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Outlook for 2016: Adult Swim Only Outlook for 2016: Adult Swim Only We Approach Early 2016 with Caution INSIGHTS GLOBAL MACRO TRENDS VOLUME 6.1 • JANUARY 2016 Outlook for 2016: Adult Swim Only Outlook for 2016: Adult Swim Only We approach early 2016 with caution. In our view, 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. Also, ongoing Chinese yuan depreciation is significant; it literally means that every other country now must think through whether it needs to further devalue to remain competitive. Not KKR GLOBAL MACRO & ASSET surprisingly, we are below consensus in terms of both GDP ALLOCATION TEAM growth and inflation forecasts for most regions. With these HENRY H. MCVEY Head of Global Macro & Asset Allocation thoughts in mind, we are electing to tilt our portfolio defensively and CIO of KKR’s Balance Sheet in 2016. See below for details, but we are raising substantial Cash, +1 (212) 519.1628 initiating our first underweight position in Public Equities of this [email protected] cycle, and seeking out more idiosyncratic opportunities across DAVID R. MCNELLIS +1 (212) 519.1629 Fixed Income and Alternatives. In terms of key macro themes [email protected] to invest behind in 2016, we believe that recent gyrations in the FRANCES B. LIM financing markets are providing non-bank lenders a significant +61 (2) 8298.5553 opportunity to leverage the market’s illiquidity premium to [email protected] earn compelling risk-adjusted returns. In our humble opinion, REBECCA J. RAMSEY private financing opportunities across real estate, infrastructure, +1 (212) 519.1631 [email protected] corporate take-overs, and equipment currently appear to be the most attractive risk-adjusted opportunity in the market today. We JAIME VILLA +1 (212) 401.0379 are also increasingly confident in the outlook for certain segments [email protected] of the global consumer industry, and as such, we want to focus AIDAN T. CORCORAN on key trends like improving household formation, increased + (353) 151.1045.1 Internet penetration, and an intensifying focus on healthcare/ [email protected] beauty/wellness. Third, we think that China’s ongoing slowdown in fixed investment could lead to new and exciting opportunities for Distressed/ Special Situations investors. Finally, within Real Assets we continue to focus on investments that can provide yield and growth versus owning outright commodity positions. MAIN OFFICE Kohlberg Kravis Roberts & Co. L.P. “ 9 West 57th Street Suite 4200 Nothing gives one person so much New York, New York 10019 advantage over another as to remain + 1 (212) 750.8300 COMPANY LOCATIONS always cool and unruffled under all AMERICAS New York, San Francisco, circumstances. Washington, D.C., Menlo Park, Houston, Louisville, São Paulo, Calgary EUROPE ” London, Paris, Dublin, Madrid ASIA Hong THOMAS JEFFERSON Kong, Beijing, Singapore, Dubai, Riyadh, Tokyo, AMERICAN FOUNDING FATHER, PRINCIPAL AUTHOR OF THE DECLARATION OF Mumbai, Seoul AUSTRALIA Sydney INDEPENDENCE, SECOND VICE PRESIDENT, THIRD PRESIDENT OF THE UNITED © 2016 Kohlberg Kravis Roberts & Co. L.P. All STATES AND FOUNDER OF THE UNIVERSITY OF VIRGINIA Rights2 Reserved.KKR INSIGHTS: GLOBAL MACRO TRENDS Without question, recent gyrations across the global capital markets EXHIBIT 1 have been unsettling, reflecting growing concerns about the uneven, With Volatility Increasing and Returns Falling, We Are No asynchronous recovery that has unfolded. In 2015 alone, the fallout Longer Getting Paid to Move Out the Risk Curve from a Chinese devaluation, Swiss National Bank unpegging of the Swiss franc to the euro, precipitous fall in commodity prices, and a Efficient Frontier of Last Two Years vs. 2010-2013 third Greece bailout – just to name a few – are all important ex- 20 amples of market-moving, macro events that investors had to weave 18 into their portfolio construction processes during the year. 2010-2013 16 ) % 2014-2015 ( Unfortunately, as we look ahead, we do not see 2016 as a less 14 s n chaotic year. In fact, we expect global GDP to likely come in well r u t 12 below consensus in 2016, believe that global inflation forecasts are Re l 10 a generally too high, and envisage that operating margins have essen- c i r o tially peaked in the U.S. We also think that uncertainty surrounding t 8 s i The efficient frontier has flattened China’s currency devaluation is not a one-off event. Consistent with H 6 out; there is now less return per this view, we have lowered our target multiple on equities to reflect 4 incremental unit of risk taken heightened macroeconomic and geopolitical risks in 2016. 