KKR’s Outlook For 2016: U.S. Equity Market – Adult Swim Only

Outlook For 2016: U.S. Equity Market – Adult Swim Only by KKR

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 surprisingly, we are below consensus in terms of both GDP growth and inflation forecasts for most regions. With these thoughts in mind, we are electing to tilt our portfolio defensively in 2016. See below for details, but we are raising substantial Cash, initiating our first underweight position in Public Equities of this cycle, and seeking out more idiosyncratic opportunities across Fixed Income and Alternatives. In terms of key macro themes to invest behind in 2016, we believe that recent gyrations in the financing markets are providing non-bank lenders a significant opportunity to leverage the market’s illiquidity premium to earn compelling risk-adjusted returns. In our humble opinion, private financing opportunities across real estate, infrastructure, corporate take-overs, and equipment currently appear to be the most attractive risk-adjusted opportunity in the market today. We are also increasingly confident in the outlook for certain segments of the global consumer industry, and as such, we want to focus on key trends like improving household formation, increased Internet penetration, and an intensifying focus on healthcare/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.

Without question, recent gyrations across the global capital markets have been unsettling, reflecting growing concerns about the uneven, asynchronous recovery that has unfolded. In 2015 alone, the fallout from a Chinese devaluation, Swiss National Bank unpegging of the Swiss franc to the euro, precipitous fall in commodity prices, and a third Greece bailout – just to name a few – are all important examples of market-moving, macro events that investors had to weave into their portfolio construction processes during the year.

Unfortunately, as we look ahead, we do not see 2016 as a less chaotic year. In fact, we expect global GDP to likely come in well below consensus in 2016, believe that global inflation forecasts are generally too high, and envisage that operating margins have essentially peaked in the U.S. We also think that uncertainty surrounding China’s currency devaluation is not a one-off event. Consistent with this view, we have lowered our target multiple on equities to reflect heightened macroeconomic and geopolitical risks in 2016.

We also forecast that overall corporate credit conditions will not improve in 2016. Key to our thinking is that intensifying competition from China within the high-end export market, slowing global trade, and surging Internet activity could collectively cast a further pall over many areas of traditional corporate credit. We also see traditional fixed income franchises on Wall Street under siege. If we are right, 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 also means that equities as an asset class generally look rich relative to credit.

For macro and asset allocation wonks like us, we view the current environment as one where the efficient frontier curve has now flattened relative to earlier in this cycle because volatility has increased in recent months, but the potential return profile for many asset classes has not increased commensurately (Exhibit 1). Hence, investors are not getting paid to extend their portfolios further out along the risk curve.

In laymen’s terms, today’s market conditions are somewhat akin to swimming at the beach when there is a strong undertow that could pull a less experienced athlete out to sea. It might not happen, but the probability is certainly higher than under normal circumstances. As such, we think that the mantra “Adult Swim Only” seems to be a prescient catch phrase for the current macro investing environment.

Consistent with this view, we are starting the year with a more defensive asset allocation, including a notable overweight to Cash (seven percent versus one percent in September). For the first time in years, cash could offer a competitive return relative to other asset classes if the Fed hikes three times as we currently expect.

However, please do not mistake our message: The current macro backdrop does not mean that there are no good investment opportunities. Rather, one just needs to – as Thomas Jefferson said – “remain cool and unruffled under all circumstances” to take advantage of them. To this end, we think that it may make sense for us to outline what we believe will be key important macro influences in 2016. They are as follows:

1. Global trade has stalled; focus on domestic stories with pricing power. In the past we have consistently argued that China’s slowdown in fixed investment was the most important macro trend on which to focus. Today we are less certain, as the recent downturn in global trade may be even more noteworthy – and potentially under appreciated by the investment community. An important part of this story centers on the fact that many countries have devalued their currencies in recent years to improve exports; unfortunately, though, this strategy has not worked. In fact, it has only raised the cost of imports, particularly in many emerging market countries. If there is good news in terms of global growth trends, we think it now centers on the health of the global consumer. However, we want to underscore that even the bullish consumer story many folks are championing is likely to be much more nuanced than in past cycles, we believe. Specifically, we think that investors should largely focus their attention towards only companies that provide value-added experiences and/or can deliver differentiated value to the end-user consumer. Otherwise, we think the risk of either disintermediation or disenfranchisement is significant.
2. The traditional fixed income market is under siege in what we believe is a secular change across Wall Street. After a rash of disappointing earnings, leadership changes across the sector, and increased regulatory oversight (e.g., Basel III, TLAC), it is clear that most global wholesale banks will continue to move more aggressively to shrink their lending/trading footprints and capital bases in 2016. Against this backdrop, traditional credit availability and liquidity is under siege. As such, we see a further convergence of public and private credit, as the role of traditional Wall Street firms becomes further diminished by this shifting competitive landscape. If we are right, then the burgeoning private credit market could emerge as one of the most important sources of capital for corporations to fund their business initiatives in 2016.
3. Meanwhile, be careful at this point in the cycle about macro stories where in the past nominal lending has exceeded nominal GDP. We remain wary of investment situations – either direct or indirect – where there has been too much lending relative to both growth and profitability. In particular, we are increasingly concerned that in recent years too many EM countries took on too much debt relative to GDP, particularly in the corporate sector, in an effort to apparently capture all the growth upside associated with China’s fixed investment splurge. In our view, we are still in the early stages of this misplaced bet unwinding; thus, we want to form capital (both long and short) around this long-tailed macro trend.
4. Main Street begins to finally outperform Wall Street. Since the Global Financial Crisis, loose monetary policy — among other things — has led to a significant improvement in the prices of most risk assets that institutions and wealthy individuals own. Corporations have exacerbated the upward move in equities in many instances by often deploying more than 100% of their free cash flow towards buybacks. Today, however, with margins peaking, an unsettled currency market, intensifying geopolitical headwinds, and rising corporate defaults, we see a more lackluster environment for Wall Street. By comparison, global consumers, particularly in the U.S., are now enjoying lower fuel prices, improving wages, and continued home price appreciation. Hence, there is the potential in 2016 that life actually feels better on Main Street than it does on Wall Street, which would represent a significant shift in the investment landscape versus the prior six years of central-bank driven liquidity nirvana for portfolio managers.If we are right about the macro backdrop, then an investor may need to consider revamping his or her portfolio allocations. To this end, we provide a framework for thinking through what global asset allocation is best aligned with our key themes for 2016. Our thoughts are as follows:
5. After tactically upgrading global Equities to overweight amidst the China-driven dislocation in September 2015 (see U.S. Equities: Begin the Process of Leaning In, dated September 8, 2015), we are moving to underweight after getting the cyclical bounce we were looking for in 4Q15. Overall, we see lower multiples in 2016, as investors discount where we are in the economic cycle as well as increased uncertainty linked to China’s transition towards a markets-based economy. Within Equities, our strong preference remains for developed market equities. Specifically, parts of the U.S. equity market (e.g., risk arbitrage stories and rising ROE stories) and parts of the European equity markets (e.g., dividend yielders with growth) will likely outperform again in 2016, we believe. By comparison, we remain underweight emerging markets, with a particular concern surrounding Latin America (e.g., Brazil) and Asia (e.g., China, Malaysia). As we detail below, we think that the bear market in EM public equities is in its later stages – but it is not over. As such, in our view, investors must remain selective, favoring consumer-oriented markets like Mexico and India when these markets trade down to more reasonable valuation levels.
6. We are raising Cash to seven percent, up from one percent. As such, Cash now stands at its highest level since we came to KKR in 2011. Similar to what we did last January (see Getting Closer to Home, dated January 2015), we want to create a cash buffer at the start of the year that we can deploy amidst any downdraft in risk assets. Investors should also take this cash pile as an indication of where we think we are in the cycle, including our forecast that the Federal Reserve will raise rates three times in 2016.
7. After the sell-off, credit looks more attractive than equities; we favor Levered Loans within credit. As an asset class, liquid credit notably underperformed equities in 20151. We see this divergence as unsustainable, and therefore, we currently favor credit over equities (i.e., either credit snaps back or equities sell-off meaningfully). See below for details, but we see strong relative value across credit particularly in high quality Levered Loans. Separately, we still hold a significant underweight to Government Bonds in 2016 (three percent versus a benchmark of 20%). We think Treasury returns will be slightly negative in 2016, and as such, we think we are better off in Cash as a defensive allocation.
8. We are increasing Direct & Asset Based Lending, raising our position to a sizeable ten percent versus a benchmark of zero. As is being detailed in the press almost daily, many major financial institutions are again shrinking their footprints even further after a slew of trading snafus and risk-related issues in 2015. So, we want to capitalize on this withdrawal of capital and personnel via the private lending market, which we view as a direct beneficiary of the significant downsizing we see in both underwriting and distribution of fixed income products across Wall Street. Also, as the liquid markets have become more unsettled, private credit is playing an increasing role in financing acquisitions and growth initiatives, a trend we expect to continue. Importantly, deal terms improved notably for the lenders (e.g., covenants, call provisions, etc.) in 2H15, and we now see opportunities extending well beyond traditional private credit to include asset-based lending, with secured assets as collateral in many instances.
9. In Real Assets we continue to eschew pure liquid commodities in favor of private investments that can deliver yield and growth. In real estate, for example, we favor non-core assets with the potential for operational improvements and/or asset dispositions. Flexible capital structures too are a must, we believe, at this point in the cycle. In addition, similar to our thesis on Direct Lending, we favor off-the-run, complex real estate lending opportunities that previously were controlled by Wall Street firms with large real estate footprints. Meanwhile, in infrastructure, overall prices are high, so one has to be disciplined. Our advice is to focus on opportunities where cap rates can fall by taking measurable – but not outsized – development risks. In energy, our view is that that we want to engage with large conglomerates that are being forced to sell non-core assets to raise cash, repay debt, or streamline footprints.
10. In private markets we maintain our underweight to Growth Investing and our overweight to Distressed/Special Situations. However, this year we lower our Distressed/Special Situations weighting to 10% from 15% versus a benchmark weighting of zero. We are still bullish on the dislocated credit opportunities that we see in Europe (largely financial institutions) and Asia (corporate sector), but we have taken five percent of capital from Distressed/Special Situations to help further fund our overweight to Direct & Asset Based Lending (where we see some of the stronger risk-adjusted returns right now) and to further boost Cash (which is our best diversifier in a rising volatility world). Separately, we reiterate our 2015 decision to underweight Growth Investing, as both valuations and flows have become excessive in many instances, we believe. To this end, we see an increasing number of examples where IPO values could end up being 10-40% below where the last round of private financing took place. In our view, this de-rating of “unicorn” investments is not an aberration, but the beginning of a trend where fundamentals and public market-based valuations begin to converge.
11. We still favor the USD, but we are covering our long held short on Gold. Against the U.S. dollar, we would short the Korean won, Singapore dollar, and the one-year forward on the Chinese yuan. See below for details, but we think that China needs to further devalue its currency in 2016. The “knock-on” effect to other parts of EM could be significant, in our opinion. Against the developed market currencies, however, we think the dollar has a less exciting year, with the potential for the JPY to actually rally in 2016. Separately, we are finally covering our short in Gold. While we are not recommending the asset class, we do think that heightened volatility means that Gold can experience periodic bouts of outperformance in 2016.

