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.

To view the article in its entirety, click here.

Commodities at a Crossroads

Our CEO, Jack Rivkin, recently revisited his thus far prescient view of economic issues facing “The Rest of the Americas.” There are several key drivers one should pay attention to when evaluating the Americas, most of which ultimately lead to the commodity markets.

From the Fed’s decision on interest rates (which is highly data dependent), currencies, the dependence of Chinese demand for commodity exports out of Canada and Latin American countries, and nearly ubiquitous political disharmony, commodities are at an inflection point. Here is why:

 

US Economic Data and the Fed
April retail sales were up 1.3%. Job creation is improving and wages are starting to improve as well. Economic data is getting better, but it’s not necessarily good enough for the Fed to take action. What are the possible scenarios and impacts on commodities?

  • Good Data: If we continue to see decent economic data, it could spur the Fed to raise interest rates at the upcoming meeting in June. An increase in the Fed Funds rate generally leads to strength in the US dollar (USD) relative to other currencies. Conventional wisdom stipulates that a strong USD is typically a negative for commodity markets; the two are negatively correlated since commodities are priced in USD. If the USD strengthens, commodities tend to suffer because it will take more dollars to buy the commodities. While that’s been true the majority of the time, it’s not always the case as one can see below:

Fig1of3_Charts_USD+CommoditiesCorrelation_051916

  • Great Data: That said, if the data out of the US is very positive—one could view this as a growth theme. In this case, the Fed will almost definitely raise rates in June; the USD will rise; but if the US is consuming more, spending more, and on an improved economic growth trajectory, that could spur increased demand, which could actually push commodity prices higher.
  • Bad Data: The last scenario is if the US data gets worse. We don’t think this is all that likely, but low inflation could make the Fed blink. Where we may see bad data is globally. With global markets more intertwined than ever, it would be bold for the Fed to ignore any further and significant global weakness. Moreover, the big Brexit vote shortly after the June Fed meeting could give Yellen pause, ultimately postponing a hike until July.

 

China
According to both the World Economic Forum and the Wall Street Journal (WSJ), in 2015, China consumed “roughly an eighth of the world’s oil, a quarter of its gold, almost a third of its cotton and up to a half of all the major base metals.” In addition, as Jack pointed out in his Perspectives piece, China also produces about half the major base metals. One cannot discuss commodities without discussing China.

Fig2of3_WorldEconForumGraphic_low-res

All eyes are on Chinese growth to continue fueling this impressive demand. Chinese growth is less than it was in prior years but their growth target remains between 6.5%-7.5%. While momentum has slowed, 6.5%-7.5% is not insignificant. To give some obvious context, the U.S. economy grew 0.5% on an annualized basis for the first quarter of 2016.

As Chinese demand for and production of commodities vacillates and its growth moderates, we could see more idiosyncratic Chinese market movements. For example, during September of 2015, China’s National Administration provided new standards for the use of aluminum cables. Aluminum is significantly cheaper than copper and China is rich in aluminum resources—substituting aluminum for copper allows for lower costs and less importing. Prior to September of last year, copper and aluminum prices moved fairly closely together. Since this time, however, we’ve seen more dispersion, periods in which aluminum rallied and copper declined. Thus demand may be increasing right now for base metals, but one may continue to see more substitution versus base metals moving in concert.

The remainder of 2016 should be interesting. If China backs off stimulus or increases local production, it could spell trouble for commodities given their significant share of commodity consumption. We tend to agree with the team from Gavekal Research, who recently stated the following:

 

 

“Since GDP growth in 1Q16 remained above the 6.5% target, it seems likely
that policymakers will now focus more on averting a major bubble and
dialing back leverage, than adding fresh stimulus. This is not to say that
the central bank will cause another interbank liquidity crunch, but it will instead
focus on keeping rates low and stable. Hence, do not expect more easing
policies in the next 3-6 months; after accelerating for the last year credit growth
is likely to stabilize at the current level.”

Gavekal Research, Chen Long, The Daily—“No More Easing Likely,” May 15, 2016;
http://research.gavekal.com/author/chen-long

 

If this is true, we may not see more stimulus from the Chinese central bank. Yet, a complete economic slowdown followed by stunted commodity demand seems unlikely.

Political Unrest
With the exception of Trudeau’s white knight status in Canada, much of the rest of the Americas’ leadership remains on shaky ground. Democracy in its raw form is coming to the USA, Rouseff is on her way out of Brazil, while Mauricio Macri is still sorting out the pieces in Argentina—and he’ll be doing that for a long time. Any perceived weakness in leadership could be viewed by investors as a sign of a weak economy. This too matters because as faith in these governments declines, so may their currency as we witnessed several times last year. For example, one of Brazil’s largest exports is coffee. A weak Brazilian real led to lower coffee prices. In fleeting moments of real strength, coffee rallied alongside.

Fig3of3_Charts_Brazil Real+CoffeePrices_051916

For countries that rely heavily on commodities for exports, a weak currency is not necessarily a positive. Therefore the impact of political unrest on commodities could make for a bumpy ride, at least in the short-term.

Commodities Now?

One may ask, is this a good time to get into commodities? The reality is, it depends on what sector, what commodity, and when. The question also assumes that investors only have the option to go long commodities. Imagine if you could have been short crude oil over the last two years? Our preference is to invest in strategies that can go long and short, such as trend following managed futures strategies. These strategies are systematic in nature with the goal of following price trends. If gold continues to rally, trend following systems will likely add more and more long gold exposure. In fact, most managers we follow are positioned long after gold’s rally this year. If the trend abates, these systems will typically reduce exposure and if the trend reverses strongly, these systems will follow the price trend in the other direction. Investing in systematic trend following strategies allows for long and short investing while taking out the discretionary judgement of trying to time these often volatile markets.

Commodities are indeed at a crossroads with some dispersion likely. Much of what can move individual commodity markets for the remainder of 2016 remains to be seen, as various other cross currents make it difficult to predict. In other words, even if we get Fed clarity, China and other variables could remain uncertain. Investors may want to look for trend following managed futures strategies that have the ability to follow commodity markets directionally once the fog clears.

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?