Volume 4.5 • June 2014 Midyear Outlook: Four Big Macro ... · tainly critical in all facets of...

Volume 4.5 • June 2014

Midyear Outlook: Four Big Macro Trends at Work

InsIghtsGlobal macro Trends

2 KKR InsIGhTs: Global macro Trends

Midyear Outlook: Four Big Macro Trends at WorkOur updated asset allocation framework reflects the four big macro trends we currently see driving returns across the global capital markets. First, in the developed equity markets we continue to see a lot of reasonably valued mid- and large-cap stocks with excess cash balances and low leverage. This backdrop remains a constructive one for certain private and public equity investments, and it too suggests that corporate M&A activity is likely to remain robust. Second, in a low rate environment we think the sizeable illiquidity premium that has been created by heightened regulation throughout the banking system remains compelling. On the margin, Europe appeals more to us than the United States, which represents a change in our thinking. Third, many emerging market companies now need to restructure or recapitalize their balance sheets at the exact time that the cost of capital in their countries is going up. This backdrop should reward both credit and equity investors, particularly in countries where there is now new government and/or central bank leadership. Fourth, while tapering is on track, many central banks around the world still remain committed to keeping nominal interest rates below nominal GDP. In such an environment, we believe owning real assets that can deliver yield, growth and inflation hedging makes sense.

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 +1 (212) 519.1630 [email protected]

Rebecca J. RaMsey +1 (212) 519.1631 [email protected]

JaIMe VIlla +1 (212) 401.0379 [email protected]

aIDan t. coRcoRan + (353) 151.1045.1 [email protected]

MaIn oFFIce

Kohlberg Kravis Roberts & Co. L.P.9 West 57th streetsuite 4200new York, new York 10019+ 1 (212) 750-8300

coMPany locatIons

aMeRIcas new York, san Francisco, Washington, d.c., menlo Park, houston, louisville, são Paulo, calgary euRoPe london, Paris, dublin, madrid asIa hong Kong, beijing, singapore, dubai, riyadh, Tokyo, mumbai, seoul austRalIa sydney

© 2014 Kohlberg Kravis roberts & co. l.P. All Rights Reserved.

“ Nothing can stop the man with the

right mental attitude from achieving his goal; nothing on earth can help the man with the wrong mental attitude.

”thoMas JeFFeRson

amerIcan FoundInG FaTher, The PrIncIPal auThor oF The declaraTIon oF IndePendence, and The ThIrd PresIdenT oF The unITed sTaTes

3KKR InsIGhTs: Global macro Trends

as a native Virginian and a graduate of the university of Virginia, I have come to view Thomas Jefferson as one of the u.s.’s most thoughtful americans. In particular, his aforementioned advice that “nothing can stop the man with the right mental attitude” is cer-tainly critical in all facets of life, including the investment business. In particular, an investor has to be able to bounce back when asset allocation and/or security selection decisions backfire or even just do not go as planned.

moreover, in an environment where fiscal and monetary stimulus in the united states is now 4.5x what occurred post the Great depression, we believe having the “right mental attitude” these days also means thinking outside the box. Indeed, with the Fed’s balance sheet at more than $4 trillion and the european central bank (ecb) cutting deposit rates into negative territory1, we are clearly living in unprecedented times – times that require both a strong historical perspective as well as a forward-thinking one.

Given the environment in which we find ourselves operating, we have purposely shied away from reacting too much to quarterly fluctuations in stock or bond prices that might otherwise encour-age us to make significant changes to our strategic asset allocation framework. rather, we have tried to stay the course on what we believe are the big important macro themes that could materially drive performance on a three- to five-year basis.

That said, we also acknowledge that economies and markets remain continuously in motion. as such, we thought it might make sense to put forth a mid-year update that reflects some key changes that we believe are now impacting the current macro and asset allocation landscape. see below for details, but our primary macro conclu-sions and target asset allocation changes are as follows:

1. The global economic recovery has become less synchronous. In the 1990s and early 2000s, an acceleration in consumption from the developed economies drove export demand in the emerging market economies, which in turn stimulated demand in these same economies. however, our recent visits to europe, asia and latin america suggest the global economy does not appear to be enjoying a “virtuous cycle” during this economic expansion. What’s different this cycle is that developed market economies – while improving – do not seem to be creating enough outsized demand to jump-start economic growth in em exporter nations the way they did in the past. at the same time, many emerging market countries, including brazil and India, have been forced to fight higher inflation through higher rates – and hence, are experiencing slower growth.

2. We see new opportunities “emerging” in several developing markets. Many of them relate to corporate restructurings and deleveraging stories. As such, we are increasing our allocation to Distressed Debt/Special Situations to a 9% allocation from 7% and a benchmark weighting of 0%. see below for details, but our most recent trip to India crystallized our view that many parts of em are now enduring a modern-day version of stagfla-tion. against this backdrop, banks are overweight bad corporate credit, in our view, and as such, there is a growing role for

1 data as at may 31, 2014. source: Exhibit 45 and the ecb, bloomberg.

private lenders and restructuring professionals to step in and provide value-added capital to struggling corporations across a variety of sectors. Importantly, this opportunity set is just unfolding, particularly in asia. hence, whereas we have been highlighting the merits of special situations/distressed in europe for quite some time, an incremental rotation towards restructur-ing opportunities in emerging markets now appears to make a lot of sense to us.

3. We are reducing our Actively Managed Opportunistic Credit al-location by 2% to 4% from 6%. Given such strong performance in 1h14, our thought is now to trim opportunistic credit, which we introduced in January 2014 to allow a manager to toggle between high yield and bank loans. however, with tight credit spreads, low volatility and booming issuance (collateralized loan obligations in particular), we are seeking to take some profits in liquid credit at this point in the cycle. Within our remaining ac-tively managed opportunistic credit, we favor basically a 50/50 split of loans to high yield. details below.

4. We maintain a 55% allocation to global equities versus a benchmark of 53%. Importantly, though, we are narrowing our focus within equity markets. To review, we thought many equity trading multiples were “ahead of themselves” coming into the year. however, with many growth stocks now deflated and overall earnings poised to reaccelerate, we think the market internals now look more balanced. In particular, we see a lot of what we believe will be performance leaders in the public equity arena trading just 13-17x earnings, and many of them still display solid cash flow profiles. outside of the united states, we continue to favor europe and mexican mid-caps, while we are more constructive on internal domestic consumption stories in Indonesia and India.

5. We retain our positive bias towards real assets, particularly those that provide low-cost inflation optionality. In an environ-ment where many central banks are using quantitative easing (Qe) to aggressively suppress nominal interest rates below nomi-nal GdP, we strongly believe owning real assets that can provide a combination of yield, growth and inflation protection makes a lot of sense at this point in the cycle. Importantly, we continue to see much more value in private assets, particularly infrastructure and midstream, than in public notes and/or swaps. To be sure, we do not see inflation looming in the developed markets, but if we can find real asset strategies that provide yield, growth and low-cost inflation optionality, we still recommend purchasing them.

6. We continue to significantly underweight government bonds and high-grade debt in favor of “spicier” credit. our basic premise remains that non-traditional credit, including high yield, private credit, mezzanine, and special situations, will outper-form low-yielding government bonds and high grade credit as long as we are right on the duration and pace of the current economic cycle. since the recovery began in 2009, this strategy has unfolded favorably, though we fully acknowledge the strong performance of Treasury bonds in 1h14 tested our thesis. We remain undeterred; our base case for 10-year Treasury yields by december 31, 2014 remains 3.3% versus the current level of 2.7%. Further details below.


exhIbIt 1

KKR GMAA* Revised 2014 Target Asset Allocation

ASSeT ClASS

KKR GMAA June 2014 TARGeT (%)

STRATeGy BenCh-

MARK (%)

KKR GMAA JAnuARy 2014 TAR-GeT (%)

