5 Key Investment Themes: Finding Focus in the Volatility

September 15, 2016

Henry H. McVey

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Rising macroeconomic and geopolitical tensions are creating both opportunities and risks for global investors across global capital markets. KKR’s Global Macro and Asset Allocation team continues to emphasize five key macro themes amid the tumult, many of which we think can perform against a variety of economic backdrops. We note the following:

Interest rate outlook. We remain in the lower-for-longer camp regarding rates. Significantly, recent events across Asia and Europe — the Brexit vote in particular — only give us further confidence in our outlook. We also think that it is critical for investors to understand that the U.S. Federal Reserve may be signaling that it is now actually at an already modestly accommodative stance, with rates at record lows and the Fed’s balance sheet near a record high. If we are right, then the traditional neutral rate for the federal funds rate could be significantly lower than many economists now think. Not surprisingly, given 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 midstream assets such as pipelines and real estate credit.

Chinese GDP growth is still slowing. 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. This transition is a big deal and warrants investor attention, for both offensive and defensive reasons, in sectors such as telecommunications equipment, health care equipment, and optical equipment. Also of note, 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 fish on the bottom 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.

New outlook for certain economies. We expect an upward revaluation in countries that have large domestic-oriented consumer economies in the wake of the Brexit referendum, particularly relative to trade-oriented economies that rely more on exports to grow. The U.S. 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 of traditional financial services companies becoming more ultilitylike is ongoing, given the move toward low and negative rates by central banks, as well as the desire by governments for significantly heightened regulation. Somewhat ironically, one outcome of trends across traditional financial intermediaries is that credit creation will actually be harder to stimulate, which means that 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 nonbank 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, 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 or being cyclically out of favor. For our nickel, we think that — with some value-added restructuring, repositioning and maybe 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. In contrast, it also feels to us that investors are now willing to potentially overpay for earnings visibility and yield. Indeed, with simplicity being such a hot topic, 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.

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