Risk to the Front End of the
Curve by 2H15/1H16
U.S. Average Hourly Earnings Y/y For Various U.S.
Unemployment Rates (1985-2013), %
3%
1.75%
0.7%
Current unemployment
rate = 5.8%
4.5
3.8
4.0
3.5
3.1
3.0
2.7
+70bp
2.5
+40bp
2.0
Food
2.3
+30bp
1.5
-12%
Core CPI (ex
Food & Energy)
2.4
Energy
1.0
Headline CPI
0.5
0.0
Data as at December 19, 2014. Source: KKR Global Macro & Asset
Allocation estimates.
≤ 5%
5–6
6–7
7–8
> 8%
Based upon monthly data from January 1985 to December 2013. Source:
Bureau of Labor Statistics, Haver Analytics.
EXHIBIT 52
Our Fed Expectations Are Above the Market’s, but Below
the Fed’s Own Forecasts
Fed Funds Expected Rates
FOMC Forecast
GMAA Forecast
EXHIBIT 54
We Finally Think Some Wage Growth Could Be a Risk by
2H15 as More Firms Commit to Adding Workers
Market
Net % Planning to Raise Worker Compensation (L)
4.0%
US: Average Hourly Earnings Y/y (R)
30%
6%
25%
5%
2.0%
20%
4%
1.5%
15%
3%
10%
2%
5%
1%
3.5%
3.0%
2.5%
1.0%
0.5%
FOMC Forecast = Median forecast of Federal Open Market Committee
participants as of December 17, 2014. Market = Pricing based on Fed
Funds futures through June 2017 and Eurodollar futures thereafter.
Source: Federal Reserve, Bloomberg, KKR Global Macro & Asset
Allocation analysis.
Dec-19
Jun-19
Dec-18
Jun-18
Dec-17
Jun-17
Dec-16
Jun-16
Dec-15
Jun-15
Dec-14
0.0%
0%
85
88
91
94
97
00
03
06
09
12
15
0%
Data as at November 30, 2014. Source: Bureau of Labor Statistics,
National Federation of Independent Business, Haver Analytics.
Our low near-term inflation backdrop also influences our short-term
rate views. Specifically, while we believe that growth and employment trends remain solid, we see few examples of the wage inflation
that might be required to inspire the Federal Reserve to hike aggressively in 2015 and beyond. At the moment, our base case is that the
Fed begins hiking around June 2015, then proceeds at a historically slow pace of just 150 basis points per year (Exhibit 55), which
KKR
INSIGHTS: GLOBAL MACRO TRENDS
23
EXHIBIT 55
We Believe Next Interest Rate Hike Cycle Will Be Historically Mild Relative to History
TROUGH
MONTH
PEAK
MONTH
FEB-83
PEAK RATE
CHANGE
(BASIS
POINTS)
RATE OF
CHANGE (BASIS
POINTS/YR)
CPI Y/Y AT
PEAK
REAL FED
RATE AT
PEAK
11.50%
300
200
4.3%
7.2%
394
163
5.4%
4.4%
300
279
2.9%
3.1%
175
175
3.2%
3.3%
5.25%
425
205
4.3%
1.0%
4.6%
7.8%
319
204
4.0%
3.8%
0.25%
3.00%
275
150
2.0%
1.0%
MONTHS
TROUGH
RATE
AUG-84
18
8.50%
DEC-86
MAY-89
29
5.88%
9.81%
JAN-94
FEB-95
13
3.00%
6.00%
MAY-99
MAY-00
12
4.75%
6.50%
MAY-04
JUN-06
25
1.00%
19
~20-24
AVERAGE
KKR GMAA ‘15-’17 EST.
Data as at December 4, 2014. Source: Federal Reserve, Bloomberg, KKR Global Macro & Asset Allocation Forecast.
Separately, we retain a zero percent weighting in Emerging Market
Debt in 2015. We continue to see EM growth as disappointing, and
we believe that the recent explosion in both sovereign and foreign
debt means that issuer quality may have declined more than the
consensus may now currently think.
24
KKR
INSIGHTS: GLOBAL MACRO TRENDS
U.S. High Yield STW vs. U.S. Equities Earnings Yield*
10%
Mar-09
7.7%
8%
6%
Dec-00
4.7%
4%
Jan-10
-0.5%
2%
0%
Dec-14
-1.0%
-2%
Apr-13
-2.6%
May-07
-3.7%
-4%
2013
2011
2009
2007
2005
2003
2001
1999
1997
-6%
1995
At the moment, our work shows that instruments still appear attractive on both an absolute and relative basis. As Exhibit 56 shows, the
implied “earnings yield” on high yield bonds versus stocks has not
been this compelling since January of 2010. We see a similar message when compared on a relative basis as one can see in Exhibit
57. To be sure, we are not arguing that we are back to a 2009-like
buying opportunity, but – following the recent energy-related sell-off
in 4Q14 – the risk profile of credit, high yield in particular, now appears more attractive in our view. As Exhibit 58 also shows, we think
that high yield looks attractive relative to bank loans at the moment,
though we fully acknowledge that this may change during the year
as technical forces and renewed fears about the Fed gain momentum
(hence, the desire to bolster our Opportunistic Credit allocation this
year).
