We on the KKR global macro and asset allocation team stick to our base case from earlier this year: that we remain in an “Adult-Swim Only” investment environment, as we see more asynchronous growth ahead. Nonetheless, we still anticipate significant opportunities.
Halfway through 2016, markets have cut a wide swath, enticing investors to buy or sell often at what was — in hindsight — likely the time to do the exact opposite of what one’s emotional core was suggesting. Significantly, as we have seen with recent events in the U.K., there is certainly more to making good investments these days than just understanding the fundamentals. Indeed, similar to other postcrisis periods in history, we are now seeing a notable splintering of political harmony around the world. In our view, this shift in the geopolitical landscape could be a secular, rather than a cyclical, phenomenon.
We are sticking to the part of our playbook that says we are in the later stages of an economic cycle, favoring idiosyncratic opportunities over beta-related plays. We still prefer credit to equities, and within credit we are most intrigued by the opportunities we see related to periodic dislocations and structural changes across the banking system.
On the one hand, our overall belief is that financial assets with predictable cash flows could now be overpriced in many instances. On the other hand, complexity now seems to be trading at a discount, particularly in unloved sectors of the market. In our view, this discrepancy may be one of the most important arbitrage possibilities in the market right now.
Despite the negative overhang of Brexit, we are not yet calling for a bear market. We still see more limited upside to financial asset appreciation than in prior years, however, and with higher volatility. If we are right, then an investor should expect a lower return per unit of risk across most asset classes.
Key to our thinking is that, compliments of global quantitative easing, many asset price returns have been pulled forward amid below-average volatility as central banks have driven yields down to record lows. Consistent with this outlook are two important global macro trends that we believe are worthy of investor consideration:
•First, with $11.7 trillion in negative-yielding bonds, we think that there are now diminishing returns to quantitative easing at this point in the cycle.
•Second, given the recent surge in debt financing across public and private capital structures, we believe returns on incremental leverage in many parts of the global economy may have peaked — and in many instances may actually be declining.
That said, global central bank policy remains formidable. We’ve been encouraged of late that the Federal Reserve is now more focused on the trajectory of currencies, the U.S. dollar in particular. The dollar, when undeterred in its movement upward, can restrict financial conditions — sometimes more than what an actual rate increase might otherwise accomplish.
With these thoughts in mind, we are making a few tweaks, though no major changes, to our portfolio in an effort to reflect our latest insights:
We are reducing cash to 4 percent from 7 percent in January, versus a benchmark of 2 percent, and adding 3 percent to mezzanine/asset-based lending within our private credit allocation. Our total weighting in private credit-related investments — including both mezzanine/asset-based lending and direct lending — moves to 13 percent from 10 percent in January, versus a benchmark of zero across the two asset classes. Given the shift toward negative interest rates and intensifying regulation of the banks, we are seeing a major spike in opportunities in the mezzanine and asset-based lending areas of the global economy — in Europe in particular.
More than ever, we feel confident about our outsize bet across private credit. As we mentioned earlier, we are seeing a variety of different opportunities across private credit, which makes us feel comfortable with an allocation that is 13 percent outside our benchmark and could likely lead to a significant tracking error over time. Our positive rationale rests on three pillars: First, with leveraged lending guidelines now being enforced more strictly, corporate and financial acquirers must look beyond traditional financial intermediaries to support their deals. Second, there is less capital available for small to medium-size businesses as banks reduce their footprints amid shrinking net interest margins and heightened regulation. Third, we think that current deal terms now often favor the lender, not the borrower, which is different from the case 12 to 18 months ago.
We are moving 5 percent from distressed/special situations toward actively managed opportunistic credit. Without question, we are seeing attractive opportunities in niche credit markets such as closed-end funds, certain collateralized loan obligation assets and periodic “hung” loans. By comparison, we think quantitative easing is denting some of the distressed/special situations opportunities that we originally thought might occur at this point in the cycle.
We continue to favor real assets with yield and growth, but we also think that certain commodities are bottoming. We believe that areas such as infrastructure, real estate credit and master limited partnerships remain potentially interesting investment opportunities for institutions and individuals looking to earn not only above-market yield but also some above-average growth in the value of the underlying assets. Our research also shows that several commodities have corrected toward the level of prior secular bear markets, both in terms of price and time. Selectivity is still required, though, and at the moment, we favor oil and copper over assets with fewer supply-side adjustments, including iron ore.
We no longer anticipate any interest rate increases from the Fed in 2016, which also has implications for the U.S. dollar. If there is one area in which our thinking has changed since the beginning of the year, it is around Fed hikes and the dollar. Of note: In its recent communications the Fed now appears to openly acknowledge that dollar strength could tighten global financial conditions to an uncomfortable level. In essence, it appears that the Fed has expanded its criteria for monetary policy changes to include not only domestic growth and inflation but also a multitude of foreign risks — China’s growth and Brexit, in particular. After recent events in Europe like Brexit, we see the dollar reemerging as a safe haven against many currencies, including the pound and the euro, in the second half of 2016.
We are still comfortable being underweight public equities relative to private equity at this point in the cycle. Within private equity, we continue to favor consumer-facing investments, spin-offs and restructurings. Overall, though, similar to public markets, valuations are reasonably full in many instances, and as such, some other levers are likely required to hit one’s return hurdle 84 months into the current economic expansion. Within global public equities, we have concentrated our developed-markets positions with an overweight in the U.S. and have equal positions in Europe and Japan.
We are less inclined to make big sector and style bets at this point in the cycle. The investment community today better appreciates that there are limits to central bank intervention — negative rates, in particular. Our conclusion is that investors better understand that lower rates and more stimuli suggest that slowing nominal growth and low returns likely lie ahead.
We continue to look for ways to mitigate risks. Although we have reduced our cash position to 4 percent, when volatility is increasing and correlations are doing funny things, there is no substitute for cash as an asset class. We also think that having some hedges makes sense. Shorting the Chinese yuan and buying protection in high-yield credit default swaps make sense at this point in the cycle. We also think that the pound has further downside, if we are right that the U.K. may face a stagflation-type environment in 2017.
Henry McVey is head of global macro and asset allocation at KKR in New York.
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