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Special thanks to all members of the KKR Global Macro, Balance Sheet, Public Markets Risk, Private Markets Risk, Strategic Partnership, and Customized Portfolio Solutions teams for their insights on this collaborative report.
Low bond yields, a surge in geopolitical tensions, and a shift towards fiscal stimulus are all fueling a fundamental rethinking by the investment management industry of how to generate the best risk-adjusted returns. Against this backdrop, we have tried to articulate actionable solutions to many of the most complex investment questions that we are increasingly fielding from clients who like us use a rigorous, top-down approach to asset allocation. An important message, we believe, is that amidst lower expected returns the traditional relationship between stocks and bonds is now starting to mean revert after a 20-year hiatus. As such, we think that most multi-asset class portfolios likely need to be restructured to thrive in the new environment that we envision. Within the private markets, we remain constructive on the illiquidity premium, especially in Private Equity and Real Assets at this point in the cycle. Overall, though, as investors migrate towards more thoughtful multi-asset class portfolios to overcome the headwind of lower absolute returns, we think that there are some important Rules of the Road to follow surrounding pacing, correlations, volatility, and liquidity, all of which matter to create successful outcomes for those who are currently rethinking their asset allocation.
Ones destination is never a place but rather a new way of looking at things.
There has certainly never been a dull moment in the macro and asset allocation business since I entered it in the early 2000s. What has changed in recent years, though, is that the complexity of mandates has taken an exponential step function upward. Record low bond yields amidst outsized intervention by the global central banking community as well as a surge in nationalist sentiment have fueled a rethinking of how to best generate strong risk-adjusted returns for pensions, endowments, foundations, sovereign wealth funds, and even individual investors. Without question, the growing complexity of the opportunity set has required a much deeper immersion into multi-asset class investing mandates. At KKR, we view this shift as a secular, not cyclical change, and as such, we have been increasingly addressing our clients requests by using a broader, more integrated tool kit than just our traditional macro and asset allocation work streams, including liability management, downside protection, hedging, and portfolio construction. Consistent with this initiative, we have also begun to work much more closely with accomplished CIOs to integrate and structure both liquid and illiquid mandates across a variety of investment disciplines, including insurance companies, run-off pension plans, and sovereign wealth funds.
Beyond the aforementioned strategic partnership and asset allocation mandates, we have completed two in-depth surveys on asset allocation strategies of the insurance and high net worth markets to better understand our clients needs and preferences within the Alternatives arena. In recent years we have also worked closely with KKRs senior management to help better allocate the Firms own Balance Sheet, which now totals $17 billion in assets across all of the Firms major investment businesses, including Private Equity, Real Estate, Credit, Infrastructure, etc., on a global basis. Finally, we have become much more integrated with our Customized Portfolio Solutions team (CPS), which was formed by Saleena Goel in 2010 as a one-stop shop for those seeking a more thoughtful way to access a broader swath of private markets.
As one might expect, we are increasingly fielding an array of questions on market-related topics, including current macro trends, expected returns, illiquidity premiums, and portfolio construction. To be sure, we dont have all the answers and we are constantly learning alongside our clients as well as evolving our business model. However, given the steady drumbeat of questions around a few of todays hot topics, we thought we might share our thoughts on several key areas where we think most global CIOs should likely have a strong view. They are as follows:
Given lower expected returns, how does one think about a portfolio optimization process that leverages many of KKRs top-down investment themes?
Because of our forecast for lower returns, we think that portfolio optimization becomes even more important in the new environment we are envisioning for macro players and global asset allocators. Importantly, beyond a more thoughtful approach to asset allocation, we also believe that investing behind long-tailed investment themes that leverage both periodic dislocations as well as secular growth drivers will become an increasing source of alpha for CIOs who run multi-asset class portfolios that extend across regions. To this end, we detail below four long duration, macro-oriented investment themes that we believe can help investors generate significant outperformance during the next 5- to 10-years. Importantly, while each theme is different, there is a common thread amongst all of them: Buy Complexity and Sell Simplicity.