High Yield Relative Valuation Is Most Attractive Since
Mid-2010, but Still Near Low End of Historical Range
Because of QE
Debt Relatively
Attractive
In terms of credit, we have bolstered our Opportunistic Credit allocation in 2015 to take advantage of ongoing dislocations we are now
seeing across high yield, bank loans, and other credit instruments. In
addition to heightened government regulation on the dealer community, pure technical flows, including the now sizeable ETF market,
can periodically create attractive entry prices for managers who are
patient and nimble.
EXHIBIT 56
Equity Relatively
Attractive
equates to hiking 25 basis points at six of its eight meetings each
year. Thereafter, we see rates topping out around 3.0% in 2017, then
rolling over in 2018 as a mild recession takes hold. Exhibit 52 shows
that our medium-term Fed expectations are considerably higher than
current market pricing as expressed by Fed Funds and Eurodollar futures, but considerably lower than the Fed’s own forecasts. Hence, we
continue to think that this arbitrage between market pricing versus ours
and the Fed’s forecasts is one of the more interesting hedging opportunities in the global rates space.
Data as at December 31, 2014. * Spread to worst of U.S. high yield
market, sector-weighted to match the S&P 500 vs. NTMe EPS yield of
the S&P 500. Source: Bloomberg.
“
We are now 12 months later in the
cycle at a time when asset prices
are higher and the world’s most
influential central bank is about to
shift its stance on monetary policy.
“
EXHIBIT 57
EXHIBIT 59
On a Spread Basis, Junk Yields vs. Equity Earnings Yields
Are the Most Attractive Since Mid-2010
Bond Index Fund Flows Have Increased Over 400% Since
2008
Debt Relatively
Attractive
Current Yield Spread of U.S. High Yield vs. U.S. Equities*
12%
Dec-00
9.7%
10%
8%
350
Mar-09
9.6%
300
250
6%
200
Jun-10
0.9%
2%
0%
-2%
150
Dec-14
0.3%
Apr-13
-2.0%
Data as at December 31, 2014. * Yield to worst of U.S. high yield market,
sector-weighted to match the S&P 500 vs. NTMe EPS yield of the S&P
500. Source: Bloomberg.
The Spread Between U.S. High Yield and Leveraged
Loans Has Moved Back Towards 2011 Levels
Spread: US High Yield - Leveraged Loans (bp)
500
Nov-08
445
450
400
350
300
Sep-11
159
250
200
Dec-14
120
Avg Since
'07, 112
50
0 May-07
47
-50
07
50
0
04
06
08
10
12
14
Data as at October 31, 2014. Source: Investment Company Institute,
Haver Analytics.
Other Alternatives: Growth Capital Allocation / VC/ Other Comes
Down
EXHIBIT 58
100
100
02
2013
2011
2009
2007
2005
2003
2001
1999
1997
-4%
1995
Equity Relatively
Attractive
4%
150
Exchange-Traded Fund Assets:
Bond Index Funds (Bil.$)
08
Dec-09
49
09
10
11
Apr-13
-10
12
13
14
15
Data as at December 31, 2014. Source: JPMorgan High Yield Bond Index
STW US (CSSWUS), JPMorgan Leveraged Loan Index Loans Spread to
Maturity (JLSMLLI), Bloomberg.
Beyond the sizeable opportunities we see in Distressed / Special
Situation, we retain a five percent allocation to Traditional Private
Equity because we believe that this asset class can play a meaningful role in both boosting performance and increasing diversification.
From a regional perspective, we are particularly bullish on Asia private equity as we believe it is a superior asset class to public emerging market equities, many of which are plagued with large state-affiliated — and often underperforming — companies. Also, private equity
allows an investor to get access to key themes, including healthcare,
environmental services, and education, that may not be available
or well represented in a public stock market index. That said, in the
traditional public markets EM’s relative underperformance has been
extreme in many instances, which now seems to be creating valuation opportunities not currently seen in the developed public equity
markets these days in sectors like consumer durables and industrials. Separately, we are more reserved in Latin America, as we think
that a Dilma Rousseff-led Brazil still needs to do more to stabilize its
macro backdrop. Mexico clearly has a better macro backdrop than
Brazil, but we think a local presence and solid industry expertise are
prerequisites for success.
