INSIGHTS

GLOBAL MACRO TRENDS

VOLUME 6.5 SEPTEMBER 2016

Time to Focus: Five Key

Investment Themes

Time to Focus: Five Key

Investment Themes

KKR GLOBAL MACRO & ASSET

ALLOCATION TEAM
HENRY H. MCVEY
Head of Global Macro & Asset Allocation
+1 (212) 519.1628
henry.mcvey@kkr.com
DAVID R. MCNELLIS
+1 (212) 519.1629
david.mcnellis@kkr.com
FRANCES B. LIM
+61 (2) 8298.5553
frances.lim@kkr.com
REBECCA J. RAMSEY
+1 (212) 519.1631
rebecca.ramsey@kkr.com
AIDAN T. CORCORAN
+ (353) 151.1045.1
aidan.corcoran@kkr.com
BRETT J. TUCKER
+1 (212) 519.1634
brett.tucker@kkr.com

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 Chinas structural slowing, though we do finally
see some emerging investment opportunities in Chinas
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.

Research assistance was provided by

Amanda See.

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2
KKR INSIGHTS: GLOBAL MACRO TRENDS
Rights Reserved.

What good is the warmth of

summer, without the cold of winter
to give it sweetness.

JOHN STEINBECK
AMERICAN AUTHOR

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. Thats
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 Feds
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.
1 KKR GMAA Target Asset Allocation uses a benchmark similar to that of a large
U.S. public pension.

The United States is clearly the most obvious beneficiary, given

its economys 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 todays 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 companys earnings
visibility, something that the market desperately craves in todays
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.2
2 Data as at August 18, 2016. Source: FT, Desperate investors turn to US junk
bond market.
KKR

INSIGHTS: GLOBAL MACRO TRENDS

EXHIBIT 1

EXHIBIT 3

Returns for Financial Assets (Treasuries, Private Equity,

MSCI ACWI and High Yield) Have Been Falling Since
1995

With Bond Yields So Low, Equity Needs to Deliver

Double-Digit Returns for Pensions to Come Even Close to
Hitting Their Return Hurdles

Trailing 5 Year Average Returns by Main Asset Class, %

25

Treasury Returns

Global PE Return

ACWI Return

HY Return

Expected Returns for a 60% Equities, 40% Bond Portfolio

EXPECTED BOND RETURNS OVER THE NEXT 5 YEARS

4

-1

-2

-2

0.4

0.0

-0.4

-0.8

-1.2

-1.6

-2.0

1.6

1.2

0.8

0.4

0.0

-0.4

-0.8

2.8

2.4

2.0

1.6

1.2

0.8

0.4

4.0

3.6

3.2

2.8

2.4

2.0

1.6

5.2

4.8

4.4

4.0

3.6

3.2

2.8

6.4

6.0

5.6

5.2

4.8

4.4

4.0

10

7.6

7.2

6.8

6.4

6.0

5.6

5.2

12

8.8

8.4

8.0

7.6

7.2

6.8

6.4

14

10.0

9.6

9.2

8.8

8.4

8.0

7.6

EXPECTED STOCK RETURNS

20
15
10
5
0

1990

1995

2000

2005

2010

2015

Data as at December 31, 2015. Source: Bloomberg.

EXHIBIT 2

Five-year Trailing Nominal GDP Growth Rate in the

U.S. Has Fallen by More Than 40% Since 2000. Not
Surprisingly, Returns Too Have Slipped
Trailing 5 Year Average Returns of
Four Key Asset Classes vs. U.S. Nominal GDP Growth, %
Avg.
16

EXHIBIT 4

Near-Term Returns for the Investment Management

Industry Are Likely Headed Lower

Nominal GDP (rhs)

CAGR Past 5 Years: 2010-2015, %

CAGR Next 5 Years: 2015-2020e, %

14.2

14

12
11.7

10
8

8.3

6.6

3
2

1995

2000

2005

2010

2015

Four key asset classes include: Global Private Equity, U.S. Treasuries,
Global Listed Equities and U.S. High Yield. Data as at December 31, 2015.
Source: Bloomberg.

We believe we have entered an

environment of lower absolute
returns for many asset classes.

KKR

INSIGHTS: GLOBAL MACRO TRENDS

11.1

12.2
10.7

7.5

1990

12.6

10.0

Data as at August 12, 2016. Source: KKR Global Macro & Asset
Allocation.

5.5

4.6

5.0

6.1

2.3

-0.3
U.S. 10 Year
Treasury
Bond

S&P 500

Private
Equity

Hedge
Funds

Real Estate
(unlevered)

e = KKR GMAA estimates. Data as at May 13, 2016. Source: Bloomberg,

Cambridge Associates, NCREIF, HFRI Fund Weighted Composite Index,
KKR Global Macro & Asset Allocation.

To be sure, we think that the one-two punch of monetary and fiscal

stimulus can help to mitigate some of the aforementioned macro
headwinds, including the slowdown in nominal GDP, in the near term.
However, what we believe is really needed to sustain an improve-

ment in the outlook for absolute growth and returns, particularly in the
developed world, is a reacceleration in long-term productivity trends.
Unfortunately, as Exhibits 5 and 6 illustrate, productivity has been
consistently declining this cycle. Given that productivity is one of the
two key inputs to GDP growth (with labor force growth as the other
one, and we do not currently see any major positive changes to immigration policy), recent trends are quite concerning, in our view.

EXHIBIT 7

U.K. CFOs Confidence Has Fallen to the Lowest

Ever Level
U.K. CFO Survey Next 12 Months, %
(Axis Inverted)
Decrease in Capex Spending
Decrease in Hiring
Decrease in Operating Margins
Decrease in Corporate Profits At or Greater Than 50%

EXHIBIT 5

Productivity Has Been Falling Around the Globe

0

Productivity: 10 Year CAGR, %

10%

20

Japan

China

U.S.

Euro Area

40
60

8%

80

6%

100
4%

Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
Dec-11
Mar-12
Jun-12
Sep-12
Dec-12
Mar-13
Jun-13
Sep-13
Dec-13
Mar-14
Jun-14
Sep-14
Dec-14
Mar-15
Jun-15
Sep-15
Dec-15
Mar-16
Jun-16

120

2%
0%

Data as at June 30, 2016.Source: Deloitte LLP, Haver Analytics.

70

75

80

85

90

95

00

05

10

15

Note: Real GDP growth equals labor force growth times productivity
growth. Data as at April 12, 2016. Source: IMF, UN, Haver Analytics.

EXHIBIT 8

Uncertainty Is Driving Defensive (Simplicity)

Outperformance; We Now Favor Complexity

EXHIBIT 6

U.S. Policy Uncertainty Index and Performance

of Russell Defensive / Small Cap

and Has Actually Been Negative In the U.S. This Cycle

Productivity Growth Comparison, %
2005-2010 CAGR

News Based Uncertainty Index

2010-2015 CAGR

Russell Defensive / Small Cap (RHS)

320

10.9%

290
10.3%

0.60

260

0.55

230
200

0.50

170

0.45

140

0.40

110

Note: Real GDP growth equals labor force growth times productivity
growth. Data as at April 12, 2016. Source: IMF, UN, Haver Analytics.