Probably more than ever, global risks to one’s portfolio are worth considering in 2016. Beyond the recent surge in geopolitical concerns (including rising resentment of austerity as well as the negative fall-out from globalization), we believe the biggest potential headwinds for 2016 are likely linked to the recent performance dichotomies that we now see unfolding across multiple parts of the global capital markets. In particular, we note the following:

• An increasing interest rate differential (i.e., Fed raises rates as others central banks ease), which is being manifested in huge currency dispersions;
• Strong growth in global services versus a decline manufacturing;
• Surging Internet retailers/shared economy franchises versus softening traditional retailers/old economy franchises;
• Improving fiscal balances of commodity users versus declining fiscal balances of commodity producers; and
• Increasing yield differentials between U.S. versus European high yield and U.S. equities

For our nickel, if these bifurcations become too extreme or cause too much carnage in the financing markets, then they could be perceived as potentially destabilizing for the overall health of all risk assets. Indeed, similar to what we saw in 1999 and 2006, these ‘winner takes all’ types of markets typically end in tears, not smiles, when either 1) investors overpay for expected growth because there are limited alternatives available; 2) already impaired parts of the capital markets (e.g., energy and industrial credits) corrode what are currently perceived to be safe havens, including high quality junk bonds and growth equities.

Our bottom line: Our message is that we see less upside to many markets than we have in recent years. As we mentioned earlier, financing conditions on Wall Street – though maybe not Main Street – could be turning more difficult than many investors, equity folks in particular, now appreciate. Yet, valuations are not cheap enough in many instances to reflect the risk we see from the aforementioned macroeconomic headwinds. Also, we do believe that risks are not correctly priced across asset class and region, which could lead to additional instability in 2016. In particular, after the recent sell-off in credit during 2H15, we think that equities appear expensive.

Hence, we believe that investors should tilt portfolios defensively in ways that 1) focus more on idiosyncratic opportunities (particularly ones with steady and achievable coupon payments), not beta-related bets; 2) overweight investment vehicles that benefit – not suffer – from rising defaults 3) increase Cash so that one has the opportunity to harness volatility to an investor’s advantage; 4) watch out to make sure that one does not pay too much for growth or buy something that is too cyclical near what we believe is the peak in the economic cycle. Consistent with this macro outlook (and as we discuss below), we think that there are some straightforward hedges worthy of investor attention that can help to cushion the blow if we are right that more volatility lies ahead.

Section I: Key Themes/Trends

It Is No Longer Just the Slowdown in China’s Fixed Investment; Global Trade Has Stalled

Without question, China’s slowdown in fixed investment remains an ongoing challenge to global growth; that is not new news, as we have documented this slowdown on multiple occasions (see our latest Thoughts from Road: Asia, dated October 8, 2015). What is new, however, is that in recent quarters global trade has decelerated sharply, which is quite odd at this point in the cycle.

There are several forces at work that we think investors should consider. For starters, lower commodity prices have hurt the “price x volume” equation in global trade, a trend that we do not expect to improve overnight. Second, weaker currencies have clearly not helped to improve demand the way they did in the past. Rather, currency depreciation has just boosted import prices, further sapping demand in many instances. As such, many countries have seen their exports and nominal GDP growth actually decline in local currency terms (Exhibit 10).

While real GDP growth is important, nominal GDP growth tracks the actual income earned, which can have a significant impact on the global economy. This viewpoint is becoming increasingly critical today, we believe. Key to our thinking is that many countries no longer have the same buying power they once did because, despite their real GDP growing, their nominal GDP growth – which is most often connected to their income growth — has actually turned negative. One can see the magnitude of the fall-off in nominal GDP in U.S. dollar terms in Exhibit 4 as well as in local currency terms in Exhibit 10.

Third, developed market consumers have not been as active as in past cycles. In fact, personal consumption growth in the United States during this recovery has expanded at just 3.7% on a nominal basis and 2.0% on a real basis versus 7.1% and 3.7%, respectively, on average since 1950. Thus, personal consumption growth is now running at just 55% of the level achieved during the average economic recovery cycle since 1950. Somewhat ironically, this slowdown in global demand comes at a time of extraordinarily low rates around the world, which has helped fuel overbuilding and excess capacity in many global markets including energy, metals, and select regional pockets of manufacturing and real estate, particularly in EM.