Meanwhile, we still see some interesting opportunities in the traditional developed market buyout space, though less so at this point
in the cycle. In the U.S., for example, we think that managers must
find companies where there is substantial opportunity for consolidation and/or operational improvement. Even so, given that we are
67 months into an economic recovery, we think any new long-term
investment likely needs to incorporate some type of recession into its
base case forecast. As Exhibit 60 shows, we are also becoming more
skeptical of sponsor-to-sponsor transactions, given the recent surge
in activity. Separately, in Europe, we believe that the consumer “trade
down” thesis, which was so vibrant in the United States post-2009,
KKR
INSIGHTS: GLOBAL MACRO TRENDS
25
is now gaining momentum. We also see the opportunity for PE firms
to acquire global players that are occasionally trading at discounted
valuations because they are domiciled in Europe.
EXHIBIT 60
Sponsor LBO Volume Spiked Notably in 2014, While
Traditional LBO Volume Has Shrunk
Real Assets: Strategy Still Working – Outlook Largely Unchanged
Distribution of LBO Volume by Type
(Based on Transaction Volume)
Sponsor
Public
Corporate
Other
80%
70%
60%
50%
40%
30%
20%
3Q14
Jan-Sep 14
2013
2012
2011
2010
2009
2008
2007
2006
2005
2003
2002
2004
10%
0%
Data as at 3Q14. Source: S&P Capital IQ, S&P LCD.
EXHIBIT 61
The Valuations of Hyper-Growth Investments Now Appear
Rich to Us in Many Instances
Price-to-Book, Change From January 2012 to
December 2014
Nasdaq Internet Index
Nasdaq Biotechnology Index
8.0
4.0
4.0
2.0
Jan-12
Dec-14
Data as at December 15, 2014. Source: Bloomberg.
26
KKR
INSIGHTS: GLOBAL MACRO TRENDS
As we mentioned in our introduction, we are less sanguine on
growth/VC investments. Valuations have moved up considerably in
both the private and public markets (Exhibit 61), and we now view
this part of the market as more expensive relative to risk-adjusted
return profiles we think that investors can achieve being higher up
in the capital structure at this point in the cycle in restructurings,
recapitalizations, and certain de-leveragings.
Whether we have been lucky or good, we have been strong advocates of owning private real assets with yield, growth, and inflation
hedging versus traditional liquid commodity swaps and notes. We
have held this view for two reasons. First, our cautious view of the
China growth story, fixed investment in particular, has made us
question the sustainability of permanently elevated commodity prices.
Second, as Exhibit 62 shows, the negative roll feature has made these
investments both beta and alpha destroyers in recent years. All told,
the S&P GSCI index has underperformed the underlying commodities
by a full 89% since 2004.
Importantly, as we look ahead, we are neither bullish on prices nor
on the roll feature on which liquid products depend. In fact, our most
recent analysis shows that a full 18 of the 24 underlying commodities in the GSCI are now in contango, as measured by spot (or front
month) to 1-year future/forward price. This sizeable percentage is
meaningful as these 18 commodities represent a full 89% weighting
in the index. Moreover, in many instances the discounts are quite
large. Indeed, as shown in Exhibit 63, the major weights in the GSCI,
including Brent, WTI, Gas Oil, Corn and Wheat, are all currently in
1-year forward contango, with a range of five to 18%.
By comparison, we still see a somewhat differentiated opportunity
in the private market for real assets. Key to our thinking is that by
owning value-added real estate, energy wells and infrastructure, we
get real assets that yield cash flow and are less dependent on pure
commodity prices and/or the shape of their respective curves. As
such, an investor can often get paid handsomely each year to own
non-correlated assets that also have the capability to outperform if
inflation does ultimately rear its ugly head. Without question, we like
this type of broad-based optionality, particularly in today’s low rate
environment. Importantly, the yield on offer is quite compelling as
infrastructure and other real assets often allow us to earn a coupon
that is in many instances higher than what one can get in most traditional fixed income instruments – and sometimes without the same
level of credit risk.
“
We think that EM consumers who
binged on credit are likely to see
some retrenchment in 2015.
“
EXHIBIT 62
EXHIBIT 64
S&P GSCI Has Underperformed Commodity Prices for
Quite Some Time
We Believe Inflation Is Running Too Low Today and Will
Rise Over Time
S&P GSCI Total Return
Relative to S&P GSCI Spot Return
20%
KKR GMAA U.S. Inflation Forecast
2.25%
0%
2.25%
-20%
2.0%
2.0%
2018
2019
-40%
-60%
-89%
-80%
-100%
-120%
In essence, this is the “roll
return” which has been
negative due to contango
(upward sloping futures curve)
-140%
-160%
-180%
0.7%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Data as at December 31, 2014. Source: Bloomberg.