Jul-15

Sep-12

Nov-09

Jan-07

0.25

Mar-04

20

May-01

China

0.30
Jul-98

-1.1%
U.S.

50
Sep-95

Euro Area

0.9%

Nov-92

Japan

0.3% 0.6%

0.35

80

Jan-90

0.5% 0.4%

0.65

Data as at July 31, 2016. Source: Bloomberg, Measuring Economic

Policy Uncertainty by Scott Baker, Nicholas Bloom and Steven J. Davis
at www.PolicyUncertainty.com.

KKR

INSIGHTS: GLOBAL MACRO TRENDS

Beyond the need for a notable improvement in productivity, we

also think some clarity around the global political landscape is now
required too. Unfortunately, however, we do not see an imminent
improvement in this area. For starters, we are still poised to have a
divisive election in the United States; maybe more important, though,
is that we also face surprisingly murky electoral outlooks across
Italy, the Netherlands, Germany and France during the next 12-18
months. In each of these markets, protectionism, anti-immigration,
and populism will likely feature prominently, we believe. Finally, we
face increasing global uncertainty from the emergence of strong
men leaders such as Vladimir Putin, Xi Jinping, and Recep Tayyip
Erdoan. Importantly, all these games of political chess are occurring
at a time of notable instability across the Middle East.
In our view, it is the unusual and sometimes unsettling intersection
of all these macroeconomic and geopolitical forces that still keeps
us in an environment that we refer to as Adult Swim Only. As such,
we continue to favor an asset allocation that rewards yield, embraces
volatility, and tilts more idiosyncratic in nature at this point in the
cycle. To this end, our most significant overweight positions include
Private Credit, Opportunistic Liquid Credit, and select parts of Real
Assets. One can see this in Exhibit 9.
EXHIBIT 9

Select Overweight Positions in KKR GMAAs 2016

Target Asset Allocation
ASSET OR SUB-ASSET CLASS

KKR GMAA STRATEGY

JUNE 2016 BENCHTARGET, %
MARK

U.S. PUBLIC EQUITIES

22

20

DIRECT LENDING

10

REAL ASSETS

ACTIVELY MANAGED OPPORTUNISTIC CREDIT

DISTRESSED / SPECIAL SITUATION

MEZZANINE / ASSET BASED LENDING

Please note that as of December 31, 2015 we have recalibrated Asia

Public Equities as All Asia ex-Japan and Japan Public Equities. Strategy
benchmark is the typical allocation of a large U.S. pension plan. Data as
at July 31, 2016. Source: KKR Global Macro & Asset Allocation (GMAA).

If we are wrong in our outlook and growth reaccelerates more than

expected, we think that returns across risk assets will ultimately be
capped. Key to our thinking is that sustained stronger global growth
would turn central bankers more hawkish (or at least less dovish),
which likely would not be good for the global capital markets, currencies and rates in particular. As such, our base case remains a
volatile backdrop that never fully favors the bulls or the bears, lending
support to our base view that the global economy and the capital
markets that support it remains in an asynchronous recovery.

DETAILS
In the following section we provide both further analyses on the key
macro themes mentioned above as well as what we believe to be the
key investment implications.
Interest Rate Outlook: Lower for Longer Continues to Drive the
Yearn for Yield and Growth
Since we arrived at KKR in 2011, we have been pushing our Brave
New World thesis (see Brave New World: The Yearning for Yield Across
Asset Classes, December 2011), which we originally developed during
our time at Morgan Stanley in macro strategy during the 2004-2007
period. Our basic premise has been and remains that secular
macro forces, disinflation and demographics in particular, would ultimately drive an upward revaluation of securities that could provide
investors with both yield and earnings growth. Put another way, the
cash flow required to grow the dividend needs to be regenerative
in nature, as we think that investors would ultimately shun levered
entities that just squeeze yield out of a declining stream of cash from
operations.
Whether we have been lucky or good, our Brave New World thesis has played out nicely in recent years. Today, however, we have
begun to wonder whether this investment theme has fully run its
course, given that the global capital markets are now filled with more
than $13 trillion in negative yielding fixed income securities as well
as many dividend yielding equities trading with valuations north of
20 times.3
To be sure, one has to be more selective at this stage in the cycle (including buying complexity), but our base view remains that technical
forces are likely to win out over fundamentals in the near term, given
that central bank buying is now overwhelming supply. One can see
this in Exhibit 10, which shows that net issuance minus quantitative
easing (QE) has actually shrunk to negative $300+ billion, compared
to positive net issuance less QE of $1.1 trillion in 2011.

We believe that the Federal

Reserve may be signaling that
it is now actually at an already
modestly accommodative stance;
if so, then the traditional neutral
rate for the Fed Funds rate could
be significantly lower than many
economists now think.

3 Data as at July 31, 2016. Source: Bloomberg.

KKR

INSIGHTS: GLOBAL MACRO TRENDS

EXHIBIT 10

G4 Aggregate Net Issuance Is Now Actually

Negative
G4 Total Net Issuance in U.S.$B Equivalents
NET ISY/Y %
CENTRAL
Y/Y %
NET ISY/Y %
SUANCE CHANGE BANK PUR- CHANGE SUANCE CHANGE
CHASES
LESS QE
2011

2,446

1,300

1,146

2012

2,064

-16%

1,508

16%

557

-51%

2013

1,890

-8%

1,063

-29%

826

48%

2014

1,482

-22%

809

-24%

674

-18%

2015

1,044

-30%

1,091

35%

-48

-107%

2016E

1,045

0%

1,414

30%

-369

-669%

2017E

987

-6%

1,360

-4%

-373

-1%

TOTAL

10,958

8,545

2,413

G4 equals U.S., Japan, U.K., Euro (Germany, France, Italy, Spain,

Netherlands, Austria, Finland, Belgium, Greece, Ireland, Portugal).
QE = quantitative easing. Data as at July 23, 2016. Source: National
Treasuries, Morgan Stanley Research.

EXHIBIT 11

More Than a Third of Developed Market Bonds Now

Have Negative Yields
% of Negative Yielding Government Securities
U.K.
U.S.
Spain
Italy
TOTAL DM
Slovakia
Slovenia
Belgium
Ireland
Denmark
France
Austria
Netherlands
Finland
Japan
Germany
Sweden
Switzerland
Luxembourg

Importantly, we believe these statistics are likely to be revised downward (i.e., more shrinkage) following the Bank of Englands recent
announcement on August 4, 2016 (BoE will be buying 60 billion
additional gilts as well as 10 billion of corporate bonds). Also, we
expect the European Central Bank to initiate some additional easing
measures on September 8th, 2016; at the same time, we look for
intensifying efforts from the Bank of Japan to buy both equity and
fixed income products.
Beyond the aforementioned quantitative easing, there is another
influence that shapes our view on our lower for longer thesis regarding rates. Specifically, despite a lot of the recent banter in the press
surrounding the potential for higher rates, we are increasingly of the
mindset that the Federal Reserve is closer to the real neutral rate
through the cycle than many investors may now think. One proxy to
measure this viewpoint is the Atlanta Fed, which shows that something akin to 75-85 basis points is where the neutral rate may be.
One can see this in Exhibit 12.
We also believe that the Fed is sending important signals about how
long and how low short-term rates may stay. At the June 2016
FOMC press conference, Federal Reserve Chairwoman Janet Yellen
succinctly said that there are long-lasting, more persistent factors that may be at work that are holding down the longer-run level
of neutral rates. She followed up by indicating that It could stay
low for a prolonged time... All of us are in a process of constantly
reevaluating where the neutral rate is going, and what you see is a
downward shift over time, that more of what is causing this to be low
are factors that will not be disappearing. Not surprisingly, given all
these types of remarks as well as sluggish growth, the Fed Funds
rate is now below one percent, and we think it will stay there over
most of the time through 2020. One can see this in Exhibit 13.
EXHIBIT 12

0%
0%

Some Fed Measures Suggest That Much of the Requisite

Tightening Has Already Occurred

16%
19%

Recessions
Federal Funds Target Rate, %
Atlanta Fed Shadow Fed Funds Rate, %

36%
44%
49%
56%
57%
63%
66%
67%
74%
74%
80%
84%
84%

8
6
4
2
0
97%
100%

Data as at July 19, 2016. Source: Bloomberg. Universe: Bloomberg Global

Developed Sovereign Bond Index.