As part of this slower growth profile in the U.S., consumers have also been deleveraging. Not surprisingly, this credit downsizing affects overall buying power as well. All told, overall household debt as a percentage of GDP has fallen to 78% as at 3Q15 from 96% in 2007, while household debt to disposable income for the same period is now just 101%, down sharply from 127% in 2007. While these trends are positive for the long term, they obviously reduce short-term to medium-term growth of consumption, trade, and ultimately GDP.

Fourth, many emerging market economies are underperforming relative to both history and expectations. Recent performance results are actually quite shocking. Indeed, as shown in Exhibits 10 and 11, many EM economies are running far below their potential as well as lagging growth rates seen in both 2007 and 2011. In many instances cheap financing led to over-investment. Today, with activity down and commodity prices lower, many private sector companies in EM are experiencing declining returns on equity, and looking ahead, we think the potential for sizeable write-downs and write-offs of property, plants, and equipment is noteworthy.

Finally and potentially most importantly for investors, we think that China has shifted its export strategy to high value-added from low value-added, which has significant implications for leading players across the global trade universe. To review, when China joined the WTO in 2001, its rapid ascent in low-end manufacturing dramatically reduced profits and jobs linked to manufacturing activities in major markets like the United States. Fast forward to today, and we now fear that China is doing the same thing at the high end of the market, which has negative implications for pricing and margins in sectors like industrials, telecom and healthcare equipment, automation, etc. Indeed, as Exhibit 12 shows, China is actually still gaining market share in exports; moreover, it is taking share in higher value areas of the market. China is also insourcing more parts of the total production “food chain,” which means that its supply chain is more vertically integrated and there is less intermediate trade with its trading partners. One can see this in Exhibits 12 and 13.

What does all this mean? In our humble opinion, the current slowdown in both trade and cross border flows has significant implications for the global economy over the next three to five years. First, it means that more and more economies will likely have to become inward facing to drive growth, which has implications for tariffs, foreign policy, political agendas, etc. Unfortunately, for many of the economies that relied on the commodity export boom to China for growth, this transition could prove to be quite serious.

Second, it means that some of the capital used to build trade-related infrastructure will likely need to be restructured and/or written off. We see this headwind as a particular issue for Southeast Asia and Latin America. Without question, the banking systems in these two regions will be saddled with a growing percentage of non-performing loans. Third, companies that can export their services, particularly towards countries like China, will benefit mightily from the shift we envision. Finally, with less upside to traditional global trade, global GDP growth is likely to be slower in the near term, which has important implications for wealth creation, distribution, and transfer, particularly among large EM economies that have traditionally relied on exports to boost GDP-per-capita.

Global GDP: We Expect Slower GDP Growth Everywhere Except Europe; Consensus Forecasts for Inflation Are Too High

Against this global macroeconomic backdrop of sluggish trade, we look for global services and consumption to outperform, while we expect manufacturing and goods to lag. If we use the United States as a proxy for our thinking, then we already see several important data points confirming our view. Specifically, as Exhibit 18 shows, services PMIs in the United States are at near-record highs; by comparison, manufacturing PMIs, compliments of a strong dollar and a slowing China, continue to decline. Not surprisingly, this divergence in PMIs is bleeding into job growth. Indeed, as we show in Exhibit 19, growth in services jobs remains particularly robust relative to the significant weakness we continue to see in the goods/manufacturing parts of the economy, a trend we expect to continue in the near term.

However, as we mentioned at the outset, we do not think that manufacturing can totally disconnect from global services over the long haul. Maybe more important, though, is that in the near term we forecast that a weak manufacturing sector will keep a lid on global GDP growth. Specifically, we think that the 2016 consensus forecast, which we detail in Exhibit 20, is too optimistic. As such, we are using below consensus forecasts in many of the major regions of the world. One can see this in Exhibit 21.

Ironically, we are more optimistic on cyclical growth in a region that has amongst the worst long-term growth fundamentals: Europe. Indeed, based largely on some thoughtful work done by colleague Aidan Corcoran in Dublin, we again look for GDP to be above the consensus in 2016 (1.9% versus consensus of 1.7%), driven by a lower currency, lower rates, and lower oil prices, all of which should help boost consumption above consensus expectations.

In terms of inflation, we are also more cautious than the consensus that a pick up is imminent. A critical issue is energy costs, which represent a full seven percent of the total U.S. CPI basket. From what we can tell, economists have overstated the potential rebound in commodity prices for 2016. For example, if Brent stays at its current price of $37, then oil prices will be closing down 25% from their average 2015 price of $49. Put another way, for oil prices to be flat in CPI calculations, Brent would need to appreciate 32% to average $49 per barrel in 2016. By comparison, the current forward curve for 2016 currently prices in an average of $41 per barrel. So, even if oil were to follow the path of the forwards and close 2016 at $41 per barrel, it would still be down 16% versus 2015 on an average price versus average price basis.

Separately, while we do expect higher wages and benefits in many sectors (a trend we are now seeing in both EM and DM countries), we think the ability to pass through costs will be difficult. Put another way, while we see key input costs such as wages and healthcare increasing in 2016, we do not see the ability for companies to pass these costs through to end-users, particularly if we are right about China moving aggressively up the value-added food chain across the global export sector. Hence, inflation should stay low in 2016, even if many traditionally inflation influencing inputs begin to rise.

Bet on Consumers, Not Producers; But We See a Different Consumer This Cycle

As we mentioned in the introduction of this year’s outlook piece, our travels lead us to believe that we are seeing a major bifurcation between commodity producer and consumer nations. On the one hand, with lower prices, lower currencies, and higher debt burdens, the outlook for many commodity-linked economies including Brazil, Russia, and Malaysia is now definitely more subdued.

Maybe more important, though, is that – in many instances – neither the central bankers nor the government officials with whom we speak in these countries indicate any real structural reform is imminent to deal with the dramatic changes that we are all watching unfold across the global economic landscape. As such, we think that investors will either need to wait until we see a sustained rebound in commodity prices or things get so bad economically that vested interests are pushed aside in favor of aiding the masses. To be sure, we believe either one could happen in 2016, but neither outcome is currently part of our base case outlook.

On the other hand, we are more sanguine on the outlook for parts of the global consumer. In particular, we think we are still in the early innings of the U.S. consumer benefitting from – among other things – lower commodity prices, including oil, natural gas, and corn.

However, some important research by my colleague David McNellis suggests that much of the commodity dividend is already being spent on healthcare, something that we do not think many economists and portfolio managers may totally appreciate. Dave’s thesis centers on the notion that there are currently two strong and countervailing forces denting the majority of the benefit one might expect from significantly lower oil prices. First, as we show in Exhibit 24, a rising tax burden is now pushing down disposable income by 60 basis points. Second, as we show in Exhibit 25, a notable uptick in healthcare spending linked to Obamacare is eating into many of the gains linked to lower prices at the pump.

That said, we do not want to get too discouraged. Why? Because, after years of rigorous balance sheet repair, our work shows that the consumer – even if he or she is diverting more towards healthcare and taxes – has built enough incremental capacity to finally spend again. One just needs to look towards more non-traditional places of consumption to find where the money could be spent in this new environment that we are envisioning. Indeed, as we show in Exhibit 27, we believe that a major decoupling within retail sales is now occurring, with consumers choosing to spend on “experiences” rather than “things.”

Major beneficiaries include health and beauty, dining, and travel, while traditional consumer items like clothing and electronics appear to be in secular decline. We also seeing a surge in activity linked to housing. All told, during the last three quarters we have seen household formation surge to 1.6 million Y/y on average, compared to 1.1 million Y/y in the prior three quarters. Put another way, the impulse to the economy from new household formation has increased by almost 50% in recent quarters.2

In the Eurozone we too see more spending on experiences. For example, in the United Kingdom we find that at least three of the top five spending categories are actually linked to experiences, including transport, recreation & culture, and restaurants & hotels (with the other two categories being housing and miscellaneous). Importantly, this trend holds across most of the region, including large consumer markets such as Germany and Italy. One can see this in Exhibit 28.