2015
S&P GSCI Set Up to Underperform: 1-Yr Forward Curves
of Largest Index Weights in Contango by Five to 18
Percent
Degree of 1yr Forward Contango; Measured as % of Spot
U.S. Fed Funds Rate, % Points Above/(Below)
U.S. Nominal GDP Growth
Wheat
Corn
Restrictive Policy Rates
115%
110%
105%
Data as at December 31, 2014. Source: Bloomberg.
Jan-16
Dec-15
Nov-15
Oct-15
Sep-15
Aug-15
Jul-15
Jun-15
May-15
Apr-15
Mar-15
100%
Feb-15
Current Monetary Policy Is Rewarding Real Assets With
Yield and Growth
6%
3yr Moving Avg.
1982
5.7%
4%
2009
1.0%
2%
0%
2019e
-1.1%
-2%
-4%
-6%
1978
-5.6%
2005
-4.2%
2014e
-3.8%
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
2011
2014e
2017e
Brent
WTI
Gas Oil
Heating Oil
EXHIBIT 65
Loose Policy Rates
120%
Jan-15
2017
Data as at December 31, 2014. Source: KKR Global Macro & Asset
Allocation forecast.
EXHIBIT 63
95%
2016
e = KKR Global Macro & Asset Allocation estimate. Our estimate assumes
the Fed does not tighten until mid-2015 and that nominal GDP growth
averages 4.5% annually between 2012 and 2014. Data as at December
19, 2014. Source: KKR Global Macro & Asset Allocation analysis.
Within Real Estate, we did lower our allocation in 2015 to three percent from five percent. This reduction is predicated on our view that
certain gateway cities have gotten expensive. We note that London
and New York have now become a “safe haven” for foreign capital,
driving up property values while reducing existing inventory. By comparison, we still continue to see good opportunities across non-core
KKR
INSIGHTS: GLOBAL MACRO TRENDS
27
and opportunistic in the U.S., Europe and even certain parts of Asia.
Consistent with this view, we still see buyers finding opportunities to
enter at seven to eight percent capitalization rates, with the opportunity to create property improvements that can drive valuations down
100 to 300 basis points and still retain upside to annual lease-based
pricing.
Currencies: Expect Periods of Volatility; U.S. Dollar Bull Market
Continues
When a train goes through a tunnel and it gets dark, you don’t throw
away the ticket and jump off. You sit still and trust the engineer. Corrie
Ten Boom
While there will certainly be periods of “darkness” along the way
that might test one’s conviction, our “trust” level is still high as we
remain convinced that we have entered a sustained, multi-year U.S.
dollar bull market. We certainly appreciate our pro-dollar outlook is
now somewhat the consensus view, but in this instance we think the
consensus is right.
There are several important forces at work that should be considered, in our view. Indeed, at a time when both the Bank of Japan
and the ECB are embracing even more extreme forms of quantitative
easing (QE), the Federal Reserve has not only ended its tapering
campaign but also laid out a rate increase forecast that is still notably
more aggressive than the market consensus. Moreover, our research
leads us to believe that lower oil prices could provide $278 billion of
increased purchasing power to U.S. consumers by early 2016 (Exhibit 18). As such, we think that the dollar could have another compelling
year against the yen, the euro and even the British pound.
EXHIBIT 66
We Are Less Than Halfway Through the Dollar Bull
Cycle…
US Trade Weighted Major Dollar:
Trough to Peak: Indexed: Trough=100
160
Sep 1980 (54m)
139.7
Aug 2011 (40m to-date)
140
130
Aug-98
Dec-14
120
Oct-99
110
100
154.5
Apr 1995 (82m)
150
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80
Data as at December 31, 2014. Source: Bloomberg.
28
KKR
INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 67
…And the Dollar Is Still Undervalued
US Dollar REER: % Over (Under) Valued
45%
Mar-1985
38.1%
35%
+2
25%
Feb-2002
16.0%
+1
15%
5%
Dec-2014
-3.3%
Avg
-5%
-15%
-25%
70
–1
Sep-1980
-7.5%
–2
75
80
85
Jun-1995
-12.6%
90
95
00
Jul-2011
-17.7%
05
10 15
Data as at December 31, 2014. Source: Federal Reserve Board, JP Morgan,
Bank of England, OECD, IMF, World Bank, BIS, Haver Analytics, Bloomberg.
Within the emerging market currencies arena, we again look for the
Mexican peso to outperform the Brazilian real in 2015. Growth in
Mexico remains largely linked to the U.S. recovery, while growth in
Brazil is related to the China story, in our view. Furthermore, there
has been significant progress on the reform front in Mexico, while
Brazil continues to face the same issues of slow growth, high inflation, twin deficits and policy paralysis. We also like the Indian rupee
against the Japanese yen. While both countries benefit from weaker
oil prices, the Indian rupee has a higher carry of five percent versus
the yen. India is also benefiting from lower inflation, which is positive
for the rupee, while Japan is trying to increase inflation, which is
negative for the yen. Finally, while reforms in India work to unleash
its demographic dividend in order to raise real growth to seven
percent from five percent, reforms in Japan are fighting against its
demographic decline in order to lift Japan towards a nominal growth
rate of just three percent. Notably, India has already made great
strides in achieving lower inflation, a lower fiscal deficit, and a lower
current account deficit, while Japan is still struggling to raise inflation and growth, narrow its fiscal deficit and lower its debt burden.