-2
-4

98

00

02

04

06

08

10

12

14

16

Note: Unlike the observed federal funds rate, the shadow rate does not
have a zero lower bound because it accounts for other monetary policy
tools beyond rate cuts. Data as at July 31, 2016. Source: Federal Reserve
Board, Federal Reserve Bank of Atlanta, National Bureau of Economic
Research, Haver Analytics.

KKR

INSIGHTS: GLOBAL MACRO TRENDS

EXHIBIT 13

EXHIBIT 14

We Think That the Fed Funds Rate Could Trend Below

One Percent Until At Least 2020

With Rates So Low, We Think That Traditional Pension

Plans Will Struggle To Achieve Their Target Returns

U.S. Federal Funds Rate, %

(Dotted Line Represents KKR GMAA Forecasts)

Performance: Portfolio 60% Equities, 40% Bonds

15 Yr CAGR

7.0

10 Yr CAGR

5 Yr CAGR

25

6.0
5.0

20

4.0
15

3.0

We think central tendency

of Fed Funds could remain
below 1.0% until 2020

2.0
1.0

5
Dec-95
Mar-97
Jun-98
Sep-99
Dec-00
Mar-02
Jun-03
Sep-04
Dec-05
Mar-07
Jun-08
Sep-09
Dec-10
Mar-12
Jun-13
Sep-14
Dec-15
Mar-17
Jun-18
Sep-19
Dec-20
Mar-22

0.0

10

Data as at August 10, 2016. Source: Federal Reserve Board, KKR Global
Macro & Asset Allocation analysis.

Separately, Fed Governor John C. Williams recently authored a

somewhat provocative essay that indicated that new important
forces, such as global supply, shifting demographics and slower trend
productivity, would all lead to a lower neutral rate. The key takeaway from these global trends is that interest rates are going to stay
lower than we have come to expect in the past, he wrote. Interestingly, he also noted that, this future low level of interest rates is
not due to easy monetary policy; it is the rate expected to prevail
when the economy is at full strength and the stance of monetary
policy is neutral4.
Against this backdrop, we think that the asset allocation implications
of our thesis are quite significant for long-term investors. Specifically, we think that the opportunity for a traditional 60/40 equity/bond
strategy to achieve a seven or eight percent return for its constituents is now quite limited. Indeed, if bond yields stay flat or increase
from current levels, then public equities would have to return 10% or
more per annum for most allocators of capital to meet their hurdle
rates, a feat we see as highly unlikely after seven straight up years
in the S&P 500 (Exhibit 15). Importantly, as we outlined in Exhibit 4,
which details our forward looking expected returns for the major asset classes we track, our fundamental work suggests an annual total
return of around six percent for stocks (including dividend yields),
while we have an even more modest total return for bonds (i.e., essentially flat).

0
-5

55 60 65 70 75 80 85 90 95 00 05 10 15

Data as at July 2016. Source: Shiller data http://www.econ.yale.

edu/~shiller/data.htm, Thomson Financial, S&P, Factset, Haver Analytics.

EXHIBIT 15

Including 2016 YTD, the S&P 500 Has Actually Delivered

Positive Returns for Eight Years, Which Is Highly Unusual
# OF CONSECUTIVE
YEARS OF POSITIVE
RETURNS

END

CUMULATIVE
RETURN

START

CAGR

1904

1906

67%

19%

1954

1956

111%

28%

1963

1965

60%

17%

1970

1972

40%

12%

1942

1945

143%

25%

1958

1961

102%

19%

2003

2007

83%

13%

1947

1952

148%

16%

2009

2015

159%

17%

1921

1928

435%

23%

1982

1989

291%

19%

1991

1999

450%

21%

AVG. CAGR

19%

Data as at December 31, 2015. Source: Standard & Poors, Shiller data.
4 http://www.frbsf.org/economic-research/publications/economic-letter/2016/
august/monetary-policy-and-low-r-star-natural-rate-of-interest/

KKR

INSIGHTS: GLOBAL MACRO TRENDS

EXHIBIT 16

We Are Leaving a Period of Very Strong Returns For Traditional Asset Allocation Programs
Annualized Real Returns for a 60% Stocks, 40% Bonds Portfolio, %
12.2%

11.8%
9.4%

8.4%
4.4%

3.9%

9.3%

9.1%
4.7%

3.2%

2.5%

2.0%

1.1%

-1.4%
-4.3%
1900s

1910s

1920s

1930s

1940s

1950s

1960s

1970s

1980s

1990s

2000s

2010-15

Avg

Best
Other
Four Decades
Decades

Data as at December 31, 2015. CPI adjusted returns. Source: Bloomberg, Factset, S&P, Shiller data.

Given this outlook, our strong belief is that there will be a meaningful shift in allocation strategies by certain pensions, endowments, and
even individual investors. For our nickel, we think that most major allocators of capital will likely shift from a diversified cross-asset strategy
(including both active and passive) towards more of a barbell one that
includes: 1) active, idiosyncratic managers that can truly deliver either
alpha and/or operate in a market of higher returns relative to traditional liquid assets; and 2) extremely low-cost index funds that maximize
beta exposure with limited tracking error. If we are right, then tolerance for performance mediocrity, particularly for liquid products with
periodic drawdowns of significance, will become quite limited.
On the other hand, we think that the opportunity set for certain managers, particularly in private credit, is large and growing. Indeed, in an
environment where the risk-free rate is near zero in real terms and
between one and two percent in nominal terms, the opportunity to pick
up three percent via an illiquidity premium (Exhibit 17), particularly
if there is sound credit underwriting, is quite attractive, in our view,
against a traditional seven to eight percent hurdle rate. Private equity
too should benefit in both developed and emerging markets. Within the
public equity markets, we are finally beginning to see more value in EM
markets than DM markets. One can see the basis for our argument in
Exhibit 18 which shows that some mean reversion might be likely after
70 consecutive months of EM under-performance.