Ones destination is never a place but rather a new way of looking at things.
Is Private Equity still an attractive asset class, particularly given the amount of capital that has now been raised in the sector?
As our work below shows, we think that the underlying premise of Private Equity as a high returning asset class still holds true in absolute terms. Maybe more importantly, we think that Private Equity can handily outperform Public Equity at the asset class level in this part of the cycle. However, unlike many of the other asset classes in which our clients invest, manager selection in Private Equity is of paramount importance. So too is a thoughtful deployment schedule. Details below.
How should we think about the illiquidity premium in Credit and Equity? What are the key drivers and is it still attractive in absolute and relative terms?
See below for full details, but we identify several commonly watched macro factors that can help investors to better explain what drives the illiquidity premium across both Credit and Equity during different periods in the cycle. At the moment, our work shows that the illiquidity premium is appropriately priced (i.e., an investor is not overpaying for the return per unit of illiquidity). Interestingly, despite more capital coming into the alternatives arena, our research shows that illiquidity premiums have thus far remained fairly constant in recent years. However, as we detail below, there are parts of the alternatives market where we do have our concerns, including the lower end of the Direct Lending business. Our bigger picture conclusion, though, may be more important: given where absolute rates and relative credit spreads are trading in the liquid markets, the pick-up in return if a manager of illiquid assets can perform is as high as it has been since just after the GFC.
How do you think about interest rates in a post-Quantitative Easing (QE) environment?
This question is a tricky one, but we think the key relationship on which to focus is the relationship between nominal rates relative to nominal GDP. Also, the rate at which inflation is increasing is a key input. Our base case remains that, while nominal GDP is accelerating, we do not see upward inflationary pressures massively destabilizing the long-end of the curve. Key to our thinking is that some of the largest contributors to inflation, including rent and healthcare costs (
), are actually poised to plateau. As such, we see U.S. 10-year yields reaching 3.25% in 2018 and peaking at 3.50% in 2019. If we are wrong and rates do exceed our forecast, then we believe it will be linked to a combination of higher wages and a depreciating dollar.
As one builds a more substantial private markets portfolio (in addition to a traditional liquid portfolio), what are the key portfolio construction metrics on which to focus?
While there are many aspects of portfolio construction to consider, we focus on our top four for this note: pacing, correlations, proper comparisons for private market assets, and liquidity. There is no exact or right way to approach these topics, but we strongly believe that there are tools that can be implemented to create better risk-adjusted outcomes, particularly as more and more CIOs increase their mix of private and public assets in their portfolios. One can also mitigate the negative effects of the J-curve in areas such as Private Equity through thoughtful implementation strategies, we believe. See below for details.
Looking at the big picture, our view is that we have entered a period of lower forward returns (SeeExhibit 1, below). Indeed, given high margins and generally lofty multiples amidst low interest rates, more modest return forecasts certainly make sense to us. So, the real challenge is in implementing investment processes that minimize the downside and unequivocally, we see the penalties for getting this wrong rising exponentially as QE comes to a close. We believe, for one, that there needs to be a greater emphasis on asset allocation than in the past rather than reliance on security and manager selection alone. Our visits with many CIOs, particularly in the pension, high net worth, and endowment communities, suggest that this shift is not as far along as it needs to be. Indeed, many plans are still only earning alpha from manager selection, not from asset allocation. We do not think this approach will be adequate in the new environment we are entering. Our world view also suggests that more allocators of capital should consider an investment in their global footprints including a local presence in key markets to better understand the profound impact that key considerations such as China, the millennial populations, and central bank policy are having on the macroeconomic and geopolitical landscape in each world region.
Data as at July 15, 2018. Source: Bloomberg, Cambridge Associates, NCREIF, HFRI Fund Weighted Composite Index (HFRIFWI Index), KKR Global Macro & Asset Allocation analysis.
