Although the general backdrop for risk assets remains favorable, we are no longer suggesting that folks “stay the course,” as we did in January 2014. Rather, given where we are in the cycle and the magnitude of gains in recent years, we have begun the inevitable process of “getting closer to home,” in terms of our asset allocation targets.
Significantly, we think this transition should be more evolutionary than revolutionary, by raising some cash and tilting the invested part of a portfolio to become more opportunistic in 2015.
In terms of key themes, we see several compelling arbitrages in the global macro landscape that chief investment officers and portfolio managers should pursue this year. These include the following five themes:
•We believe that China’s slowdown is not an aberration. As such, its role in the global economy is materially shifting, which means we expect to see sizable restructuring and recapitalization opportunities in sectors that previously overearned and/or stretched themselves beyond their footprints.
•In our view, many corporations still have inefficient capital structures, including too much cash and too little debt. But investors can still benefit from corporate or shareholder actions — or both — to lower companies’ cost of capital and improve growth. These may include buybacks, dividends, capital expenditures and acquisitions.
•Despite lots of liquidity in the system, many companies across both emerging and developed economies still can’t get proper access to credit. Hence we still see a compelling illiquidity premium that is worth pursuing, particularly in today’s low-rate environment.
•In a world of contango commodity pricing, we continue to favor private real asset investments with up-front yield, growth and long-term inflation-hedging relative to traditional liquid commodity notes and swaps.
•Government deleveraging in developed markets is disinflationary, which drives our thinking about the direction of long-term interest rates as well as the relative value of risk assets against the risk-free rates.
Several influential macro considerations shape our more opportunistic approach. First is the cumulative performance of risk assets this cycle. All told, the Standard & Poor’s 500 has now appreciated for six consecutive years, returning a full 204 percent through December 31, 2014, versus a historical average of 115 percent during bull markets. During this six-year period, its multiple has expanded a full 40 percent, now in line with the historical median of 42 percent.
Outside the U.S., valuations are certainly less demanding. However, we still expect some additional bumpiness in 2015 as many parts of Europe, Latin America and Asia must endure some important but painful economic restructuring initiatives, including debt deleveraging, fiscal belt-tightening and wage compression.
We think the monetary backdrop is growing more complicated. On the one hand, central banks in Europe, Japan and China are all likely to be more accommodative during 2015 to stoke growth. On the other hand, the Federal Reserve is now in the process of reducing its ultra-accommodative stance. Hence, unlike in past years, central bank policy around the world is now less in sync, which could create some tension in global capital markets, and currencies in particular, during parts of 2015.
So against the macro backdrop that we envision for 2015, how do we think a multiasset class portfolio should be positioned? Our highest-conviction asset allocation ideas are as follows:
•We further embrace our “asynchronous global recovery” theme by lifting our highest-conviction idea, distressed/special situation, to a 15 percent allocation from 9 percent previously. Our bottom line: This sizable allocation allows us to efficiently invest behind — not against — the asynchronous global recovery we continue to forecast. Of note: beyond the European restructurings/recapitalizations that we have been highlighting for some time, two recent trips to Asia confirm to us that we are now seeing emerging opportunities in Asia as the China growth miracle wanes and companies are forced to restructure, recapitalize and resize. Finally, we believe some notable dislocations across the energy market, in the U.S. in particular, are starting to emerge for managers of opportunistic capital.
•To pay for this increased overweight position, we have lowered our growth equity allocation in our other-alternatives bucket. To underwrite our increased distressed/special situation allocation, we take 5 percent from growth capital/VC/other and reduce this weighting to zero, versus a benchmark of 5 percent. Significantly, given the carnage we are seeing in areas like U.S. energy, European banks and Asian commodity plays, we are more interested in taking advantage of current dislocations around the globe, and in so doing we seek to avoid some of the hefty valuations we now see in hot growth parts of the market, including the Internet and life sciences.