EXHIBIT 17

Given Changes in the Banking Sector, We View the

Illiquidity Premium as More Secular Than Cyclical
Weighted Average Yield of Originated Senior Term Debt
12-Month Average Yield of Traded Loans
11.4%
12.0%
11.3%
10.7% 10.8%
11.2%
9.7% 9.6%
8.3%

7.8%
5.8% 5.8% 6.0%

8.7% 8.5%
8.2% 8.5%

5.1% 4.9% 5.5%

2007 2008 2009 2010 2011 2012 2013 2014 2015

5.9% 6.1%

Q1 Q2
2016 2016

Data as at June 30, 2016. Source: Bloomberg, Ares company filings, KKR
Credit.

We do worry that the inability of

banks to earn their cost of capital
means that their capacity to repair
their balance sheets by issuing
accretive equity has vanished.

KKR

INSIGHTS: GLOBAL MACRO TRENDS

EXHIBIT 18

EXHIBIT 19

If the Fed Is Now More Dovish, the Long Drought in EM

Underperformance Could Finally Be Over

350%
81
months

300%
250%

28

Sep-10
305%

24

Sep-94
288%
84
months

70
months

100%

0%

Sep-08
27

Mar-16
22

20
16

150%

50%

Global Merchandise Exports as a % of Global GDP

Relative Total Return, MSCI EM/DM

(Feb'89 = 0%)

108
months

200%

Global Trade Has Actually Declined in Recent Years

Jul-16
128%

Sep-01
17%
87 89 91 93 95 97 99 01 03 05 07 09 11 13 15

Data as at July 31, 2016. Source: KKR Global Macro & Asset Allocation
analysis.

Chinese GDP Growth Is Still Slowing; a New Playbook Is Required

for Global Trade
Anybody who has had the opportunity to read our Insights papers
in recent years knows that we feel strongly that China has endured
a distinctly hard landing when it comes to nominal GDP growth.
Indeed, one can see the severity of the trend in Exhibit 20, which
shows that nominal GDP has actually fallen over 12 percentage points
since 2Q11, compared to just the 3.3 percentage point decline that
many sell-side forecasts use when describing real GDP during the
same period. A decline of such magnitude in nominal terms is a big
deal. In particular, from the perspective of an owner and operator
of businesses, nominal not real is what matters because the
revenues that cover overhead, pay employees, and hopefully generate
a profit for investors are measured in nominal, not real terms.

12

80

85

90

95

00

05

10

15

Data as at March 31, 2016. Source: IMF, Haver Analytics, KKR Global
Macro & Asset Allocation analysis.

EXHIBIT 20

Nominal GDP Growth in China Has Fallen a Full 12.4%

in Absolute Terms Since 2Q11, While Real GDP Has
Slipped a More Modest 3.3%
China Real vs. Nominal GDP Growth, Y/y, %
2Q11

2Q16
19.7%

-63%
10.0%

-33%
6.7%

China: Real GDP Y/y

7.3%

China: Nominal GDP Y/y

Data as at June 30, 2016. Source: China National Bureau of Statistics,

Haver Analytics.

We see the opportunity for

a significant and potentially
sustained upward revaluation
in the securities of large
domestically-oriented economies.

10

KKR

INSIGHTS: GLOBAL MACRO TRENDS

That Chinas overall growth at this point is slowing is certainly not

new news to investors, we fully acknowledge. What we believe
may not be fully understood are all the long-term consequences and
long-term nature of this slowdown. We see several important ones
to consider. First, as we show in Exhibit 19, global trade is slowing
as China downshifts. To be sure, some of this reduction is linked to
lower commodity prices, but there is another factor to consider. From
what we can tell (and our data shows), China is also insourcing more
of its production of intermediate goods, which means it now relies
less on ships, planes, and content from its traditional trading partners. One can see the magnitude of this shift in Exhibit 21.

EXHIBIT 21

Another important issue to consider is that less global trade means

less foreign direct investment (FDI). Interestingly, a larger percentage of FDI is now coming from countries like China moving assets
overseas than developed market economies putting fresh capital into
fast-growing emerging markets. For example, in 2013 and 2014,
Greater Chinas cross border M&A made up 28% and 24% of world
cross-border M&A, respectively.5 Trends of late have been even more
powerful, as Chinas outbound direct investment surged to $64B in
2Q16 from just $9B in 1Q11 and zero (yes zero) in 1Q07.6

The Gap Between Imports and Exports in China

Continues to Widen
China: LTM Current Account Balance, U.S.$B (L)
China Exports as a % of Global Exports, 12mma (R)
China Imports as a % of Global Imports, 12mma (R)
600

14

500

12

400

China Is Rebalancing to Higher Value Add Exports; We

Now Think That Investors Should Focus on Facilitating Not Fighting - This Transition

China % Total Exports, 12mma

10

300
200
100

-100

90 92 94 96 98 00 02 04 06 08 10 12 14 16

EXHIBIT 23

Data as at March 31, 2016. Source: Source: IMF, State Administration of

Foreign Exchange, Haver Analytics.

60

Ordinary Trade (Higher Value Add)

Reexports (Lower Value Add)
Jul-16
55.0

55
Focus Here
50
45
Avoid Here

40

EXHIBIT 22

Notably, the Mix of Imports Is Shifting Towards

Consumers and Away From Investment-related Goods
China: Imports as a % of Total Goods Imports, 12mma
70%

60%

Investment Related

35
30

Jul-16
33.9
02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Data as at July 31, 2016. Source: China Customs, Haver Analytics.

Consumer Related

Oct-08
67%

Jun-16
60%

50%

40%

30%

Jun-16
40%

Oct-08
33%

95 97 99 01 03 05 07 09

11

13

15

Data as at June 30, 2016. Source: China Customs, Haver Analytics.

Even within its import sector, China is importing less traditional

goods and services. Indeed, as Exhibit 22 shows, investment-related
imports have fallen to 60% in June 2016 from a peak of 67% in
October 2008. On the other hand, consumer-related imports have
jumped to 40% from 33% over the same period. We look for both
trends to gain momentum in the quarters ahead.

From our vantage point, Chinas

slowdown is secular, not cyclical,
and we see continued pricing
pressure amidst slower activity
across not only Asia but parts of
Europe and Latin America.

5 Greater China includes China, Hong Kong, Taiwan, and Macao. Source:
UNCTAD.
6 Data as at June 30, 2016. Source: United Nations Conference on Trade and
Development, Haver Analytics.
KKR

INSIGHTS: GLOBAL MACRO TRENDS

11

EXHIBIT 24

EXHIBIT 25

Outward FDI Has Started to Flow from the EM World to

the DM World
Cross-Border M&A by Purchaser, U.S.$B
Emerging & Developing Economies
Developed Economies
EM % World (R)

1200
1000

CHINA EXPORTS AS A % OF GLOBAL EXPORTS

30%

600
20%

400

10%

200
0

90 92 94 96 98 00 02 04 06 08 10 12 14

0%

Data as at December 31, 2015. Source: United Nations Conference on

Trade and Development, Haver Analytics.

