24
VOLUME 8.2 • MARCH 2018 Diverging Paths INSIGHTS GLOBAL MACRO TRENDS
VOLUME 8.2 • MARCH 2018
Diverging Paths
INSIGHTSGLOBAL MACRO TRENDS
2 KKR INSIGHTS: GLOBAL MACRO TRENDS
Diverging PathsAs we position our portfolio for the later stages of the economic recovery, we are further tilting our asset allocation targets to take advantage of the many compelling opportunities we see abroad. To be sure, we believe that the opportunity set in the U.S. remains substantial, particularly as the recent tax cuts and de-regulation efforts are likely constructive for the positioning of U.S. corporations. However, much of this benefit now seems to be in the price from a tactical perspective. Maybe more important, though, is that strong pro-growth fiscal and regulatory policy amidst bigger deficits will likely inspire the central bank in the U.S. to become more aggressive than it might like to be, which represents a ‘diverging path’ relative to what we currently see in Europe and Asia. Moreover, our recent trips across these regions give us additional confidence that Europe and Asia appear to be increasingly elegant plays on many of our most important macro themes, including Deconglomeratization, Experiences over Things, and the Illiquidity Premium in Private Credit. In addition, many of our quantitative macro models are suggesting a heavier allocation to non-U.S. equities, Emerging Markets in particular. Finally, both implicit and explicit in what we are saying is that the U.S. currency has peaked in terms of structural outperformance, a trend we outlined in our 2018 outlook in January.
KKR Global Macro & Asset Allocation Team
Henry H. McVey Head of Global Macro & Asset Allocation +1 (212) 519.1628 [email protected]
David R. McNellis +1 (212) 519.1629 [email protected]
Frances B. Lim +61 (2) 8298.5553 [email protected]
Paula Campbell Roberts +1 (646) 560.0299 [email protected]
Aidan T. Corcoran + (353) 151.1045.1 [email protected]
Rebecca J. Ramsey +1 (212) 519.1631 [email protected]
Brian C. Leung +1 (212) 763.9079 [email protected]
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“ Travel makes one modest. You see what a tiny place you occupy in the world.
”GUSTAVE FLAUBERT FRENCH NOVELIST
3KKR INSIGHTS: GLOBAL MACRO TRENDS
While many of the conversations we are having with investors in the United States these days are championing the merits of more U.S.-centric strategies, this approach just does not seem to dovetail well with the way we are seeing the world from an asset allocation perspective, particularly after several back-to-back trips to Europe and Asia.
Our shift in relative value towards more non-U.S. assets is consis-tent with what we laid out in our January 2018 outlook piece, You Can Get What You Need, and we are now using this current update after our most recent travels to further increase both our Europe and Asia weightings to 17% from 16%, while our U.S. weighting drops to 15% from 17% and a benchmark weighting of 20%. One can see this Exhibit 1, which looks quite different than the overweight we were ad-vocating to the U.S. in recent years (see Insights: U.S. Equities: Begin the Process of Leaning In, September 2015).
EXHIBIT 1
In Our Target Allocation, We Are Increasingly More Constructive on Europe and Asia Relative to the U.S., Particularly for Dollar-Based Investors
20%
12% 12%
15%
17% 17%
20%
15%
12%
U.S. Europe Asia
GMAA Target Asset Allocation to Public Equities by Region, %
January 2012 February 2018 Benchmark
Note: Asia includes All Asia ex-Japan and Japan. Data as at February 28, 2018. Source: KKR Global Macro & Asset Allocation analysis.
However, despite our optimism towards non-U.S. assets, we fully appreciate that the U.S. capital markets represent a formidable com-petitor. In particular, U.S. equity markets are generally overweight Technology stocks relative to many other markets, President Trump has ushered in a compelling corporate tax cut, and sentiment across both consumers and executives towards the future is booming.
So, in an effort to pressure test our thesis on regional preferences for non-U.S. assets, I recently made two trips to Europe and one to India. In addition, I also have drawn on the expertise of my colleagues Frances Lim, who leads the macro endeavor for the KKR Asian region out of the firm’s Sydney office, and Aidan Corcoran, who leads our European Macro & Asset Allocation effort out of Dublin.
EXHIBIT 2
With the U.S. Leading the Charge Across Equity and Credit, Financial Assets Have Outperformed. We Are Now Calling for Some Mean Reversion
-100%
-50%
0%
50%
100%
150%
200%
250%
300%
Financial and Real Economy Prices Total ReturnPerformance in Local Currency Since January 2009
S&P
500
Euro
pean
HY
US H
YM
SCI W
orld
SXXP
MSC
I EM
Topi
xUS
IGEu
rope
an IG
Germ
. Bon
dGo
ldUS
Bon
dJa
pan
Bond
US N
omin
al G
DPEU
Nom
inal
GDP
US w
ages
Euro
pean
wag
esUS
Hou
se P
rice
US C
PIEu
rope
an C
PIEA
Hou
se P
rice
Com
mod
ity
Data as at December 31, 2017. Source: Goldman Sachs.
Our bottom line: Though the internal landscape does have certain macro bumps (e.g., Brexit, higher oil prices in India, increased risk of conflict on trade policy, etc.), our recent meetings with CEOs, CIOs, and dedicated macro folks give us additional confidence that our original thesis of an overweight to Europe and Asia is poised to play out well during the next few years. To this end, I note the following insights from these recent trips with Aidan and Frances, described in more detail below, that support our geographical bets as well as our asset allocation preferences:
• Central bank policy is less hawkish outside of the United States (e.g., Japan and Europe), which makes it easier to lock in low-cost liabilities – a key macro priority for us in 2018. As most folks know, the Federal Reserve in the United States is working hard to normalize its short-term interest rates and its balance sheet. However, we continue to believe that the market is too dovish about the pace of tightening that is likely to occur in late 2018 and into 2019; we are now using six Federal Reserve rate hikes over this period, compared to four for market participants. By comparison, the European Central Bank is still expanding its balance sheet in 2018 – likely to the tune of $270 billion or more this year. Moreover, the ECB’s deposit rate is still negative, a situ-ation that we believe can continue until 2019. Meanwhile, in Asia, the Bank of Japan recently reappointed Haruhiko Kuroda to a second term as governor, which we believe signals a continuation of accommodative monetary policy. Given this backdrop of diverg-ing monetary policy amidst a synchronized global recovery, we think that there is a clear ‘call to arms’ for investors to canvas both Europe and Asia, Japan in particular, for sources of low-cost liabilities that can be used to buy assets with good free cash flow prospects, particularly if they currently trade at a complexity discount.
4 KKR INSIGHTS: GLOBAL MACRO TRENDS
• With surging deficits and threats of increased protectionism, the U.S. has become a more unpredictable place to hold assets. As we detail below, the U.S. government is adding fiscal stimulus – in the form of higher deficits – into the American economy at a time when it is already at full employment, which should lead to more volatility across U.S.-based financial assets, we believe. In fact, there is not another time that we can find outside of war that U.S. deficits have been so high and unemployment so low. With-out question, we think that this additional stimulus could pressure the U.S. dollar, particularly if trade tensions accelerate. In Europe, by comparison, deficits are being reduced, and the region is run-ning a huge current account surplus. Not surprisingly, the euro appears well-bid, and with QE poised to slow at some point, we see more upside risk than downside risk to the European curren-cy. Meanwhile, higher real rates in many parts of emerging Asia should allow for greater monetary accommodation if and when economic and/or financial conditions deteriorate. Our bottom line: while the U.S. has clearly improved its competitive positioning in the global corporate arena with lower taxes, it comes at a price – one that we think could ultimately reverse some of the outper-formance that the U.S. enjoyed during the most recent dollar bull market. If we are right, then investors should be diversifying both bond and equity positions into more non-U.S. assets.