No doubt, the recent tragic events in Paris could dent consumer psychology to some degree on the Continent, but we do take some comfort that a recent visit we made to Europe in late fall suggests that there is still continued acceleration of the region’s ongoing consumption recovery, a story that we think many investors continue to underestimate. Recent macro data releases in Europe appear to support our constructive viewpoint. Specifically, consumer confidence reports in both the Eurozone and EU moved upward again in December, with the Eurozone report reaching its 82nd percentile value since 1985.3

Bottom line: the global consumer, particularly in Europe and the United States, is in good shape, but he or she is spending much differently than in the past. As such, one should not look for a major rebound in traditional retail sales, or a surge in credit card linked spending. Rather, we recommend focusing on areas of the market where companies creating differentiated offerings for consumers that leverage technology and allow consumers to feel good about the entire shopping experience, not just the final basic purchase of a good or service. Without these aforementioned attributes, however, we believe that investors could be quite disappointed by the level of rebound in consumer activity across many traditional retail areas, apparel in particular.

Traditional Financial Services Are Under Siege; the Illiquidity Premium Is a Large and Growing Market Opportunity

Given that the illiquidity premium has been a big theme of the Global Macro and Asset Allocation team since our arrival at KKR, we are not going to spend a lot of time describing its evolution. However, we do want to underscore that the global macro backdrop as well as the regulatory environment continues to suggest that the outlook for our illiquidity premium thesis remains not only robust and actually could even expand further in 2016, in our view. This conclusion might seem odd this late in the cycle, but in our view, that is exactly why we are now even more bullish on the opportunity set (and hence, the increased weighting in our asset allocation).

Based on recent meetings with financial services executives in both Europe and the U.S., we see four large opportunities for private lenders that are directly linked to the ongoing reshaping of the global financial services footprint. First, we continue to see significant opportunity in the direct corporate lending arena being created by Wall Street shrinking both its headcount and its footprint. In many instances a lender can get high up in the capital structure and enjoy some call on the collateral. Second, we see a growing opportunity in the asset-based lending market, including airplanes, real estate, renewables, rail cars, and housing. In our view, most deals with any real complexity are now being offloaded from Wall Street to the private lending markets, a trend we expect to accelerate under new and increasingly onerous regulatory-driven retention rules. They are also coming with better terms, including lower leverage, improved call protection, and more rigorous documentation. Third, given recent market volatility in an environment of tighter leveraged lending guidelines, there is definitely the opportunity for investors to again embrace mezzanine-like lending structures. In particular, with liquid credit markets souring of late, the opportunity for private lenders to opportunistically provide mezzanine-like capital in complex corporate take-overs at attractive rates of return has definitely gained momentum in recent months, a trend we expect to accelerate in 2016. Finally, there are a growing number of corporate deleveraging and restructuring opportunities, particularly in the small-to mid-size market, that Wall Street no longer considers core to its lending franchise.

If we are right in our assessment of the situation, then we firmly believe that both Direct Lending and Asset-based Lending opportunities represent extremely elegant “plays” on our illiquidity premium thesis. To be sure, these strategies are not the panacea for the low return world the investment community now faces. However, we do think that the relatively secure high single digit to low double digit returns that one can now earn across many areas in the private, direct lending market are extremely attractive, particularly for pensions and endowments that need to generate an annualized five to seven percent yield to satisfy their constituents.

Beware: Nominal Lending Above Nominal GDP

As we mentioned in the introduction, we have become increasingly wary of situations where nominal lending has grown too fast relative to nominal GDP. From almost any vantage point, we conclude that QE-driven low rates have allowed many countries, EM nations in particular, to borrow too much too quickly and too cheaply, which has in turn led to overcapacity and declining returns on capital. Moreover, as countries are forced to bring nominal lending back down below nominal GDP, we expect both slower growth and rising credit defaults.

Importantly, unlike in prior cycles, the lion’s share of the increase in debt has come from the corporate sector this cycle. By comparison, government and household debt have grown at a much more modest clip. One can see this dichotomy in Exhibit 36. Though almost all EM countries have benefitted from the accommodative central bank policies of late across Europe, the United States, and Japan, China has been the biggest catalyst for the sizeable increase in overall global corporate debt. All told, as we show in Exhibit 38, the divergence in the pace of annual credit growth relative to nominal GDP growth in China has widened to a staggering 870 basis points in 2H15 from essentially zero in 2011.

So, as we think more today about tomorrow, our base case is that too many companies have spent too much money too quickly, and as a result, credit creation now needs to come down below nominal GDP. Without question, this transition will further pressure growth rates and returns on invested capital. Another big issue is that much of the spending was concentrated on factories and projects that are not likely to meet their cost of capital in the current low commodity price, slow trade environment that we are currently experiencing. If we are right, then credit conditions are likely to tighten in many of these markets, further exacerbating what we already believe is a burgeoning credit cycle.

Importantly, while we think that China will endure pain (and its manufacturing sector already is), we are actually more concerned about the impact of nominal lending over nominal GDP in many other emerging countries. Specifically, as we show in Exhibit 40, we think that countries like South Africa, Malaysia, Brazil, and Thailand could all face notable growth adjustments if they are forced to slow nominal lending levels relative to GDP in the quarters ahead.

Section II: Asset Class Review

Equities

As we mentioned in the introduction, in 2016 we have moved towards an underweight position in global equities for the first time since we arrived at KKR in 2011. There are two catalysts for our shifting recommendation, both of which are linked primarily to a deterioration in trading multiples. First, given the recent sell-off in credit, equity multiples likely need to adjust downward in 1H16 to be competitive with credit after the recent carnage we have seen in markets like high yield. One can see the magnitude of the current differential in Exhibit 42. Second, we think that rising global risks, including China’s shift towards a market-based economy and rising tensions in the Middle East, mean that investors should now pay less for future cash flow streams.

As a further sanity check for our conservative posture on multiples, we looked at U.S. equities as a percentage of GDP at the point in the cycle when the Federal Reserve is raising rates. One can see the results in Exhibit 44, which show that – excluding June 1999 – U.S. equities have never been more fully valued on this metric at the beginning of a Fed tightening campaign. As such, we do not necessarily buy into some of the investment rhetoric that P/E multiples can actually expand after the Fed begins to tighten. In fact, we believe that the Fed actually began to adjust the liquidity cycle in January 2014 when it began to taper, and as such that we are actually much farther along in the tightening cycle than the absolute level of Fed Funds would currently suggest (and which is when multiples historically have begun to actually contract).

In terms of specifics, our base view is that the S&P 500 could achieve a target of around 2,016 to 2,080 in 2016, compared to its closing level of 2,043.94 at December 31, 20154. As such, our forecast, including a dividend yield of 1.9%, implies a total return of around 0.5-3.5% in 2016. Importantly, to formulate this target (and reflective of what we mentioned above), we are now using a 16.0-16.5 multiple on our 2016 EPS forecast of $126, compared to 17.5x in 2015 against what we believe will be $119 in EPS for the S&P 500.

With $126 in EPS, the S&P 500 earnings would grow an estimated 5.8%, compared to zero growth in EPS during 2015 and a consensus forecasted growth of 6.7% for 2016. We feel comfortable using $126 in EPS for two reasons. First, earnings expectations for many of the largest sectors in the S&P 500, including Consumer Discretionary, Healthcare, Information Technology, and Financials, appear achievable, in our view. Key to our thinking is that these sectors rely more on domestic trends in the U.S., not international investment and/or trade. We also think that it is worth noting that Energy now represents just 4.6% of total S&P 500 earnings, compared to 14.9% in 20115. As such, its ability to adversely impact overall earnings trends in the S&P 500 is now much more limited.