2 We also forecast that overall corporate credit conditions will not 0 improve in 2016. Key to our thinking is that intensifying competition 0 2 4 6 8 10 12 14 from China within the high-end export market, slowing global trade, Historical Volatility (%) and surging Internet activity could collectively cast a further pall over Based on liquid market asset class indices as available on Bloomberg. many areas of traditional corporate credit. We also see traditional Data as at December 31, 2015. Source: Bloomberg, KKR Global Macro & fixed income franchises on Wall Street under siege. If we are right, Asset Allocation analysis. then the near historic wide spread between BB-rated and CCC-rated high yield bonds likely gets resolved by higher quality bonds trading down, not lower quality bonds trading up. Importantly, our viewpoint EXHIBIT 2 also means that equities as an asset class generally look rich relative We Expect Volatility to Head Higher Amidst a Period of to credit. Low Absolute Returns Across Many Asset Classes For macro and asset allocation wonks like us, we view the current Annualized Volatility of Key U.S. Asset Classes environment as one where the efficient frontier curve has now flattened LTM Ending June 2014 LTM Ending December 2015 relative to earlier in this cycle because volatility has increased in recent months, but thse potential return profile for many asset classes has not Memo: Trailing 10 Year Avg. increased commensurately (Exhibit 1). Hence, investors are not getting 16% 14.5 13.7 paid to extend their portfolios further out along the risk curve. 14% 12% In laymen’s terms, today’s market conditions are somewhat akin to 10.2 9.5 swimming at the beach when there is a strong undertow that could 10% pull a less experienced athlete out to sea. It might not happen, but 8% 6.3 6.4 the probability is certainly higher than under normal circumstanc- 5.8 5.7 6% es. As such, we think that the mantra “Adult Swim Only” seems 4.3 4.7 to be a prescient catch phrase for the current macro investing 4% 2.7 2.9 environment. 2% 0% U.S. Investment 10 Year U.S. U.S. High Yield S&P 500 Grade Treasuries Data as at December 31, 2015. Source: Barclays, Haver Analytics, Bloomberg, KKR Global Macro & Asset Allocation analysis. KKR INSIGHTS: GLOBAL MACRO TRENDS 3 Consistent with this view, we are starting the year with a more 4. Main Street begins to finally outperform Wall Street. Since the defensive asset allocation, including a notable overweight to Cash Global Financial Crisis, loose monetary policy — among other (seven percent versus one percent in September). For the first time things — has led to a significant improvement in the prices of in years, cash could offer a competitive return relative to other asset most risk assets that institutions and wealthy individuals own. classes if the Fed hikes three times as we currently expect. Corporations have exacerbated the upward move in equities in many instances by often deploying more than 100% of their However, please do not mistake our message: The current macro free cash flow towards buybacks. Today, however, with margins backdrop does not mean that there are no good investment opportu- peaking, an unsettled currency market, intensifying geopolitical nities. Rather, one just needs to – as Thomas Jefferson said – “re- headwinds, and rising corporate defaults, we see a more lacklus- main cool and unruffled under all circumstances” to take advantage ter environment for Wall Street. By comparison, global consum- of them. To this end, we think that it may make sense for us to out- ers, particularly in the U.S., are now enjoying lower fuel prices, line what we believe will be key important macro influences in 2016. improving wages, and continued home price appreciation. Hence, They are as follows: there is the potential in 2016 that life actually feels better on Main Street than it does on Wall Street, which would represent a signif- 1. Global trade has stalled; focus on domestic stories with pricing icant shift in the investment landscape versus the prior six years power. In the past we have consistently argued that China’s slow- of central-bank driven liquidity nirvana for portfolio managers. down in fixed investment was the most important macro trend on which to focus. Today we are less certain, as the recent downturn If we are right about the macro backdrop, then an investor may need in global trade may be even more noteworthy – and potentially un- to consider revamping his or her portfolio allocations. To this end, we der appreciated by the investment community. An important part of provide a framework for thinking through what global asset allocation this story centers on the fact that many countries have devalued is best aligned with our key themes for 2016. Our thoughts are as their currencies in recent years to improve exports; unfortunately, follows: though, this strategy has not worked. In fact, it has only raised the cost of imports, particularly in many emerging market countries. 1. After tactically upgrading global Equities to overweight amidst the If there is good news in terms of global growth trends, we think it China-driven dislocation in September 2015 (see U.S.
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