“
Traditional financial intermediaries
are now unable to participate in
many of the higher margin, nontraditional lending opportunities
at a time when many small- to
medium-size businesses need
access to credit.
“
EXHIBIT 68
Outside of Russia, Volatility in Most EM Currencies Has
Remained Surprisingly Low
RUB, MXN, BRL, CLP and COP 3 Month Implied Volatility
Russian Ruble
Mexican Peso
50
Colombian Peso
Brazilian Real
40
Chilean Peso
Importantly, because of the significant excess capacity that exists
because of over-investment, we think China is likely to continue to
run with a negative producer price index (PPI). Thus far, this cycle
China’s PPI has been negative for 33 consecutive months14. Our take:
As the world’s leading export economy, there is a growing risk that
China begins to export some of its deflation to other parts of the
global economy. If we are right, then this issue is likely to affect both
internal prices for consumer goods as well as the underlying currencies in which these goods are bought and sold in local terms.
30
20
12/1/2014
11/1/2014
10/1/2014
9/1/2014
8/1/2014
7/1/2014
6/1/2014
5/1/2014
4/1/2014
3/1/2014
2/1/2014
1/1/2014
10
0
Data as at December 31, 2014. Source: Bloomberg.
EXHIBIT 69
We Think BRL Remains Overvalued, and As Such, Faces
Further Depreciation Headwinds
U.S.$/Brazil Real Spot Rate
2.70
2.50
2.30
2.10
1.90
1.70
Dec-14
Aug-14
Apr-14
Dec-13
Aug-13
Apr-13
Dec-12
Aug-12
Apr-12
Dec-11
Aug-11
1.50
Apr-11
bring nominal lending back down towards nominal GDP13. As this
transition unfolds further, we believe commodity prices are likely to
remain under pressure on a global basis as the Chinese try to pivot
their economy more towards services. Importantly, our recent trip
to China underscored that environmental concerns are now a major
focus, which means that the government is more focused on services
growth than construction/manufacturing. This economic transition
is a big deal, and it significantly affects our thinking on where we
expect stress in the global economy during 2015.
Second, the European economy now seems to be running with
dangerously low inflation. As wages are brought down to be more
competitive, this development is likely to affect demand – and hence,
inflationary expectations. Also, with oil and other commodity prices
falling, we think that inflation could turn negative in 1H15. Our recent
travels confirm this threat. In fact, in France, for example, already
about one third of the CPI inputs are in deflation.
Against this backdrop, bond yields have collapsed around the world.
Not surprisingly, risk assets, equities in particular, look attractive relative to low yielding government bonds in this environment. We tend
to agree with this argument, but we are watching two areas closely.
First, as we saw with Japan in the 1990s, low interest rates were
foreshadowing a fall-off in corporate profitability and growth. Our
current global outlook is more positive, but we do want to continue
to remind ourselves that there is historical precedent for bonds and
stocks giving investors the wrong macro signals. Second, because
of central bank intervention, long-term interest rates are likely below
fair value. Indeed, as we described in the fixed income section of this
report, our quantitative value for the U.S. 10-year Treasury is closer
to 3.0%, not the 2.2% at which it is currently trading – compliments
of QE (Exhibit 50). So, the correct conclusion may – in fact – be that
bonds are expensive – not that stocks are cheap.
Data as at December 31, 2014. Source: Bloomberg.
Risks
The sources of deflation are not a mystery.
Ben S. Bernanke, Deflation: Making Sure “It” Doesn’t Happen Here, November 1, 2002
Without question, we see any downside risk to the global markets
through the lens of a deflationist in the near term. There are two
macro situations we are watching closely that are heavily influencing
our thinking. First, China gross capital formation, which accounted
for 48% of GDP in 2013, is slowing as the government is forced to
13 Data as at November 30, 2014. Source: China National Bureau of Statistics,
Haver Analytics.
14 Ibid.14.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
29
EXHIBIT 70
the periods of volatility we expect in 2015.
Credit per Unit of GDP in China Is on an Upward
Trajectory That We View as Worrisome
China: Credit per Unit GDP
12
9.9
10
5.9
6.6
5.6
5.2
3.5 3.3 3.6
3.0
4
2
03
04
05
06
07
08
09
10
11
12
13
Data as at October 31, 2014. Source: China National Bureau of Statistics,
Haver Analytics.