That said, our overall view for 2016 EPS growth trends is that the risk is clearly to the downside. A major consideration, we believe, is the absolute high level of corporate margins. Beyond CEOs signaling to the market that there are less operational optimization opportunities, there appears to be upward cyclical pressure on wages across many industries at a time of limited pricing power.

Probably more important, though, is that our research leads us to conclude that there are also several structural forces that are beginning to adversely affect margin sustainability. One is that in a world of excess capacity – compliments of QE-driven cheap money financing – a growing number of global companies, particularly Chinese high-end producers, are now electing to compete aggressively on price to gain market share.

Second, increased transparency – compliments of the Internet – is radically shifting consumer behavior, and in some instances, it is rendering obsolete business models that had previously withstood the tests of recessions, wars, and devaluations. Traditional retailing is the most obvious example, but traditional providers in areas like hospitality, education, and transportation now all also appear increasingly at risk, we believe.

As for the rest of the developed equity markets, we believe that the story is now more complicated. On the one hand, we expect Europe to outperform again in 2016. As the Federal Reserve previously showed, more liquidity often leads to lower risk free rates, which often forces investors to move further out along the risk curve. Already, in Europe over 40% of the entire European sovereign bond market now has a negative yield6. Against this backdrop, many equities appear attractive, we believe. All told, we estimate that a full 70% of the Eurostoxx index now has a dividend yield in excess of its bond yield.

On the other hand, we are less optimistic about Japan in 2016 than in the past. A big change in our thinking is that, along with an overall increase in volatility, there is the potential that the yen appreciates in 2016, causing investor concern about the sustainability of EPS growth. In addition, we believe that China’s ongoing economic slowdown will bleed further into the Japanese export market, which could potentially dent both EPS and investor sentiment. That said, we do think that there are some important restructuring stories in the Japanese multi-national sector that still warrant investor attention. Also, as we show in Exhibit 52, there are still some compelling mid-capitalization stories with improving returns in idiosyncratic industries that can still deliver impressive return profiles, we believe.

Meanwhile, the macro story in emerging market public equities remains challenging, and as such, we retain our underweight weighting on this asset class again this year, including both non-Japan Asia and Latin America. We do so for two reasons. First, as we show in Exhibit 53, our rules-based dashboard for timing EM equity allocations continues to show more “red flags” than “green” ones. Indeed, similar to what we originally outlined in our May 2015 piece Emerging Market Equities: The Case for Selectivity Remains, we remain concerned that EM ROEs are being bogged down by bloated balance sheets (Rule 1), that FX is likely to remain a headwind even when EM markets finally begin to improve in local terms (Rule 3), and that it will be difficult for EM to outperform until commodity prices bottom (Rule 4), which we think is unlikely until later this year.

To be sure, some things have changed in EM since we last updated our dashboard in early May, with the most important being valuations (Rule 2). Indeed, from May 14th through the end of 2015, EM equities fell fully 23%, and as a result, they now trade at a sizeable 7.3 trailing P/E discount versus the DM markets. That gap represents a discount similar to what we saw even at the trough of the 2008 bear market (Exhibit 54) ? enough for us to judge that EM valuations have now finally moved into our “strike zone” of favorability. Unlocking attractive valuations usually requires a catalyst, however, which is something we are not yet seeing from the other parts of our framework. Bottom line, we continue to believe that selectivity is required in EM, as we remain wary of ?catching falling knives? in what has historically been a highly momentum-driven market (Rule 5 and Exhibit 55).

Within EM, we look for some of the same countries to underperform again in 2016. For example, despite the massive adjustment in the currency and domestic asset prices that has occurred in recent quarters in Brazil, we still believe that caution and selectivity are required (hence the 200 basis point underweight to Latin America again this year). To review, in 2014 we first highlighted our concerns that Brazil’s economic trajectory was likely to deteriorate and that the government would become a source of volatility (Global Macro Outlook: Soft Spots Emerge, dated April 2014). In early 2015, we became even more concerned about the medium term outlook for Brazil upon visiting Sao Paulo and concluded that the country was facing a “Perfect Storm” as the already weakened economy was being hit with a massive corruption investigation that is still weighing down on consumer and business confidence.

Looking ahead, we actually still think that there could be another leg down in Brazil, as credit contraction and sagging consumer confidence weigh further on profits. That said, given the severity of the underperformance in recent years, we do acknowledge that we could finally be approaching an opportunity to “lean in” – and finally be adequately compensated for the country and currency risk as traditional sources of capital, including bank lending and corporate issuance, are becoming increasingly scarce. Indeed, according to my colleague Jaime Villa, Brazil sports a country risk premium that is now higher than Nigeria (which has instituted capital controls) and just lower than Argentina (which is still in technical default).

Meanwhile, we look for more of the same in terms of sector performance trends across the Chinese equity market in 2016. Specifically, we expect services-based companies, healthcare, food safety, Internet, and environmental ones in particular, to perform well, as long as valuations do not get too excessive along the way. On the other hand, we look for export, manufacturing, and trade related enterprises to remain under pressure. Overall, though, we see risks to the downside for China, as the recent acceleration in anti-corruption initiatives as well as increased government intervention in the markets are weighing heavily on consumer and business confidence.

In addition, we believe that the Chinese market may not be as attractively priced as some folks currently think. Indeed, while the overall MSCI China Index is only at a trailing P/E ratio of 10.5, the market is still not that cheap; in fact, ex-Financials the market’s P/E is actually north of 15x, according to my Asian-based colleague Frances Lim7.

On a more positive note, we think that Mexico can continue to outperform again in 2016. The country has good fiscal policy, a thoughtful central bank, and close ties to the United States. In particular, we are constructive on areas that benefit from a growing formal economy. Also, with credit penetration and real wages finally growing, we think that Mexican consumer plays should perform well. Separately, India could too perform well on a relative basis, but we do think the elevated levels of absolute multiples will keep it from being a star performer.

Fixed Income

As a general rule since we arrived at KKR in 2011, we have remained in the “lower-for-longer” camp on long-term U.S. interest rates and inflation. Key to our thinking is that the less favorable demographics, ongoing deleveraging, and low inflation would keep U.S. rates – and global rates for that matter – at low levels relative to history. To date, that view remains largely unchanged.

On the short-end of the curve, our outlook too remains largely consistent. Specifically, we continue to think that the Fed’s forecast is too hawkish, while other market participants appear to be too dovish. One can see the divergence of the various constituents’ predictions in Exhibit 57.

The logic guiding our Fed Funds forecast is that we see the FOMC hiking at a rate of 75 basis points in 2016 (three hikes of 25 basis points each) versus our prior (and the Fed’s current) forecast of four hikes and the market’s forecast of two hikes in 2016. For 2017, we expect the FOMC to accelerate, hiking at a rate of 100 basis points (four hikes of 25 basis points until they reach what we think will be a cycle-peak rate of 2.13%). Our 2017 forecast is in-line with the Fed’s current call for four hikes, but it is notably above the market’s prediction that the Fed will only boost rates twice in 2017. Our bottom line: Now that the Fed has already begun tightening, we think it will stay the course longer and more consistently than what the market is pricing in (Exhibit 57), but it will not go any faster than four hikes per year at most.

In general, our investment thesis for interest rates is linked to the Fed’s dual mandate of employment and price stability. First, on the employment front, we see the unemployment rate falling well into the 4% range in 2016, which is below the Fed’s own long-run target of 4.9% (Exhibit 58). Second, in terms of inflation, we have long viewed wage inflation as the key metric to watch, and we now see signs that wages are heading higher this year. Probably most importantly, we are increasingly hearing from front-line managers that it has become harder to source and retain top job market talents. Beyond this qualitative evidence, however, we are also now seeing quantitative evidence such as the National Federation of Independent Business (NFIB) survey in Exhibit 59, which has historically foreshadowed rising wages with a lead of about 15 months.