• Corporations in both Europe and Asia are benefitting more di-rectly from our belief that China has already crashed in nominal terms. See below for details, but this viewpoint is significant be-cause Japanese and European firms typically enjoy significantly more global operating leverage than their American counterparts (Exhibit 27), as they export more to China. By comparison, U.S. goods exported to China as a percentage of total exports are less than six percent, while U.S. exports to China as percentage of U.S. nominal GDP is just 70 basis points.
• Our quantitative models for both European growth and EM Public Equity outperformance both suggest favorable outcomes for investors. As we describe below in more detail, our Emerging Markets timing model, which turned positive in January 2016, is now suggesting that we are entering into a more volatile mid-cycle phase of EM outperformance. Importantly, these cycles last years, not months, we believe. Within Europe, our GDP model is suggesting, similar to what we saw unfold with our U.S. quantita-tive GDP model in 2013, that outsized monetary policy represents an incredibly supportive tailwind to growth. Moreover, if the U.S. is any proxy, then strong monetary policy tailwinds should soon ignite the cyclical parts of the European economy as measured by our housing activity input.
• Both Europe and Asia have emerged as elegant plays on two of our most important macro themes: ‘Deconglomeratization’ and ‘Experiences over Things.’ While we are bullish on these themes on a global basis, we are seeing signs of ‘break out’ type activ-ity in Europe and Asia right now. We certainly picked up on this momentum during our recent whirlwind tour to India, the United Kingdom, and Ireland, and my colleagues Aidan Corcoran in Europe and Frances Lim in Asia concur with the view that these trends are expanding throughout both regions beyond just these three countries. Details below.
• We also see the fixed income ‘Illiquidity Premium’ as a compel-ling feature to earn solid risk-adjusted returns in today’s low interest rate environment. In Europe, we see a surge in oppor-tunities linked to Private Asset-Based Lending; hence, we are now using a six percent weighting, compared to a benchmark of zero. In Asia, our trip to India confirmed a burgeoning market for Private Direct Lending across the region. Specifically, within India, we favor structures that are backed by hard assets, with additional coverage being provided at the holding company level as well.
However, we did pick up on some key areas of mounting concern that we need to watch closely. First, rising oil prices could dent both growth and macro stability in Europe and Asia if prices move up much more from current levels. In India, for example, 80% of oil is imported, which makes the country’s current account deficit nota-bly susceptible to higher oil prices. Importantly, our forecast is that oil inventories will drop more aggressively towards the OPEC base case than what agencies like the IEA are forecasting, which suggests crude oil prices are not returning to their 2016 lows (Exhibits 3 and 4). Second, investors are now assigning limited downside to geopo-litical risks, which represents a change from prior visits. In particular, anxiety in Asia surrounding North Korea has largely abated, despite the low likelihood of near-term resolution, and our visit to Rome confirmed that investors underappreciated the chances of a populist parties gaining ground in the recent elections.
Higher input costs are also now a reality, and we are likely more con-cerned than the consensus that they may both sap consumer demand as well as dent corporate margins, a business headwind we heard loud and clear as it pertains to both the packaging and chemical sectors in the U.K. and India. Finally, if international growth further accelerates meaningfully from current levels, the ECB and BoJ could be forced to react more quickly (and not just jawboning) than we currently envision.
“ The U.S. government is adding stimulus – in the form of higher
deficits – into the American economy at a time when it is
likely not needed, which should lead to more volatility across U.S.-based financial assets, we believe. In fact, there is not another time that we can find outside of war that U.S. deficits have been so
high and unemployment so low. “
5KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 3
We Believe that OECD Inventories Are Getting Cleaned Up Much Faster Than the IEA and Its Peers Are Suggesting, Supporting Our View for Higher Medium-term Prices…
Recent Pace(Aug 2019)
OPEC(Dec 2019)
EnergyIntelligence
IEA, EIA,IHS
2,500
2,600
2,700
2,800
2,900
3,000
3,100
'08 '10 '12 '14 '16 '18 '20 '22 '24
Inventories (mb)Deficit -0.70mbd (Pace since Aug 2017)Deficit -0.60mbd (OPEC forecast)Deficit -0.01mbd (Energy Intelligence forecast)Surplus 0.20mbd (IEA, EIA, IHS forecast)
OECD Total Commercial Inventories (Seasonally Adjusted)
Note: our global production (surplus/deficit) projection is adjusted for the fact that OECD comprises ~48% of total world demand. Data as at January 29, 2018. Source: KKR Global Macro & Asset Allocation analysis, Bloomberg, Haver Analytics, IEA, EIA, Energy Intelligence.
EXHIBIT 4
…And Recent Data Supports This View as Total U.S. Inventories Are Decreasing at a Fast Pace
Avg1,061
Jun-171,351
Feb-181,199
980
1,030
1,080
1,130
1,180
1,230
1,280
1,330
1,380
'09 '10 '11 '12 '13 '14 '15 '16 '17 '18
DOE Total Petroleum Stocks, Level in Millions of Barrels, excl. SPR
Data as at February 22, 2018. Source: KKR Global Macro & Asset Allocation analysis, Bloomberg, Haver Analytics, IEA, EIA, Energy Intelligence.
EXHIBIT 5
The Recent U.S. Tax Cuts Offer a Significant Upside Boost to Corporate Earnings Growth
BASE CASE $/SHARE Y/Y % CHG
GMAA 2017e EPS $132.10
Revenue Growth 4.5%
Earnings Growth 8.0%
Baseline GMAA 2018e EPS $142.7
Adj. for Tax Rate Change $13.80 10.4%
Adj. for Buybacks / Repatriation $2.60 2.0%
Adj. for One-time Tax on Foreign Profits -$4.20 -3.2%
Adj. for Interest Deductibility -$1.00 -0.8%
Total Adjustments $11.20 8.5%
Pro-forma GMAA 2018e EPS $153.90 16.5%
Data as at December 31, 2017. Source: KKR Global Macro & Asset Allocation analysis.
EXHIBIT 6
Europe, Too, Is Finally Seeing Positive Fiscal Stimulus After Years of Heavy Contraction
-68
-151
-71
-31
-4 -1
5 7
-160
-140
-120
-100
-80
-60
-40
-20
0
20
2011 2012 2013 2014 2015 2016 2017 2018
Eurozone Structural Balance, Y/y Difference, PPTs of GDP
Data as at November 9, 2017. Office of the European Communities, Haver Analytics.
6 KKR INSIGHTS: GLOBAL MACRO TRENDS
Overall, our big picture macro view is that we feel that the regime change that we first described in our January 2017 outlook piece, Paradigm Shift, is playing out nicely. Specifically, we continue to see four seismic shifts occurring across the global economy that we believe require a different investment playbook than what worked during the 2011-2016 period. They are as follows:
• We believe that we have shifted from monetary policy to fiscal policy as a key determinant of growth and financial market conditions. The U.S. is leading the charge in this area, though Europe has become more fiscally supportive as well. If we are right, then this likely means faster growth, bigger deficits, and more of a reflationary bent across the global capital markets.
• Second, we believe that we are transitioning from a period of re-regulation post the financial crisis in the U.S. to one of de-regulation. Financial Services should be a major beneficiary. Already, CLO risk retention rules have been repealed; at the same time, banks are now being given more latitude around leveraged lend-ing guidelines. We also believe that Energy and select parts of Healthcare in the U.S. could also enjoy an additional boost as we relax regulatory requirements.
• Third, our Paradigm shift framework suggests that global agendas are shifting towards more nationalistic ones. President Trump has certainly ushered in the America First era (and potentially took it to a new level with his recent announcements surround-ing tariffs), but our travels lead us to conclude that there is now a more nationalistic bent across many countries in Asia and Europe, not just the U.S. This economic nationalism has likely put the brakes on assumptions of ever-greater trade facilitation in the West, while giving a boost to a greater role in the East for China in setting the global economic policy agenda. More inward looking mindsets across countries are also coincident with the
rise of ‘political strong men,’ including President Donald Trump, President Xi Jinping, President Recep Erdoğan, President Vladi-mir Putin, etc. – all of whom have very different levers of power, sources of legitimacy, and domestic political restraints but share in having more latitude to pursue their more nationalist agendas. Given this geopolitical backdrop, investors are likely to further migrate towards large domestic economies that face less reliance on global trade and connectivity, we believe.