In this section below we specifically address in greater detail our response to the five questions that we most frequently field from our clients, global CIOs in particular.
Given lower expected returns, how does one think about a portfolio optimization process that leverages many of KKRs top-down investment themes?
As any CIO who benchmarks his or her performance to a multi-asset class passive index knows, the traditional 60/40 portfolio has done exceedingly well in recent years. One can see this inExhibits 3and4, which underscore that not only performance has been strong but also on a risk-adjusted basis, it has been even better.
The Traditional 60/40 Portfolio Has Done Exceedingly Well Over the Past Five Years, But the Path Ahead Is Now Becoming Much More Challenging, We Believe
Stocks = S&P 500 Total Return, Bonds = U.S. Long Bond Returns. Data as at September 30, 2018. Source: Shiller data Bloomberg, KKR Global Macro & Asset Allocation analysis.
The Risk Adjusted Return Ratio of a 60/40 Portfolio Has Recently Been Significantly Above Average, But We Now Expect Lower Returns and Higher Volatility Ahead
However, as our expected returns assumptions indicate inExhibit 1, the forward outlook could be quite a bit more muted, in our view. Indeed, assuming equity returns are roughly five percent over the next five years while bond returns are three percent, then a traditional 60% stock, 40% bond portfolio should only return about four percent in aggregate, which is well below most asset allocators return requirement of about seven percent. Even in a bull case scenario of 10% equity returns, high rates would result in zero percent bond returns, causing the portfolio to fall short of the seven percent target (Exhibit 6).
The other relationship that is changing, which we think could be a big deal for all macro and asset allocation professionals, is the correlation between stocks and bonds.To review, since the tech bubble peak in 2000, stocks and bond prices have been negatively correlated. As a result, weakness in the stock market has actually largely been offset with strong bond market performance amidst falling interest rates. One can see this inExhibit 7. Not surprisingly, this macro backdrop has been a boon for multi-asset class investors, particularly levered ones such as Risk Parity.
However, this relationship is actually somewhat anomalous an input that we think many current investors may be underappreciating. In fact, if you take a longer term perspective, the relationship between stocks and bonds since 2000 is actually an outlier, as stock and bond performance is traditionally positively correlated, not negatively correlated. So, in the event of a market dislocation in the future,we believe that many multi-asset class portfolios could endure much greater downside capture than in the past. The catalyst, we believe, will be the notable shift that we are now seeing amongst the global Authorities away from monetary policy towards more fiscal policy (which likely means bigger deficits). As a result, bond prices will likely no longer rally in the event of an equity sell-off.
Consistent with this view, there is also the risk of much higher volatility ahead across the global capital markets. So, beyond the threat of lower absolute returns, our work also shows that the Sharpe ratio, or return per unit of risk, could be poised to fall. A mean reversion in Sharpe ratios would come as a significant jolt to many investors as return per unit of risk has been running well above trend line across most asset allocation accounts we monitor in recent years. We link the boost in return per unit of risk to the notable increase in coordinated global QE that started with the Federal Reserve and accelerated following the ECBs commitment to do whatever it takes in 2012. However, with QE shifting towards quantitative tightening (QT), we think that a secular shift in asset allocation is now upon us.
If we are correct in our macroeconomic forecasts, then all allocators of capital need to consider either lowering their liability payout amounts and/or shifting their allocations towards higher returning products. Just consider, if volatility remains constant from current levels, risk adjusted returns will fall a full 40% on average across asset classes as returns are expected to be lower across the board. This automatically results in lower Sharpe ratios, even before making any adjustments for potentially higher levels of volatility (which we think is inevitable). One can see this inExhibits 11and12.
Note: MSCI AC World Gross USD for Listed Equities; Barclays GlobalAgg Total Return Index Unhedged USD for Fixed Income; Cambridge Associates Global Private Equity for Private Equity; HFRI Fund Weighted Composite Index for Hedge Funds; and Barclays US T-Bills 3-6 Months Unhedged USD for Cash. Data as at 1Q86 or earliest available to 4Q17, and de-emphasizing 2008 and 2009 returns at one-third the weight, due to the extreme volatility and wide range of performance which skewed results. Source: Cambridge Associates, Bloomberg.
