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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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/

Not Quite Impotent, but a World Away from Omnipotent

In this blog, Bob says let’s not blame all today’s problems on the US Fed (although some find that tempting). We are in a complex, idiosyncratic, interlinked world. This supports Bob’s view that we have to look at the pieces. Of course, China is a big one.—Jack Rivkin

 

Not Quite Impotent, but a World Away from Omnipotent by Bob Barbera

Suppose the world’s economic policy makers ceded authority to a central entity, in recognition of the fact that national economic prospects, increasingly, are largely influenced by global developments. What would a Keynesian benevolent despot do, if she had control of all nations’ economic policy levers?

She would embrace the notion that the world suffered from an insufficiency of demand. She would acknowledge that three striking imbalances are in place, one international, one financial and one within most nations. She would impose policy changes meant to resuscitate global demand and unwind global imbalances.

She would acknowledge the obvious and point out that in the aftermath of the Great Recession, global recovery has been strikingly sluggish. Only China and the United States registered meaningful recoveries. China embarked upon a state government financed real estate boom, which temporarily lifted its economy and other emerging economies. When this stimulus ended, so did recovery for China and the rest of the developing world. The USA embraced fiscal stimulus, early on, but reversed course soon. Aggressive monetary policy stimulus, did deliver modest expansion through 2015. Europe has failed to deliver any meaningful recovery.

Equally obvious, she would note, China and Germany run large and destabilizing trade surpluses. The USA and Europe are saddled with large and still deteriorating trade deficits. So, too, is it obvious that monetary policy, alone has limited ability to right the global ship, in a world where the most common short term interest rate is ZERO. Financial system excesses are a genuine risk, when central banks are forced to deliver ever more liquidity into asset markets, in their attempts to lift real economic activity.

Finally, she would lament the violent shift toward income inequality, noting that the super-wealthy spend very little of their income, worsening demand deficiency, even if one ignores any notion of equitable outcomes.

She would declare, therefore, that policies would need to do the following:

  1. Jump start global demand.
  2. Reduce global trade imbalances.
  3. Relieve pressures on central banks.
  4. Reverse income inequality pressures.

She would declare China and Germany as the new places to look for demand stimulus. Major tax cuts would be enacted in both nations. Tax cuts would be super progressive.

Large tax adjustments would be made globally, so as to shift after tax incomes toward low and middle income earners. She would slowly remove developed world monetary policy stimulus. This would occur, however, only after clear evidence of strong global growth and a return to inflation rates above 2% in developed world economies.

Alas, our savior is a fiction. Nations have no intention of ceding control of their policy levers. Any one nation, therefore, pursues a policy that is focused solely on its nation, while accounting for global influences on its nation, arriving in part a consequence of policy moves taken by other nations.

Worse still, policy makers in many nations are likely operating with many self-imposed constraints. Fiscal stimulus? Tax changes to modify income inequality? In most nations the only game in town is monetary policy. That is, of course, excluding European nations. European nations don’t even have an empowered central bank that they can alone control.

It is in this spirit that one has to feel genuine empathy for Janet Yellen. Monetary policy in the USA has delivered modest recovery. And after over seven years of zero interest rates, USA central bankers, recalling the financial bubbles that precipitated the last several recessions, decided they might try to slowly wean markets away from full throttle liquidity provision. But increasingly it appears that China’s efforts to create a new growth engine have failed and the rest of the developing world is contracting as a consequence. In Europe, Germany steadfastly refuses to pursue any sort of pro-growth policies. As a consequence, the U.S. dollar has resumed its ascent. Thus the USA faces both faltering rest-of-world demand and rising dollar rising [sic]. As a consequence the mismatch between USA spending gains and output gains is destined to worsen. Likewise, despite low U.S. unemployment, inflation looks set to fall in the quarters ahead, not rise.