• Finally, our base view is that within the capital markets, volatility will continue to transition out of the currency markets into the fixed income markets, sovereign debt in particular. This ‘baton hand-off’ is definitely under way in 2018, and we look for a continuation of this theme well into 2019. Key to our thinking is that market participants are too dovish on U.S. central bank policy, particularly as we head into 2019. Also, over time we do expect more volatility outside of the U.S. in interest rates, including India and Germany.
Given this backdrop, we believe that there are significant asset alloca-tion implications for investors who agree with our Paradigm Shift the-sis (Exhibit 7). Indeed, we believe that a new playbook is required – one that could look dramatically different from what worked in the first part of the current decade. Specifically, we advocate shorter duration and smaller positions in government bonds (hence, our 17% underweight in our asset allocation targets, our largest underweight since we have been providing asset allocation targets). Within Credit, we have tilted towards Opportunistic Credit in the Liquid Markets and Asset-Based Lending in the Private Markets. In Private Equity, we would advocate shifting from more of a Growth bias towards one that favors com-plexity, particularly around corporate carve-outs. Finally, within Real Assets, we increased our overweight even further in January, and we now favor both Infrastructure and Energy Income vehicles, including restructured MLPs.
EXHIBIT 7
Our 2018 Asset Allocation Reflects Our Preferences for International Equity Markets, Opportunistic Liquid Credit, and Yield and Growth in the Private Markets
-20
-15
-10
-5
0
5
10
FI: G
ovt
FI: I
G
FI: H
Y
Alt:
Grow
th
Eq: U
S
Eq: L
atam
RA: G
old/
Corn
RA: R
eal E
stat
e
Eq: E
urop
e
Cash
FI: D
ir Le
ndin
g
Alt:
SS
Alt:
PE
FI: L
oans
Eq: A
sia
RA: E
nerg
y/In
fra
FI: O
pp C
r
FI: A
sset
-Bas
edFi
nanc
e
Data as at February 28, 2018. Source: KKR Global Macro & Asset Allocation analysis.
KKR GMAA Target Global Asset Allocation vs. Strategy Benchmark, PPT
7KKR INSIGHTS: GLOBAL MACRO TRENDS
DETAILS
In recent years my travel pattern has been to focus on one region per trip, either visiting Asia or going to Europe. However, I recently embarked on ‘New World/Old World’ trip that took me to India as well as to several spots in Europe. Interestingly, what I learned during my time outside of the United States is that there are several important macro themes that apply to both Asia and Europe, reinforcing our be-lief that an international overweight to Europe and Asia likely makes more sense at this point in the cycle than a U.S.-centric strategy. To this end, we note the following:
Central bank policy is less hawkish outside of the United States. While the Federal Reserve has clearly telegraphed that it is on course to reduce the size of its balance sheet by nearly $400 billion in total during 2018 (Exhibit 8), we believe that some investors may not fully appreciate how different the U.S. macro backdrop may look relative to Europe and Asia during the next twelve months. For starters, we are now forecasting the Fed will raise rates six times between now and the end of 2019 amidst stronger growth and upward trending inflation, compared to a market consensus of four hikes and a fore-cast of five times for the Federal Reserve (and we note that this is the first time we have been above the Fed’s dot plot) during the same period. Previously, we were using a forecast of four rates hikes, compared to a market view of 2.5 hikes at the time.
By comparison, as we show in Exhibit 9, the ECB is still on course to add around 270 billion euro-denominated bonds to its balance sheet in 2018. Moreover, its deposit rate is still negative 40 basis points, compared to a U.S. overnight rate of 1.42% (and we expect it to hit 2.375% by year-end 2018). Recent central bank minutes further underscore the disparity in approach. On the one hand, the ECB recently stated that it “continues to expect them [interest rates] to remain at their present levels for an extended period of time, and well past the time of our asset purchases.” On the other hand, the Federal Reserve changed its guidance in January 2018 to state that it would make “further gradual adjustments” in interest rates; its prior state-ments mentioned just “gradual adjustments.” Importantly, this more hawkish stance was evident even before the Congress submitted its budget, which materially increases both the prospects for growth and higher deficits in the United States.
EXHIBIT 8
The Fed Balance Sheet Is Expected to Shrink by $394 Billion in 2018 (Compared to a $1.1 Trillion Increase in 2013)
+$1.1 Trillion
-$394 Billion
2013 2018
Size of Fed Balance Sheet, Comparative Increaseand Shrinkage, 2013 vs. 2018
Data as at January 2018. Source: Cornerstone Macro.
EXHIBIT 9
The ECB Is Set to Add Around 270 Billion of Euro-Denominated Bonds to Its Balance Sheet in 2018
- 500
1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000
Dec-17 Incremental 270B in 2018 Dec-18
Size of ECB Balance Sheet, 2017 vs. 2018, Euro Billions
Sovereign Bonds ABS Corporates
Liquidity (LTROs…) Other
Data as at 4Q17. Source: ECB, KKR Global Macro & Asset Allocation analysis.
Meanwhile, in Japan, the BoJ continues to expand its balance sheet as inflation is still well below its two percent target and as such, it is still committed to overshooting its inflation target through aggressive monetary policy. While Governor Kuroda’s five-year term is set to expire on April 8, 2018, he has already been reappointed to another term, which we view positively. Maybe more important, though, is that we continue to believe that the institutional directive of the Bank of Japan – under almost any scenario – will be to lag the global tight-ening cycle, as it is likely to maintain easy monetary policy for much
“ Our base view is that within the capital markets, volatility will continue to transition out of the currency markets into the fixed income markets,
sovereign debt in particular. “
8 KKR INSIGHTS: GLOBAL MACRO TRENDS
longer than its counterparts. In particular, we expect a continuation of Quantitative and Qualitative Easing (QQE) with Yield Curve Control (YCC), with a target around zero on the 10 year-yield, albeit at a more measured pace of buying than in the past. One can see this in Exhibits 10 and 11, respectively.
EXHIBIT 10
The BoJ Continues to Expand Its Balance Sheet, Making It Amongst the Most Accommodative Central Banks in the World
Dec-17441
0
50
100
150
200
250
300
350
400
450
500
01 03 05 07 09 11 13 15 17
Bank of Japan Balance Sheet Expansion, JPY Trillion
BoJ Held: TBills
BoJ Held: JGBs
BoJ Held: JGB & TBills
Data as 4Q2017. Source: Bank of Japan, Haver Analytics.
As my colleague Frances Lim recently indicated to me after an in-depth macro trip to Tokyo, ultra-easy monetary conditions in Japan are beginning to change corporate behavior and there has been steady growth in corporate capex spending in recent years (Exhibit 13), a trend we expect to continue in the current environment of an extremely tight labor market. Said differently, unlike in the U.S. (where we view a tight labor market as potentially problematic), we view Japan – a country desperate for reflationary trends – as a direct beneficiary of tight labor markets and faster growth. Indeed, if the global backdrop is beginning to shift from one of disinflation to one of reflation, then Japan – more so than almost any other country we invest in – should benefit mightily for years.
EXHIBIT 11
The Fed’s Path Towards Normalization Is Now Way Ahead of Europe and Japan
2.375
0.000
-0.100
Fed
ECB
Bank of Japan
Central Bank 2018 YE Consensus Policy Rates, %
Note: Fed rate represents KKR Global Macro & Asset Allocation estimates. Others are consensus as per Bloomberg. Data as at February 23, 2018. Source: Bloomberg, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 12
While Financial Conditions in the U.S. Are Tightening, Japan Continues to Be Extremely Accommodative…
-2
-1
0
1
2
07 08 09 10 11 12 13 14 15 16 17 18
LTM Financial Conditions Index
Easing
Tightening
Tigh
teni
ng
<<<
FCI
>>
> E
asin
g
U.S. Euro Area Japan China
Data as January 31, 2018. Source: Bloomberg, Morgan Stanley.