PuBlIC equITIeS 55 53 55

u.s. 20 20 20

EuRoPE 16 15 16

all asIa 13 12 13

laTIn amerIca 6 6 6

TOTAl FIxeD InCOMe 18 30 20

Global GoVernmenT 3 20 3

mezzanIne 5 0 5

hIGh YIeld 0 5 0

banK loans 0 0 0

hIGh Grade 0 5 0

emerGInG marKeT debT 0 0 0

acTIVelY manaGed oPPorTunIsTIc credIT

4 0 6

FIxed Income hedGe Funds 3 0 3

dIrecT lendInG 3 0 3

ReAl ASSeTS 8 5 8

real esTaTe 5 2 5

enerGY / InFrasTrucTure 5 2 5

Gold -2 1 -2

OTheR AlTeRnATIveS 19 10 17

TradITIonal Pe 5 5 5

dIsTressed / sPecIal sITuaTIon

9 0 7

GroWTh caPITal/em Pe/oTher 5 5 5

CASh 0 2 0

source: *KKr Global macro & asset allocation (Gmaa) as at June 26, 2014. strategy benchmark is the typical allocation of a large u.s. pension plan. Please visit www.KKrinsights.com to review our Outlook for 2014: Stay the Course note, which further reviews these ideas.

overall, we still feel comfortable with our asset allocation frame-work, given the four big macro trends we see driving returns across the global capital markets. First, in the developed equity markets we continue to see a lot of reasonably valued mid-and large-cap stocks with excess cash balances and low leverage. This backdrop remains a constructive one for certain private and public equity investments, and it too suggests that corporate m&a activ-ity is likely to remain robust. second, in a low rate environment we think the sizeable illiquidity premium that has been created by heightened regulation throughout the banking system remains

attractive. on the margin, europe appeals more to us than the united states, which represents a change in our thinking. Third, we believe many emerging market companies should now restruc-ture or recapitalize their balance sheets at the exact time that the cost of capital in their countries is going up. This backdrop could reward both credit and equity investors, particularly in countries where there is now new government and/or central bank leader-ship. Fourth, while tapering is on track, many central banks around the world still remain committed to keeping nominal interest rates below nominal GdP. In such an environment, owning real assets that can deliver yield, growth and inflation hedging makes sense, in our view.

In terms of risk, we continue to view china as a big risk. In par-ticular, housing activity is slowing as the government tries to bring nominal lending rates back below nominal GdP. In addition, the country’s role as “manufacturer” to the world has clearly come under pressure as soaring wages have made the country less competitive with other low-cost labor rivals. another risk we think investors should monitor is credit spreads, high yield in particular. In europe, for example, periphery credit spreads are trading, on average, inside of core credit spreads. While we are not predicting spreads will blow out any time soon in either the u.s. or europe, the research we detail below supports the thesis that high yield spreads can often act as an important signaling mechanism when the cycle begins to crest. Finally, credit spreads are also tight at a time when the risk-free rate feels low, u.s. inflation is bottoming, and volatility remains dampened.

DeTAIlS: Key TheMeS/ReCOMMenDATIOnS

This recovery will not be a synchronous one

“It has been said that arguing against globalization is like arguing against the laws of gravity.” Kofi Annan

There is little doubt in my mind that, as Kofi annan’s quote sug-gests, globalization is an undeniable force in economics. however, when I focus less on theory and more on the reality of what I am seeing during my travels, my “gut” instinct is that globalization is not working the way it should, or at least the way folks in the investment business thought it should.

From my vantage point, there are at least three detrimental forces at work. First, developed economies are not growing fast enough to inspire a virtuous cycle where consumption increases in the u.s. and europe ultimately lead to a demand increase in emerging market producer nations. Indeed, we are now five years into this re-covery, with nominal GdP growth in the u.s. materially slower than in prior recoveries. In particular, as Exhibit 2 shows, shortfalls in consumer and government spending have been the primary factors keeping nominal GdP growth well below trend this cycle.


exhIbIt 2

Among Other Things, Lackluster GDP Growth in the U.S. Has Helped to Dent a Virtuous Cycle in the Global Economy

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

Nom

inal

GD

P

PC

E

Inve

stm

ent

Gov

ernm

ent

Expo

rts

Annualized Nominal Growth During Periods of Economic Expansion

Post 1950 Average Post 1980 Average Current Recovery

Pce = personal consumption expenditure. data as at march 31, 2014. source: bureau of economic analysis, haver analytics.

exhIbIt 3

Profit Margins Are High, But Earnings Relative to Trend Appear Reasonable

3Q97 16.9%

3Q00 24.1%

2Q02 -12.8%

2Q07 27.5%

3Q09, -39.6%

Apr-14 -2.0%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

1990 1994 1998 2002 2006 2010 2014

S&P 500 % Earnings Deviation vs Trend

Peak earnings cycle

No earningsbubble

Trend, average and standard deviation for January 1984 to current. earnings deviation versus trend = percentage difference between trailing twelve months earnings and trend earnings. data as at april 30, 2014. source: s&P, First call, Factset.

second, many emerging market economies are being forced to run restrictive monetary policy, despite sluggish growth. The culprit, as Exhibit 5 shows, is stubbornly high inflation. based on our recent trips to brazil, India and Indonesia, we can confidently assert that lack of adequate infrastructure as well as high food and labor costs

seem to be creating structural inflation headwinds that likely won’t be remedied overnight.

exhIbIt 4

Developed Markets PMIs Have Picked Up, While Emerging PMIs Remain Sluggish

46

48

50

52

54

56

58

09/0

1/09

01/0

1/10

05/0

1/10

09/0

1/10

01/0

1/11

05/0

1/11

09/0

1/11

01/0

1/12

05/0

1/12

09/0

1/12

01/0

1/13

05/0

1/13

09/0

1/13

01/0

1/14

Manufacturing PMI Index EM DM

data as at april 1, 2014. source: haver analytics, Goldman sachs Investment Research.

exhIbIt 5

CPI Has Been Rising Modestly In Emerging Countries Since 2012, But Falling in Developed Countries

-2%

0%

2%

4%

6%

8%

10%

Jan-

00

Nov

-00

Sep

-01

Jul-

02

May

-03

Mar

-04

Jan-

05

Nov

-05

Sep

-06

Jul-

07

May

-08

Mar

-09

Jan-

10

Nov

-10

Sep

-11

Jul-1

2

May

-13

Mar

-14

GDP Weighted CPI y/y

Emerging Developed

Stubbornlyhigh inflation

Low inflation

data as at april 30, 2014. source: haver analytics.

Third, as we have documented in several recent pieces (China: Repositioning Now Required and Outlook 2014: Stay the Course), the chinese economy is structurally slowing. We linked the slowdown to three factors: 1) anti-corruption initiatives; 2) a forced decline in nominal lending growth rates back towards nominal GdP growth;


and 3) increased competition across many of china’s export businesses. Though we think the current leadership is doing the “right” things from a macro perspective, china’s issues now run deep after a decade of excess. as such, we see little reason that these macro headwinds should reverse course in the near term.

against this global growth backdrop, we have made several noteworthy changes to our regional GdP forecasts. In the united states, we have raised our inflation forecast to 2.0% from 1.7% on the back of higher oil prices and tightening capacity in certain areas. by comparison, we have lowered our 2014 u.s. GdP to 2.4% from 2.8% for several reasons. First, as has been well documented, adverse weather during first quarter 2014 was a major deterrent to growth. second, while autos, energy and manufacturing continue to be economic star performers, continued lack of mortgage credit availability is now putting downward pressure on our u.s. forecast-ing models. both our new and old housing forecasts are outlined in Exhibit 7.

exhIbIt 6

We Have Lowered Growth Forecasts Across the Board, Except in Europe

2014 GroWTh & InFlaTIon base case esTImaTes

GM

AA

TA

RGET

REA

L G

dP

Gr

oW

Th

BLo

oM

BER

G

con

sen

su

s

rea

l G

dP

G

ro

WTh

KKR

GM

AA

TA

RGET

In

FlaT

Ion

BLo

oM

BER

G

con

sen

su

s

InFl

aTIo

n

u.s. 2.4% 2.5% 2.0% 1.7%

EuRo AREA 1.1% 1.1% 0.75% 0.8%

chIna 7.2% To 7.5% 7.3% 2.5 To 3.0% 2.5%

BRAzIL 1.0% 1.8% 6.5% 6.4%

GdP = Gross domestic Product. bloomberg consensus estimates as at June 6, 2014. source: KKr Global macro and asset allocation, Bloomberg.

exhIbIt 7

We’ve Updated Our Housing Forecast to Reflect Slower Construction Patterns

u.S. neW hOuSInG COnSTRuCTIOn (000 unITS)

MAy’14 neW

FOReCAST

APR’13 OlD

FOReCAST ChAnGe

NEw FORECAST DETAIl

1-FAMIly MulTI-FAMIly

2012 641 641 nm 479 162

2013 929 1,000 -71 621 308

2014e 1,020 1,200 -180 660 360

2015e 1,200 1,300 -100 800 400

2016e 1,350 1,400 -50 950 400

2017e 1,450 1,400 50 1050 400

april 2013 old Forecast was an internal revision of our published forecast found in the march 2012 Insights note U.S. Housing: A Changing Dynamic. data as at april 29, 2014. source: KKr Global macro and Asset Allocation estimates.

separately, we have also trimmed our brazil GdP forecast to 1.0% from 1.5%. The consensus remains, in our view, too optimistic at 1.8% growth in 2014. major influences affecting our brazil forecast are the significant declines in both business and consumer con-fidence in recent months. meanwhile, given ongoing supply con-straints affecting the economy, we have raised our inflation forecast to 6.5% from 6.1% and a consensus forecast of 6.4%.