In terms of investment implications, there are several things to

consider, in our view. First, we generally think that much of the commodity complex linked to Chinas aggressive build-out during the last
decade is likely to remain under pressure. Key commodities to potentially avoid, in our view, include iron ore, steel, and coal, all of which
we still expect to trade flat to down in the coming quarters. Consistent with this view, we also think that many of Chinas traditional
trading partners, particularly those with an old economy interface,
are not as well positioned to benefit from the countrys shift towards
more consumer-oriented imports. This shift in focus by the Chinese
is a big deal, in our view, and it will likely put additional pressure on
much of South East Asias existing export product suite.
There are also unanticipated knock-on effects. For example, given the
slowdown in Chinas exports as well as the shift in its import mix, we
remain leery that excess capacity in over-built areas such as ships
and logistics may not snap back as quickly as the consensus now
thinks. Separately, as China moves up the value chain in terms of
value-added offerings (Exhibit 25), it is likely to increase competition,
denting margins of well-known incumbents in key markets like the
U.S. and Europe. If we are right, then shareholder returns for publicly
traded companies in certain key markets could be at risk, we believe.

We continue to favor an asset

allocation that rewards yield,
embraces volatility, and tilts more
idiosyncratic in nature.

12

KKR

INSIGHTS: GLOBAL MACRO TRENDS

1995

2000

2010

2015

2015 VS
2000

TELCO EQUIPMENT

3%

6%

30%

38%

32.9%

OPTICAL INSTRUMENTS AND

APPARATUS

5%

8%

29%

37%

28.7%

HOUSEHOLD TYPE
EQUIPMENT

4%

10%

30%

37%

26.5%

VAPOR GENERATING
BOILERS, AUXILIARY PLANT;
PARTS

1%

4%

32%

24%

20.4%

MOTORCYCLES AND CYCLES

5%

12%

27%

31%

19.6%

ELECTRIC POWER MACHINERY, AND PARTS THEREOF

7%

10%

23%

29%

19.4%

MINERAL MANUFACTURE

2%

2%

9%

17%

15.2%

RAILS AND RAILWAY TRACK

CONSTRUCTION MATERIAL

2%

4%

10%

18%

14.0%

CIVIL ENGINEERING AND

CONTRACTORS PLANT AND
EQUIPMENT

1%

1%

8%

12%

10.5%

ELECTRO-DIAGNOSTIC
APPARATUS FOR MEDICAL
SCIENCES

0%

1%

5%

8%

7.0%

50%
40%

800

China Is Gaining Dominant Global Market Share in

Higher Value-Added Sectors as Well as Moving Into New
Important Growth Sectors

Data as at December 31, 2015. Source: UNCTAD, Haver Analytics.

Given this backdrop, we think that an opportunity on the positive

side of the ledger, particularly for global private equity firms and
certain multinationals, is to partner with Chinese companies looking
to expand abroad. In many instances, European and U.S. firms can
provide local knowledge about consumer behavior, help to overcome
regulatory hurdles, and teach operational best practices. Chinese
firms will also need help with mergers and acquisitions, which
should drive incremental need for local strategic advice, financings,
and management talent.
The Upward Revaluation of Domestic-Facing, Consumer-Oriented
Economies
While many investors are focused on the negative long-term ramifications of Brexit, including slower global trade, less tolerance
around immigration, and growing social/economic discord, we see
an important silver lining. Specifically, we think that there will be a
notable upward revaluation opportunity in the economies of countries
with large domestic markets that are less affected by many of the
aforementioned macroeconomic concerns. Key to our thinking is that
investors increasingly do not want to be dependent on economies
that are overly reliant on global connectivity (i.e., trade and/or flows)

to deliver growth. Said differently, after the boom in globalization that

we have seen over the past 20-30 years, we now think that intensifying geopolitics and macroeconomic concerns may lower the risk
premium for countries that do not have to depend on outside forces
to sustain their current way of living.

lution9. Today, by comparison, rig count in the U.S. is now just 408,
compared to a peak of 1,608 in October 2014, supporting our view
that an important part of the U.S. manufacturing/commodity sector
has already experienced a major boom-to-bust cycle.

A favorite within our framework is the United States, which we keep

as the one overweight position within Public Equities (where we are
actually underweight as an asset class) in our target asset allocation.
We see several important positives to consider:

Consumption In the U.S. Is Almost 70% of GDP and Far

Outpaces Other Global Economies

The U.S. consumer is in much better shape From our vantage point,
it appears that the U.S. consumer has been acting well very
un-American during the current expansion. Indeed, 86 months into
a recovery, savings rates are going up, not down; at the same time,
consumption of basic consumables is running well below trend7. Also,
given low rates and improving net worth, debt service burdens have
actually reached historic lows. However, the consumer is spending,
but as we detail below, investors should focus more on businesses
that can deliver value-added experiences to the consumer.
U.S. corporate profits are not so far above trend relative to prior
cycles After essentially no earnings growth during the last 36
months in the U.S., it is abundantly clear we have not had the typical broad-based earnings recovery that defines the average cycle.
In fact, earnings growth for the S&P 500 has delivered just a 2.6%
CAGR in EPS since 2009, compared to a solid 15% during the prior
cycle8. To be sure, margins are now high across several sectors, but
earnings relative to nominal GDP suggest less of a shock than what
investors endured in the 1987 and 2007 downturns.
We have already experienced a manufacturing/trade recession in
the United States With Chinas notable slowing reverberating across
Asia as well as the oil bust in the U.S., many parts of the manufacturing sector have already experienced peak to trough declines
in their businesses. To be sure, manufacturing does not hold the
same influence in the U.S. the way it did in the past, but it is still an
important part of the U.S. economy. Moreover, until recently the energy industry and its related sectors were key drivers of U.S. capital
expenditures. Specifically, we estimate that roughly 15% of total U.S.
investment growth from 2011 to 2014 was related to the shale revo-

7 Data as at August 31, 2016. Source: U.S. Bureau of Economic Analysis, Haver
Analytics.
8 Data as at August 24, 2016. Source: Bloomberg.

PRIVATE CONSUMPTION
(US$ TRILLIONS)

PRIVATE
CONSUMPTION
CAGR 2015
AS A % OF
VS. 2005 (%)
GDP

2005

2015

U.S.

8.8

12.3

6.9%

68.4%

JAPAN

2.5

2.4

-0.3%

59.0%

GERMANY

1.6

1.8

2.6%

53.0%

U.K.

1.5

1.8

4.2%

63.1%

FRANCE

1.2

1.3

2.6%

54.0%

CHINA

0.9

3.7

31.9%

33.9%

BRAZIL

0.6

1.0

11.6%

54.1%

AVERAGE

8.5%

55.1%

Data as at July 26, 2016. Source: IMF, Haver Analytics.

EXHIBIT 27

The Savings Rate Is Now More Than Double 2007 and

On Par with the Beginning of the Last Cycle (2003)
U.S. Personal Savings as a % of
Personal Disposable Income
9
8
7
6

Jul-03
5.5

Jul-16
5.7

4
3
2

Nov-07
2.5

1
0

Jan-00
Oct-00
Jul-01
Apr-02
Jan-03
Oct-03
Jul-04
Apr-05
Jan-06
Oct-06
Jul-07
Apr-08
Jan-09
Oct-09
Jul-10
Apr-11
Jan-12
Oct-12
Jul-13
Apr-14
Jan-15
Oct-15
Jul-16

U.S. housing is still well below trend See below for details, but we
continue to think that U.S. residential construction is one of the least
cyclically extended areas of the global economy. Just consider that
we estimate that residential construction is currently near a historic
low of just 55% of structural demand. By comparison, we estimate
that construction activity was running at 116% and 115% of true
structural demand in 1986 and 2005, respectively (which were the
big housing busts). As such, we retain the bullish outlook we laid
out on the housing sector and its subcomponents dating back to U.S.
Housing: A Changing Dynamic, March 2012.