EXHIBIT 72
EXHIBIT 71
Equities, Including the S&P 500, Only Look Attractive
Relative to the Risk Free Rate if Earnings Trends Are
Sustainable
S&P 500 Earnings Yield
US 10 Year Yield
18
16
14
12
10
8
6
4
2
0
EUR/USD 3-month Implied Volatility, % per Year
23
18
13
So, in the event that the aforementioned macro risks do dent investor
confidence, we think that long volatility strategies can work, including
equity index, interest rate, and certain FX “crosses” – if purchased
and traded tactically. In S&P options, for example, three- and sixmonth put spreads remain attractive hedging vehicles when implied
volatility compresses. In our view, the periodic times when the VIX
trades to 12% - 13% are often the best times to accumulate put
spread structures. At the moment, the “skew” or premium of downside puts over the “at the money” levels can drastically reduce the
cost of just owning outright puts. We believe this could be the most
attractive vehicle for leveraged protection against risk assets during
KKR
INSIGHTS: GLOBAL MACRO TRENDS
Data as at December 31, 2014. Source: Bloomberg.
15 Data as at December 31, 2014. Source: Bloomberg.
Mar-14
Aug-14
Oct-13
Dec-12
May-13
Jul-12
Feb-12
Apr-11
Sep-11
Nov-10
Jan-10
Jun-10
Mar-09
3
Aug-09
Jan-2011
Jan-1999
Jan-2005
Jan-1987
Jan-1993
Jan-1981
Jan-1975
Jan-1969
Jan-1963
Jan-1957
Jan-1951
Jan-1945
Jan-1933
Jan-1939
Jan-1921
Jan-1927
8
Data as at December 31, 2014. Source: Source: S&P, Shiller, Thomson
Financial, Federal Reserve Board, Haver, Factset.
30
Options Can Provide Substantial Leverage to an Idea at
Current Prices…
Oct-08
0
Finally, U.S. interest rate volatility remains low by historical standards, despite the end of QE and pending removal of historic accommodative conditions. For example, 6-month, 10-year swaption
volatility – which represents the costs of owning a 6-month option
to short 10-year swaps (i.e., 10-year bonds) – is currently 77 basis
points. At 77 basis points, the market is pricing 10-yr swaps to move
just +/- 5 basis points a day to break even on a long option position.
This is a historically “cheap” level that should conceivably move back
to its long run average of 100 to 120 basis points once the Fed suppression of interest rate levels returns to normal. As such, if one had
a bias towards higher rates, owning swaption volatility would be a
smart way to leverage those protection bets.
May-08
6
9.9
Dec-07
8
9.4
Secondly, we think euro currency volatility is also cheap enough to
own. While it has moved from 6 to 8.5% over the last few months,
EURUSD volatility consistently realized between 12-16% for over four
years following the financial crisis15. While EUR volatility is probably
not going back to premium levels seen during the worst bouts of the
euro crisis, if one has a directional view, options afford smart leverage at current prices.
EXHIBIT 74
…Particularly Given That Volatility is Low by Historical
Standards
The KKR GMAA Target Portfolio Has Both Strong
Absolute and Relative Returns Since its Inception
US 6-month Into 10-year Swaption Volatiltiy,
Basis Points per Year
190
15.0%
KKR GMAA Global Asset Allocation Jan 2012
to Dec 2014 (%)
Monthly Returns
GMAA Portfolio
170
10.0%
130
110
90
5.0%
0.0%
-5.0%
Aug-14
Oct-13
Dec-12
May-13
Jul-12
Sep-11
Feb-12
Apr-11
Nov-10
Jun-10
Jan-10
Aug-09
Oct-08
Mar-09
May-08
Dec-07
50
Mar-14
70
Data as at December 31, 2014. Source: Bloomberg.
Conclusion: Getting Closer to Home
As we have detailed in this outlook piece, we are of the mindset that
the general backdrop for risk assets remains favorable. However,
given where we are in the cycle and the magnitude of gains in recent
years, we have begun the inevitable process of “Getting Closer to
Home” in terms of our asset allocation targets, including raising cash
and tilting the invested part of the portfolio to be more opportunistic
in nature during 2015.
Importantly, given some of the dislocation we are already seeing
across Europe and Asia as well as in the U.S. energy complex, we
feel confident having a sizeable 15% of our portfolio in the Distressed
/ Special Situation investing bucket. We like this investment opportunity not only for its global appeal but also because it allows us to
move up in the capital structure – and potentially still earn equity-like
returns but often with less volatility/risk.