“ Indeed, if the global backdrop
is beginning to shift from one of disinflation to one of reflation,
then Japan – more so than almost any other country we invest in – should benefit mightily for years.
“
9KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 13
…And We See Corporate Behavior Changing: Corporate Capex Has Been Rising Steadily Since 2010
130
140
150
160
170
180
190
200
20
30
40
50
60
70
80
90
94 96 98 00 02 04 06 08 10 12 14 16 18
Corporate Profits (L) Corporate Capex (L) Labor Costs (R)
Data as 4Q2017. Source: Ministry of Finance Japan, Cabinet Office of Japan, Haver Analytics.
So, our bottom line is that while we agree with many investors that we may be enjoying a synchronized global economic recovery, monetary policy in 2018 is about as divergent as we can remember. Not surprisingly, our call to action is to overweight regions and asset classes where monetary policy is currently more accommodative. Within Europe, we currently favor Spain, Germany, and France, while in Asia our top picks include India, Japan, and Indonesia.
Despite a more hawkish central bank, holding local assets in the U.S. has gotten riskier. One of the most underappreciated aspects of investing, we believe, is getting the currency right. It can have a huge impact on returns, particularly around turning points. Importantly, we believe that we are at one of those turning points, with our call that the dollar is now peaking after a 79 month bull run. One can see this in Exhibit 14.
EXHIBIT 14
While We Acknowledge That the U.S. Dollar Could Bounce Tactically in 2018, We Believe that the USD Is Structurally in the Process of Peaking
Oct-78-11.8%
Mar-8540.8%
Jun-95-15.9%
Feb-0224.8%
Jul-11-16.9%
Dec-1616.6%
Avg
+1σ
–1σ
-30%
-20%
-10%
0%
10%
20%
30%
40%
70 75 80 85 90 95 00 05 10 15 20
Real Major Trade-Weighted US Dollar REER:% Over (Under) Valued
LatamCrisis
ASEANCrisis,RussianDefault
CommodityProducer Crisis
Data as at February 28, 2018. Source: Federal Reserve, Bloomberg.
EXHIBIT 15
U.S. Net Issuance Is Projected to Be $1.05 Trillion in 2018 and $1.15 Trillion in 2019
669533
824
488
1,0511,150
0
200
400
600
800
1,000
1,200
1,400
2014 2015 2016 2017 2018e 2019e
U.S. Net Treasury Issuance Projections, US$ Billions
Data as at February 28, 2018. Source: Global Macro & Asset Allocation, U.S. Treasury.
To be sure, the dollar may periodically rally in 2018 when investors begin to appreciate more our view that the Federal Reserve will be hiking faster than market expectations. However, current U.S. policy could be potentially dollar destructive, not dollar supportive, over the longer-term, we believe. Key to our thinking is that the U.S. deficit should be shrinking, not expanding, at this point in the cycle. One can see this in Exhibit 16, which shows that there has been no other time – excluding periods of war – where unemployment has been so low and deficits have been so high relative to GDP. The actual dollar
“ Not surprisingly, our call to action is to overweight regions and asset
classes where monetary policy is more accommodative. Within
Europe, we currently favor Spain, Germany, and France, while in
Asia our top picks include India, Japan, and Indonesia.
“
10 KKR INSIGHTS: GLOBAL MACRO TRENDS
amount of the potential deficit is also massive in absolute dollars. Indeed, as my colleague Brian Leung shows in Exhibit 17, the U.S. budget deficit is projected to reach $774 billion in 2018, surging to $1.1 trillion in 2019, which would be the largest budget deficit the U.S. has run since 2011. Importantly, the $326 billion jump from 2018 to 2019 would be the largest year-on-year increase since 2009.
EXHIBIT 16
The Combination of Tax Cuts and Budget Deal Could Increase the Budget Deficit to 5.6% of GDP in 2019
KoreanWar
VietnamWar
-12%-10%-8%-6%-4%-2%0%2%4%6%8%0%
2%
4%
6%
8%
10%
12%1948 1958 1968 1978 1988 1998 2008 2018
Divergence Between Unemployment & Budget Deficit
Unemployment Rate (LHS, inverted)Budget Balance % GDP (RHS)Budget Balance % GDP, GMAA Forecast (RHS)Budget Balance % GDP, Jun'17 CBO Baseline (RHS)
Data as at February 12, 2018. Source: Department of Labor, Department of Commerce, CBO, Goldman Sachs.
EXHIBIT 17
All Told, the Budget Deficit Is Projected to Jump 42% Between 2018 and 2019
2018e$774bn
2019e$1.1tn
-1,500
-1,300
-1,100
-900
-700
-500
-300
-100
100
300
1980 1985 1990 1995 2000 2005 2010 2015
Projected U.S. Budget Balance, Billions
Data as at January 2018. Source: www.cbo.gov/publication/52801.
EXHIBIT 18
The U.S. and Euro Area Have Divergent Approaches to Fiscal Policy, Particularly Post 2018…
-12
-10
-8
-6
-4
-2
0
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
Euro Area vs. U.S.: Fiscal Balance as a % of GDP
Euro Area U.S.
Data as at October 10, 2017. Source: IMF, Statistical Office of the European Communities.
“ To be sure, the dollar may
periodically rally in 2018 when investors begin to appreciate
more our view that the Federal Reserve will be hiking faster than
market expectations. However, current U.S. policy could be
potentially dollar destructive, not dollar supportive, over the longer-
term, we believe. “
11KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 19
…And Current Account Balances Are Also on Divergent Pathways, With More Than Six Percentage Points of Differential At a Time When the U.S. Is Imposing Trade Tariffs
-2.06
4.42
-7-6-5-4-3-2-1012345
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Current Account as a % of GDP
U.S. Euro Area
Data as at September 30, 2017. Source: Bureau of Economic Analysis, European Central Bank, Haver Analytics.
Separately, if we transition from developed to developing markets, we note that in emerging markets real rates are notably higher than in developed markets. One can see this in Exhibit 21, which shows a solid improvement in recent years. As a result, they have more flex-ibility to ease and still not approach such dramatically low levels of interest that other parts of the world now endure.
EXHIBIT 20
Inflation Is Rising, But Generally Remains Under Control in the Emerging Markets…
0
2
4
6
8
10
12
Indi
a
Viet
nam
Turk
ey
Braz
il
Russ
ia
Indo
nesi
a
Phili
ppin
es
Thai
land
Chin
a
Kore
a
Select Emerging Markets CPI, %
2012 2014 2016 2018
Data as October 11, 2017. Source: IMF WEO estimates, Haver Analytics.
EXHIBIT 21
…As Emerging Markets Have Retained Positive Real Yields
-2.4 -2.1 -2.0-1.5 -1.5
-0.4 -0.1 0.0
0.6
2.1 2.2
3.2 3.6 3.8 4.1
U.K.
Germ
any
Swed
en
Euro
Are
a
Japa
n
Aust
ralia
U.S.
Cana
da
Kore
a
Indo
nesi
a
Indi
a
Chin
a
Turk
ey
Braz
il
Russ
ia
Real 3-Month Yield, %
Emerging markets havepositive real yields
Advanced economies still havenegative real yields
Data as at February 28, 2018. Real 3m yield = 3m LIBOR rate - inflation. Source: Bloomberg.
Our bottom line: where you hold your assets can often be almost as important as which assets you hold at certain times in the cycle. Now is one of those times, we believe. As such, we prefer to hold more European and Asian assets. Already, in 2018, the penalty for owning dollars has cost investors 2.4% in total return, which has been particularly significant for holders of 10-year U.S. Treasuries (which are down 3.7% YTD before any currency penalty). Moreover, volatility in U.S. assets is likely to increase against a backdrop of larger fiscal and current account deficits, and as such, return per unit of risk for U.S. assets, which has been stellar in recent years, is likely to also come under pressure, particularly if there is more follow through around emerging markets trade tariffs.