EXHIBIT 26

Data as at July 31, 2016. Source: U.S. Bureau of Economic Analysis,

Haver Analytics.

9 Data based on the growth of investment in oil and oilfield machinery, mining
exploration/shafts/wells, and power facilities. Data as at August 22, 2016.
Source: Bureau of Economic Analysis, Haver Analytics, KKR Global Macro &
Asset Allocation analysis.
KKR

INSIGHTS: GLOBAL MACRO TRENDS

13

EXHIBIT 28

Historically, Residential Construction Downturns Have

Been Split Between Mild and Extreme
Peak-to-Trough Change in U.S. Housing Starts

-4%

-6%

When housing activity is

running near structurally low
levels, the cyclical downturns
tend to be mild

Beyond the U.S., we think that investors should too consider increasing exposure to some of the larger consumer-facing EM economies, including Indonesia, India, and Mexico. Indeed, as we show in
Exhibit 30, these three economies have, on average, a full 62% of
their economies, or $2.5 trillion in absolute buying power, linked to
domestic consumption, which should provide them with more of a
buffer than many other countries to the slowdown in trade, crossborder flows, and China growth that we continue to forecast. They
are all fast growing, representing a major force in the 16% increase in
EMs share of total global consumption since 2003.10
EXHIBIT 30

In Addition to the U.S., We Believe Investors Will Seek

Out Large EM Consumption Stories in the Coming Years

-44%

HOUSEHOLD CONSUMPTION IN U.S.$ TRILLIONS

'86-91

'94-95

-73%
'05-09

'99-00

Data as at July 19, 2016. Source: Census Bureau, Haver Analytics, KKR
Global Macro & Asset Allocation analysis.

EXHIBIT 29

The Mild GDP Downturns Tend to Occur When

Construction Activity Isnt Structurally Excessive, Which
Is Clearly the Story Today

2005
115%

110%
90%

1999
96%

70%
Mild downturns
o low bases

50%

0.5

1.2

150%

59%

INDONESIA

0.2

0.5

167%

57%

MEXICO

0.6

0.8

35%

69%

U.S.

8.8

12.3

40%

68%

Data as at 2015. Source: World Bank, Haver Analytics.

Forward Price-to-Earnings Ratio

'68-'08
Avg.
100%

2020e
85%

22

+/-1 Std Dev

Current Forward P/E

20

19.0

18

2015
55%

Avg

18.7

17.4

16.9

16
14
12

1968
1971
1974
1977
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
2013
2016e
2019e

30%

1994
81%

INDIA

As a Macro Theme, We See Global Capital Supporting/

Improving Valuations in Large Domestic Economies

150%
1986
116%

2015

COUNTRY

CONSUMPTION AS A
% OF GDP,
2015

EXHIBIT 31

U.S. Residential Housing Completions

as a % of Structural Demand*

130%

2005

% CHANGE
FROM
2005 TO
2015

* Structural housing demand is a KKR GMAA estimate composed of the

following:
1. Structural demand from household formation: This is the demand that
would come from pure population growth, assuming no change in household headship rates (grouped by age decile) vs. the prior year

10
8

U.S.

India

Mexico

Indonesia

Data as at July 31, 2016. Average since January 2006. Shaded area
represents +/- one standard deviation. Source: Bloomberg.

2. Structural demand from scrappage: This is the demand that would come
from the scrappage of existing housing stock, assuming that it is scrapped
at the 10yr trailing average rate relative to the total housing stock

e = KKR GMAA estimate. Data as at July 19, 2016. Source: Census

Bureau, Haver Analytics, KKR Global Macro & Asset Allocation analysis.

10 Data as at December 31, 2015. Source: World Bank, Haver Analytics.

14

KKR

INSIGHTS: GLOBAL MACRO TRENDS

EXHIBIT 32

Global Household Consumption Has Roughly Doubled

Since 2013; EM Consumption Is Now Growing 3x as Fast
as DM Consumption
Global Household Consumption
(U.S.$ Trillions)

50
45

Developed Markets

40

Emerging Markets

2014
44.8

The Ongoing Dismantling of Levered Financial Services Intermediaries

35
2013-2014 CAGR:
DM 4.0%
EM 11.9%

30
25

2003
23.3

20
15
10
5
0

90 92

94

96

In our view, another point to consider is that strategic buyers are

likely to deploy more capital into these economies, which means
cross-border M&A could accelerate further. Importantly, we expect
to see both private and strategic capital intensify their focus on
these countries. Finally, with a backdrop of a more dovish Fed, local
currencies and bond yields in these economies are likely to remain
well bid, which should help with cost of capital decisions, particularly
those linked to refinancing opportunities.

98 00 02 04 06 08

10

12

14

Over the years we have had the good fortune to meet with a variety
of central bank officials from around the world. Inevitably, after the
obligatory deep-dive into growth and inflation trends, our discussions
turn towards interest rates and the banking system. To date and
despite a lot of attempts to sway our thinking we still have not had
anyone convince us that Negative Interest Rate Policy (NIRP) makes
sense. Simply stated, we believe that negative rates fundamentally
violate the unwritten but fundamental tenets of financial services theory that:

Data as at December 31, 2014. Source: World Bank, Haver Analytics.

A bank should be able to make money from holding risky inventory;

EXHIBIT 33

Users of capital should be charged some economic rent for

borrowing capital

EM Share of Global Consumption Has Exploded

in Recent Years, Despite a More Sluggish Growth
Environment
40

Emerging Market Consumption as a % of Global

Consumption
36.5

35
30

Since 2003, EM's share

of global consumption
has grown 16.1 ppt

Beyond negative rates, we also note that reregulation has become a

major negative headwind for banks in two ways. First, as we show
in Exhibit 34, banks have paid out nearly 14% of their equity in fines
since 2009. In addition, banks are increasingly being forced to hold
huge sums of money against their positions, which all but ensures an
inability to earn their costs of capital. One can see this in Exhibit 35.

25
20.4
20
15

90 92 94 96 98 00 02 04 06 08 10

12

14

Data as at December 31, 2014. Source: World Bank, Haver Analytics.

If we are correct in the notable change in investment perception that

we are forecasting, then the long-term implications are significant.
Specifically, large, consumer-oriented countries could see their valuation multiples stay at the high end of their historical ranges or
even increase further as global investors reallocate towards more
stable, consumer-oriented economies. Under this outcome (which we
think likely), multiples are not likely to contract quite as much during
recessions, which mean trough multiples could be higher than in the
past (Exhibit 31).

What we believe is really needed

to sustain an improvement
in the outlook for absolute
growth and returns, particularly
in the developed world, is a
reacceleration in long-term
productivity trends.

