We at KKR certainly appreciate that generating outsize returns has gotten more complicated as this economic cycle has progressed. Yet we still see five distinct macro “disconnects” — arbitrages that we view as attractive for long-term, patient capital.
First, given the continued deleveraging of financial services, we still find the illiquidity premium that has emerged in many lending arenas quite compelling. Second, in an environment in which central banks are holding nominal interest rates below nominal gross domestic product growth, we favor real assets that offer yield, growth and a hedge on inflation. Third, in pursuing rising GDP-per-capita stories in the emerging markets, we encourage folks to look beyond traditional public equities. Fourth, in light of China’s structural slowdown, we see an increasing number of restructuring opportunities emerging across Asia, Europe and Latin America. Fifth, in developed markets we still see some opportunities among inefficiently run corporations.
To fund these five distinct macro disconnects, we continue to recommend a massive underweight to traditional government bonds.
In today’s rapidly globalizing capital markets, there appears to be an increasing premium being placed on managers who can react quickly to world events and, when necessary, reposition an investment portfolio in a relatively short period of time. Without question, the ability to change one’s mind and move quickly in and out of investments should be heralded as a positive development across the entire financial services industry. Through trial and error, we have also learned that there is a balance. Sometimes the best thing an investor can do is just sit idle, letting one’s existing bets play out and avoiding the risk of diminishing the true courage of one’s conviction.
Now is one of those times. Key to our thinking is that the major long-tail macro themes that we presented in January are still playing out nicely, and we do not want to get distracted by any short-term gyrations in the marketplace. Our key beliefs for our target portfolio are as follows:
•We retain our 1,700-basis-point underweight in government bonds. From a strategic perspective, we still believe that the traditional role of government bonds as both an attractive yield vehicle and a portfolio shock absorber is just not that applicable in the low-rate, central-bank-affected environment of today. As we look ahead, we see several catalysts confirming the merits of our massive underweight, including price growth, lessening unemployment and more robust wage growth by April 2016. Therefore, we are inching up our 2015 year-end yield target for the U.S. ten-year Treasury to 2.6 percent from 2.4 percent. Our other interest rate forecasts remain unchanged.
•Our biggest overweight remains in special situations and distressed assets at 15 percent, versus a benchmark of zero. As the asynchronous economic recovery unfolds, we continue to see lots of periodic dislocations favoring opportunistic capital that can be placed high up in a company’s capital structure, earn some coupon and potentially also enjoy some equity upside through options or warrants. From a regional perspective, the slower growth in China now makes Asia the most attractive region for this specific investment opportunity. We also think that there are some appealing situations in Europe, the U.S. — and Brazil.
•The one material change that we are making to our asset allocation in the second half of 2015 is to raise our direct lending to 6 percent from 3 percent, versus a benchmark of zero. We pay for this increase by reducing our high-grade bond exposure to zero from 3 percent, versus a benchmark of 5 percent. The catalyst for the increase: We continue to hear about more traditional financial intermediaries shrinking their footprints and backing away from nontraditional opportunities. The well-publicized unwinding of GE Capital is the highest-profile example of late in this ongoing saga, but our international travels lead us to conclude that there are still an increasing number of lower-profile exits occurring elsewhere around the world. Also, with dealer inventories now down 81 percent, we continue to see a convergence between the liquid and illiquid markets, particularly during periods of market stress.
•Across the rest of the portfolio, we continue to believe in owning yield and growth. This strategy drives our overweight in real assets, including infrastructure, real estate and energy. It also dovetails with our approach to public equities. With greater than 65 percent of European equities trading with dividend yields above their corporate bond yields, we think this region of the world in particular is still highly attractive. To this end, we are using recent stock price weakness to boost our European public equity allocation a percentage point, to 16 percent, versus a benchmark weighting of 15 percent. To adjust for this increase, we further reduce our Latin American exposure to 4 percent from 5 percent, compared with a benchmark of 6 percent.
•Selectivity in emerging markets means thinking beyond just public equities. Although we believe many emerging-markets public equities could be in the process of bottoming, we still favor selectivity. We advocate India, China and certain sectors of Mexico among the larger markets during 2015. Our bigger-picture conclusion, though, is that real estate and fixed income (both public and private credit) may make more sense in countries in which nominal rates and inflation are high. In our view, this potential investment arbitrage of owning emerging-markets debt over equity in certain instances is still underappreciated by many investors, particularly in markets such as Brazil and India.
There are risks to our macro world view that bear watching, particularly after nine consecutive quarters of positive performance in the S&P 500, the longest winning streak in 17 years. We now feel that corporate mergers and acquisition activity seems a little frenetic, given that in the present low-rate environment, almost everything is technically accretive. Separately, we continue to watch China closely, as the macro data have been much weaker than was expected. At the moment, we think this slowdown is more of a negative for many of China’s trading partners than for China, although this view could prove too optimistic.
At a time when 60 percent or more of the global economy is in easing mode, the Federal Reserve is likely to embark on its first tightening campaign since the 2008–’09 financial crisis. With valuations now higher, volatility generally low and the dollar breaking out, there is a significantly elevated risk for a synchronized disruption to global capital markets.
Henry McVey is the head of global macro and asset allocation at KKR in New York.
See KKR’s extended 2015 midyear outlook.
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