The Role of Private Equity in a Volatile World

We live in a world of increasing complexity—one in which technological revolutions are unmaking and remaking every industry. The private equity model offers a way to adapt to, and potentially benefit from, these profound changes.

Private equity can also continue to help investors advance toward their financial goals despite a challenging climate. Since the 2009 market bottom, global public equity markets have seen tremendous appreciation driven primarily by quantitative easing and much lower interest rates around the world. With interest rates currently near all-time lows and equity market valuations at historically high levels, we believe financial market returns are unlikely to repeat the past eight years’ performance over the next eight years. In our view, this suggests that investment strategies with return-enhancing capabilities could play an increasingly important role in investors’ portfolios.

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Our Global Trend Watchlist for Private Equity

In today’s global landscape we see trends that hold a variety of unfolding opportunities and risks—and often they are the converse of each other. At Kohlberg Kravis Roberts & Co. L.P. (together with its affiliates, “KKR”), close attention is paid to these big-picture trends as we work to source investments and systematically de-risk our portfolio companies.

A Reduction In Global Trade

Even before the last US presidential election, we were seeing a clear decline in global trade over the past several years. This trend clearly benefits companies with ample domestic markets and more reliance on local supply chains. That profile fits many firms in the US, the world’s biggest market, and others in Indonesia and India. What we might call “deglobalization” could also lead some companies, especially those with strong pricing power, to spin off some of their units, creating separate entities that could present new investment opportunities.

Increased Global Defense Spending

KKR is looking closely at this area today, especially in Europe and the US, with a particular focus on cybersecurity.

The Rise of The United States of Asia

We’re seeing a big uptick in inter-Asia exports based on trade deals and proximity. Infrastructure is a particularly interesting facet of that trade, and one where we see strong growth potential.

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My Investment Strategy: Find Tenants Who Stay Put

After a career of nearly three decades investing in commercial real estate, it is my opinion that the sector performs best when these conditions exist: tenants are reluctant to leave because they have few options; developers have limited options to add new supply; and tenants’ demand for space is growing, requiring more real estate. Who are my dream tenants?

Before I identify them, let me back up. I invest in commercial real estate via real estate securities, which includes Real Estate Investment Trusts (REITs)1 and C-Corporations2.  Most of these companies typically specialize in one property type, giving investors the chance to invest in “pure plays” of property types they otherwise may not have investment access to, such as shopping malls, cell-tower networks, data centers, casinos or ski areas. Specialization requires that the people who put these securities together become experts in the underlying properties.

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1) A REIT (real estate investment trust) is a type of real estate company that mainly owns and operates income-producing real estate; some engage in financing real estate. Most REITs trade on major exchanges.

2) A C-Corporation generally refers to any corporation that is public and for-profit, unless the corporation elects the option to treat the corporation as a flow-through entity.

How to Potentially Enhance Equity Performance in a Climate of Uncertainty

As challenging as the investment landscape has been, we expect it to be even more so going forward. Global growth is slow, and the returns we have seen in recent years have been pulled forward by quantitative easing and the low interest-rate environment. Over the next ten years, returns are likely to be lower across all asset classes than they were during the past ten years.

In that context, we offer three themes investors can potentially utilize to enhance the returns of their equity portfolios. These themes underscore the reasons we believe private equity can be a useful component of investor portfolios in this kind of climate.

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2017: A Challenging Year Ahead for Portfolio Allocation Decisions

Surprising many investors and pundits alike, the S&P 500 posted a solid return for 2016, finishing the year up close to 10%. If investors never looked at their statements, one might be naïve to how much markets zigged and zagged throughout the year.

Can we expect more of the same in 2017?

 

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The Political Bull Market and Your Portfolio

In the eight years since the financial crisis, we have been in what I call a political bull market—a time when the thinking, decisions, and activities of political actors have had a disproportionate impact on the performance of companies around the globe. By “political actors,” I mean elected officials, other policy makers and NGOs as well as critics of business and the increasingly restive populations we see in various parts of the world.