“ Volatility in U.S. assets is likely
to increase against a backdrop of larger fiscal and current account deficits, and as such, return per unit of risk for U.S. assets, which has been stellar in recent years,
is likely to also come under pressure, particularly if there is more follow through around emerging markets trade tariffs.
“
12 KKR INSIGHTS: GLOBAL MACRO TRENDS
Both Europe and EM are benefitting from our belief that China has already crashed in nominal terms. As we have been describing since late 2016, our base case is that China has already bottomed in nominal terms. One can see this in Exhibit 22, which shows that nominal GDP declined to 6.4% in 2015 from 19.7% in 2011 before recovering to 11.1% in December 2017.
Interestingly ─ and somewhat to our surprise ─ on our recent trip to India, we heard several businessmen corroborate this view. In particular, because China has taken out capacity in several important cyclical, ‘old economy’ industries, it is leading to better profit growth not only in China but also in key Indian sectors such as steel and chemicals, many of which had been suffering from a lack of pricing power. To be sure, stymied credit extension will prevent China from V-bottoming (and we should not ignore that China is in fact tightening financial conditions), but the country’s attempt to boost its PPI and industrial profits is helping other countries in Asia, India in particular. It has also helped to limit NPL formation, which helps the economy to better embrace a more realistic cost of capital for new projects.
EXHIBIT 22
Nominal GDP in China Fell 67% from 2011 to 2015; as Such, China’s Economy Has Already Crashed, in Our View
Jun-1119.7
Dec-156.4
Dec-1711.1
0
5
10
15
20
25
30
-8
-4
0
4
8
12
00 02 04 06 08 10 12 14 16 18
China: PPI, Y/y, %, LHSChina: Nominal GDP, Y/y,%, RHS
Inflation peakedin 1Q17
83% correlation betweenPPI and GDP
A 67%decline
Data as at December 31, 2017. Source: China National Bureau of Statistics, Haver Analytics, Bloomberg, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 23
By Shrinking Capacity in the Industrial Sector, China Has Enabled Profits to Increase; This Development Is an Important One, We Believe
6.8
Jun-1518.8
4.0
Dec-179.1
0
4
8
12
16
20
11 12 13 14 15 16 17
China: Real GDP Growth Y/y, %
Real GDP
Financials (16%)Ex-Financials (84%)
Data as at December 31, 2017. Source: China National Bureau of Statistics, Haver Analytics.
EXHIBIT 24
Improved Supply Demand Balance Has Lifted Utilization Rates, Prices, and Profitability…
72
73
74
75
76
77
78
79
-20%-10%
0%
10%
20%
30%
40%
50%
60%
05 07 09 11 13 15 17
China: LTM Industrial Profits, %, Y/y, LHSChina: Industrial Capacity Utilization, %, RHS
Data as at December 31, 2017. Source: China National Bureau of Statistics, Haver Analytics.
“ Both Europe and EM are
benefitting from our belief that China has already crashed in
nominal terms. “
13KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 25
…It Has Also Helped China Address Its NPL Problem
-100%
-50%
0%
50%
100%
150%
200%
250%
300%
-50%
0%
50%
100%
150%
09 10 11 12 13 14 15 16
China: Nonperforming Loan Growth, Y/y, %
Agriculture ConstructionManufacturing Mining (R)
Data as at December 31, 2016. Source: China Banking Regulatory Commission, Haver Analytics.
These positive developments in China are significant, in our view, because they support our belief that 1) the significant macro head-wind faced by Asia from 2011 to 2015 (when nominal GDP fell nearly 70%) has now abated; 2) Asia should be an overweight in terms of both deployment and positioning in global asset allocation accounts. It also has implications for U.S. and European capital markets. Specifically, it leads us to believe that wide valuation differences be-tween Defensives versus Cyclicals in non-U.S. markets will continue to narrow. Already, one can see the reversal we are predicting has begun to unfold nicely in Exhibit 26.
EXHIBIT 26
If We Are Right That China Has Bottomed, Then Europe’s Cyclical Stocks Should Continue to Outperform
-10
0
10
20
30
40
50
75 78 81 84 87 90 93 96 99 02 05 08 11 14 17
European Defensives % Premium to MSCI Europe
Defensives Premium vs MSCI Europe Median
Note: Average Across P/E, P/B and Dividend Yield. Data as at December 31, 2017. Source: MSCI, IBES, Morgan Stanley Research.
EXHIBIT 27
Companies in the Eurozone and Japan Are More Sensitive to Global Growth Compared to Other Firms
1.1x 1.2x
1.8x
2.9x
3.6x
EmergingMarkets
Asia ex.Japan
U.S. Europe ex. UK Japan
Historic Sensitivity of Net Profits to Sales Growth
A one percent increase in sales would generate a 2.9%increase in Eurozone profits. This is due to the higher proportion of fixed costs inEurozone (and Japan) businesses
Data as at December 2017. Source: Goldman Sachs Research.
Our quantitative models for both European growth and EM Public Equity outperformance both suggest favorable outcomes for inves-tors. While we have traditionally managed money using fundamental analysis, quantitative inputs have increasingly become an important part of our macro framework. To this end, we take comfort from two important insights that our proprietary models are underscoring. First, as we show in Exhibit 29 below, three of our five indicators have turned up in our EM model. We view this quite positively, as the model has demonstrated a strong ability to capture long-term turning points in EM outperformance (as well as underperformance).
“ These positive developments in
China are significant, in our view, because they support our belief
that 1) the significant macro headwind faced by Asia from
2011 to 2015 (when nominal GDP fell nearly 70%) has now abated; 2) Asia should be an overweight
in terms of both deployment and positioning in global asset
allocation accounts. “
14 KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 28
It Has Been a Long, Hard Road in EM. However, We Now Believe a Structural Turn Is Occurring
Sep-94288%
Sep-0117%
Sep-10305%
Jan-16113%
Feb-18153%
0%
50%
100%
150%
200%
250%
300%
350%
87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 17
Relative Total Return, MSCI EM/DM(Dec-'87 =0%)
81months
84months
108months 25
months
64months
Data as at February 28, 2018. Source: MSCI, Bloomberg, Factset, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 29
EM Is Now Entering the ‘Mid-Cycle’ Phase of Its Recovery Wherein Relative Valuation Is No Longer Compellingly Cheap, but Momentum Has Turned and Fundamentals Are Improving
‘RULE OF THE ROAD’MAY ’15
JAN ’16
AUG ’16
MAY ’17
SEP ’17
1 Buy When ROE Is Stable or Rising
2 Valuation: It’s Not Different This Time
3 EM FX Follows EM Equities
4 Commodities Correlation in EM Is High
5 Momentum Matters in EM Equities
Overall: EM now seems to be entering a more ‘mid-cycle’ phase of its recovery. Valuation is no longer compellingly cheap, but equity and FX momentum have re-asserted themselves relative to DM. Maybe even more importantly, fundamentals are now improving, as manifested by rising ROEs, upward earnings revisions, and positive economic surprises. A firmer commodity backdrop recently also helps bolster our conviction in the sustainability of this EM cycle.
Data as at December 31, 2017. Source: KKR Global Macro & Asset Allocation analysis.