In europe, our GdP forecast remains unchanged at 1.1%, but we have trimmed our inflation forecast to 0.75% from 1.0% on the back of ecb President mario draghi’s most recent comments. Though we respect his most recent initiatives to thwart outright deflation, we do expect ongoing bank deleveraging to adversely affect the re-gion’s ability to deliver higher inflation in the near to medium term.

Finally, as we detailed in our china note from February (China in Transition), we are now using 7.2% to 7.5% GdP growth in 2014, compared to our prior estimate of 7.4% to 7.7%. anti-corruption initiatives, slowing real estate sales, and weaker low-end exports all continue to weigh on growth at a time when the government is trying to reduce nominal lending growth back towards nominal GdP levels. We have also lowered our inflation target in china to 2.5% to 3.0% from 3.0% to 3.5%, driven by not only lower food prices but also increased concerns about excess capacity in the system.

...But our forecasted duration for this cycle still appears reason-able

“Remember, it is hard to really hurt yourself falling out of a basement window.” anonymous

as we described earlier, the synchronicity of this recovery is certainly not consistent with recent economic expansions. by

“ The global economic recovery has become less synchronous.

“


comparison, the pacing and the duration of the cycle actually appear more in line with history. specifically, if we use the u.s. as a proxy, we are now 60 months into an economic recovery, compared to an average of 95 months for the past three recoveries (Exhibit 8). Put another way, we still see more running room in terms of the dura-tion of this economic expansion, even if it is running at a painfully slow pace versus history.

at the moment, our base forecast is unchanged: The current u.s. recovery will extend through 2017, which would be about in line with the past three economic cycles. however, when we do have a downturn, we actually do not expect the earnings fall-off to be as dramatic as what we experienced in 2001/2002 and 2007/2008. Key to our thinking is that we just do not see the same type of out-sized earnings growth from one sector that we did during the 2000 cycle. To review, in 2006 the financial sector accounted for 50% or more of total incremental earnings growth (with energy being the other big driver). as a result, when credit deteriorated and leverage collapsed, the downward earnings trajectory was historic. by com-parison, as we look towards 2015-2016, no one sector is expected to account for more than 20% of total incremental earnings growth. as such, we think the next earnings downturn is likely to be more modest than what occurred from June 2007 through september 2009 (Exhibit 9).

exhIbIt 8

We Are Now in the 60th Month of Economic Expansion

21 33

19 12

44 10

22 27 21

50 80

37 45

39 24

106 36

58

12 92

120 73

60

December 1900 - September 1902 August 1904 - May 1907

June 1908 - January 1910 January 1912 - January 1913

December 1914 - August 1918 March 1919 - January 1920

July 1921 - May 1923 July 1924 - October 1926

November 1927 - August 1929 March 1933 - May 1937

June 1938 - February 1945 October 1945 - November 1948

October 1949 - July 1953 May 1954 - August 1957

April 1958 - April 1960 February 1961 - December 1969

November 1970 - November 1973 March 1975 - January 1980

July 1980 - July 1981 November 1982 - July 1990

March 1991 - March 2001 November 2001 - December 2007

June 2009 - Current (Jun 2014)

Duration of US Economic Expansions (Months)

Median = 37

data as at June 30, 2014. source: national bureau of economic research, KKr KKr Global macro and asset allocation analysis.

exhIbIt 9

We Think the Next Earnings Correction Will Be Less Dramatic Than the 2007-2009 Period

S&P 500 eARnInGS BeAR MARKeTS

PeAK ePS

TROuGh ePS

# OF MThS

PeAK ePS

TROuGh ePS

ePS PeAK TO TROuGh

dec-16 dec-21 61 1.53 0.29 -81%

dec-29 dec-32 37 1.61 0.41 -75%

seP-37 seP-38 12 1.22 0.62 -49%

mar-56 seP-58 30 3.69 2.88 -22%

seP-59 Jun-61 21 3.43 3.03 -12%

seP-69 dec-70 15 5.89 5.15 -13%

seP-74 seP-75 12 9.17 7.77 -15%

mar-80 mar-83 37 15.32 12.58 -18%

Jul-89 dec-91 29 25.30 19.30 -24%

seP-00 mar-02 18 56.79 44.28 -22%

Jun-07 seP-09 33 92.15 50.84 -45%

AveRAGe SInCe 1900 28 -34%

AveRAGe POST WAR 25 -21%

data as at may 29, 2014. source: robert shiller, s&P, Thomson Financial, Factset.

“ We see new opportunities

‘emerging’ in several developing markets, particularly as they

relate to corporate restructurings and de-leveraging stories.

“


exhIbIt 10

Our U.S. GDP Forecasts for 2014-2017e Assume That Growth Falls Off in 2017

2.7%

1.8%

-0.3%

-2.8%

2.5% 1.8%

2.8% 1.9% 2.4%

3.1% 2.7%

1.6%

2006

2007

2008

2009

2010

2011

2012

2013

2014

e

2015

e

2016

e

2017

e

US Real GDP Forecast

KKR Consensus

2.5%3.1%3.0%N/A

'14e = 2.4%'15e = 3.1%'16e = 2.7%‘17e = 1.6%

e = KKr Global macro and asset allocation estimates. data as at June 6, 2014. source: bureau of economic analysis, KKr Global macro and Asset Allocation analysis.

exhIbIt 11

The U.S. Economy Will Soon Have to Face the Impact of Higher Interest Rates

1.00

3.00

4.25 4.25

0.25 0.25 0.50

3.25

0.30

1.20

2.53

3.78

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2014 2015 2016 Long Term

Distribution of Fed Estimates for Policy Rate

High Fed Estimate

Low Fed Estimate

Weighted Avg of Fed Dots

data as at June 18, 2014. source: Federal reserve board.

Importantly, we continue to watch influences that could drive upside or downside to our base case. To this end, we thought it might be worth mentioning what is going better – and worse – than anticipated so far since we laid out our initial macro framework in october 2011 (see Phase III: The last Stage of a Bumpy Journey). on

the one hand, the u.s. consumer is now in much better shape than our original baseline. net worth has risen a record $26.2 trillion to $81.8 trillion, or 47% above the trough of $55.6 trillion in march 20092. not surprisingly, as consumers have repaired their balance sheets, net charge-offs have plummeted (Exhibit 12), while debt service obligations have declined precipitously (Exhibit 13).

exhIbIt 12

The Consumer Credit Environment Has Become Very Benign as Charge-Offs Have Declined Dramatically

0%

2%

4%

6%

8%

10%

12%

14%

2005

2006

2007

2008

2009

2010

2011

2012

2013

Credit Card Charge Off to Avg Total Loan

AXP COF DFS MEGA BANK

data as at march 31, 2014. source: Federal reserve board, haver Analytics.

exhIbIt 13

The Household Debt Service Ratio in the U.S. Has Declined by Nearly 30%

2Q87, 12.33

4Q93, 10.64

3Q07, 14.08

4Q13 9.96

9.5

10.0

10.5

11.0

11.5

12.0

12.5

13.0

13.5

1980 1984 1988 1992 1996 2000 2004 2008 2012

U.S. Household Debt Service Ratio (%)

data as at march 18, 2014. source: Federal reserve board, haver Analytics.