KKR

INSIGHTS: GLOBAL MACRO TRENDS

15

EXHIBIT 34

EXHIBIT 36

Seven Years of Fines Have Taken a Heavy Toll on Banks,

Wiping Out the Equivalent of 14% of Total Equity Capital

The U.S. Yield Curve Is Actually Still Steep Relative to the

Eurozone, the U.K. and Japan
10y-2y Government Bond Yield, %

Ten Banks Total Equity Capital

2/10 Curve (LHS)

0.9

Loss Due to
Fines and
Penalties
14%

10y Rate (RHS)

1.6

0.8

1.4

0.7

1.2
1.0

0.6

0.8

0.5

0.6

0.4

0.4

0.3

0.0

0.1

-0.2

Ten Banks include Barclays, Bank of America, Citigroup, Credit Suisse,

Deutsche Bank, GS, HSBC, JPM, MS and UBS. Data as at March 27,
2016. Source: FT, Corlytics.

0.2

0.2

US

*Japan

*Germany

*France

UK

-0.4

*Part or all of curve in negative yield despite upward slope. Data as at

July 29, 2016. Source: Bloomberg

EXHIBIT 37

Given Current Valuations, Capital Raises Across the

Global Banking Industry Are Now Dilutive

EXHIBIT 35

Banks Have Built Over $100 Billion of Common Equity

Between 2012 and 2015, Deteriorating Their Core ROEs
by At Least 100 Basis Points
Aggregate Core ROEs for Money Centers and WFC

8.6%

Select Bank Indices Price To Book Ratio

0.90

0.66
0.50

0.48

Euro Stoxx
Banks

Topix Banks

-0.4%
-0.4%
-0.3%
7.6%
S&P 500 Banks FTSE All Share
Banks

Data as at July 30, 2016. Source: Bloomberg.

2012 Core 2013 Capital 2014 Capital 2015 Capital 2015 Core
ROE
Build
Build
Build
ROE on
2012
Earnings

Data as at May 16, 2016. Source: Company documents, Goldman Sachs

Global Investment Research 2016 CCAR Preview.

Without question, we are all living in an unusual time when a banks

cost of capital is actually rising as its leverage profile is declining. As
a result, today banks can only issue dilutive equity (i.e., below book
value, as shown in Exhibit 37), which ensures that they may not be
able to create the necessary equity buffer required to sustain a cyclical downturn in credit quality.
For investors, we think that the most actionable opportunity is to
participate as a substitute lender where complex transactions are
moving off-market. We see this opportunity best presenting itself in
the direct lending arena, which often includes mid-market financings,
acquisitions, and divestitures. In addition, within the asset-based

16

KKR

INSIGHTS: GLOBAL MACRO TRENDS

Assets / Tangible Common Equity

Assets / Market Capitalization

50

43.6

40
30

20.4

20

Jun-16e

Dec-15

Dec-14

Dec-13

Dec-12

Dec-11

Dec-10

Dec-09

Dec-08

10

Dec-07

Japan

U.S.

U.K.

110
100
90
80
Europe and
Japan move to
negative yields

70
60

Jul-16

Aug-16

Jun-16

Jun-16

May-16

Apr-16

Feb-16

Mar-16

Jan-16

Jan-16

Nov-15

40

Apr-16

Brexit
uncertainty

50

Buy Complexity, Sell Simplicity

60

Europe

Data as at August 16, 2016. Source: Bloomberg.

Major European Bank Capital

70

120

Dec-15

Current Bank Market Capitalizations In Europe Appear

Notably Sub-Scale Relative to Their Asset Bases

Bank Equity Performance (Oct '15 = 100)

Oct-15

EXHIBIT 38

Central Bank Policy Towards Negative Rates Has

Significantly Affected Bank Performance

Nov-15

Separately, given that we continue to forecast slow nominal GDP,

we think that the potential for non-performing loans to increase,
particularly in regions where nominal lending growth is still running
well above nominal GDP growth, is significant. If we are right, then
distressed credit and restructuring managers in markets ranging
from Italy to Greece to China to India should prosper, especially if
we are right about a more synchronized global economic slowdown
in 2018. Finally, unless central bank strategy shifts in major markets like Japan and Europe, we think that the opportunity for active
management across both public and private markets to outperform
relative to static benchmarks (the lions share of which are heavily
weighted towards banks) is now quite significant. Implicit in what we
are saying is that services-based investments, particularly those that
are levered to rising GDP-per-capita, are likely to outperform spread
lending institutions in todays low rate world.

EXHIBIT 39

Sep-15

finance market, we believe there are a growing number of off-market

financings now occurring, including first or second lien loans with
some form of upside equity participation.

Data as at June 30, 2016. Source: Bloomberg.

Our base view remains that

technical forces are likely to win out
over fundamentals in the near term,
given that central bank buying is
now overwhelming supply.

As we mentioned in our mid-year update (see Adult Swim Only:

2016 Mid-year Update, June 2016), we believe that the market is now
potentially over-pricing assets with steady cash flows, while underpaying for complexity, particularly around cyclical earnings, conglomerates, and/or busted deals. On the one hand, there are an increasing
number of opportunities to monetize cash flows on long-term investments, particularly in areas such as Real Estate, Infrastructure, and
Private Equity. Specifically, there have been more and more opportunities to carve out and sell certain long-term leases at low cap rates
and use proceeds to essentially de-risk much of the overall real estate
investment project. On the other hand, we see forced sellers across
the private markets that need capital to avoid downgrades and/or
reposition their businesses to compete more effectively. Importantly,
this opportunity set is a global one; in fact, we actually believe that
there will be more near-term activity surrounding complex situations
in Europe and Asia, Japan in particular, than in the United States over
the next 12 months. Key to our thinking is that slower growth in Japan
and Europe are forcing executives in these regions to think more thoroughly through the strategic value of their existing footprints.
Looking at the big picture, our base view is that a 1998-2000 analogy is a good one to use. In 1998, the Federal Reserve eased, which
fueled a concentrated bet into speculative technology and telecom
stocks at the same time that many other parts of the market became extremely unloved. Just consider that in the fall of 1998 (right
before the China Growth Miracle unfolded), Caterpillar was trading
at 9 times depressed earnings, while Deere was trading at 8 times
near-trough earnings. At the same time, however Cisco and Microsoft commanded multiples of around 48 times forward earnings.
Meanwhile, the S&P 500 was trading 21 times, so these technology
multiples were over 200% of the markets elevated multiple, while
KKR

INSIGHTS: GLOBAL MACRO TRENDS

17

CAT was at 50% of the markets multiple. This was right before the
decade that saw CATs earnings triple11.
Today, we see yield not high flying technology and telecommunications stocks per se getting expensive. Just consider that at 1.5%,
the 10-year Treasury trades at ~66 times its yield, while U.S. Utility
stocks trade at 20 times earnings. A similar revaluation has occurred
in the U.S. REIT sector.

EXHIBIT 41

Bottom Quintile Performing Stocks in the S&P 500 Are

the Most Volatile; We Would Shop for Bargains in This
Area of the Market
Average Volatility of S&P 500 Stocks, By 1 Year
Performance Quintile, as of July 2016 and July 2014
Jul-16

32.7

While we do expect rates to remain low, we are increasingly of the

mindset that investors are starting to overpay for the forward earnings stream of many yield-oriented equity securities. If we are right,
investors could similar to 1999 end up buying great companies
that prove to be less stellar investments because the entry multiple
was just too high to provide solid, above average performance.

