Although equity market conditions appear quite unsettled, we at KKR Global Macro and Asset Allocation believe that now is the time to start allocating more incremental capital back toward risk assets, particularly in the U.S. We see negative sentiment, decent — albeit unspectacular — growth in earnings per share and reasonable valuations as signals to what we call leaning in to certain parts of the U.S. market. To this end, we are making the following two changes to our target asset allocation:
• We are reducing cash to 1 percent from 3 percent, compared with a benchmark of 2 percent. With prices down and volatility up, we now feel compelled to start spending some of the rainy-day funds we husbanded back in January. Implicit in our decision is our view that the equity cycle is mature — but not yet over.
• We are using our cash proceeds to boost our global equity allocation to overweight from equal weight by putting 22 percent of our portfolio toward U.S. equities, up from 20 percent and compared with a benchmark of 20 percent. We retain our 1 percent overweight to Asia — with a focus on Japan — and our 2 percent overweight to Europe, offset by our 2 percent underweight to Latin America, especially Brazil.
Whereas we expect there to be plenty of debate about whether to add to U.S. equities at present valuations, at this point in the economic cycle, we think that the long-term outlook for the U.S. has become much less controversial, particularly relative to its global peers. A major positive, we believe, is that the long-term outlook for the U.S. consumer has improved materially in recent quarters. We now see more gains ahead, specifically around household formation. U.S. corporations are leveraging innovation across a variety of sectors, including health care, technology and energy services. Against this constructive macro backdrop, our allocation framework now argues for an increased weighting on both a short- and long-term basis to the U.S.
Consistent with this view, we see five large-scale investment opportunities in the U.S. that we think will garner an increasing proportion of capital flows and investor attention over the next few years:
U.S. household formation is breaking out; invest behind this development. Key sectors that should prosper include housing, multifamily rental and home repair.
Although we do not see a major shift in consumer preferences toward luxury goods, we do expect more consumer spending in many areas, including recreation, beauty and wellness. Consumer experiences are taking precedence over products — a trend we expect to continue at an increased pace. Also, given that we look for little improvement in productivity, we expect strong employment growth trends to continue in the U.S.
U.S. noncyclical growth stocks, particularly in health care and technology, should continue to appreciate. We acknowledge that near-term valuations are stretched in certain instances, but we like big-market opportunities like insulin systems for diabetes patients, immuno-oncology therapies and cybersecurity. We also think that the U.S., given its proximity to Mexico and Canada, is reestablishing itself as a compelling place for reshoring initiatives. We do not see a true “manufacturing renaissance,” though we believe there are some noteworthy tailwinds that warrant investor attention.
We expect U.S. financial stocks to perform well too. In particular, we favor domestic banks, insurance companies and credit card companies, which should benefit from better credit conditions. Consistent with this view, performance of mortgage credit and asset-based lending should be better than current expectations, especially if we are right that long-term rates will remain low. As part of our strategy, we focus on financial companies with aggressive capital management programs.
Our value idea for the U.S. equity market centers on the energy sector, which is suffering from an overhang of excess capacity and capital. With valuations down meaningfully, however, we think that now is the time to begin the search for long-term winners amid the rubble. In particular, it appears that in certain instances the market is not discerning properly between low-cost and high-cost producers, as well as between recurring revenue infrastructure stories and more speculative exploration and production brands.
To be sure, there are risks to our reallocation. U.S. corporate margins have likely peaked, mergers and acquisition trends appear frothy, and financial conditions have become less favorable. Our concern in the bigger picture is that we remain stuck in an asynchronous recovery, with lack of global demand from developed markets weighing on the virtuous cycle that defined the economic recoveries of the 1990s and 2000s. Also, we believe the China fixed-investment slowdown has yet to fully play out. True, growth in year-over-year fixed investment is down to just 11 percent in 2015, compared with nearly 34 percent year-over-year in 2009. We still see more downside ahead as the Chinese government tries to bring nominal lending growth below nominal gross domestic product.
Significantly, though, we think we mitigate any potential issues two ways through our portfolio recommendations. First, our asset allocation targets at KKR Global Macro and Asset Allocation still retain a massive 15 percent overweight to distressed and special situations, which we think should continue to thrive amid the dislocations we are seeing across many emerging markets. Second, if China and its emerging-markets peers do create some form of global contagion, we think the U.S., with 70 percent of its economy linked to the consumer, will be more insulated than many in its peer group. We believe that any significant pullback in U.S. equity markets should be viewed as an opportunity for long-term investors to increase exposure to what we believe is emerging as one of the more interesting country-specific macro stories across the global capital markets in the coming years.
Henry McVey is the head of KKR Global Macro and Asset Allocation in New York.
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