Kohlberg Kravis Roberts analysts look at the year ahead with a bit of trepidation. While KKR predicted volatility in 2016, they didn’t expect the events to unfold as they did. In 2017, eyeing a global movement, KKR’s Global Macro & Asset Allocation Team sees a “paradigm shift” taking place for which investors might do well to adjust their investment sails to catch the tailwind.
KKR laments: Who could have predicted 2016 the year that was?
Looking back on 2016, Henry H. McVey, KKR’s Head of Global Macro & Asset Allocation, shakes his head. While their 2016 market analysis predicted a bumpy ride in the markets, it was the idiosyncratic events that were difficult to model.
“We did not predict a record $13 trillion in negative yielding securities, Brexit, President-elect Trump, and most importantly, a Chicago Cubs’ victory in game seven of the World Series,” the 48 page 2017 macro analysis quipped.
These political movements are creating global trends that will carry into the near future:
- Fiscal policies are now favored over monetary ones to stimulate growth
- Deregulation over reregulation
- Domestic agendas take precedence over global ones
- Heightened volatility spills over from the currency markets to the interest rate markets
KKR: Correlation between stocks and bonds is over, long bull market will end with a bang not a whimper
From an execution standpoint, KKR thinks the positive correlation between stocks and bonds is going to be broken, private equity is likely to outperform publicly listed stocks, with the analysis particularly concerned about multi-national corporations that are dependent on trade. KKR estimates that for every one percent move in the US dollar, S&P 500 earnings are reduced by 0.40%. This is expected to result in a pass through hit to 2017 earnings of at least -$2.85, or 2%.
“Our desire to favor Liquid Credit over Public Equities seems less compelling than in the past,” the report said. “We now think that the returns profiles will be more similar and have positioned our 2017 portfolio accordingly.”
While the US economic cycle might last longer than anticipated during their 2016 update, markets are nonetheless in the later innings of a bull market. Unlike analysts who have been calling for inflation and significant interest rate hikes in 2017, KKR does not see interest rates “surging too high in the near-term.” They expect the current technical bid for bonds to wane by 2018.
In this environment, where a US dollar uptrend is expected to extend, KKR is anticipating emerging markets to have “a bumpier bottoming process” than was initially considered. Brazil is one country that KKR is particularly negative on regarding growth.
With a deregulatory trend sweeping the US, financial stock earnings are estimated to grow 11.9% year over year, up dramatically from 2016 growth of 0.6%. “Given higher absolute rates, steeper yield curves, and the potential for less regulation, we think that the consensus forecast could still be too low.” KKR added 500 basis points of growth on top of the consensus forecast $23.90, boosting the sector’s earnings by $1.20 to $25.10.
Earnings are typically a key driver of stock prices, and here KKR sees three factors moving markets:
Contribution to earnings in 2017 from lower multiple sectors is now much more significant than in the past. One can see this in Exhibit 29. All told, 44% of total earnings growth in 2017 comes from Energy and Financials. Second, we think that higher rates and more uncertainty surrounding policy will stifle any additional multiple expansion this cycle. From what we can tell, it currently feels like we are being more conservative than the consensus about the proper discount rate that we should now use for valuing long duration assets, equities in particular. Third, one-time tax cuts are generally not multiple enhancing events, particularly if it leads to tighter monetary conditions and/or a stronger dollar.
Overall KKR sees a 4% to 7% returns potential for stocks in 2017, with 2% of that return coming from dividends. When one of the longer bull markets in history does come to an end, however, it won’t go quietly. Noting that “bull markets end with bangs not whimpers,” the trend towards market volatility is anticipated to remain intact.