2 data as at march 31, 2014. source: Federal reserve board, haver analytics.


on the other hand, corporate margins appear high relative to GdP growth as corporate executives have worked tirelessly to maximize efficiency in their companies. however, given that there are so few levers left to pull on the cost side, we feel strongly that when GdP growth does slow, margins – and hence ePs growth – will likely both fall much faster than folks suspect. Importantly, we already feel like we got a “sneak preview” of what might happen when consensus margin expectations for 2014 contracted a full 1.6% on an expected sales decline of just 0.4% (i.e., a 4x decline in margins relative to sales). one can see this in Exhibit 15. so if we are right and we do get a more sustained slowdown in GdP during 2017, we feel strongly that negative operating leverage and its subsequent impact on earnings growth could surprise both analysts and execu-tives with its abruptness.

exhIbIt 14

Corporate Profit Growth Is Outpacing GDP Growth by Levels Not Seen Since the 1990s

3Q87 1.3

3Q90 0.3

3Q97 2.4

4Q01 -0.3

3Q06 3.2

4Q08 -0.5

1Q14 2.6

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

1Q55

4Q58

3Q62

2Q66

1Q70

4Q73

3Q77

2Q81

1Q85

4Q88

3Q92

2Q96

1Q00

4Q03

3Q07

2Q11

Ratio of U.S. Corporate Profits Growth

to U.S. Nominal GDP Growth (5yr CAGRs, Rolling)

data as at may 30, 2014. source: bureau of economic analysis, haver Analytics.

exhIbIt 15

Expectations for Margins in 2014 Have Fallen Much Faster Than Those for Sales

2014 boTTom uP consensus s&P 500 earnInGs esTImaTes

consensus ePs esTImaTeconTrIb. To % chG

GIcs secTor Yea

r-e

nd

12

/30/

2013

cu

rr

enT

4/21

/201

4

$ eP

s c

hG

% c

hG

sa

les

ma

rGIn

s

enerGY 14.47 13.70 -0.77 -5.3% -0.2% -5.2%

maTerIals 3.92 3.74 -0.18 -4.6% -1.1% -3.5%

InFo Tech 22.69 21.73 -0.95 -4.2% -0.8% -3.4%

cons dIscreTIonarY

12.69 12.24 -0.45 -3.6% -1.0% -2.5%

FInancIals 23.15 22.43 -0.72 -3.1% 0.4% -3.5%

cons sTaPles 10.52 10.20 -0.31 -3.0% -1.1% -1.9%

IndusTrIals 11.95 11.85 -0.10 -0.8% -0.6% -0.2%

uTIlITIes 3.57 3.61 0.03 0.9% -2.6% 3.5%

Telecom serVIces 3.40 3.43 0.03 1.0% 0.4% 0.5%

healThcare 14.19 14.37 0.19 1.3% 1.4% -0.1%

s&P 500 $120.89 118.48 -$2.41 -2.0% -0.4% -1.6%

data as at april 21, 2014. source: Factset, s&P, First call.

so, what’s our bottom line? our base view remains that we have passed the midpoint in the recovery, and we are now likely fast ap-proaching the two-thirds marker in the next few quarters. as such, from an investment standpoint, we believe that the macro tailwinds will no longer be enough. The micro is now required, in our view. specifically, with the economy on the back half of its growth trajec-tory, we are considering migrating more towards companies that 1) can drive revenue growth; and/or 2) have the potential to repair margins; and/or 3) have the ability to use cash to drive acquisitions, buybacks or growth capital expenditures.

Further Raising Distressed/Special Situations Allocation to 9% from 7% and a Benchmark Weighting of 0%

I am neither a math major nor am I an economist, but I do know I am witnessing something new – and potentially extraordinary – on the macroeconomic front as I travel around the emerging markets. spe-cifically, I am seeing a growing convergence between distressed investing and traditional private equity across many of the emerging market countries I visit. For example, what I saw in India during my most recent trip was that the bulk of the near-term opportunities are helping entrepreneurs delever and/or restructure as they face the reality of slower structural growth.

“ DM economies are not growing fast enough to inspire a virtuous

cycle where consumption increases in the U.S. and Europe

ultimately lead to demand increases in EM producer nations.

“


In many instances these deals are large and chunky, requiring not only expertise in financial engineering but also in operational capa-bility. This insight is important, we believe, because many invest-ment managers in emerging markets are currently set up to either do public investing and/or private equity, not the restructurings, recaps, and deleveraging that we think are now required. as a re-sult, we think many firms, particularly in the alternative 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 transition from being a luxury offering to becoming a prerequisite for success in the new era of em investing we now envision.

In our view, there are two important catalysts that are now driving the opportunity set we see unfolding across several key emerging markets. First, because of quantitative easing, emerging markets have had easy access to credit – too easy, in our view. as a result, capital was not allocated properly in many instances, which has dented the earnings power of the corporate sector. In addition, poor capital allocation has clogged many countries’ banking systems, and now fresh capital is needed to “fix” the problem.

second, the global liquidity cycle is starting to actually turn in some instances. already, the u.s. is now tapering to the tune of $10 billion per Fomc meeting, while the bank of england is poised to finally lift rates3. This viewpoint on liquidity is significant, in our view, because it now means that the cost of capital in many emerg-ing market countries is going up for the first time since before the Great recession. If we are right in this view, then many corpora-tions across the entire em spectrum may be forced to restructure and/or delever to incorporate more expensive funding costs.

against this macroeconomic backdrop, we think the opportunity for principal investors to lend to corporate entities high up in the capital structure during what we believe are near-trough ebITda multiples is compelling. moreover, in addition to what can be earned from re-structuring the debt, we have seen several instances where a sliver of equity upside can be earned. as such, the net total return is now on par with private equity, though the placement in the capital structure is often more favorable.

our bigger picture conclusion is that the traditional lines between traditional private equity and distressed investing in em are likely to blur over the next three to five years. In a country like India, for example, the yield on private corporate debt is now upwards of 18-20% (and in some instances, one can get equity participation), up from 14-16% during my last visit4. as such, that return profile is now consistent with a more traditional P/e–like investment. meanwhile, the deal sizes are now big enough to warrant attention from traditional private equity players, many of whom have previ-ously focused more on just the equity portion of a company’s capital structure.

In our view, the convergence of both returns and investment op-portunities means that alternative asset managers will increasingly need to move towards a structure that rewards solution-oriented

3 data as at June 17, 2014. source: bloomberg, Federal reserve board, bank of England.

4 data as at may 10, 2014. source: bloomberg.

firms that can deliver both principal and agency expertise across a firm’s entire capital structure. To be sure, few firms offer this broad-based capability today, but if I am looking through my macro lens correctly, then this is where the industry is likely to head over the next three to five years.

exhIbIt 16

Asian Companies Are Now Beginning to Feel the Pinch of Slower Growth and Higher Interest Costs

0%

2%

4%

6%

8%

10%

12%

2008 2009 2010 2011 2012 2013 2014e

GNPLs Restructured Loans

India Impaired Loans Ratio

5.1

3.4

6.9

6.0 7.8

9.2 10.2

GnPl stands for Gross non-Performing loans. data as at december 31, 2013. source: morgan stanley research, bloomberg, ceIc data.

exhIbIt 17

Brazilian Consumer Debt Service Obligations Are Now at Levels That We Think Will Result in Credit Deterioration

14

15

16

17

18

19

20

21

22

23

24

Jan-

05

Aug

-05

Mar

-06

Oct

-06

May

-07

Dec

-07

Jul-

08

Feb-

09

Sep

-09

Apr

-10

Nov

-10

Jun-

11

Jan-

12

Aug

-12

Mar

-13

Oct

-13

Brazil Household Debt Service ss a % of Total Income

Total Ex Mortgage

data as at march 31, 2014. source: Global source Partners.


exhIbIt 18

Credit as a % of GDP Has Ballooned in Many EM Countries

0

50

100

150

India Turkey Brazil Vietnam China Thailand

Domestic Credit to Private Sector % GDP

2000 2007 2012

data as at december 31, 2012. source: World bank.

exhIbIt 19

Chinese Companies Now Face Tougher Funding Issues

0.0

5.0

10.0

15.0

20.0

25.0

0

4

8

12

16

Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec-13

EBIT

DA

/ In

tere

st C

over

Real

GD

P -

Rea

l Rat

es G

ap

Real GDP — Real Rates %, EBITDA Interest Cover

Real GDP - Real Rate

EBITDA / Interest cover

Declining Interest coverage is a reflection of narrowing real GDP- real rates gap

note: ebITda/Interest cover carried out on mscI axJ universe. data as at december 31, 2013. source: morgan stanley research, bloomberg, ceIc data.