Should Yellen reverse course, end the plans to tighten and hint at a potential reversal for short rates? That may be in cards. But is it the issue of the hour? More to the point, did a 25 basis point move up for short rates in the USA doom China’s economy? Did a promise of perhaps four tightening moves in the USA over the next year shut down European growth? In sum, is the Fed the precipitator of emerging evidence of a global reversal of fortunes? If Chair Yellen were our global Keynesian benevolent despot, and global barometers were heading south, we could confidently say yes. Given her complete inability to adjust the many policy levers around the globe that are wrongly positioned, how can you lay today’s madness at her feet?

Argentine Elections, Other Elections and the Markets

Por fin, un elección importante y idiosincrásico rompe una cadena

Mauricio Macri, the conservative mayor of Buenos Aires, defeated Daniel Scioli, the ruling party’s candidate, in the runoff election in Argentina held on Sunday.  So, given everything else that is going on in the world, why does an election in a country that represents less than 1% of global GDP deserve any space? At least, wouldn’t it make more sense to write about the gubernatorial election in Louisiana which represents 1 ½% of the US GDP?

Actually, both elections represent significant changes. Louisiana hasn’t elected a Democrat in any statewide election since 2008, and certainly not a centrist candidate. Argentina has been in the hands of a Kirchner since 2003 during which time there has been a steady deterioration in the economy, understated high inflation, a currency collapse and, ultimately, an inability to access the global debt markets. In the end, populist policies did not overcome the finally recognized impact of corrupt and incompetent governance of a beautiful country with abundant resources and a reasonably well-educated population.

Argentina takes on some level of importance as a possible indicator of a broader shift of governance in the rest of South America. In addition, the country has resources to exploit under a more normal relationship between the producers and the government. This would include shale gas reserves that may represent the second largest known fields on the planet. A portion of these reserves lies in the same region as earlier conventional gas where gathering systems and other infrastructure still exist. Under a different and friendlier government, the technology that would be necessary to access the fields may be more readily available to YPF or in other business combinations. Finally, we will likely see some settlement of the remaining debt that is preventing Argentina from accessing the global credit markets.

None of these elements will occur overnight, but the markets will likely reflect positively the possibility of the ultimate outcomes as suggested above. Macri will have his work cut out for him to reverse the path that Argentina has been on for some time. While he won the election, almost 47% of the voters did support Scioli. Macri will have to take some hard steps in a problematic economy, similar to what Carlos Menem had to do some 26 years ago. There will likely be some ups and downs domestically, including some steps that would appear to be more like the populist actions of the Kirchner administrations. But, the chain of bad governance would appear to be broken.

What may happen more quickly is resolution of the debt situation in order to get access to the global markets, and have funding for whatever actions Macri may need to take to turn the economic situation around. That means that the holdouts from the earlier settlements will see some kind of positive conclusion to their battles. There is the possibility that the settlements will be accompanied by some changes in the covenant structure of sovereign debt in order to avoid a future situation where a small number of holdouts can prevent full closure and access to the capital markets. This will likely raise the cost of debt for other global issuers. This is a speculative observation, but it is hard to imagine a country willingly putting itself in the position of denied access to the capital markets caused by a minority subset of its original creditors, much less the purchasers of the debt on the open markets.

There are many other variables in motion in the markets these days. It remains to be seen if increased QE in Europe will have the same positive effect on the capital markets as it has been having previously. The geopolitical issues and the impact of the terrorist actions on local growth may not be passing events as most such actions have been subsequent to 9/11.  There are questions about growth in the US. The employment reports in early December may provide some answers and determine whether the Fed proceeds with raising the Funds rate.  We expect that the numbers will be supportive of a Fed move.  In general, though, with some exceptions, one could make the case that active management confined to the Americas, North and South, could produce as good a set of returns in 2016 as a more diversified portfolio. We are seeing dispersion among US stocks. The same may apply to Canada as it most likely experiences continuing problems in the energy sector and spreading in the housing and banking sector. With the Argentine election as a backdrop, we may see some interesting but dispersed opportunities developing elsewhere south of the United States. More to come.