Time to Focus: Five Key Investment Themes

by Henry McVey, Member & Head of Global Macro & Asset Allocation, CIO of KKR Balance Sheet

Rising macroeconomic and geopolitical tensions are creating both opportunities and risks for global investors across the entire global capital markets. We continue to emphasize our five key macro themes, many of which we think can perform against a variety of economic backdrops. First, we believe that assets with Yield and Growth will continue to outperform. Second, we would avoid exposures linked to China’s structural slowing, though we do finally see some emerging investment opportunities in China’s ‘new’ export strategy. Third, we see the opportunity for a significant and potentially sustained upward revaluation in the securities of large domestically-oriented economies. Fourth, the dismantling of the traditional financial services industry has emerged as both a blessing and a curse for investors; we outline our approach for navigating this complicated segment of the global economy. Finally, given the bifurcation across markets that we are now seeing, we believe folks should consider increasing exposure to complex stories, including earnings misses, restructurings, and/or corporate repositionings; at the same time we would be selling simplicity in instances where future earnings streams appear over-priced.

Summer is usually the time of year that allows investors to take a step back and reflect on some of the key long-term trends in our business. However, with Brexit, speculation of helicopter money in Japan, and another punk U.S. GDP reading in 2Q16, it certainly has felt like anything but vacation time for many in the investment community. That’s the bad news.

The good news, we believe, is that dislocations and distractions create opportunity for our approach to investing. Indeed, recent geopolitical and macro-related events have only increased our conviction about our key investment themes, as well as the upside potential in our current target asset allocation positioning1. See below for full details, but we note the following five macro trends on which we believe that performance-oriented, multi-asset class investors should focus:

• Interest Rate Outlook: Lower for Longer Continues to Drive the Yearn for Yield and Growth Without question, we remain in the lower for longer camp regarding rates. Importantly, recent events across Asia and Europe, Brexit in particular, only give us further confidence in our outlook. We also think that it is critical for investors to understand that the Federal Reserve in the U.S. may be signaling that it is now actually at an already modestly accommodative stance, despite rates at a record low and the Fed’s balance sheet at a record high. If we are right, then the traditional neutral level for the Fed Funds rate could be significantly lower than many economists now think. Not surprisingly, against this backdrop, we remain overweight both Opportunistic Liquid Credit and Private Credit, including Direct Lending and Mezzanine/Asset Based Lending. We also favor Real Assets that can produce both Yield and Growth, including Real Estate, Real Estate Credit, and Infrastructure assets such as pipelines, and are three hundred basis points overweight the asset class. One can see our preferences in Exhibit 9.
• Chinese GDP Growth Is Still Slowing; a New Playbook Is Required for Global Trade Despite temporary periods of economic reacceleration, we believe that China is structurally slowing. Embedded in this view is our cautious outlook for global trade, particularly as it relates to traditional Chinese imports. On the export side, our research shows that China is making huge inroads into higher value-added exports (Exhibit 25); this transition is a big deal and warrants investor attention for both offensive and defensive reasons in sectors such as telecommunications equipment, healthcare equipment, and optical equipment. At the same time, China appears to be flooding certain global markets with excess capacity in low value-added exports. If we are right, then it is too early to bottom fish in several cyclical industries, particularly those with excess capacity, unless valuations are extremely compelling. We also see additional margin headwinds in industries previously dominated by U.S. and European multinationals. By comparison, we think that there are increasing opportunities to partner with Chinese firms as they expand abroad. Details below.
• Post-Brexit, the Upward Revaluation of Domestic-Facing, Consumer-Oriented Economies Is Coming In a post-Brexit environment, we expect an upward revaluation of countries that have large domestic-oriented consumer economies, particularly relative to trade-oriented economies that rely more on exports to grow. The United States is clearly the most obvious beneficiary, given its economy’s absolute size as well as the health of its consumers. However, we also anticipate India, Indonesia, and Mexico to be major beneficiaries of this change in investor perception. If we are right, then valuations in these countries could actually hold or even increase from current levels in certain instances.
• The Ongoing Dismantling of Levered Financial Services Intermediaries Our travels across Europe, the U.S., and parts of Asia lead us to believe that the trend towards traditional financial services companies becoming more “utility-like” is ongoing, given the move towards low/negative rates by central banks as well as the desire by governments for significantly heightened regulation. Somewhat ironically, one outcome of these headwinds across traditional financial services is that credit creation will actually be harder to stimulate, which means central banks will likely have to continue to overcompensate with even more aggressive monetary policy initiatives. The other consequence of the current financial services backdrop is that more and more complex transactions will move into the non-bank market, which could provide significant opportunities for investors to step in and serve as important providers of liquidity.
• Buy Complexity, Sell Simplicity Given today’s increasingly bifurcated market (one that feels similar to what we saw in 1999/2000 when tech and telecomunications stocks traded expensively at the same time cyclical stocks traded cheaply), we want to move capital to take advantage of the arbitrage we now see between complexity and simplicity. Indeed, despite record highs in the S&P 500, we are increasingly finding attractively complex stories that the market does not like because of limited earnings visibility, increased volatility, and/or cyclically out of favor offerings (Exhibit 41). For our nickel, we think that — with some value-added restructuring, repositioning, and/or “tuck-in” acquisitions — there is a significant opportunity today to dramatically boost valuation by merely improving a company’s earnings visibility, something that the market desperately craves in today’s low rate, slow growth world. On the other hand, it also feels to us that investors are now willing to potentially overpay for earnings visibility and/or yield. Indeed, with simplicity of story being so “hot” right now, we believe opportunities exist across the corporate and real asset sectors to carve out and monetize distinct earnings streams that are trading at what we believe are premium valuations relative to their long-term intrinsic value.

While we believe that our macro themes can help deliver differentiated relative performance for investors, we must also acknowledge that at this point in the cycle we have entered an environment of lower absolute returns for many asset classes. This insight is not, however, “new” news. One can see in Exhibits 1 and 2 that returns have been actually trending down since 2000 in absolute terms, largely consistent with a 41% decline in nominal GDP growth (and interest rates) over the same period. However, with $13 trillion in negative yielding bonds around the globe, we have clearly entered into a new and more complicated era of financial repression. Just consider that, despite accounting for only four percent of the Barclays Multiverse index, U.S. junk bonds now make up almost 20% of total remaining positively yielding bonds in the world.

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