From an asset allocation perspective, our macro viewpoint is significant because it reinforces our decision to further increase our overweight to special situations & distressed Investing at this point in the economic cycle. From a regional standpoint, our recent travels to europe confirm to us that the upcoming bank stress test has already brought an end to the “extend and pretend” mentality that has defined european banks over the past few years. as such, we believe that the ecb’s new role as supervisor to the european

banking sector is bullish for accelerating the pace and scope of as-set dispositions in the region.

however, as we mentioned earlier, what has us most excited about increasing our weighting to this asset class is what we are now seeing in the developing economies. specifically, our strong belief is that we are just starting a long-tail credit cycle in the emerging markets, asia in particular. We fully acknowledge that these invest-ment opportunities will likely be lumpy and complicated, but we also think the opportunity to earn attractive risk-adjusted returns is as high in this area as in any other area of our asset allocation universe.

Reducing Actively Managed Opportunistic Credit; Continue to ex-ploit Arbitrage in Private Credit Market

at the risk of sounding like a broken record, we still think that the fixed income arena offers investors a tremendous arbitrage. spe-cifically, we continue to favor spicier investments, including high yield, levered loans, mezzanine and private credit at the expense of sovereign bonds and high grade debt. since our arrival at KKr in 2011, this strategy has generally served us well as we have been able to pick up incremental spread and return as investors have gained confidence about the pace and duration of the economic cycle.

exhIbIt 20

Performance Across Fixed Income Has Been Strong

1.8

1.9

2.9

3.4

4.2

4.6

5.6

6.3

Local EM Sovereign

Levered Loans

Euro Investment Grade

7-10 Year US Treasuries

Euro High Yield

U.S. High Yield

U.S. Investment Grade

Corporate EM Debt

YTD Total Return in USD (%)

data as at may 31, 2014. source: bloomberg.


exhIbIt 21

Sovereign or Credit Spreads Have Tightened Across All Markets

200

300

400

500

600

700

800

900

1000

1100

1200

11 12 13 14

Bond Spreads (bps)

U.S. Europe EMBI

embI = emerging market bond Index. data as at may 30, 2014. source: JPm, bloomberg.

Importantly, we do not see defaults spiking in the near to medium term, and as such, we still like being pretty far out on the risk curve in credit. also, as we describe in more detail later on, we do not see interest rates moving materially higher over the next 12-24 months.

however, with the economy 60 months into its expansion, credit spreads tight and rates low, the prudent thing to do, in our view, is to take a few chips off the table in the liquid part of our spicy credit portfolio. as such, we are reducing our opportunistic credit account by two percent to four percent from six percent. see Exhibits 22 and 23 for details, but our base view is that volatility in the credit markets is now being underpriced. moreover, as Exhibit 24 and 25 under-score, spread compression has been significant in recent years.

exhIbIt 22

Implied Volatility Is Low Across Many Asset Classes

1.17% 1.47%

5.85% 6.48%

US Investment Grade

Europe Investment Grade

Europe High Yield US High Yield

Implied Price Volatility on Corporate Bonds

data as at may 29, 2014. source: KKr Global macro and asset Allocation analysis.

exhIbIt 23

Implied Volatility Relative to Realized Volatility Has Also Compressed

InveSTMenT GRADe 3 MOnTh PRICe vOlATIlITy

hIGh yIelD 3 MOnTh PRICe vOlATIlITy

PeRIOD IMPlIeD ReAlIzeD DIFF. IMPlIeD ReAlIzeD DIFF.

2011 3.1 1.9 1.2 14.2 10.0 4.2

2012 2.6 1.8 0.8 11.7 8.2 3.5

2013 1.8 1.4 0.4 8.0 6.3 1.8

currenT 1.2 0.8 0.4 6.0 3.6 2.3

data as at may 30, 2014. source: Goldman sachs research, bloomberg.

exhIbIt 24

High Yield Credit Spread Compression Has Been Significant…

-2.6

2.8

-1.1

5.3

7.4

4.6

-4

-2

0

2

4

6

8

2013 YTD

US Credit Total Return

US Govt US Investment Grade US High Yield %

High yield gain from spread compression

IG doing better than HY

data as at may 31, 2014. source: bloomberg, barclays.

“ Though we think the current leadership is doing the ‘right’

things from a macro perspective, China’s issues now run deep

after a decade of excess. “


exhIbIt 25

...But Is Now Running Out of Momentum

-176

-108

-22

-200

-180

-160

-140

-120

-100

-80

-60

-40

-20

0

2012 2013 YTD

Change in US High Yield Spread (bp)

Smaller spread compression

data as at may 31, 2014. source: bloomberg, barclays.

looking ahead, we see three possible concerns with regards to credit allocations, particularly on the liquid side of a portfolio. First, the risk free rate feels compressed at a time when a) economic fundamentals appear to be turning more positive, and b) the Fed’s liquidity momentum will be slowing. second, by almost any mea-sure credit spreads are now quite tight, so any external shock to the macro outlook could quickly force a reset. Third and finally, the implied volatilities in both high grade and high yield are actually be-low the three-year moving average, which signals to us heightened investor complacency.

our bottom line: we do not think the credit cycle is over, but at this point we are inclined to redeploy capital towards investments that benefit from a negative turn in the credit cycle (e.g., Special Situa-tions/Distressed) rather than investments that are levered to the cycle remaining robust (e.g., liquid credit) . also, we continue to favor global private credit because the illiquidity premium generally gives us a greater total return cushion if the absolute level of rates backs up more than what we currently expect.

exhIbIt 26

A Yield Comparison of Originated vs. Traded Leveraged Loans Suggests the Illiquidity Premium Is Still Significant

11.2% 12.0% 11.4%

10.8%

9.7% 9.6%

7.9% 7.8% 8.3%

11.3% 10.7%

5.8% 5.8% 6.0% 5.1% 5.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

2007 2008 2009 2010 2011 2012 2013 2014 YTD

Weighted Average Yield of Originated Senior Term Debt 12-Month Average Yield of Traded Loans

Weighted average yields of senior term debt and senior subordinated debt. data as at march 31, 2014. source: s&P lsTa, public company filings of ares capital corporation.

exhIbIt 27

Our Analysis Suggests That Both the Illiquidity Premium and the Default Premium Still Appear Outsized

1.3

4.2

5.5 11.0

0

2

4

6

8

10

12

US Govt Agg Yield

High Yield Spread

Illiquidity Premium on Mezzanine

Mezzanine Yield*

Illiquidity premium seems too

high

*KKr asset management estimate. data as at may 31, 2014. source: barclays us agg Government Yield to Worst, bloomberg, KKr Global Macro and Asset Allocation analysis.


equities: narrow the Focus

after a fairly lackluster first six months in global equities, we now think the multiples on many stocks appear more reasonable for several reasons. First, earnings growth appears to be reaccelerat-ing after a slow start to the year (Exhibit 29). second, as Exhibit 30 shows, we still think that there is upside to m&a cycle. Key to our thinking is that, with valuations still reasonable, companies are now able to use their excess cash flows to grow their businesses and earnings. Initial indications appear positive, given that nearly 80% of the acquirers’ stocks exhibit positive price performance on the day of the announcement (Exhibit 31).

exhIbIt 28

Multiple Expansion Got Ahead of Schedule in 2013…

60%

70%

80%

90%

100%

110%

120%

130%

0%

5%

10%

15

%

20%

25

%

30%

35

%

40%

45

%

50%

55

%

60%

65

%

70%

75

%

80%

85

%

90%

95

%

100%

60-75th Percentile of Cycle Time

S&P 500 P/E (% of Value at Start of Cycle)

Memo: Current Cycle (2Q09-4Q16e)

% of Cycle Completed

All Cycle Average, ex 1Q83-3Q90

Past u.s. economic cycles analyzed: i) 3Q38-1Q45, ii) 2Q61-4Q69, iii) 2Q75-1Q80, iv) 1Q83-3Q90 [excluded here], v) 2Q91-1Q01, vi) 1Q02-4Q07. data as at april 1, 2014. source: KKr Global macro & asset allocation analysis of s&P data.

exhIbIt 29

…But Earnings in 2H14 Are Now More Supportive

8.9

7.0

1.4

7.2

4.5

6.0 6.3

8.6

5.3

6.8

10.1

12.2

1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14

S&P 500 Quarterly EPS Y/y (%)

data as at may 29, 2014. source: s&P, Thomson Financial, Factset.

exhIbIt 30

The M&A Cycle Has Begun to Accelerate

Sep-07 8.8%

Dec-11 5.2%

Sep-12 3.9%

Mar-14 5.1%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

00 01 02 03 04 05 06 07 08 09 10 11 12 13

Announced M&A, % of GDP

North America

data as at march 31, 2014. source: morgan stanley.