•Our fixed-income allocation also becomes less what we call spicy in 2015, but we increase flexibility in the liquid credit portion of our portfolio. For the past three years we have been substantially overweight spicy credit, including mezzanine, direct lending and fixed-income hedge funds, based on our view that 1) the economic cycle would be longer than expected in duration, 2) the illiquidity premium represented a massive opportunity amid lower rates, and 3) the return profile of spicy credit would approach that of equities but with less risk. In 2015, however, we are shifting course by beginning to dial back some of our less liquid, spicy credit positions. Specifically, we are moving our mezzanine allocation to 2 percent from 5 percent, versus a benchmark weighting of zero. Within our liquid book, we are reducing our hedge fund allocation, but we are increasing our weighting toward actively managed opportunistic credit to 7 percent from 4 percent. Our intent is to allow investment managers to toggle between bank loans, high yield and other credit-sensitive products as opportunities/dislocations present themselves this year. Separately, we have added 3 percent to investment-grade credit, versus a benchmark of 5 percent and a previous weighting of zero. Our goal is to add some ballast to the fixed-income portion of the portfolio during what we believe could be a more volatile year for the asset class. Overall, our total fixed-income book remains small at just 18 percent of the portfolio, versus a benchmark of 30 percent, unchanged from June 2014.
•We are reducing our long-term overweight positions in public equities back to equal weight and are now more opportunistic at this point in the cycle. Our research suggests less upside for equities than in past years, and as such, we now want to be a little more opportunistic in our approach. Our base view is not only that the absolute return in global equities is likely to be lower on a go-forward basis but also that the Sharpe ratio is likely to decline. From a regional perspective, we stay overweight Asia and move to underweight Latin America to reflect our cautious view on Brazil’s near-term prospects.
•To become more opportunistic in equities, we are raising cash to start 2015 — boosting this allocation to 3 percent from zero during the entire 2011–’14 period. Whereas we think that 2015 could be another up-year for many stocks, our view is that more volatility lies ahead than in recent years. So at the moment, we think it finally makes sense to have a little dry powder to add to risk assets in the event of a downdraft in 2015.
•Within real assets, we believe investors should still avoid traditional commodity notes and swaps with no yield; we stay overweight income-producing real assets and short gold. As in past years, we continue to stay away from liquid commodity swaps/notes in 2015, particularly given 1) near-record negative roll features and 2) our view that spot oil and other commodity prices could display some additional downside volatility in the first half of the year.
•We also stay short gold again this year, as we see deflation, not inflation, as the big near-term risk. By comparison, we still think that there is a substantial opportunity to own cash-flowing hard assets that can produce yield, growth and long-term inflation hedging. Our favorites include real estate, infrastructure and pipelines. Given the significant price appreciation in certain gateway cities, however, we have reduced our real estate weighting to 3 percent from 5 percent and a benchmark weighting of 2 percent.
•We believe the U.S. dollar freight train remains on track. At the risk of staying in a crowded trade, we remain positive on the dollar against most major currencies, including the euro, the yen and commodity currencies, including the Brazilian real, Russian ruble and Nigerian naira. Within the emerging-markets currency arena, we favor the Indian rupee, whereas in terms of emerging-market crosses we again champion the Mexican peso over the Brazilian real in 2015.
•As for risks and hedges, tactically, we consider buying downside protection in equities, currency and rates when volatility compresses. We think that investors should expect spasms of risk-asset deratings in 2015 when either growth or forward inflation expectations periodically drop to uncomfortable levels. We are also increasingly concerned that, consistent with this view, the currencies of commodity-exporting countries may cause further dislocations across the global capital markets in 2015. Our research shows that we are not likely to have a full 1997 unwind, but we are going to continue to endure a sizable adjustment period ahead. In terms of implementation, we believe an investor should use periodic compression of volatility levels to purchase tactical protection across equity, currency and fixed-income markets.
Of course, there are always macro risks to consider. One risk for 2015 lies in maintaining inflation expectations at proper levels. Stocks and high-yielding credit are really only attractively priced relative to sovereign debt if the earnings come through. Our base case is that they will, but when inflation expectations crater (as they did in October 2014), multiples can get derated quickly.
At the moment, the U.S. seems to be decoupling from some of the “bad” inflation levels we see in China, Japan and Europe, but history has often shown that — over time — decoupling tends to be a flawed investment theory, particularly in an increasingly global economy.
Separately, although reserves are higher and external debt is lower in many emerging-market countries than in 1997, many developing countries are increasingly facing both fiscal and export-related headwinds. Finally, we think that emerging-market consumers who binged on credit are likely to see some retrenchment in 2015.
For more information, read the full 2015 outlook here.
Henry McVey is the head of global macro and asset allocation at KKR in New York.
