Private Credit - Adult Swim Only: 2016 Mid-Year Update

Private Credit – Adult Swim Only: 2016 Mid-Year Update By Henry H. McVey, KKR

We stick to our base case that we remain in an “Adult Swim Only” investment environment, as we see more asynchronous growth ahead. Against this backdrop, however, we still see significant opportunity. Private Credit has emerged as one of our favorite investment ideas in today’s current environment of low rates and uneven global growth. Not surprisingly, we also favor Real Assets that can deliver yield and growth, and our research suggests Private Equity is likely to outperform Public Equity at this point in the cycle. We are not advocating huge sector and style bets at present; rather, we would focus on opportunities where quality assets with complexity are trading at discounts to their intrinsic values. By comparison, we are growing increasingly concerned about the valuations of defensive and certain growth-oriented assets.

From our macro perch at KKR, it definitely feels like 2016 has emerged as a year of “Adult Swim Only.” Markets have cut a wide swath so far this year, enticing investors to buy and/or sell often at what was – in hindsight – likely the time to do the exact opposite of what one’s emotional core was suggesting.

Importantly, as we have seen with recent events in the United Kingdom, there is certainly more to making good investments these days than just understanding the fundamentals. Indeed, similar to other post-crisis periods in history, we are now seeing a notable splintering of political harmony – one that extends from Europe to the United States, Latin America, and even Asia. In our view, this shift in the geopolitical landscape could be a secular, not a cyclical, phenomenon.

We are sticking to our playbook that we are later cycle, favoring idiosyncratic opportunities over beta-related plays. We still prefer Credit to Equities, and within Credit, we are most intrigued by the opportunities we see related to periodic dislocations and/or structural changes across the banking system.

As we discuss in more detail below, our bigger picture belief is that financial assets with predictable cash flows could now be overpriced in many instances. On the other hand, “complexity” (i.e., stories that lack EPS visibility or some type of industry taint) now seems to be trading at a discount, particularly in unloved sectors of the market. In our view, this discrepancy may be one of the most important arbitrages in the market right now.

Despite the negative overhang of Brexit, we are not yet calling for a recession and/or bear market. However, similar to what we laid out in our January Insights piece, Outlook for 2016: Adult Swim Only, we still see more limited upside to financial asset appreciation than in prior years – and with higher volatility. If we are right, then an investor should expect a lower return per unit of risk across most asset classes. Key to our thinking is that – compliments of global QE – many asset price returns have been pulled forward amidst below average volatility, as central banks have driven yields down to record lows. Consistent with this outlook are two important global macro trends that we believe are worthy of investor consideration:

First, with $9.9 trillion in negative yielding bonds, we think that there are now diminishing returns to QE at this point in the cycle1;
Second, given the recent surge in debt financing across public and private capital structures, we believe returns on incremental leverage in many parts of the global economy may have peaked and may actually be declining in many instances.

That said, global central bank policy remains formidable, and of late, we are encouraged that the Federal Reserve is now more focused on the trajectory of currencies, the U.S. dollar in particular. Key to our thinking is that the dollar, when undeterred in its movement upward, can restrict financial conditions – sometimes more than what an actual rate increase might otherwise accomplish.

With these thoughts in mind, we are making a few tweaks, though no major changes, to our portfolio in an effort to reflect our latest thinking. In addition, we are also using this mid-year update to provide some additional color on where our conviction levels have increased and/or decreased. See below for details, but we note the following:

We are reducing Cash by three percent to four percent from seven percent versus a benchmark of two percent and adding three percent to Mezzanine/Asset Based Lending within our Private Credit allocation. See Exhibit 1 for details, but our total weighting in Private Credit related investments — including both Mezzanine/Asset Based Lending and Direct Lending — moves to 13% from 10% in January and a benchmark of zero across the two asset classes. Given the shift towards negative interest rates and ongoing and intensifying regulation of the banks, we are seeing a major spike in opportunities in the mezzanine and asset-based lending areas of the global economy, Europe in particular. Indeed, some of the more interesting risk-adjusted opportunities we are seeing from a direct and co-investment standpoint are now occurring in situations where banks have fallen away as the traditional lender of choice. Moreover, many of these opportunities are occurring when volatility heads higher, not lower; as such, we like the somewhat counter cyclical component to this offering.

More than ever, we feel confident about our outsized bet across Private Credit. As we mentioned earlier, we are seeing a variety of different opportunities across Private Credit (Direct Lending, Asset Based Lending, Mezzanine, etc.), which makes us feel comfortable with an allocation that is 13% outside our benchmark and could likely lead to significant tracking error over time. Our positive rationale rests on three pillars. First, with leveraged lending guidelines now being enforced more strictly, corporate and financial acquirers must look beyond traditional financial intermediaries to support their deals. Second, there is less capital available for small-to-medium-size businesses, as banks reduce their footprints amidst shrinking net interest margins and heightened regulation. Finally, we think that current deal terms now often favor the lender, not the borrower, which is different than 12 to 18 months ago.

We are moving five percent from Distressed/Special Situations towards Actively Managed Opportunistic Credit. Without question, we are seeing attractive opportunities in niche credit markets such as closed-end funds, certain CLO assets, and periodic “hung” loans. By comparison, we think QE is denting some of the Distressed/Special Situations opportunities that we originally thought might occur at this point in the cycle.