“ Our bigger picture conclusion is that the traditional lines between

private equity and distressed investing in EM are likely to blur

over the next 3-5 years. “


exhIbIt 31

Since October 1, 2013, 79% of Acquirers Have Exhbited Positive Returns on Day of M&A Announcement

79%

21%

Positive Return Negative Return

U.S. Target Announcement > $1 Billion October 1, 2013-March 31, 2014

data as at march 31, 2014. source: morgan stanley.

Importantly, while some of the folks we speak with think now is the time to bottom fish in beaten down growth names, we disagree. our base view is that tapering is a mild but important form of tightening, and as such, the discount rate used to value hyper growth stocks in areas like social media and biotechnology should be higher. as Exhibit 32 shows, the market has done a good job of de-rating speculative parts of the market without ceding a lot of ground in aggregate. In fact, the average underperforming stock in the russell 2000 is down a full 15.9%, though the index itself is only down 40 basis points year-to-date. We also think it is worth highlighting that in both 1994 and 2004 (additional periods of changes in Fed policy), shares of crowded high growth stocks were also beaten down badly.

exhIbIt 32

Crowded Growth Investments Tend to Underperform Around Changes in Monetary Policy

yTD RuSSell 2000

russell 2000 Index reTurn (%) -0.4%

number oF sTocKs ouTPerFormInG Index 897

% oF marKeT caP ouTPerFormInG Index 56.4%

aVeraGe reTurn oF ouTPerFormInG sTocKs (%) 19.0%

number oF sTocKs underPerFormInG Index 1,099

% marKeT caP underPerFormInG Index 43.6%

AveRAGe ReTuRn OF unDeRPeRFORMInG STOCKS -15.9%

data as at June 12, 2014. source: bloomberg.

exhIbIt 33

Growth in India, Indonesia, and Mexico is Driven by Internal Demand

58

27 20

25 25

58

35

9

25 25

69

22

12

32 32

Private Consumption

Private Investment

Government Consumption

Exports Imports

GDP Breakdown by Expenditure (%)

India Indonesia Mexico

GDP is driven by domestic demand Relatively low external trade % GDP

data as at december 31, 2013. source: India central statistical organization, badan Pusat statistik Indonesia, Instituto nacional de estadística Geografía e Informática, haver analytics.

In the emerging markets, we think the competitive landscape is changing meaningfully in two areas. First, we strongly favor internal domestic consumption stories over investments linked to the china growth miracle. second, we think focusing on countries that are embracing new political and/or economic reforms makes the most sense at this point in the cycle. right now India and mexico (mid-cap stocks in particular) certainly meet these criteria, in our view, but we are also watching the upcoming elections in Indonesia with a close eye.

bottom line: We still remain constructive on equities on a 12-24 month basis. While Fed tightening will likely keep asset prices from soaring the way they did in 2013, we think the path ahead is still upward. no doubt, there will be more bumps along the way, but his-tory shows that markets tend to peak sometime after the Fed starts raising rates. one can see this in Exhibit 34. however, we think that this cycle peaks earlier than the historical average, given that the economic expansion is already 60 months in duration. In addi-tion, because tapering is now occurring, we think it may represent a marginal change in the flow of capital out of the global capital markets.


exhIbIt 34

The Market Typically Peaks on Average 29 Months After the First Rate Hike. We Think It Will Be Sooner This Time

hIsTorIcal bull marKeT cYcles – s&P 500s&P 500 & Fed Funds raTe hIKe

daTe oF TrouGh

daTe oF PEAK

FIrsT Fed raTe hIKe

monThs From FIrsT Fed Funds hIKe To eQuITY marKeT PeaK

seP-53 auG-56 dec-54 21

dec-57 Jul-59 auG-58 11

ocT-60 dec-61 Feb-61 10

Jun-62 Jan-66 auG-63 29

seP-66 noV-68 noV-67 12

Jun-70 Jan-73 mar-71 22

ocT-74 dec-76 Jun-75 18

mar-78 noV-80 aPr-78 31

auG-82 auG-87 maY-83 51

dec-87 Jul-90 mar-88 28

ocT-90 mar-00 Feb-94 73

ocT-02 ocT-07 Jun-04 40

AvERAGE 29

mar-09 ? ? ?

data as at april 30, 2014. source: Federal reserve, omega advisors.

exhIbIt 35

If Past Relationships Hold True, This Economic Cycle Has More Room to Run

June 2009 - Current (June

2014)

June 1938 - February

1945

March 1991 - March 2001

February 1961 - December

1969

y = 0.519x + 33.142 R² = 0.529

0

20

40

60

80

100

120

140

-50 0 50 100 150 200 D

urat

ion

of E

cono

mic

Exp

ansi

on (m

onth

s)

Change in Monetary Base (%)

data as at June 2, 2014. source: bureau of economic analysis, KKr Global Macro and Asset Allocation analysis.

Real Assets: Stay the Course

John maynard Keynes once said that “by a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” While he wrote this in 1919 in response to post-World War I economic policies, we think his comment remains valid today, given that the developed world is again awash in indebtedness—much of it government-related. moreover, with growth lagging as well as a general unwillingness to cut social benefits, some amount of heightened inflation trends could be needed to lower the debt burden at some point.

If our macro assessment is right, then implementing an inflation hedge that protects against Keynes’ alleged “confiscation of wealth” would therefore make sense, we believe. at the moment, we continue to favor private assets that can provide yield, growth and inflation protection. Within energy, we continue to favor what we call “bonds in the ground,” or energy-related assets that can pro-vide a steady stream of production, particularly those that benefit from higher commodity prices. In addition, we favor energy delivery assets, including midstream, transportation/logistics, and safety-related. Within real estate, our base view is that core pricing has gotten more difficult, and as such, turnaround stories and/or certain international markets, including mexico and europe, may make more sense. We also think that there is a bullish case to be made for global infrastructure. at this point in the cycle, however, we favor infrastructure assets that depend less on leverage and more on operational opportunities to generate returns.

“ We continue to favor ‘spicier’ investments, including high

yield, levered loans, mezzanine, and private credit at the expense

of sovereign bonds and high grade debt.

“


exhIbIt 36

History Shows That Pinning Fed Funds Below GDP Growth Leads to Rising Inflation Rates Over Time

1978 -5.6%

1982 5.7%

2005 -4.2%

2009 1.0%

2012 -3.9%

2015e -4.2%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

1960 1966 1972 1978 1984 1990 1996 2002 2008 2014e

3yr Moving Avg.

End ofStagflation

End ofDisinflation?

Fed Funds - Nominal GDP Growth

e = KKr Global macro and 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 march 20, 2014. source: KKr Global macro and asset allocation, haver Analytics.

exhIbIt 37

More Investment/Infrastructure Needed to Boost Long-Term GDP Growth In EM

0%

2%

4%

6%

8%

10%

12%

2005 2006 2007 2008 2009 2010 2011

India China Indonesia Mexico

Infrastructure Spend (% of GDP)

data as at 2012. source: ceIc data, morgan stanley research.

by comparison, we continue to basically eschew liquid commod-ity notes and swaps for several reasons. First, given all the ongo-ing improvements in production, we are not particularly bullish on commodity prices from current levels. as such, we do not think a pure long-only strategy makes sense. second, we continue to think

that the current structures offered by most Wall street firms are inherently flawed. as Exhibit 38 shows, the s&P GscI has woefully underperformed underlying commodity prices for quite some time.

exhIbIt 38

S&P GSCI Has Underperformed Commodity Prices for Quite Some Time

-180%

-160%

-140%

-120%

-100%

-80%

-60%

-40%

-20%

0%

20%

04 05 06 07 08 09 10 11 12 13 14

S&P GSCI Total Return Relative to S&P GSCI Spot Return

In essence, this is the “roll return” which has been negative due to contango (upward sloping futures curve)


exhIbIt 39

Long-Dated Natural Gas and Oil Could Be an Interesting Investment Play

75

80

85

90

95

100

105

3.5

4.0

4.5

5.0

5.5

Jul-1

4

Nov

-14

Mar

-15

Jul-1

5

Nov

-15

Mar

-16

Jul-1

6

Nov

-16

Mar

-17

Jul-1

7

Nov

-17

Mar

-18

Jul-1

8

Nov

-18

Mar

-19

Jul-1

9

Nov

-19

Natural Gas Futures Curve $/mmbtu (Left)

WTI Crude Oil Futures Curve $/bbl (Right)

data as at at may 30, 2014. source: bloomberg.