As far as the coming election is concerned, we see some areas of business where the impacts could be quite different depending on outcome of the vote (see page 2). But the bigger issue—the politicization of business—isn’t going to diminish, no matter whether the next president is Donald Trump or Hillary Clinton. In fact, all indications are that it will not only continue, but accelerate. Grasping this is especially important for investors in private equity, real estate, and any other asset class involving long-term commitments.

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Q3 2016 Market Update and Outlook: A Golden Summer

At the end of Q2 2016, uncertainty was on the rise, the geopolitical environment was fragile and financial markets appeared highly susceptible to exogenous shocks. Global stock indices wobbled, safe haven trades such as long Japanese yen and long US treasuries gained steam, all while gold rallied in tandem with investor uncertainty. We expected much of the same for the summer months of Q3 2016 as the US election cycle unfolded. Yet, the resilience of financial markets has truly been phenomenal. The US stock market, as represented by the S&P 500 TR index is up over 8% for the year. The NASDAQ composite hit another all-time high in September. Truly, this resilience may not be an anomaly after all. Excluding 2008, the US stock market has been up every year since 2003, many of these years it’s been up double digits, though past performance is no guarantee of future results. For those of us who value fundamentals and see the current economic landscape as a highly intricate house of cards, the continued rally, and subsequent drop in equity market volatility, is perplexing. Chairwoman Janet Yellen punted on increasing interest rates this quarter. Although the yield on the 10-year treasury was ultimately up in the third quarter, it also hit an all-time low in July of 1.36% in the post Brexit flight to quality. Ongoing massive global central bank stimulus (bond buying) led to an even larger supply of negative yielding bonds globally, making our US 10-year treasury look like a high yielding security relative to our foreign brethren. Can this continue forever? Surely, at some point in the not too distant future, negative interest rates will be viewed as some kind of insane experiment where we all should have known better. Yet, we feel that the financial markets seem as complacent as ever, comfortable and warm in a central bank security blanket.

We firmly believe the Fed should raise interest rates this year; yet, this assertion is materially dependent on the strength of economic data as we move into Q4. At the same time, the US is not an economic island. We could see economic data continue to improve; but if Europe continues to struggle, growth in China slows further, or other global forces take hold, the potential for a Fed rate hike could disappear. As we sit here today, the yield curve continues to flatten; which has been an economic harbinger. What’s nearly for certain in our minds is that global central banks will intervene with appropriate liquidity to prevent any political crisis from turning into a financial crisis. But, with zero to negative interest rates globally, central banks are already constrained and have limited tools to stabilize markets.

Accordingly, we believe investors should look to diversify portfolio risks away from long-only holdings in stocks and fixed income, dependent of course, on the individual’s goals and risk tolerances, among other factors. The traditional 60/40 portfolio has been a winning asset allocation since the depths of the financial crisis but in our opinion has overstayed its welcome. We are in no way predicting a crisis; rather, we view this as a market in which preemptive thinking is paramount.

The Times They Are A-Changin’

As we approach the end of summer, here’s my perspective on economic issues worth watching.

Employment
The big new noise is the July employment report. Job growth surged, according to the Department of Labor. The US economy added 255,000 positions, according to the Department of Labor, far more than the 180,000 increase that economists had been predicting. Average hourly wages rose 0.3 percent, also higher than expected. The unemployment rate remained unchanged at 4.9 percent.