-10.0%
35%
30%
5
4
3
2
0
0
3
4
1
2
1
2
0
0
2
2
4
25%
3
3
1 1
1 1
-1
-2
-2
-2
22
2
01
20%
15%
-1
-3
-2
-6
10%
5%
Jan-12
Mar-12
May-12
Jul-12
Sep-12
Nov-12
Jan-13
Mar-13
May-13
Jul-13
Sep-13
Nov-13
Jan-14
Mar-14
May-14
Jul-14
Sep-14
Nov-14
Monthly Returns (%)
150
40%
Cumulative Returns (%)
EXHIBIT 73
0%
Gross returns. Weights as per KKR white paper “Where To Allocate,”
January 2012, “Real Estate: Focus on Growth, Yield and Inflation
Hedging,” September 2012, “Outlook for 2013: A Changing Playbook,”
January 2013, “Asset Allocation in a Low Rate Environment,” September
2013, “Outlook for 2014: Stay the Course,” January 2014, and “Midyear
Outlook: Four Macro Trends at Work,” June 2014. Private equity returns
as of 2Q2014, and using 0% for remaining months. Data as at December
31, 2014. Source: KKR Global Macro & Asset Allocation, Bloomberg,
Factset, MSCI, Cambridge Associates.
“
We think the ability to move
up and down the capital
structure and provide
corporate partners with
value-added financial and
operational expertise will
become a prerequisite for
success.
“
KKR
INSIGHTS: GLOBAL MACRO TRENDS
31
EXHIBIT 75
macro landscape that CIOs and portfolio managers should pursue.
First, China’s slowing is not an aberration. As such, its role in the
global economy is materially shifting, which means that we expect to
see sizeable restructuring and recapitalization opportunities in sectors that previously over-earned and/or overstretched their footprints
during the China Growth Miracle.
2014 Returns Were Driven by Real Assets and
Alternatives, Though Equities and Fixed Income
Selections Lagged
KKR GMAA Global Asset Allocation Performance Relative to
Benchmark Jan 2012 to Dec 2014 (basis points)
GMAA vs Benchmark
Cumulative Outperformance (bp)
94
100
80
60
40
96
1000
73
65
57
56
49
454542
43
3632
24 26
9 11
20
11
325
1
800
40
600
28
1919 16 16
7
0
11
16
1
21
12
400
0
-10
-1
-20
1200
-29
-29 0
Jan-12
Mar-12
May-12
Jul-12
Sep-12
Nov-12
Jan-13
Mar-13
May-13
Jul-13
Sep-13
Nov-13
Jan-14
Mar-14
May-14
Jul-14
Sep-14
Nov-14
-40
200
Performance vs Benchmark (bps)
Outperformance in Basis Points
120
Third, despite a slew of liquidity in the system, many companies
across both emerging and developed economies still can’t get proper
access to credit. As such, we still see a compelling illiquidity premium
that is worth pursuing, particularly in today’s low rate environment.
Importantly, with Wall Street leverage low and an increasing portion
of the global economy under stress, we see a more intense blurring
across many parts of the liquid and illiquid fixed income markets in
2015.
Fourth, in a world of contango commodity pricing, we continue to
favor private real asset investments with upfront yield, growth, and
long-term inflation hedging relative to traditional liquid commodity
notes and swaps. Already, performance between these two subasset classes in the real asset arena has been substantial, but we still
see more opportunity ahead.
Gross returns. Weights as per KKR white paper “Where To Allocate,”
January 2012, “Real Estate: Focus on Growth, Yield and Inflation
Hedging,” September 2012, “Outlook for 2013: A Changing Playbook,”
January 2013, “Asset Allocation in a Low Rate Environment,” September
2013, “Outlook for 2014: Stay the Course,” January 2014, and “Midyear
Outlook: Four Macro Trends at Work,” June 2014. Private equity returns
as of 2Q2014, and using 0% for remaining months. Data as at December
31, 2014. Source: KKR Global Macro & Asset Allocation, Bloomberg,
Factset, MSCI, Cambridge Associates.
Overall though, we do think now is the time in the cycle to start “Getting Closer to Home” in terms of risk exposure. Importantly, we think
this transition should be more evolutionary than revolutionary. Rates
are low, global growth should be solid, and central banks are easing
in many instances.
Moreover, we still see several compelling “arbitrages” in the global
Second, many corporations still have inefficient capital structures,
including too much cash and too little debt, in our view. As such, investors can still benefit from corporate actions to lower their costs of
capital and/or improve growth, including buybacks, dividends, capital
expenditures and acquisitions.
Finally, government deleveraging in the developed markets is disinflationary, which drives our thinking about the direction of long-term
interest rates as well as the relative value of risk assets against the
risk-free rates. In particular, given our view that the economic cycle
will stretch into 2017, we think that many public and private equity
stories with capital management and operational improvements still
appear attractive.