EXHIBIT 30
MSCI EM Is Up 24% on an Annualized Basis Since 2015, Outpacing the S&P 500, Which Is Only Up 16.8% Annualized During the Same Period
QUARTERLY PERFORMANCE
ANNUALIZED PERFORMANCE
1Q17 2Q17 3Q17 4Q17 2017 2 YRS 3 YRS 5 YRS
S&P 500 -12.9% 3.1% 4.5% 6.6% 21.8% 16.8% 11.4% 15.8%
Russell 2000 -10.6% 2.5% 5.7% 3.3% 14.6% 17.9% 10.0% 14.1%
MSCI ACWI -14.1% 4.5% 5.3% 5.8% 24.6% 16.3% 9.9% 11.4%
MSCI EAFE -14.5% 6.4% 5.5% 4.3% 25.6% 12.9% 8.3% 8.4%
MSCI Emerging Markets -19.1% 6.4% 8.0% 7.5% 37.8% 24.0% 9.5% 4.7%
CSFB High Yield -4.4% 2.0% 2.0% 0.5% 7.0% 12.6% 6.4% 5.7%
Barclays US Agg -2.6% 1.4% 0.8% 0.4% 3.5% 3.1% 2.2% 2.1%
Barclays US 5+ Yr TIPS -2.9% -0.3% 1.1% 2.1% 4.7% 5.2% 2.6% 0.2%
Note: Returns are Gross USD. Data as at December 31, 2017. Source: Bloomberg.
Interestingly, of the two indicators that are not green, one is valua-tion, which has turned less constructive after the trading multiple gap between developed and developing markets shrunk to a five multiple from seven in recent quarters. While a two multiple point contrac-tion is significant, we do take some comfort that a five multiple point discount is still quite compelling in absolute terms.
Meanwhile, in Europe our model still suggests a strong tailwind from central bank support. Indeed, as one can see in Exhibit 31, the ECB’s zero interest rate policy (ECB ZIRP) is the single biggest driver of the positive outlook we are envisioning. Interestingly, our U.S. model looked eerily similar in 2013, suggesting to us that Europe has sev-eral attractive years of growth ahead.
On a more ‘micro’ perspective, we see several things in the macro data that make us constructive. First, though one of the drags in the model in Exhibit 31 is housing activity, our leading indicator for our leading indicator in housing (and we acknowledge it is always dan-gerous to lead a leading indicator) has inflected upward. One can see this in Exhibit 33. Second, unlike in recent years, the recovery we are now seeing in Europe is extremely broad-based. One can see that in Exhibit 32, which shows the cross-country growth trajectory has narrowed materially. We view this constructively because in the past, the gap between Germany and its European peers had approached extreme levels, in our view.
15KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 31
Housing (e.g., Residential Mortgages and Residential Permits) Is Still Not Yet Fully Contributing to the Eurozone Recovery
Baseline EasierCredit
Conditions
FallingEUR
TW ECBZIRP
FallingBrent(EUR
terms)
StagnantHousing
Mkt
Forecast
1.5%0.2% -0.4%
0.9% -0.1%-0.5%
1.6%
ZIRP = zero interest rate policy. Data as at December 31, 2017. Source: KKR Global Macro & Asset Allocation analysis.
EXHIBIT 32
Cross-country Variation in GDP Growth Rates Is Near All-time Lows; This Data Point Underscores Our View that All of Europe Is Recovering this Time
1.2
1.6
2.0
2.4
2.8
3.2
3.6
4.0
4.4
4.8
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Standard Deviations of Real GDP GrowthDivergence, Euro Area, %
Cross-country variation in GDP growth rates is falling
Data as at 3Q17. Source: Eurostat, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 33
Building Permits Are on the Upswing in Parts of Europe…
0
30
60
90
120
150
180
210
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Building Permits (Q1 2007=100)
UK France Germany
Data as at September 30, 2017. Source: Statistical Office of the European Communities, Haver Analytics.
EXHIBIT 34
…While Eurozone Construction Output Growth Is Also Improving
-20%
-15%
-10%
-5%
0%
5%
10%
15%
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Eurozone Construction Output
12m Moving Average %Chg Y/y
Data as at November 30, 2017. Source: Statistical Office of the European Communities, Haver Analytics.
16 KKR INSIGHTS: GLOBAL MACRO TRENDS
Both Europe and Asia are elegant plays on two of our most impor-tant macro themes: ‘Deconglomeratization’ and ‘Experiences over Things’. Without question, being on the ground in Asia and Europe several times in recent weeks has given us additional confidence that we are pursuing the right macro themes. Indeed, given that valu-ations are quite high in aggregate, we have been more focused on complex situations where an investor may be able to acquire an asset at a discounted price relative to its intrinsic value. Without question, this mindset is the backbone of our ‘deconglomeratization’ thesis.
There are several forces at work, we believe. First, as we show in Exhibit 35, return on capital for many global firms has been in secular decline, with European firms being the weakest performers. Poor management execution, increased competition, and heavier than expected infrastructure costs are all to blame. Second, as we show in detail in Exhibit 36, many multinationals, particularly those in Japan, just have too many subsidiaries. Indeed, fully 25% of the Nikkei 400 in Japan have 100 or more subsidiaries. As a result, there is a sig-nificant opportunity to unlock value by spinning out underperforming divisions and/or seeking outside partners to help create value.
EXHIBIT 35
Rate of Returns for FDI Declining in Many Areas of the Global Economy, Europe in Particular
0%
2%
4%
6%
8%
10%
12%
14%
16%
85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15
US UK Germany Netherlands
Data as at December 31, 2016 or latest available year. Source: National Statistics, OECD.
Third, activist funds in the public markets represent an important contributor to our thesis. Without question, the increase in dollars raised in this segment is accelerating the streamlining of corporate structures. One can see this in Exhibits 39 and 40, respectively, which show both an increase in the velocity of divestitures as well as the number of CEO changes.
EXHIBIT 36
Japan Has Emerged as One of the Most Compelling Pure Play Examples on Our Thesis About Corporations Shedding Noncore Assets and Subsidiaries
NUMBER OF LISTED COMPANIES BY NUMBER OF CONSOLIDATED SUBSIDIARIES
NUMBER OF COMP.
UNDER 10
10 -49
50 -99
100 -299
300 OR MORE
Nikkei 400 400 51 157 91 77 24
TSE First Section 1,956 882 802 155 90 27
TSE Second Section 539 467 71 1 0 0
Mothers 239 226 13 0 0 0
JASDAQ 773 693 79 1 0 0
Total 3,507 2,269 964 154 91 28
Data as at 2017. Source: Macquarie.
EXHIBIT 37
Activism Is on the Rise in Both Asia and Europe
3
2
1
5
7
7
2
8
6
9
14
9
27
59
3
4
4
6
6
7
9
11
12
12
14
15
43
60
9
6
4
4
9
8
19
11
9
12
13
28
36
61
Sweden
Malaysia
Netherlands
Ireland
Switzerland
France
Germany
China
Italy
Singapore
Hong Kong
Japan
U.K.
Australia
Non-US Companies Publicly Subjected to Activist Demands
2017 2016 2015
Data as at January 2018. Source: The Activist Investing Annual Review 2018.
17KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 38
There Has Been a Steady Increase of Assets in the Activist Space; This Trend Is Bullish for Our Thesis Around Corporate Carve-Outs
0
20
40
60
80
100
120
140
2009 2010 2011 2012 2013 2014 2015 2016 2017
Global Single Strategy Activist Hedge Funds AUM, US$ Billions
Note: Does not include multi-strategy activist hedge funds. Data as at January 2018. Source: 2018 Global M&A Outlook, JP Morgan, HFR.
EXHIBIT 39
The Number of European Union Spin-off Announcements So Far This Year Is Close to Decade Highs; This Increase Is Consistent With Our Deconglomeratization Thesis
0
2
4
6
8
10
12
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017*
Spin-off Announcements in Western Europe Since 2008
Note: 2017 data is annualized. Data as at February 22, 2018. Source: Morgan Stanley European Equity Strategy Chartbook.
EXHIBIT 40
Management Change Announcements Remain on an Uptrend in Europe
14
16
18
20
22
24
26
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
% of Companies In MSCI Europe That HaveAnnounced Management Changes
Data as at February 22, 2018. Source: Morgan Stanley European Equity Strategy Chartbook.