We continue to favor Real Assets with yield and growth, but we also think that certain commodities are bottoming. See below for details, but we believe that areas like infrastructure, real estate credit, MLPs, etc., remain potentially interesting investment opportunities for institutions and individuals looking to earn not only above-market yield but also some above-average growth in the value of the underlying assets. Meanwhile, our research also shows that several commodities have corrected towards the level of prior secular bear markets both in terms of price and time (Exhibits 57 and 58). Selectivity is still required though, and at the moment, we favor oil and copper over assets with fewer supply-side adjustments, including iron ore.

We no longer see any rate increases in 2016, which also has implications for the U.S. dollar. If there is one area where our thinking has changed since the beginning of the year, it is around Fed hikes and the dollar. In particular, in its recent communications the Fed now appears to openly acknowledge that ongoing dollar strength could tighten global financial conditions towards an uncomfortable level. In essence, it appears that it has expanded its criteria for monetary policy changes to include not only domestic growth and inflation but also a multitude of foreign risks, China and Brexit in particular. In particular, it seems the Fed is now more concerned about deflation than inflation, and as such, a flat to weaker dollar helps the reflation trade by putting an implicit bid into commodity prices. To be sure, all the aforementioned commentary suggests a weaker dollar. However, after recent events in Europe, we see the dollar reemerging as a “safe haven” play against many currencies, including the GBP and the euro, in the second half of 2016.

We are still comfortable being underweight Public Equities relative to Private Equity at this point in the cycle. Since our January outlook piece (when we went underweight Public Equities for the first time since arriving at KKR) we have done a “deep dive” into the relative attractiveness of Private Equity versus Public Equity at the later stages of an expansion, and our conclusion leads us to own more Private Equity than Public Equity. Within Private Equity, we still favor consumer-facing investments, spin-offs, and restructurings. Overall, though, similar to public markets, we think valuations are reasonably full in many instances, and as such, some other levers are likely required to hit one’s return hurdle 84 months into the current economic expansion. Meanwhile, within global Public Equities, we have concentrated our overweight in developed markets into the United States, with equal positions in Europe and Japan. We also want to highlight that our macro dashboard is actually starting to flash a more positive signal towards the equities of Emerging Markets, which represents somewhat of a sea change after 68 months of underperformance. See below for more details.

We are less inclined to make big sector and style bets at this point in the cycle. From 2000-2010 an investor profited handsomely by being long China Growth (Materials, Energy and Industrials) at the expense of growth-oriented stocks and certain defensive stocks. From 2010-2015, doing almost the exact opposite produced rewarding results. Today, we see a world where growth and defensive investments appear quite expensive, but we are not yet certain that all “value” parts of the market fully reflect some of the structural caution we feel about China’s slowdown and/or the difficult position that many large global financial institutions now face. As such, we think that some balance of approach is required – one that is cognizant that the market may be overvaluing simplicity of story relative to complexity.

The investment community now better appreciates that there are limits to central bank intervention, negative rates in particular. Indeed, despite massive amounts of bond buying, European equities are now down about 20% during the last 12 months while Japanese equities have fallen about 30% during the same period. See below for details, but our conclusion is that investors now better understand that lower rates and more stimulus suggest slowing nominal growth and low returns likely lie ahead. In our view, this realization represents a sea change from earlier beliefs that more QE means that risk assets just look even more compelling relative to a risk free rate that is being “artificially” impacted by central bank intervention.

We continue to look for ways to mitigate risks. Though we have reduced our Cash position by three percent, we still remain overweight Cash by two percent (four percent versus a benchmark of two percent). In our humble opinion, when volatility is increasing and correlations are doing funny things, there is no substitute for Cash as an asset class. Meanwhile, we also think having some hedges makes sense. See below for details, but my colleague Brett Tucker believes that shorting the Chinese yuan and buying protection in High Yield credit default swaps (CDX) makes sense at this point in the cycle. We also think that the GBP has further downside if we are right that the United Kingdom may face a “stagflationary” type environment in 2017. Details follow.

Exhibit 1

KKR GMAA 2016 Target Asset Allocation Update

*Please note that as of December 31, 2015 we have recalibrated Asia Public Equities as All Asia ex-Japan and Japan Public Equities. Strategy benchmark is the typical allocation of a large U.S. pension plan. Data as at June 24, 2016. Source: KKR Global Macro & Asset Allocation (GMAA).

Looking at the big picture, our base case remains that we are still in an “Adult Swim Only” environment. Our indicators still point to the notion that we are later cycle, volatility is headed higher, growth versus value valuation divergence is extremely wide, and profit margins/ returns on capital have peaked. To be sure, we feel better today than in January that the U.S. dollar will not restrict financial conditions as much as it has in recent years, but we remain increasingly concerned about the diminishing impact of monetary stimulus on economies around the world. Also, our research leads us to conclude that there is little to no evidence supporting increased capex spending from negative interest rates on the corporate side.

Meanwhile, public market equity valuations appear full in many instances, and we see limited expansion for price-to-earnings ratios from current levels. See below for details, but even with relatively generous assumptions, our five-year forward expectation for Public Equities is now just less than six percent. Finally, the rise of populism in Europe, the U.S., and China will complicate reforms needed to spur economic growth (tax reforms, sustainable pensions, focus on productivity). Instead, we see proposals to restrict trade, immigration and anti-business regulation and rhetoric. This viewpoint is important because it suggests a higher risk premium is now required to compensate for outcomes that support the politics of blame at the expense of the politics of growth.

Exhibit 2

Post-Crisis Returns of a Standard 60/40 Equities and Bond Portfolio Have Been Remarkably Strong…