To be sure, there are risks to our strategy amid what remains an unsettled time across the global capital markets. First, in terms of both
duration and performance, the economic cycle in the United States
is already notably beyond average at 67 months. However, with oil
EXHIBIT 76
Arithmetic Returns, Volatility, and Return/Risk of the Target Portfolio as at December 2014
RETURNS
VOLATILITY
RETURN / RISK
GMAA
BENCHMARK
DIFFERENCE
GMAA
BENCHMARK
DIFFERENCE
GMAA
BENCHMARK
DIFFERENCE
2012
14.8
11.3
3.5
9.3%
8.9%
0.4%
1.6
1.3
0.3
2013
14.6
10.6
4.1
7.4%
6.9%
0.5%
2.0
1.5
0.5
2014
4.2
2.2
1.9
6.7%
6.4%
0.3%
0.6
0.3
0.3
Gross returns. Weights as per KKR white paper “Where To Allocate,” January 2012, “Real Estate: Focus on Growth, Yield and Inflation Hedging,”
September 2012, “Outlook for 2013: A Changing Playbook,” January 2013, “Asset Allocation in a Low Rate Environment,” September 2013, “Outlook for
2014: Stay the Course,” January 2014, and “Midyear Outlook: Four Macro Trends at Work,” June 2014. Private equity returns as of 2Q2014, and using 0%
for remaining months. Data as at December 31, 2014. Source: KKR Global Macro & Asset Allocation, Bloomberg, Factset, MSCI, Cambridge Associates.
32
KKR
INSIGHTS: GLOBAL MACRO TRENDS
prices falling and consumer leverage low, we still feel comfortable
owning a pro-growth portfolio. Also, while we think China’s economy
will continue to slow, we do not think it is poised to collapse. As we
discussed earlier, Europe and Japan should again be able to muddle
through with less government drag in 2015.
Second, central bank differentiation is now upon us as 2015 will be the
first year since before the Great Recession where the Federal Reserve
will be reducing its liquidity profile (Exhibit 4). Third, while China is
transitioning well towards a service economy, the legacy of its fixed
investment boom remains a major overhang on the global economy.
Our bottom line: We continue to embrace a pro-risk portfolio, but we
think “Getting Closer to Home” reflects not only where we are in the
cycle but also assigns some value to the strong appreciation in asset
prices we have had in recent years. Moreover, by building up a little
cash and turning a little more conservative in our overall allocations,
we now have more flexibility to embrace volatility during 2015, an
option that was not available to our fully invested portfolio in 2014.
“
We do think now is the time
in the cycle to start “Getting
Closer to Home” in terms of
risk exposure. Importantly, we
think this transition should
be more evolutionary than
revolutionary. Rates are low,
global growth should be solid,
and central banks are easing
in many instances.
“
i Note 1: New issue leveraged loan spreads rated B+/B as per S&P LCD Q3
2014 Quarterly Report. Average senior leverage on these loans is 4.9x. Note
2: Difference in loss given default for Middle Market leveraged loans and larger
company leveraged loans. Middle Market loans are defined as those with
€200m or lower facility size. Large company leveraged loans are those with
a facility size of €200m of larger. Total default volume and leveraged loan
market size is based on the Credit Suisse European Leveraged Loan Index. The
proportionate split between middle market loans and larger leveraged loans
is based on S&P LCD loan pipeline issuance statistics with facility sizes of
less than or greater than €200m. Defaults by size is based S&P LCD Default
and Recovery Database cross-referenced versus S&P historic issuance to
evaluate facility size. Average recovery rate is assumed at 79% based on the
study “Loss-Given-Default of Corporate Bank Loans: Large-Scale Evidence
from Europe” by Laurence Deborgies-Sanches, Lyubka Sokolova & Michel Van
Beest, March 2014. Note 3: This is the difference between the average coupon
and fees described in Notes 4 and 5 and credit risk premium and spreads
described in Notes 2 and 1 respectively. Note 4: Average underwriting fees for
all European Direct Lending deals executed in KKR Lending Partners L.P. and
CCT is 2.8%. Assuming a 3 year life for the loans, this equates to an average
incremental return of c.0.9% per annum. Note 5: Based on average coupon
(including Euribor floors) based on active European Direct Lending pipeline as
at 5 November 2014. Average senior leverage of 4.7x, plus the fees described
in Note 4.
KKR
INSIGHTS: GLOBAL MACRO TRENDS
33
34
KKR
INSIGHTS: GLOBAL MACRO TRENDS
Important Information
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 being 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.
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. The views expressed herein may not be reflected
in the strategies and products that KKR offers, including
strategies and products to which Mr. McVey provides
investment advice 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 accounts. Further, Mr. McVey may
make investment recommendations and KKR and its
affiliates may have positions (long or short) or engage in
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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
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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 signifi-
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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
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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
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Neither KKR nor Mr. McVey assumes any duty to, nor
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representation or warranty, express or implied, is made
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KKR
INSIGHTS: GLOBAL MACRO TRENDS
35
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