I am going a bit out on a limb here, but I go back to what appears to be some changes in the pattern of hiring and layoffs as the US has shifted from an industrial to a service economy. Ordinarily July is a big layoff month as factories historically shut down for a good part of that month to install new, more productive equipment. In addition, some service entities, including educational facilities, also have reductions in force around that time. But the times they are a-changin’. School facilities are altering their schedules, and factories don’t necessarily have to close for upgrading. Typically, close to one million people leave the work force in July. That gets seasonally-adjusted to a positive number about which we all talk. As I have said, I have never met a seasonally-adjusted person. It will be interesting to see what happens this year with the labor market relatively tight and the patterns changing. This affected the numbers in May and June with May being understated while June more than made up for that understatement. The pattern YTD is about 100,000 short between the seasonally-adjusted numbers and the unadjusted numbers. Let’s see how the job numbers play out in coming months—revised numbers will be released in September. Meanwhile, I think we should pay more attention to the wage numbers, which are rising. Over the year, average hourly earnings have risen by 2.6 percent. Higher wages are a big component of the Fed’s inflation gauge. Both the July employment numbers and higher wages could affect the Fed’s thinking in September.

Brexit
In the meantime Brexit continues to be newsworthy. Bank of England Governor Mark Carney has taken precautions to ease the potential downside for Britain. In response, instead of punishing the UK, the EU has an opportunity to move toward a more United Europe. It has to take a harder look at what has to be done throughout Europe on the fiscal side and with regard to the debt and negative rates. The question is, will it? I think it has to. Raw democracy may get in the way.

What else?
As I have previously observed, I think the emerging markets with some volatility are where the growth is. India has to fall in that camp. The reform steps are a start. One has to remember that India is the world’s largest democracy. Whether Indian Prime Minister Narendra Modi can navigate his way through this is another question. I think he can, but it will be a volatile road.

As I have said before I find the Americas the most interesting set of markets. They have had quite a run in anticipation of change from Cape Columbia to Tierra del Fuego. Just think if our focus was to make America great in the broadest sense of the definition. We still have long-term issues of growth globally. It will be a slower pace overall, but the opportunities may prove to be broader. Maybe a measure of stability in real assets and some understanding of the value of illiquidity premiums become a focus. So, pay attention to the Americas, all of them.

Macro, Markets, and Malarkey

Stocks and Bonds
It feels like forever ago, but back in February, the S&P 500 hit its lowest level since 2014 as global growth fears spooked investors, leading to liquidations and deleveraging—most notably for sovereign wealth funds.

Fast forward to now…as of the end of July 2016, the S&P 500 closed at 2,173.60—up 7.5% from the beginning of the year. And, 10-year treasury yields started the year at 2.24%; as of the end of July 2016, rates were at 1.46%—a 35% decline in yield from the beginning of the year. These are big movements in both domestic stock and bond markets which investors shouldn’t take lightly.

Fig1_S&P+10yrTreasury

Also, more than $11 trillion in negative yielding bonds are outstanding, largely in Europe and Japan. The Financial Times wrote a great piece recently highlighting the post-Brexit surge in investor bond purchases.[1]

Fig2_GlobalNegYieldSovDebt

This means that if an investor holds one of these bonds until maturity, they actually lose money. They are also paying the issuer for the right to own these bonds, versus receiving some sort of payment in return—as Finance 101 teaches us should be the case. Governments with massive stimulus policies (ECB, Bank of Japan, and now the Bank of England) are buying up bonds, bidding up the price of these bonds and thus sending yields negative. Accelerating the decline in yields is the fact that the supply of such bonds is not ample enough to meet this demand. Negative yields are supposed to entice investors to invest in other assets, since they clearly lose money by investing in such bonds. This hasn’t happened. And yes, this is completely backwards and deflationary.

Currencies and Commodities
Currency markets have not been immune to this storyline; as Europe and Japan use monetary policy to help grow their economies, foreign investments flow to the US for its higher yields. Since May, foreign buying coupled with more hawkish Fed speak has strengthened the US dollar versus other currencies.

Fig3_USDollarIndex

If the US dollar continues to strengthen or simply stays strong on a relative basis, this has the potential effect of placing a lid on US inflation. The stronger the US economy gets versus its global counterparts, the stronger the dollar looks versus other currencies.