Overall, we continue to see less upside for long-term rates than for short-term rates. To this end, we are targeting a cycle-peak 10-year yield of about 3.0% in 2017 (Exhibit 56). Importantly, in terms of upside versus downside, we probably spend more time these days worrying about the downside risk that rates undershoot our already modest forecasts. There are both fundamental and technical reasons for our concerns. On the fundamental side, we think aging demographics are going to be a powerful long-term anchor on inflation. Exhibit 60 illustrates the close correlation over time between long-term labor force growth and long-term inflation.

On the technical side, we see the incredibly low global rates environment as a further constraint on U.S. rates. Consider for example that if today’s U.S. 10-year yield feels low on an absolute basis at 2.2%, it actually offers a lot of relative value to a German investor whose local market bonds yield just 0.5%. Indeed, as we show in Exhibit 61, this spread between U.S. and German rates is already now near a generational high of 170 basis points. We think the spread could perhaps widen to about 190 basis points this year if we are right on U.S. inflation and wage growth, but feel that global relative value flows will likely keep the spread from widening much beyond the aforementioned level. Also, with the U.S. deficit now shrinking, annual issuance of U.S. government bonds is creating more scarcity value than in past years, which should also help to keep a lid on yields, in our view.

Against this backdrop, we have maintained our tiny three percent weighting in government bonds, versus a benchmark of 20% (Exhibit 3). Our base view is that government bonds will deliver a negative return in 2016, which makes them a less attractive option relative to cash in 2016. Probably more importantly, our bigger picture view is that government bonds are no longer well-positioned to deliver their traditional role in asset allocation. Key to our thinking is that QE has largely dented their ability in recent years to provide meaningful income, with nominal yields near multi-generational lows in many parts of the world. In addition, we think that government bonds can’t be the traditional diversifier that they have in the past. Key to our thinking is that, if something does go wrong with monetary policy in the months ahead, then government bonds are likely to be highly correlated with both monetary policy and risk assets; hence, the need for cash versus bonds as an asset allocation “buffer” is now higher, we believe.

While we are not adjusting our government bond position, we are making some notable changes to our credit book. Specifically, we are reducing our Opportunistic Credit account to zero from seven percent. With the proceeds, we are establishing a six percent position in Levered Loans, but we keep the weighting of both High Yield and High Grade debt at zero.

Why the change to Levered Loans from Opportunistic Credit? We see two reasons. First, we think lack of liquidity in the liquid fixed income market makes ‘toggling’ between different asset classes (e.g., High Yield, Bank Loans, and Structured Products) via dynamic liquid credit vehicles such as Opportunistic Credit or Relative Value tougher to execute in today’s environment.

Second, as we show in Exhibit 63 we think that Levered Loans potentially represent some of the best value in the U.S. capital structure today. Though the absolute yield is not quite as robust as High Yield, Levered Loans are higher up in the capital structure. In a bumpy capital markets environment, we think the added safety net may be worth it. Also, from a benchmark perspective, Levered Loans have a much smaller allocation to Energy and Industrials. All told, based on outstanding issues, we estimate that High Yield has twice as much exposure (42.2%) to Commodity-related/Industrial sectors as Levered Loans (20.3%).

If credit markets stabilize, my colleague Jaime Villa believes that High Yield should return six to seven percent and Levered Loans should return five to six percent. Key to our thinking is the fact that spreads for both of these asset classes have already widened out quite dramatically in 20158. As such, we believe that even with an increase in defaults (i.e., our base case is a 100-150 basis points increase in defaults for 2016 from 2.5% to 3.5-4.0%) both of these asset classes should deliver mid-single digit total returns this year if markets do not get a whole lot choppier. If the cycle has in fact turned (about which we are increasingly concerned; hence, our preference for Levered Loans over High Yield), we think that 1) Levered Loans will outperform High Yield; 2) we feel strongly that both Levered Loans and High Yield will perform better than equities, given that credit has already sold off substantially and equities have not.

Meanwhile, in the private credit arena, we are making a substantial allocation this year. Specifically, we are taking a full ten percent position in Direct & Asset Based Lending. This compares to six percent previously and a benchmark of zero percent. As we detailed earlier, our basic message is that non-traditional lending, including both Direct and Asset Based, represents much better value/safety than the liquid markets at this point in the cycle for several reasons. For starters, we believe with no liquidity in the traditional fixed income markets and low rates, one might as well get paid the illiquidity premium being offered in the private markets. Second, while Energy has fallen to 13% from 18% of the High Yield Index, it is still a big number9. In private credit one has more flexibility from which to choose. Third, with financing conditions drying up in 4Q15, the opportunity set for private lending across a variety of markets has increased materially; not surprisingly, our intention is to use this dislocation to our advantage, not be penalized by it.

Alternatives

We continue to run with a large overweight to the Alternatives category, which is driven by our 10% overweight to Distressed/Special Situations. Key to our thinking is that our outsized Distressed/Special Situations allocation is an efficient vehicle for taking advantage of our thesis about nominal lending running above nominal GDP in many sectors of the global economy for too long. In particular, we are bullish on the dislocation being created from China’s structural slowing – and its “knock-on” effect across its trading partners in EM. Indeed, given this slowdown is occurring at time of excessive corporate leverage in many of China’s biggest trading partners, our base view is that we have entered a multi-year credit cycle that will require notable deleveraging initiatives across both the banking and corporate sectors. Already, we see this ‘playbook’ unfolding in India and Indonesia, and we think that the potential for additional opportunities across other emerging markets is substantial.

Distressed/Special Situations in Europe should also experience a bump up in activity in 2016. Indeed, after years of dragging their feet, European banks are finally unwinding their books. For example, in Italy stronger economic growth and more pressure from the ECB are leading to faster asset dispositions than we have seen in years. Without question, this shift in strategy by European banks is leading to large and attractive opportunities for non-bank lenders, particularly those with restructuring and operational expertise. A similar story has unfolded across certain insurance assets too.

Finally, in the United States we see an increasing number of corporate restructurings in the Retail, Energy, and Industrial sectors. However, given many of the macro considerations we laid out in our Key Themes section above, we think that many of these opportunities should be pursued in a measured, not frenetic, manner. Key to our thinking is that technological forces such as e-commerce and shale production may dent corporate margins deeper and longer than the consensus now thinks in many instances. Also, a growing “sharing economy,” including the emergence of Amazon Web Services, could lead to a dramatic shift in the competitive landscape in industries such as data storage and customer relationship management.

Meanwhile, we remain market weight on traditional Private Equity again in 2016. Within Private Equity, we think that Asia remains quite interesting, particularly Japan. Two recent trips to Tokyo give us greater conviction that many of the large conglomerates are increasingly likely to sell underperforming subsidiaries to private equity players that can help them improve productivity and boost margins. In addition, we think that the opportunity to use local Japanese companies to expand internationally using the country’s low cost funding is attractive. On the other hand, PE competition in Europe still feels strong, as there is over $300 billion of dry powder that needs to be deployed, which is a substantial amount relative to the current pace of M&A in the region. Bottom line: private markets, Europe in particular, can sometimes feel expensive relative to what is available in the public markets these days.

In the U.S., strategic buyers continue to boost overall valuations, though we like some of the developing trends we are seeing in parts of the U.S. consumer economy, including healthcare spending, wellness, and experiential shopping. Also, we think that firms that focus on the knock-on effects from the recent surge in household formation are likely to be rewarded. Finally, we believe that, if we are right on long rates remaining relatively well-behaved, the potential to own industry consolidators is compelling.

With Growth Equity, we remain cautious of the high end market, and as such, we retain our 500 basis point underweight. Without question, there is a lot of capital chasing ideas at this point in the cycle. We noted this phenomenon last year when we reduced our exposure to the sector, and recent announcements of companies pricing their IPOs below the final round of private financing legitimize our thinking, we believe. Just consider in 2015 that less than $10 billion in technology and Internet IPO proceeds were raised, compared to $40.8 billion in 2014, according to Dealogic. Moreover, there are still 140 or so private companies each with valuations of one billion, or more, and a cumulative valuation of at least $500 billion.