Meanwhile, while ‘Experiences over Things’ is not a new theme for us, the pace of implementation appears to have accelerated across both Asia and Europe in recent quarters. In India, for example, cinema is exploding, with new air-conditioned multiplexes. There is also the continued focus on wellness and beauty, including a notable increase in experiential healthy dining options. As Exhibit 42 shows, increased travel by both locals and foreigners remains a secular theme throughout Asia, a trend we heard several times during our time in Mumbai. Estimates are now that international tourist arrivals are forecast to increase by 331 million to reach 535 million by 2030 (a 4.9% increase per year), making Asia the region with the highest absolute gain in arrivals.
“ Given that valuations are quite
high in aggregate, we have been more focused on complex
situations where an investor may be able to acquire an asset at a discounted price relative to its
intrinsic value. Without question, this mindset is the backbone of
our ‘deconglomeratization’ thesis. “
18 KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 41
Travel and Tourism’s Total Contribution to Global GDP Is on the Rise
1.91 1.99 1.94 1.89 1.93 1.99 2.06 2.16 2.36 2.23 2.31
6.036.32 6.33 6.08 6.24 6.44 6.63
6.997.58
7.177.61
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Economic Contribution of Travel and Tourism toGDP Worldwide, 2006-2016, in US$ Trillions
Direct contribution Total contribution
Note: The direct contribution of Travel and Tourism to GDP reflects the total spending within a particular country on the sector by residents and non-residents for business and leisure purposes and spending by governments on Travel and Tourism services directly linked to visitors, such as cultural (e.g., museums) or recreational (e.g., national parks). Data as at 2016. Source: Travel & Tourism Economic Impact 2017 World.
EXHIBIT 42
Asia Pacific Tourists Accounted for More than 25% of Total International Arrivals in 2016
59
86
114
153
206
272294
317
1990 1995 2000 2005 2010 2014 2015 2016
International Arrivals by Asia Pacific Tourists, Millions
25.6% of worldwide touristscame from the Asia Pacific region, with four out of five of those travelling intra-regionally
Data as at 2016. Source: UNWTO.
Technology is certainly playing a role in the inflection point we are describing, but our on the ground meetings lead us to believe that there is much more going on. For example, in Japan and Germany, both Aidan and Frances report that aging demographics are boosting the use of later stage healthcare offerings, while younger individuals in India and China are embracing more wellness and leisure. All told, Chinese millennials now spend three times as much on leisure as the average Chinese citizen. One can see this in Exhibit 44.
EXHIBIT 43
The Trend Towards Greater Spending on ‘Experiences’ Is Accelerating in Europe Too
26.5%
13.5%
13.1%
9.6%
9.4%
8.4%
5.7%
5.0%
3.3%
1.9%
1.9%
1.7%
0% 10% 20% 30%
Housing
Miscellaneous
Transport
Recreation & Culture
Restaurants & Hotels
Food & Drink
Clothing & Footwear
HH Goods & Services
Alcohol & Tobacco
Communication
Health
Education
U.K. Household Expenditure, 3Q17, % of Total
Experiences includes Recreation and Culture, Other Recreational Items and Equipment, Gardens and Pets, Package Holidays, Restaurants and Hotels, Personal Care, Personal Effects n.e.c. Data as at September 30, 2017. Source: Eurostat, Haver Analytics, KKR Global Macro & Asset Allocation analysis.
EXHIBIT 44
Chinese Millennials Save Less, and Allocate Three Times More of Their Income to Leisure
49%37%
28%
16%
14%
16%
9%
30%
0%10%20%30%40%50%60%70%80%90%
100%
China Overall Chinese Millennials
Spending Breakdown China Overall vs. Chinese Millennials
Leisure Shopping, Non-Food
Shopping, Food Housing, Transport, Utilities
Data as at December 31, 2016. Source: Goldman Sachs Global Investment Research.
19KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 45
Spending on Experiences Rather Than Things Is Increasing as More People Ascend Into the Middle Class in India
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1995 2005e 2015e 2025e
Share of Average Annual IndiaHousehold Consumption as a % of Total Consumption
Health CareEducation, RecreationCommunicationTransportationPersonal Pdcts & SvcsHousehold PdctsHousing, UtilitiesApparelFood, Bev & Tobacco
Data as at May 2017. Source: McKinsey.
EXHIBIT 46
A Young Indian Population With a Rising Median Income Will Focus More on Personal Care and Convenience
22.3%
24.5%
Packaged Foods(Total)
Premium Body andPersonal Care
India Changing Consumption Patterns, 2015-2025 CAGR, %
Data as at February 2018. Source: Citi Research Securing India’s Growth Over the Next Decade, Euromonitor.
We also see the fixed income ‘Illiquidity Premium’ as a compelling feature to earn solid risk-adjusted returns in today’s low interest rate environment in both Europe and Asia. Interestingly, in both Eu-rope and Asia it has been poorly performing banks that have created opportunities for Private Credit investors in recent quarters across both the performing and non-performing parts of these markets. In India, for example, we spent a lot of time reviewing unsecured credits with influential promoters that use the non-bank market because it offers both speed of execution as well as the ability to tackle complex capital structures. As we show in Exhibits 47 and 48 these loans offer high rates of returns because they embed a significant credit risk premium. All told, this premium can reach 1000 basis points or more in some transactions, compared to a more ‘modest’ 300-400 basis points for inflation and currency risks.
To be sure, India is an interesting play on Private Credit, but our recent trips to Indonesia underscore that the opportunity is broad both in terms of geography and sector. Moreover, because Sydney is her home base, Frances can attest that compelling opportunities have emerged in several developed markets in Asia where KKR operates, including Australia.
EXHIBIT 47
India’s Rates of Return Make It a Meaningful Play on Our Yearn for Yield Thesis
0.10.7
2.93.84.14.1
4.44.8
5–76.36.4
5–8 6.6
7.77–10
9–12 10–12
~1214–18 15–18
Japan: Govt Bond 10 YrGermany: Govt Bond 10 Yr
US: Govt Bond 10 Yr
China: Gov 10 YrUS: Investment Grade
Indonesia: USD Govt 10 YrEurope: Bank Loans
US: Bank Loans
KKR InfrastructureEM High YieldUS High Yield
Indonesia: Perf. USD Bank Loans
Indonesia: Govt Bond 10 YrIndia: Govt Bond 10 Yr
US: Direct Lending (Unlevered)Indonesia: Perf. IDR Bank Loans
India: Perf. INR Bank Loans
Mezzanine (Unlevered)India: High Yld INR Loans
Indonesia: Struct.USD Loans
Yields as at February 28, 2018, %
Data as at February 28, 2018. Source: Bloomberg.
“ We also see the fixed income
‘Illiquidity Premium’ as a compelling feature to earn solid risk-adjusted returns in today’s low interest rate environment in
both Europe and Asia. “
20 KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 48
There Is a High Credit Risk Premium in India
2.9%
3.5%
7.7%
16% 16%
US 10 Yr TsyYield
SovereignRisk
Infation/ FXRisk
Credit RiskPremium
Cost of Debt
India: Cost of Debt
+800-900bp
+50-100bp
+350-450bp
Data as at February 28, 2018. Source: Central Statistical Office, Haver Analytics.
On the non-performing side in Asia, we continue to be more selec-tive. Non-performing loans in China do not appear to offer a lot of cushion to foreign investors, while India is still in the early stages of enacting its bankruptcy laws. That said, we are encouraged that the government is finally forcing the state banks to rid themselves of zombie assets, and as such, we do expect some interesting prop-erties to be revitalized in key sectors in India such as power and industrials.
