We at KKR are approaching early 2016 with caution. Valuations are not cheap at a time when central bank policy in the U.S. is changing, global trade is stalling, and corporate margins are peaking. Continuing Chinese yuan depreciation is significant: It means that every other country now must think through whether it needs to further devalue to remain competitive. Not surprisingly, we at KKR are below consensus in terms of both growth and inflation forecasts for most regions. With these thoughts in mind, we are electing to tilt KKR’s global macro and asset allocation (GMAA) portfolio defensively this year.
In terms of key macro themes to invest behind in 2016, we believe that recent gyrations in the financing markets are providing nonbank lenders a significant opportunity to leverage the market’s illiquidity premium to earn compelling risk-adjusted returns. First, certain private financing opportunities across real estate, infrastructure, corporate takeovers and equipment appear to be the best risk-adjusted opportunity in the market today. Second, we are also increasingly confident in the outlook for certain segments of the global consumer industry, and, as such, we want to thoughtfully deploy capital around key trends like improving household formation, increased Internet penetration and an intensifying focus on personal care segments such as health care and beauty. Third, we think that China’s slowdown in fixed investment could lead to exciting opportunities for investors interested in distressed assets and special situations. Finally, with regard to real assets, we continue to focus on investments that can provide yield and growth, versus owning outright commodity positions.
Without question, recent gyrations across global capital markets have been unsettling, reflecting growing concerns about the uneven, asynchronous recovery that has unfolded. In 2015 alone the fallout from a Chinese devaluation, the Swiss National Bank’s unpegging of the Swiss franc to the euro, precipitous falls in commodity prices, and a third Greek bailout — just to name a few — are all important examples of market-moving macro events that investors had to weave into their portfolio construction processes during the year.
Unfortunately, we do not see 2016 as a less chaotic year. In fact, we expect global gross domestic product to come in well below consensus this year. We believe that global inflation forecasts are generally too high and that operating margins have essentially peaked in the U.S. We also think that uncertainty surrounding China’s currency devaluation is not a one-off event. Consistent with this view, we have lowered the GMAA target multiple on equities to reflect heightened macroeconomic and geopolitical risks.
We also forecast that overall corporate credit availability and quality will worsen in 2016. Key to our thinking is that intensifying competition from China within the high-end export market, slowing global trade and surging Internet activity could collectively cast a further pall over many areas of traditional corporate credit. If we are right, then the near-historic wide spread between BB-rated and CCC-rated high-yield bonds likely gets resolved by high-quality bonds trading down, not low-quality bonds trading up. Significantly, equities as an asset class generally look rich relative to credit.
Probably more than ever, global risks to one’s portfolio are worth extra attention in 2016. Beyond the recent surge in geopolitical concerns — including rising resentment of austerity measures, as well as the negative fallout from globalization — the biggest potential headwinds for 2016 are likely linked to the performance dichotomies that we now see unfolding across multiple parts of the global capital markets:
• An increasing interest rate differential (i.e., the Fed raises rates as other central banks ease), which is driving huge currency dispersions.
• Strong growth in global services, versus a decline in manufacturing.
• Surging growth of Internet retailers and sharing economy franchises, versus softening traditional retailers.
• Improving fiscal and current-account balances of commodity users, versus declining fiscal balances of commodity producers.
• And probably the most concerning bifurcation we are monitoring across the global capital markets: increasing yield differentials between U.S. and European high-yield.
If these bifurcations become too distinct or cause too much carnage in the financing markets, then they could be perceived as potentially destabilizing for the overall health of risk assets. Indeed, similar to what we saw in 1999 and 2006, these winner-takes-all types of markets typically end in tears, not smiles, when either or both of the following come to pass:
• Investors overpay for expected growth because there are limited alternatives available.
• Already impaired parts of the capital markets — such as energy and industrial credits — corrode what is currently perceived to be safe havens, including high-quality junk bonds and growth equities.
Our bottom line: We see less upside to many markets than we have in recent years. Financing conditions on Wall Street, though maybe not on Main Street, could be turning more difficult than many investors — equity folks, in particular — now appreciate. Yet valuations are not cheap enough in many instances to reflect the risk we see from macroeconomic headwinds. Also, we believe that risks are not correctly priced across asset classes and regions, which could lead to additional instability in 2016. In particular, after the recent sell-off in credit during the second half of last year, we think that equities appear expensive.
Hence, we believe investors should tilt portfolios defensively in ways that:
• Focus more on idiosyncratic opportunities — particularly ones with steady and achievable coupon payments — rather than beta-related bets.
• Overweight investment vehicles that benefit — not suffer — from rising defaults.
• Increase cash, so that one has the opportunity to harness volatility to an investor’s advantage.
• Ensure that one does not pay too much for growth or buy something that is too cyclical near what we believe is the peak in the economic cycle.
For the full 2016 outlook report, click here.
Henry McVey is head of global macro and asset allocation at KKR in New York.
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