Real Assets

At the risk of sounding like a broken record, we continue to eschew traditional liquid commodity notes and swaps. See some of our earlier reports (The Twin Role of Real Assets, dated April 2012 and Natural Resource: A Step Further, dated February 2013) for more specific details, but our research leads us to conclude that both pure commodities and real-estate prices are economically sensitive, and their correlations with a traditional 60/40 (equity/bond) portfolio tend to increase during economic downturns. This cautionary insight is particularly true for the Goldman Sachs Commodity Index, which many popular mutual funds currently use to theoretically gain exposure to real assets.

On the other hand, we continue to favor real assets that can provide yield and growth, particularly stories with pricing power or the potential for operational improvement. At the top of our list right now in the private markets are infrastructure, non-core real estate, and energy transportation/distribution. Also, similar to what we are saying about the Direct Lending opportunity we see in the credit markets, we feel strongly that increased bank regulation is creating interesting opportunities for non-traditional lenders in real estate too. In particular, important changes in the risk retention rules surrounding CMBS could create really interesting risk adjusted returns for non-Wall Street players by the end of 2016, we believe.

Separately, we have finally seen the cost of capital increase meaningfully in the master limited partnership sector (MLP), an asset class that we have admired for years but have avoided of late because of valuation. Without question, this recent increase in the cost of funds represents a notable change from the “go-go,” retail mania that defined flows – and deal activity for that matter – in recent years. One can see this in Exhibit 69.

However, with major MLP indexes now down 50% or more during the last twelve months, we now believe that investors can dig through the rubble to find the gems across both public and private market opportunities. By comparison, we remain more cautious on “trophy” infrastructure properties where we feel like buyers have driven yields towards unsustainably tight levels.

Of course, a big question in the real asset space at this point in the cycle is whether it is time to step into the traditional exploration and production segment of the energy market, including both equity and debt. Our thoughts: definitely walk, but don’t run. There is still a lot of capital chasing deals, and we are now finally just starting to see investors receive terms that protect their downside, which was not the case in 2015.

That said, we want to acknowledge that the backdrop does finally appear to be shifting, as we are now finally seeing some interesting distressed sale opportunities from medium to large energy corporations that need to clean up their balance sheets, improve cash flow, and/or protect ratings. At the moment, we believe one should still focus primarily on companies that are divesting assets to raise cash, versus backing those that want more capital to reinvest or acquire, but we will be watching this area closely in 1H16, given there is now a sense of urgency from corporates that was previously missing in 2015.

Separately, we are finally covering our Gold position to flat, compared to minus two previously and a benchmark weight of one percent. To be sure, we are not bullish on gold as an asset class, but we do think that recent underperformance has been substantial (down 10.7% in 2014-2015). Moreover, if we are right that we have entered a period of heightened macro and geopolitical related risks, then being short likely does not make a whole lot of sense.

Currencies

Without question, much of our 2016 outlook centers on our belief that the policy divergence among major central banks — the Fed raising rates, while ECB, BoJ, and PBoC continue with accommodative policy — will result in the U.S. dollar outperforming again this year. However, we expect gains to be more muted against G10 currencies, as valuations are now becoming more extreme. Meanwhile, the impact of the steep rally in the U.S. dollar is beginning to impact domestic growth, which has clearly gotten the Fed’s attention.

We fully acknowledge that a long dollar position appears to be somewhat of a crowded trade. That said, we just do not ascribe to the view that the dollar will peak around the first Fed hike this cycle. What’s different this time is that in the developed markets many of the U.S.’s peers are still embarking on QE, and in some cases they are doing even more than in the past. Indeed, the ECB just extended its program and lowered its deposit rate guidance, while in Japan we believe that the BOJ could continue with both quantitative and qualitative easing again in 2016. However, bouts of risk aversion could cause the yen to appreciate in 2016.

Meanwhile, within EM, we fully acknowledge that a lot of pain has already been inflicted versus the dollar. We documented this earlier in Exhibit 9. However, given that we do not think the EM equity underperformance cycle is over and our experience in watching currencies is that they often undershoot fair value, we think that the road ahead for EM currencies will remain a challenging one versus the USD in 2016.

Here’s is our thinking on why EM currencies still face a tough road ahead. First, the spread between EM and DM GDP growth is now down to around just 100 basis points, down from 370 basis points in 2011 and 410 basis points in 2004.10 Importantly, this growth differential is likely to narrow further in 2016 as emerging markets are unlikely to see much improvement in growth as leading politicians across EM appear either unwilling or unable to make the reforms necessary to “fix” the imbalances that ail their economies, while developed markets, Europe in particular, could experience an acceleration of growth in 2016.

Second, we think that China’s currency will continue to devalue versus the USD. This depreciation means that every other country now must think through whether it needs to further devalue to remain competitive. Without question, this type of behavior is destabilizing not only for the currency market but also the entire global capital markets. However, the EM markets, particularly in Southeast Asia and Latin America, appear most vulnerable.

At the moment, our favorite currency crosses are long the USD against the Korean won and Singapore dollar. We believe the won and Singapore dollar give us protection against a slowing China as well as deleveraging in Asia. In both instances the cost to carry is quite low. Not surprisingly, we also like being short the one-year offshore traded renminbi (CNH) forward for both offensive and defensive reasons.

Separately, we continue to suggest being long the Mexican peso versus the Brazilian real again this year, as we are not yet convinced that Brazil has made a structural low. Key to our thinking is that Brazil’s export economy is largely linked to China-related activity, while Mexico’s fortunes are more tied to the United States.

Section III: Risks

No doubt, there are a growing number of risks on which to focus in 2016. We are now officially late cycle, geopolitical tensions have increased, credit has begun to fray, and global flows are now choppier. To this end, we have been thinking about quantifying the largest risks in the market, and more importantly, hedging against those risks.

Risk #1: While we certainly do not profess to be technical analysts, we have been watching markets for long enough to know that breadth in many markets, the S&P 500 in particular, is deteriorating. Indeed, much of the current index performance seems to be driven by just a handful of high octane growth stocks like Amazon, Facebook, Alphabet, etc. However, we are becoming increasingly worried that folks are beginning to pay too much per unit of growth for a select group of companies. All told, growth stocks can now trade at an average enterprise value multiple of sales of 9x. While this still falls short of the levels seen by similar index leadership in 1999-2000 (which reached as high as 20x during the tech bubble), these levels are quite high by any other historical measure.11

To protect against the potential that narrowing market breadth is a more ominous sign, we believe Nasdaq Index (NDX) “put spreads” make a lot of sense in this environment. We see a handful of reasons why this trade could deliver if there is a correction in 2016. First, the NDX index (Nasdaq 100) will give you exposure to the markets’ most crowded positions (as growth stocks Facebook, Alphabet and Amazon are a collective 20% of the index12). Second, the “breadth” of NDX now appears very thin, as these three names have contributed 100% of the 2015 equal weighted total return (2.95% return13).

Third, the NDX has little to no exposure to the most beaten up parts of the market (Energy, Materials) which have woefully underperformed the S&P 500 year to date. In fact, the NDX is 56% Information Technology (Apple, Microsoft, Facebook, and Alphabet) and 20% Consumer Discretionary (largely Amazon and Comcast). While we have no individual issue with any of the companies mentioned, what we see is the potential for a very high correlation between the index constituents in any market correction. Finally, the volatility market is not pricing this potential correlation spike correctly. In fact, implied volatility on the Nasdaq is trading at only a slight premium to corresponding levels in S&P 500 options, which is unusual relative to history with the exception of the 2008 financial crisis.