EXHIBIT 49
Assets Are Now Consistently Being Disposed of in Europe By the Banking Sector
€18
€49 €49 €24 €20
€9
€19
€56
€20 €32 €15
€14
€16
€31 €13
€5
€12
€17
€24 €16
€18
€2
€2
€20
€5
€31
-
€20
€40
€60
€80
€100
€120
€140
€160
2013 2014 2015 2016 2017*
European Bank Balance Sheet Transactions by LoanType, Face Value, Euro Billions
CRE Secured Retail Unsecured RetailSME/Corporate Specialized In Progress
€64
€94
€118
€140
€117
Note:*2017 is annualized; Specialized includes certain structured and asset backed products, shipping, infrastructure, energy and aviation. Data as at September 30, 2017. Source: PwC Portfolio Advisory Group Market Update.
In Europe our strong preference today is for Asset-Based Lending. We still like the Direct Lending and NPL markets, but we see more cycli-cal tailwinds in the hard asset market right now. Key to our thinking is that there is a change going on in the banking sector, which one can see in Exhibit 49. Specifically, as book values have again begun to grow throughout the European financial services industry, publicly traded financial intermediaries have finally started to ‘reposition’ their portfolios, including selling performing hard assets with onerous capital charges as well as seeking out capital-relieving joint ventures with third party investors, including alternative asset managers. ‘Last mile‘ resi-dential construction in areas such as Spain and Ireland has been a par-ticular focus of ours of late within Asset-Based Finance. We also view Asset-Based Finance as an elegant play on our desire to lock in low-cost liabilities in today’s QE-driven market, allowing investors to earn above-average spreads. Finally, we are seeing an increased opportunity set in the B-piece segment of the commercial mortgage market, driven by ‘new’ retention rules that notably favor investors with long duration liabilities who value the benefits of cash flowing hard assets.
Conclusion
As we move into later cycle positioning, our asset allocation advice is to tilt toward many of the compelling opportunities we see outside the U.S. To be sure, we believe that the recent tax cuts and de-regulation efforts are constructive for the positioning of U.S. corpora-tions. However, much of this benefit now seems to be in the price on a tactical perspective. Maybe more important, though, is that strong growth will likely challenge the central bank in the U.S. to become more aggressive than it would like — all else being equal. Moreover, U.S. central bank policy now looks dramatically different than what we are seeing in Europe and Asia, Japan in particular.
“ Beyond diverging monetary
policy, our recent trips across Europe and Asia give
us additional confidence that these regions appear
to be elegant plays on many of our most important
macro themes, including ‘Deconglomeratization,’
‘Experiences over Things,’ and the ‘Illiquidity Premium’ in
Private Credit. “
21KKR INSIGHTS: GLOBAL MACRO TRENDS
EXHIBIT 50
The Size of the Combined Fed and ECB Balance Sheets Will Likely Peak at $9.9 Trillion in June 2018
0
2,000
4,000
6,000
8,000
10,000
12,000
'17 '18 '19 '20 '21 '22 '23 '24 '25
ECB Fed
Forecasts
Peak in Jun-18 $4.1tn
$3.4tn
Size of Central Bank Balance Sheet, US$ Billions
Data as at February 28, 2018. Source: KKR Global Macro & Asset Allocation team, U.S. Treasury.
EXHIBIT 51
As a Result, the Term Premium, Which Has Fallen to Unsustainably Low Levels, Should Keep Heading Higher in the U.S.
Sep-17-0.33
Dec-18e+0.10
Dec-19e+0.25
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
'00 '03 '06 '09 '12 '15 '18
Term Premium Embedded in U.S. 10Yr Yields
e = KKR Global Macro & Asset Allocation estimates. Data as at February 28, 2018. Source: Historical data based on Kim and Wright model published by U.S. Federal Reserve.
Beyond diverging monetary policy, our recent trips across Europe and Asia give us additional confidence that these regions appear to be elegant plays on many of our most important macro themes, including ‘Deconglomeratization,’ ‘Experiences over Things,’ and the ‘Illiquidity Premium’ in Private Credit. Meanwhile, many of our quan-titative macro models are suggesting a heavy allocation to non-U.S. equities, Emerging Markets in particular. Finally, both implicit and explicit in what we are saying is that the U.S. currency has peaked in terms of outperformance, a trend we outlined in our 2018 outlook in January.
EXHIBIT 52
Equity Valuation Metrics Show That Europe, EM and Japan Have Lower Valuations At Present Than the U.S.
EQUITY VALUATION METRICS ECONOMIC AND CREDIT-RELATED METRICS
Avg. Across All Metrics
Avg. Across Equity Metrics EV/ EBITDA Fwd P/E
Market Cap % of GDP
Embedded EPS Grwth (Rate-Adj.
Equity Valu-ation) Shiller P/E
Avg. Across Credit and
Cycle-Related Metrics
Unemp. Rate (inverse)
Credit Spreads (inverse)
Trailing 5yr Equity Mkt
Return
U.S. 0.9 0.9 1.6 0.6 1.6 -0.5 1.3 0.9 1.2 0.9 0.5
Europe 0.3 0 -0.1 0.1 1.3 -1.1 -0.1 0.8 1.5 0.9 0
EM 0.3 0.3 1.6 -0.1 0.8 -0.5 -0.4 0.4 0.5 -1.0 -0.4
Japan 0 -0.5 1.0 -0.9 1.7 -1.2 -0.9 0.8 0.9 -0.1 1.6
Data as at February 28, 2018. Source: Factset, Bloomberg.
“ We also view Asset-Based Finance as an elegant play on our desire to lock in low-cost liabilities in today’s QE-driven market, allowing inves-
tors to earn above-average spreads. “
22 KKR INSIGHTS: GLOBAL MACRO TRENDS
Overall, we believe that we are at an important inflection point in global asset allocation. On the fixed income side, we are aggres-sively advocating shortening duration (as measured by our 17% underweight to government bonds), while on the equity side, we are advocating more money flow into non-U.S. companies (and we are now at our widest allocation towards non-U.S. since we began pro-viding target asset allocation models in 2012). Not surprisingly, both directives stem from our strong belief that investors should spend less time championing the benefits of a global synchronous recovery and more time understanding the difference in monetary policy that the current global growth dynamics are creating. If we are right, then the upside to these asset allocation changes could be as significant as we have seen since the introduction of quantitative easing (QE) following the onset of the great financial crisis (GFC). Therein lies the opportunity, we believe.
Important Information
References to “we”, “us,” and “our” refer to Mr. McVey and/or KKR’s Global Macro and Asset Allocation team, as context requires, and not of KKR. The views expressed reflect the current views of Mr. McVey as of the date hereof and neither Mr. McVey nor KKR undertakes to advise you of any changes in the views expressed herein. Opinions or statements regarding financial market trends are based on current market conditions and are subject to change without notice. References to a target portfolio and allocations of such a portfolio refer to a hypothetical allocation of assets and not an actual portfolio. The views expressed herein and discussion of any target portfolio or allocations may not be reflected in the strategies and products that KKR offers or invests, including strategies and products to which Mr. McVey provides investment advice to or on behalf of KKR. It should not be assumed that Mr. McVey has made or will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client or proprietary accounts. Fur-ther, Mr. McVey may make investment recommendations and KKR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this document.
The views expressed in this publication are the personal views of Henry McVey of Kohlberg Kravis Roberts & Co. L.P. (together with its affiliates, “KKR”) and do not nec-essarily 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 repre-sent a formal or official view of KKR. This document is
not intended to, and does not, relate specifically to any investment strategy or product that KKR offers. It is be-ing provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own views on the topic discussed herein.
This publication has been prepared solely for informa-tional purposes. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this docu-ment has been developed internally and/or obtained from sources believed to be reliable; however, neither KKR nor Mr. McVey guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.
There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future per-formance 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 projec-tions or other forward‐looking statements regarding future events, targets, forecasts or expectations regard-ing 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-cantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subse-quent market events or for other reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested. The indices do not include any expenses, fees or charges and are unmanaged and should not be considered investments.
The investment strategy and themes discussed herein may be unsuitable for investors depending on their spe-cific investment objectives and financial situation. Please note that changes in the rate of exchange of a currency may affect the value, price or income of an investment adversely.
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