A strong dollar is usually a negative for commodities. And in fact, the strong dollar has kept commodity markets mostly in check since early May, as we wrote about in Commodities at a Crossroads. Of note, crude oil fell to under $30 a barrel earlier this year, sliding alongside the S&P 500, touching its lowest levels since May of 2002. It then spiked to above $50, and now hovers just north of $40 due to dollar related price pressure—nearly 20% below its peak in June of $50.11.

The US Economy and Election
That’s not all. We’ve barely discussed the domestic economy. Here at home, despite anemic GDP growth of 1.2% for Q2, economic growth is indeed expanding as evidenced by the latest payroll and hiring figures. Non-farm payrolls increased by 255,000 in July on a seasonally-adjusted basis, with the unemployment rate at a very healthy 4.9%. Wage growth and labor market improvements here in the US makes a strong case for the Fed to raise rates. Our view is they should raise rates in September, ahead of the election. Whether they will or not remains another question.

Lastly, and as an homage to Vice President Biden’s favorite saying, “malarkey,” rhetoric around the US election has truly captured the American public, including ourselves. We are seeing raw democracy at work here and elsewhere. People are voting against the establishment; it’s a small segment of the human race, but it affects us all. In the meantime, it may become clearer that at extremes, when enough of the populace is truly feeling disadvantaged, capitalism has to make some changes. Otherwise capitalism and democracy are not going to work when the rule of law favors a few as opposed to the many. While this line of thinking may be too philosophical for a financial markets blog, it merits consideration because it does affect one’s view on investing.

Thus far financial markets have not reacted to the election news melee, but investors should pay attention. Should the Republicans lose their majority in the House and Senate, and Hillary Clinton is elected, this could have a dramatic impact on GDP as government spending will very likely increase…then again, it will also increase if Trump builds his wall.

What Should Investors Do?
Stocks can be at record highs throughout the year. The reality is that it doesn’t take much of a move to set a new record high when you have just made one. Odds are we will see low growth for the rest of the year, maybe the rest of the decade. One should expect dispersion by country and company with thoughtful, well analyzed decisions to make on what to own. This is going to take real professionals who are either doing real fundamental analysis or machine learning or can take advantage of the volatility and the anomalies. It’s going to be a different market. We all know that global and country growth comes from demographics and technology (of which productivity is a subset if you can measure it). But, there is a payback when the easy money goes away, causing slower growth than the demographics and technology would suggest.

In light of this, our view is that investors should have two areas of their portfolio well covered. First, there are downside risks to the market right now. Ignoring this fact would potentially leave one’s portfolio without a buffer, and we believe every portfolio needs uncorrelated assets. While it is self-serving to advocate for managed futures, Altegris has a focus on managed futures because time and time again they have performed during some of the worst periods for traditional equity markets.
Fig4_PR_ManagedFuturesPerfDuringEquityMarketStress_1288-NLD-882016

Equity markets could continue to push for new highs, but we believe they are also susceptible to periods of steep losses. Managed futures performance has historically been uncorrelated to the performance of the broad stock market, and we strongly believe all investors with risk capital should consider this diversifying return stream, given the current macro picture.

The second bookend to investors’ portfolios, given the market environment, is private equity. Private equity was one of the few areas that didn’t sell off when investors panicked earlier this year, and whose returns can be orthogonal to the returns of traditional markets. Now, private equity is not a liquid investment option, so investors must be thoughtful in terms of just how much they allocate. But it is the forgoing of frequent liquidity that makes private equity attractive in our opinion. This is what is commonly referred to as the illiquidity premium, which is essentially the potential reward of enhanced returns—over time. This potential for enhanced returns may be particularly attractive for investors given the uncertainty in traditional equities at present.

The bottom line is that investors should aim to diversify portfolios. Look for ways to grow and preserve capital in your portfolio and seek returns in areas where investment managers have a real edge and understanding of the underlying investments. Pay attention, and invest for the future of your portfolios.

 

Data sourced from Bloomberg unless otherwise specified.

[1] Financial Times, June 29, 2016: http://www.ft.com/fastft/2016/06/29/negative-yielding-sovereign-debt-rises-to-11-7tn-globally/