As we peer around the corner today on what tomorrow might bring, our work still leads us to forecast lower overall returns. Against this backdrop, however, we see five areas that we believe can help drive both absolute and relative outperformance. First, we believe that we have entered an important period of change in global corporate structures.
Driven by factors such as increased activism amidst declining returns on equity in foreign markets, we see many CEOs now striving to better simplify their global footprints. Importantly, this theme is not contained to just the corporate sector. In addition, we see our corporate ‘carve-out’ theme playing out across both the infrastructure and energy complexes. Second, we believe that investors can still deploy more capital behind the trend towards consumer experiences over things. Importantly, this theme appears to be gaining momentum across both developed and developing economies. Third, we now are more inclined to lean in on emerging market opportunities, particularly if they are linked to GDP-per-capita stories at appropriate valuations. Fourth, we still see the illiquidity premium as compelling.
Finally, we continue to embrace complexity, particularly during periods of market dislocation. Right now we think certain parts of healthcare, MLPs, and low-rated corporate credit all warrant investor attention.
“He who lives by the crystal ball will eat glass.”
Founder, Bridgewater Associates
September 2017 will mark our six year anniversary at KKR heading up the Global Macro & Asset Allocation (GMAA) analysis effort. Without question, it has been a wonderful opportunity for the entire GMAA team to engage with the Firm’s deal teams across a variety of assignments, including both entries and exits. All told, during this period KKR has deployed in excess of $36 billion across its Private and Public markets; during the same period KKR has returned in excess of $53 billion to its investors.
Beyond the day-to-day deal work, having more than 200 portfolio companies in 19 cities across 16 countries staffed by local professionals has also created a unique environment for our team to derive macro insights by leveraging the strengths of our integrated business model across asset classes and capital structures.
Not surprisingly — given the tool kit the platform provides us — we have consistently shied away from using a ‘crystal ball’ approach to make bold predictions based on a ‘gut’ feel. Rather, we have concentrated our efforts on building long-term, top-down frameworks, including both fundamental and quantitative ones that identify key investment themes behind which we can form capital (or in some instances avoid forming capital). We have also tried to guide our employees and investors on where we may be in the cycle, leveraging a variety of data sets we have built out during the past two decades of macro analysis and investing.
Today, almost all our work streams suggest that asset prices across most parts of the global capital markets are somewhere between fair value and expensive. From a cycle perspective, we believe that we are mid-to-later cycle in some of the more developed markets, including the United States. Consistent with this view, our base case remains that we have some form of an economic pullback in 2019. We also think it is worth noting that we are well below consensus in terms of inflation across most parts of the world, including the United States, Euro Area and Brazil.
Against this backdrop, we do feel inspired to narrow our investment focus towards fewer high conviction themes, relying less and less on macro tailwinds such as margin and multiple expansion than in the past. In particular, we are focused on potential macro disconnects, or financial arbitrages, where we can largely quantify where investor expectations appear offsides relative to the upside potential we envision. See below for full details, but our current highest conviction investment themes are as follows:
De-conglomeratization: Corporate Spin-Offs Are Creating ‘Rightsizing’ Opportunities As corporations around the world look to optimize their global footprints in a world that is increasingly turning domestically focused, we believe that this transition will create a significant opportunity for investors to buy, repair, and improve non-core assets from regional and global multinationals. We also see increased activism in the global public equity markets as a play on our thesis. Importantly, as we describe below, we see this trend towards entities hiving off non-core assets currently extending beyond traditional corporations to now include Infrastructure and Energy Assets.
Experiences over Things We see a secular shift towards global consumers willing to spend more on experiences than on things these days. Leisure, wellness, and beauty all represent important growth categories, all of which appear to be taking share from traditional ‘things.’ Mobile shopping and online payments are only accelerating this trend, we believe, and our recent travels lead us to believe that this shift is occurring in both developed and developing countries. On the other hand, the work we lay out below shows that true core ‘goods’ inflation has actually been negative on a year-over-year basis for the past 16 consecutive quarters and negative for 50 of the last 69 quarters since 2000. Not surprisingly, we view this deflationary pressure as a secular, not cyclical, issue for corporate profitability in several important parts of the global economy.
Emerging Markets over Developed Markets As we indicated in our 2017 Outlook Piece (see Outlook for 2017: Paradigm Shift), our five factor model has begun to inflect upwards for EM. The direction of these signals is important, because when they do collectively turn upward, EM outperformance can often last for years. Also, we are now more constructive on EM currencies, which is an important part of the EM total return equation for both equity and debt investors. If we are to be right, then commodity prices must stabilize near current levels. Details below.
Fixed Income Illiquidity Premium Despite the prospect of deregulation in financial services in the U.S., we still view the illiquidity premium as compelling, particularly in today’s low interest rate environment. Importantly, though, at the moment we think that there is likely more potential upside in Asset-Based Lending than in Direct Lending, which represents a shift in our previous view.
Continue to Embrace Dislocation While the S&P 500 Volatility Index (VIX) has been low in recent months, ongoing periodic spikes in uncertainty – often linked to geopolitical tensions – have created attractive investment opportunities since 2011. All told, the VIX has jumped 50% or more on a year-over-year basis one out of every 11 days since April 2009. That compares to similar volatility spikes on just one out of every 20 days during the prior 2003-2007 market cycle. In our view, these types of unforeseen ‘shocks’ represent a secular, not a cyclical, pattern. See below for details, but certain Master Limited Partnerships (MLPs), CCC-rated credits, and healthcare companies currently appear interesting to us.
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