For portfolios restricted to purely liquid investment options in the real asset space, however, we believe that there are two options worthy of pursuit. First, we believe that long-dated natural gas and oil could be an interesting investment play. one can see this in Exhibit 39. second, we continue to believe that certain master limited partnerships repre-sent an attractive play on our yield, growth and inflation thesis. Within the sector, our favorite areas remain mlPs that generate revenues from “toll taking” exercises (e.g., pipelines or midstream), not the


more speculative exploration and production type entities.

update on our Interest Rate Outlook: Staying the Course

Without question, it has been a wild ride in the u.s. rates market this year. To review, we entered 2014 wondering if our year-end 10-year target of 3.3% was too dovish, as it implied essentially no rise in yields versus 2013. however, since then, the yield on the 10-year Treasury has fallen to a low of 2.5%5, and now we actually find ourselves questioning if we’re too hawkish.

Interestingly, though there is growing concern about deflation in developed markets, this year’s bond rally has actually been about moderating economic expectations. Indeed, one can see this in Exhibit 40, which shows the move down in rates has come almost entirely from falling real yields, not declining inflation expectations. Put simply, investors have downgraded their expectations for real growth and the Fed’s reaction function to that growth.

exhIbIt 40

The Decline in 10-year Yields Have Been Driven by Real Rates, Not Falling Inflation Expectations

Dec-13 0.76%

5/30/14 0.23%

0.0% 0.1% 0.2% 0.3% 0.4% 0.5% 0.6% 0.7% 0.8% 0.9%

Sep

-13

Oct

-13

Nov

-13

Dec

-13

Jan-

14

Feb-

14

Mar

-14

Apr

-14

U.S. 10yr Treasury Real Rate

Dec-13 2.26%

5/30/14 2.24%

2.00%

2.10%

2.20%

2.30%

2.40%

2.50%

Sep

-13

Oct

-13

Nov

-13

Dec

-13

Jan-

14

Feb-

14

Mar

-14

Apr

-14

U.S. 10yr Treasury Inflation Breakeven

-55bp

-2bp


5 data as at may 31, 2014. source: bloomberg.

exhIbIt 41

Declining Net Issuance Across Most Major Fixed Income Categories Is an Important Factor

-150

-100

-50

0

50

100

150

200

250

300

350

400

TSY Munis Agency Debt

Agency MBS

USD HG Corps

US HY Corps

2013 YTD Thru May 2014 YTD Thru May

data as at June 20, 2014. source: bofa merrill lynch Global research u.s. rates Weekly.

not surprisingly, key issues driving this moderation in growth expectations have been winter weather and Fed-speak about lower terminal rates. While the recovery from the winter setback has been frustratingly slow, what may have been a more important influence on investor expectations were former chairman bernanke’s com-ments at recent closed-door meetings. during these meetings it has been reported that he suggested that investor perceptions about the timing and pace of Fed rate hikes are too aggressive. We believe this viewpoint is certainly important, as it’s in seeming direct oppo-sition to current Fed chairman Janet Yellen’s first press conference, where she suggested rate hikes could come as soon as early 20156.

Technical factors, including supply constraints, are also weighing on rates, in our view. as Exhibit 41 shows, u.s. bond supply has been falling across most categories. moreover, this lack of supply is occurring at a time when the Fed is still purchasing $35 billion of bonds per month (plus reinvested dividends), and the fiscal deficit in the u.s. is shrinking. separately, demand for u.s. sovereign debt has been stimulated by the widening gap between u.s. and euro-pean rates. one can see this in Exhibit 44.

6 data as at march 19, 2014. source: Federal reserve.


exhIbIt 42

The Market’s Policy Rate Assumptions for 2016 Look Too Complacent

0.30

1.20

2.53

3.78

0.30

1.04

2.11

3.73

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

2014 2015 2016 Long Term

Dots Eurodollar Futures

data as at June 18, 2014. source: Federal reserve, KKr Global macro and Asset Allocation analysis.

exhIbIt 43

Marked Acceleration in Core CPI of Late

Aug-11 2.75%

Feb-14 1.41%

May-14 2.84%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Jun-

09

Oct

-09

Feb-

10

Jun-

10

Oct

-10

Feb-

11

Jun-

11

Oct

-11

Feb-

12

Jun-

12

Oct

-12

Feb-

13

Jun-

13

Oct

-13

Feb-

14

U.S. Core Inflation,

Trailing Three Months @ Annualized Rate

data as at June 17, 2014. source: bloomberg.

exhIbIt 44

There Is a Widening Gap on Rates Between the U.S. and Europe

May-99 1.51

May-06 1.14

6/17/14 1.25

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

93 95 97 99 01 03 05 07 09 11 13

U.S. - Germany 10yr Rate Spread (%)

data as of June 17, 2014. source: bloomberg.

exhIbIt 45

Despite Tapering, the Fed’s Balance Sheet Continues to Grow

Sep-12 2,759

May-14 4,280

Dec-14e 4,435

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

Dec

-07

Jun-

08

Dec

-08

Jun-

09

Dec

-09

Jun-

10

Dec

-10

Jun-

11

Dec

-11

Jun-

12

Dec

-12

Jun-

13

Dec

-13

Jun-

14

Dec

-14

U.S. Federal Reserve, Reserve Bank Credit Outstanding ($Bn)

e = KKr Global macro and asset allocation estimate. data as at June 17, 2014. source: u.s. Federal reserve, haver analytics.

at the moment, we are sticking to our 3.3% year-end target as we believe that the fundamentals are turning more hawkish. Key to our thinking is that there has been a significant upswing in recent inflation readings. Indeed, as Exhibit 43 shows, core cPI has been running at a 2.8% annualized rate in recent months, which is a ma-jor break versus a multi-year downtrend. In fact, we have decided to revise up our 2014 inflation forecast to 2.0% from 1.75% previously, which marks the first upward revision to our cPI outlook since coming to KKr back in 2011.


Growth fundamentals are also improving, including stronger recent readings on payrolls, jobless claims and housing starts (Exhibit 46). Importantly, investor expectations for 2h14 now look relatively modest, so rates seem primed to move higher on any continued improvements in the data.

exhIbIt 46

2014 on Pace to Be the Strongest Year for Job Generation Since 1999

265

162

-145

-42

9

169 209

174 95

-298

-424

88

174 186 194 214

-500

-400

-300

-200

-100

0

100

200

300

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

td

U.S. Monthly Average Nonfarm Payrolls (000s)

data as of may 30, 2014. source: u.s. bureau of labor statistics, haver Analytics.

exhIbIt 47

U.S. Loan Growth Has Accelerated Meaningfully in Recent Months

Jan-14 2.3%

Apr-14 9.7%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

Jul-1

0

Oct

-10

Jan-

11

Apr

-11

Jul-1

1

Oct

-11

Jan-

12

Apr

-12

Jul-1

2

Oct

-12

Jan-

13

Apr

-13

Jul-1

3

Oct

-13

Jan-

14

Apr

-14

Loan and Lease Portfolos of U.S.-Chartered Banks,

3mo Annualized Rate of Change

data as of may 30, 2014. source: Federal reserve, haver analytics.

bottom-line: We still feel good about a 3%+ year-end target for the 10-year yield. no doubt, some technical factors have been weigh-ing on rates recently, but ultimately we think it’s fundamentals that matter most, and those fundamentals are starting to suggest mod-estly higher rates. however, as our forecasts indicate, we expect a gradual – not a dramatic – increase in rates because 1) we see little

structural inflation in the system at this point, and 2) we expect the Fed to move in baby steps, not quantum leaps.