Jul-14

26.2

25.5

23.6
21.4

19.8

19.9

21.0

22.1

22.0

EXHIBIT 40

Utilities in the U.S. Are Trading at 20x Forward EPS. In

General, We Are a Seller of Simplicity/Visibility of EPS

Bottom 4th Quintile 3rd Quintile 2nd Quintile

Top
Performance
Performance
Quintile
Quintile

Dow Jones Utility Index, NTM P/E Ratio

Quintile of 1 Year Performance

Data as at July 31, 2016. Source: Bloomberg.

NTM P/E Ratio

20

+2SD

18

+1SD

16
14

Avg.

12

-1SD

10

-2SD

Jan-15

Jan-16

Jan-13

Jan-14

Jan-12

Jan-11

Jan-10

Jan-09

Jan-08

Jan-07

Jan-06

Jan-05

Jan-04

Jan-03

Jan-02

Data as at August 17, 2016. Source: Bloomberg.

Large, consumer-oriented
countries could see their
valuation multiples stay at the
high end of their historical
range or even increase further
as global investors reallocate
towards more stable, consumeroriented economies.

11 Data as at August 24, 2016. Source: Caterpillar, Cisco, Microsoft company

filings, Bloomberg.

18

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INSIGHTS: GLOBAL MACRO TRENDS

Conclusion
Overall, we continue to view the current cycle as the Asynchronous
Recovery (see Investment Implications of an Asynchronous Global
Recovery, September 2014). Indeed, rising macroeconomic and
geopolitical tensions are creating both opportunities and risks
for global investors across both equities and fixed income. Our
base view is not to shun risk. Rather, we continue to suggest that
investors should embrace our key macro themes, many of which
we think can perform against a variety of economic backdrops and
capital markets environments.
First, as we discussed earlier in this paper, we believe that assets
with Yield and Growth will outperform. Strong demographic forces,
coupled with low inflation and shrinking supply, lead us to believe
that yield assets, particularly those that can compound their cash
flows, should do quite well in the environment that we envision.
Consistent with this view, we hold overweight positons across Real
Assets, including Real Estate, Real Estate Credit, and Infrastructure.
We also favor both spicy Liquid and Private Credit.
Second, we would avoid exposures linked to Chinas structural
slowing. From our vantage point, Chinas slowdown is secular,
not cyclical, and we see continued pricing pressure amidst slower
activity across not only Asia but parts of Europe and Latin America.
That said, we are increasingly of the mindset that there is the
opportunity to help Chinese companies expand abroad. Key areas of
focus include telecommunications, optical instruments, and electric
power machinery.
Third, we see the opportunity for a significant and potentially
sustained upward revaluation in the securities of large domesticallyoriented economies. Some of this has already occurred, but we think
it could go further than some in the investment community now think.
The U.S. remains our top choice, though other countries, including
India, Mexico, and Indonesia could benefit as well.

Fourth, the dismantling of the traditional financial services opportunity is both a blessing and a curse. On the opportunity side, we believe
that non-bank lending will continue to gain share, and by doing so,
provide pensions and endowments with the opportunity to earn a
yield that often exceeds their current target return rate. In our view,
this opportunity is a secular, not a cyclical one, though we do believe
that the current illiquidity premium could face some downward cyclical pressure. On the other hand, we do worry that the inability of
banks to earn their costs of capital means that their capacity to repair
their balance sheets by issuing accretive equity has vanished. This
shift in the landscape is important because it means that banks will
be forced to rely primarily on retained earnings to deal with cyclical flare-ups in credit quality not an easy task when net interest
margins are shrinking. As a result, total credit creation is likely to
remain subpar, which is not a favorable backdrop for helping global
GDP rebound towards more normalized levels.
Finally, given the bifurcation across markets, we advise folks to
consider increasing exposure to complex stories, including earnings misses, restructurings, and/or corporate repositionings. At the
moment, Japan appears to be one of the most actionable markets,
though we are also seeing some interesting opportunities in the
United States and Europe. Conversely, we think that earnings visibility and simplicity are potentially being overvalued, and as such, our
inclination is to harvest existing gains in these areas.

We believe that the market is now

potentially over-pricing assets with
steady cash flows, while underpaying for complexity.

Overall, our message is that the current environment is not likely to

change materially in the near term, and as such, pursuing idiosyncratic themes like the five mentioned above is likely to yield better performance results than increasing exposure to beta plays at this point in
the cycle. Not surprisingly, this world view leads us to overweight positions across Private Equity, Opportunistic Credit, and Private Credit.
By comparison, we fund these positions with underweight positions in
Public Equities, Government Bonds, and Growth Equities.

Important Information
The views expressed in this publication are the personal
views of Henry McVey of Kohlberg Kravis Roberts & Co.
L.P. (together with its affiliates, KKR) and do not necessarily reflect the views of KKR itself or any investment
professional at KKR. This document is not research and
should not be treated as research. This document does
not represent valuation judgments with respect to any
financial instrument, issuer, security or sector that may be
described or referenced herein and does not represent a
formal or official view of KKR. This document is not intended to, and does not, relate specifically to any investment
strategy or product that KKR offers. It is being provided
merely to provide a framework to assist in the implementation of an investors own analysis and an investors own
views on the topic discussed herein. The views expressed
reflect the current views of Mr. McVey as of the date hereof
and neither Mr. McVey nor KKR undertakes to advise you
of any changes in the views expressed herein. Opinions
or statements regarding financial market trends are based
on current market conditions and are subject to change
without notice. The views expressed herein may not be
reflected in the strategies and products that KKR offers,
including strategies and products to which Mr. McVey provides investment advice on behalf of KKR. It should not be
assumed that Mr. McVey has made or will make investment
recommendations in the future that are consistent with the
views expressed herein, or use any or all of the techniques
or methods of analysis described herein in managing client
accounts. Further, Mr. McVey may make investment recom-

mendations and KKR and its affiliates may have positions

(long or short) or engage in securities transactions that are
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for informational purposes. The information contained
herein is only as current as of the date indicated, and may
be superseded by subsequent market events or for other
reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this document has
been developed internally and/or obtained from sources
believed to be reliable; however, neither KKR nor Mr.
McVey guarantees the accuracy, adequacy or completeness
of such information. Nothing contained herein constitutes
investment, legal, tax or other advice nor is it to be relied
on in making an investment or other decision. There can
be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators
of actual future market behavior or future performance
of any particular investment which may differ materially,
and should not be relied upon as such. Target allocations
contained herein are subject to change. There is no assurance that the target allocations will be achieved, and actual
allocations may be significantly different than that shown
here. This publication should not be viewed as a current
or past recommendation or a solicitation of an offer to buy
or sell any securities or to adopt any investment strategy.
The information in this publication may contain projections or other forwardlooking statements regarding future
events, targets, forecasts or expectations regarding the
strategies described herein, and is only current as of the
date indicated. There is no assurance that such events or

targets will be achieved, and may be significantly different

from that shown here. The information in this document,
including statements concerning financial market trends,
is based on current market conditions, which will fluctuate
and may be superseded by subsequent market events or
for other reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested. The
indices do not include any expenses, fees or charges and
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The investment strategy and themes discussed herein may
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note that changes in the rate of exchange of a currency
may affect the value, price or income of an investment
adversely. Neither KKR nor Mr. McVey assumes any duty
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No representation or warranty, express or implied, is made
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INSIGHTS: GLOBAL MACRO TRENDS

19

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