RISK #2: As we have mentioned repeatedly, China’s economy is undergoing a significant transition. One can see an example of this in Exhibit 74, which shows a major slowdown in low value added exports at the same time that high value exports are increasing quite strongly. This transition, while admirable, will not always go smoothly, particularly given China’s sizeable debt load and notable slowdown in traditional fixed investment spending.

Moreover, this hand-off towards high value-added services and exports is coming at a time when the Federal Reserve in the United States has changed its monetary policy. So, in terms of risk, we see a growing risk that, on the heels of a strong dollar post Fed lift-off, China is forced to devalue its currency more significantly than investors now perceive in 2016.

Depending on one’s view about how much China may devalue in 2016, there are a variety of trades that can be executed to hedge portfolio risk. For example, if one shares our view that the yuan could devalue 5-10% in 2016, one should just sell forward CNH. However, if one had a more draconian view (e.g., the yuan could move eight to ten percent or more in some definable time frame), we believe buying USD-CNH calls and call spreads could add some convexity to the payoff profile.

To note, six month at-the-money implied volatility in CNH is currently 6.5%, but there is definitely “skew” to a weakening yuan. One can see this in Exhibit 77, which shows that implied volatility for 6.50 strikes is 6.6%. Meanwhile, for the 25-delta call (or 7.00 strike) the implied volatility is 9.0%, and for the 5 delta call (or 7.50 strike) the implied volatility is 12%. Although this skew may look prohibitively expensive to some investors, one has to remember that step change devaluations are never correctly priced into option markets, if one can get the timing right.

Risk #3: Certain Parts of the U.S. Capital Markets Appear to Be Extended

With QE pushing real yields towards record lows, folks should not be surprised that the Federal Reserve has been successful in forcing investors to move further out along the risk spectrum in search of higher yields and more robust total returns. This reallocation by investors towards “spicier” assets is also consistent with the central bank’s goal of debt reduction via driving nominal interest rates below the nominal GDP growth rate.

However, in suppressing rates, the government has increased the overall risks to the capital markets. For example, in today’s near zero rate environment the Fed has all but ensured that every M&A transaction is accretive. Not surprisingly, as we show in Exhibit 78, CEOs have responded by acquiring competitors at a torrid clip. We mention the high level of activity because 2015 activity is consistent with other prior peaks in the market, 2000 and 2007 in particular.

We also note that the thematic breadth in the market is deteriorating. When we joined KKR in 2011, EM equities, capital management stories (e.g., buybacks, dividends, and roll-ups), and pure growth stories all worked in concert. Today, it is really just high octane growth stories that are performing. On the other hand, EM equities and capital management stories have both begun to underperform meaningfully.

Another point to consider is that we are simply late in the cycle. There are multiple ways to measure this fact, but the idea that CEOs are now spending more than 100% of their free cash flow on buybacks seems misguided (Exhibit 80). What’s off in our mind is the timing. Indeed, just consider that, as Exhibit 81 shows, folks have now enjoyed seven consecutive years of positive returns in the S&P 500. We are not math majors or qualified statisticians, but this type of corporate behavior this late in the cycle seems at odds with creating long-term shareholder value, in our view.

Given this macro backdrop, we are – as we indicated earlier in this outlook piece – more than comfortable running with higher cash balances to start 2016. We would also normally argue for tactically layering in some S&P 500 put spreads when the market gets extended and/or the CBOE Volatility Index (VIX) dips below 15%. However as mentioned above, we feel today’s market is currently giving you more bang for your buck using Nasdaq put spreads versus S&P 500 put spreads as portfolio hedges.

Risk #4: After traveling through Asia in December 2015 and having not one person ask about Brexit, the U.S. political outlook, immigration, or Greece, our base view is that many political risks are currently undervalued. Key to our thinking is that we have entered a pivotal time where investors should expect more controversy surrounding key issues such as immigration, austerity, and globalization. We certainly do not have all the answers to all these risks, but we do think running with some extra protection at the aggregate level in 2016 makes sense.

There are also specific hedges that can be implemented to minimize certain event risks. For example, while we only ascribe about a one in three chance that Brexit becomes a reality, we do think that buying volatility in sterling-linked (GBP) assets makes sense. Indeed, without even discussing Brexit risks, we see the British pound as slightly overvalued for three reasons. First, our internal KKR GMAA models screen the sterling as much as 10% expensive using an internal Purchasing Power Parity model that we adjust for wealth (using per capita incomes).

Second, despite strong employment growth, the Bank of England has been very reluctant to raise rates, as they have pointed to weak external demand and a strong currency as main drivers of the observed output gap. Third, our work shows the value of the sterling is quite correlated with U.K. housing prices – which we now see softening after an aggressive cyclical upturn from 2011 – 2014.

Despite a potentially negative backdrop, the GBPUSD option market is pricing in very little fear around such a potentially disruptive event to capital markets. Specifically, nine to twelve month GBP puts are trading at around nine to ten percent implied volatility, which is only a slight (one percent) premium to one year historical realized volatility. As seen in Exhibit 82, one-year GBP implied volatility can move well into the high teens – as we saw in both the 2008 financial crisis and the broader 2010-2012 Euro financial crisis. We suggest 12 month puts struck somewhere between four to eight percent out of the money, as a cheap low cost Brexit hedge risk, that also works along our fundamental valuation framework.

Section IV: Conclusion

As we have spent time researching and writing this 2016 Outlook, our confidence that we are late cycle has only grown. Valuations are not cheap, central bank policy in the U.S. is changing, and margins appear to have peaked. We also see some structural headwinds in the credit market, including a slowdown in global trade, surging Internet sales, and intensifying weakness in commodity-related enterprises, that give us pause. Finally, we believe that we have entered a new era in China, as the country is now exporting capital and deflation, not cheap goods that benefit global consumers.

With these thoughts in mind, we elected to tilt the portfolio more defensively in 2016. We have raised Cash, turned more cautious on Public Equities, and sought out more idiosyncratic risks across Fixed Income and Alternatives.

If we are wrong and robust markets ensue in 2016, we think it will be linked to us being wrong about the dollar and the Fed. Simply stated, we believe a higher dollar from current levels will exacerbate risk-off, while a lower dollar will act somewhat as a tonic towards the stress we now see in EM equities and overall credit. Indeed, a weaker U.S. dollar would give the Chinese central bank much more flexibility around its devaluation strategy, a clear positive for global risk premiums.

Regardless of whether the market moves up or down in 2016, we think that there are still attractive ways to seek a return. For starters, we are quite bullish on the sizeable illiquidity premium that has emerged, as banks and brokers further shrink their footprints. Importantly, we saw this opportunity set expand nicely across both geography and asset class at the end of 4Q15, and as such, in 2016 we feel like lenders now control many of the key variables in transactions, including call protection, leverage, and documentation.

Second, we are increasingly confident in the global consumer. Outside of the U.S., we would continue to focus on value-added services, including insurance, environmental, and basic healthcare. In the U.S. and Europe, our message is to clearly focus on experiences, not things.

Third, we think that China’s ongoing debt unwind will lead to new and exciting opportunities for Distressed/Special Situations investors. Simply stated, too many countries have run with nominal lending above nominal GDP, and as these growth rates re-adjust, there will be significant opportunities for restructurings, recapitalizations, and repositionings.

Finally, within Real Assets we continue to focus on investments that can provide yield and growth. Infrastructure, pipelines, and parts of real estate, including complex credits, all appear appealing, though we think that some type of value-added approach is needed to justify prices paid when buying direct hard assets. In terms of traditional real assets, we remain cautious on most major commodity prices. Hence, we remain cautious on the many traditional liquid commodity notes and swaps that Wall Street has created in recent years.

Our bottom line: Now is not the time to stretch on price or overcommit to acquisition-driven stories. Be disciplined, get long idiosyncratic ideas, hedge out unwanted beta, and be patient. Sometimes being defensive, including raising some extra cash, is actually an offensive move as it creates optionality when the future appears most uncertain. In our view, now could be one of those times.