Risks: Where to Focus

as we have indicated above, we feel confident about the pace and duration of the current economic cycle. We also think that we are fi-nally reaching acceleration speed. In fact, barring a major downturn in 2h14, this year will be the fastest year of monthly job additions to the u.s. economy since 1999 (Exhibit 46).

That said, risk assets have had a sizeable run, and we now think it makes sense to start to identify potential warning lights that can prevent a portfolio from being overweight risk at a time when the macro backdrop is turning. We certainly watch a variety of indica-tors, but our primary preference is to focus on high yield spreads. Key to our thinking is some work done my colleague david mcnel-lis, underscoring why we think high yield spreads are so important. specifically, as Exhibit 48 shows, high yield has generally done a good job of alerting investors when to lean in or lean out in terms of risk posture. From what we can tell, the one time high yield spreads gave a false signal was in June 2013, when they sold off fully 96bp in response to the “taper tantrum,” but then equities went on to have a strong year. The lesson we draw is that credit signals aren’t as meaningful if they are driven by central bank posturing. rather, it matters much more when spreads widen in response to economic fundamentals.

“ We think focusing on countries

that are embracing new political and/or economic

reforms make the most sense at this point in the cycle.

“


exhIbIt 48

If You Want to Be Prepared for Equity Market Stress, Then Focus on High Yield Spreads

s&P 500 LEvEL

s&P 500 3mo max

draW-doWn Vs. 3mo max

JPm hIYld sTW LEvEL (bP)

JPm hIYld sTW 3mo mIn (bP)

Increase Vs. 3mo mIn (bP)

s&P 500 LEvEL 6mo In FuTure

% 6mo FuTure chanGe

2/27/07 1,399 1,460 -4.2% 312 280 32 1,479 6%

7/26/07 1,483 1,553 -4.5% 444 266 178 1,352 -9%

credIT sell-oFFs ForeshadoW more eQuITY sTress To come

10/19/07 1,501 1,565 -4.1% 456 395 61 1,388 -7%

6/6/08 1,361 1,427 -4.6% 674 661 13 871 -36%

10/2/09 1,025 1,072 -4.3% 811 783 28 1,187 16%

1/22/10 1,092 1,150 -5.1% 663 625 38 1,094 0%

5/5/10 1,166 1,217 -4.2% 620 579 41 1,184 2%

3/15/11 1,282 1,343 -4.6% 551 501 50 1,162 -9%

6/3/11 1,300 1,364 -4.7% 551 504 47 1,247 -4%

4/10/12 1,359 1,419 -4.3% 657 610 47 1,461 8%

11/7/12 1,395 1,466 -4.9% 578 547 31 1,627 17%

6/20/13 1,588 1,669 -4.9% 533 437 96 1,781 12% bad sIGnal From TaPer TanTrum8/27/13 1,630 1,710 -4.6% 506 475 31 1,845 13%

10/8/13 1,655 1,726 -4.1% 496 475 21 1,852 12%

mosT resIlIenT credIT resPonse YeT ThIs cYcle

1/29/14 1,774 1,848 -4.0% 457 427 30 ??? ???

4/11/14 1,816 1,891 -4.0% 423 406 17 ??? ???

signal dates represent s&P 500 down > 4% vs. 3mo high after month or more of stable-to-rising market. sTW = spread to Worst data as of april 15, 2014. source: KKr Global macro and asset allocation analysis of bloomberg data.

Summary

overall, our base view remains that we are in a strong environment for risk assets. as such, we continue to champion an overweight in equities, europe in particular. Within the emerging markets, we have clearly moved our focus towards markets where internal demand is driving results – not an over reliance on a china growth miracle, in our view. Within em equities, mexican mid-cap stocks and Indian cyclical names appear attractive for long-term investors. not surprisingly, in addition to having strong central bank leader-ship, both these countries are in the early stages of significant political reform that we believe could materially lift productivity on a five-year basis.


exhIbIt 49

KKR Target Asset Allocation Performance Relative to Benchmark

0

100

200

300

400

500

600

700

800

-40

-20

0

20

40

60

80

100

120

Jan-

12

Feb-

12

Mar

-12

Apr

-12

May

-12

Jun-

12

Jul-1

2 A

ug-1

2 S

ep-1

2 O

ct-1

2 N

ov-1

2 D

ec-1

2 Ja

n-13

Fe

b-13

M

ar-1

3 A

pr-1

3 M

ay-1

3 Ju

n-13

Ju

l-13

Aug

-13

Sep

-13

Oct

-13

Nov

-13

Dec

-13

Jan-

14

Feb-

14

Mar

-14

Apr

-14

May

-14

Perf

orm

ance

vs

Ben

chm

ark

(bps

)

Out

perf

orm

ance

in B

asis

Poi

nts

KKR GMAA Global Asset Allocation Performance Relative to Benchmark Jan 2012 to May 2014

(bp)

Gross returns. Weights as per KKr white paper “where To Allocate in 2012,” 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 and “Outlook 2014: Stay the Course,” January 2014. Private equity returns as of 4Q2013, and using 0% for remaining months. data as at may 29, 2014. source: KKr Gmaa, bloomberg, Factset, mscI, Cambridge Associates.

Within credit, the current market backdrop of tight spreads, robust issuance, and low volatility lead us to reduce our liquid credit posi-tion. however, with the illiquidity premium still high and our confi-dence in the economic cycle still robust, we retain our overweight to private credit and mezzanine.

In our alternatives bucket, we continue to see substantial opportu-nity in the special situations/distressed markets. china is structur-ally slowing at a time when the cost of capital is rising in many em countries. as a result, we now see many middle-market companies that need to restructure, delever, and/or reposition their businesses to face the new reality of more moderate global growth. To be sure, this investment opportunity set will be lumpy, but we think it is among the most attractive in our current asset allocation arsenal. separately, we continue to favor standard allocations to private equity and growth investing. Importantly, we favor a broad-based regional approach to the Pe allocation process, as our base view remains that this recovery will not be a synchronous one.

real assets also remain a priority for us. To be sure, this view-point is not linked to a sudden spike in inflation. rather, we think the private real asset market is providing the opportunity to get long growth and inflation protection, but also retain the privilege of getting paid along the way in the form of high current dividend. In a world where real rates seem extraordinarily low and monetary policy is loose, real asset investments appear to make a lot of sense to us.

Given these views, our overall asset allocation thesis is to still “stay the course,” retaining a bias towards risk assets. Interest rates are low, growth appears reasonable, and we expect corporate m&a to push prices higher over the coming 24 months. moreover, we still see ample opportunity to take advantage of illiquidity premiums and/or funding shortages that are occurring across a variety of markets at this point in the cycle.

In terms of risks, we fully acknowledge that u.s. monetary policy is poised to change direction after a multi-year shift downward. at the moment, though, we still worry less about rates spiking up and more about communication “snafus” from either the Fed or the bank of england. separately, china’s macro headwinds are sub-stantial, and part of performing well in the asset allocation game in the months ahead, we think, will be by not emphasizing investments that depend on a notable improvement in china’s growth trajectory.

“ With growth lagging as well as a general unwillingness to cut social benefits, some amount of heightened inflation trends could be needed to lower the debt burden at some point.

“


Important Information

The views expressed in this publication are the per-sonal 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. 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, is-suer, security or sector that may be described or refer-enced 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. In addition, the views expressed do not necessarily reflect the opinions of any investment professional at KKr, and 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 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. KKr and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the informa-tion and views expressed in this document.

This publication has been prepared solely for infor-mational 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 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 projec-tions or other forward-looking statements regard-ing 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 significantly 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 subsequent 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 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 adversely.

neither KKr nor mr. mcVey assumes any duty to, nor undertakes to update forward looking statements. no representation or warranty, express or implied, is made or given by or on behalf of KKr, mr. mcVey or any other person as to the accuracy and completeness or fairness of the information contained in this publication and no responsibility or liability is accepted for any such information. by accepting this document, the recipient acknowledges its understanding and acceptance of the foregoing statement.

The mscI sourced information in this document is the exclusive property of mscI Inc. (mscI). mscI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any mscI data contained herein. The mscI data may not be further redistributed or used as a basis for other indi-ces or any securities or financial products. This report is not approved, reviewed or produced by mscI.

www.kkr.com

Date post:	14-Apr-2020
Category:	Documents
Upload:	others
View:	3 times
Download:	0 times

Volume 4.5 • June 2014 Midyear Outlook: Four Big Macro ... · tainly critical in all facets of...

Documents