Data as at 1Q86 or earliest available to 4Q17, and de-emphasizing 2008 and 2009 returns at one-third the weight, due to the extreme volatility and wide range of performance which skewed results. Source: Cambridge Associates, Bloomberg.
Source: MSCI AC World Gross USD for Listed Equities; Barclays GlobalAgg Total Return Index Unhedged USD for Fixed Income; Cambridge Associates Global Private Equity for Private Equity; HFRI Fund Weighted Composite Index for Hedge Funds; and Barclays US T-Bills 3-6 Months Unhedged USD for Cash. Data as at 1Q86 or earliest available to 4Q17, and de-emphasizing 2008 and 2009 returns at one-third the weight, due to the extreme volatility and wide range of performance which skewed results.
Data as at 1Q86 or earliest available to 4Q17, and de-emphasizing 2008 and 2009 returns at one third the weight, due to the extreme volatility and wide range of performance which skewed results. Source: MSCI AC World Gross USD for Listed Equities; Barclays GlobalAgg Total Return Index Unhedged USD for Fixed Income; Cambridge Associates Global Private Equity for Private Equity; HFRI Fund Weighted Composite Index for Hedge Funds; and Barclays US T-Bills 3-6 Months Unhedged USD for Cash.
Against this backdrop, however, we do not expect allocators of capital to sit idle. Rather, we expect them to seek out pockets of alpha, align with the best managers, and cultivate relationships that allow them to drive better investment processes. To this end, we see at least four major macro themes that we believe that asset allocators, including both pensions and high net worth investors, can leverage to earn above average returns in the coming years as part of the asset allocation refresh that we are advocating in this new era of investing.
First, we advocate a diversified portfolio that now benefits more from an improvement in nominal GDP. Without question, we believe that governments around the world are shifting their focus from monetary policy towards fiscal policy (Exhibit 13). This change is a big deal, in our view, and it requires a new approach to asset allocation. Given this viewpoint, we have materially increased our exposure to Asset-Based Finance. Indeed, as book values have again begun to grow in the banking sector, publicly traded financial intermediaries have finally started to reposition their portfolios, including selling performing hard assets with onerous capital charges as well as seeking out capital relieving joint ventures with third party investors, including alternative asset managers. Last mile residential construction in areas such as Spain and Ireland has been a particular focus of ours of late within Asset-Based Finance. We also view Asset-Based Finance as an elegant play on our desire to lock in low cost liabilities in todays QE-driven market, allowing investors to earn above-average spreads. Finally, we are seeing an increased opportunity set in the B-piece segment of the commercial mortgage market, driven by new retention rules that notably favor investors with long duration liabilities.
Meanwhile, within the Infrastructure sector, we have seen a notable number of divestitures of hard assets, particularly those with contractual revenue set-ups, in recent quarters. From our perch, it appears that Europe has emerged as the most active region for infrastructure carve-outs, but trend lines in both the United States and Asia are firming too. Importantly, this carve-out opportunity is in addition to some of the structural increases in infrastructure investment that we think will occur as governments rely more on fiscal spending than monetary stimulus to bolster growth in the years ahead.
Second, we continue to see a secular shift in capital formation away from traditional banks towards more Private Credit alternatives. Recall that before the GFC, banks and specialty finance companies and proprietary trading desks were the primary providers of debt capital globally. Now, with heightened regulation around leverage levels, global banks have constrained lending activity in many instances. Thus, we expect the demand for Private Credit from non-traditional capital providers to continue, particularly for financial sponsors that want speed and certainty around financings. Real estate credit in the U.S. (both B-piece and Stabilized Credit), bank disposition sales in Europe (both performing and non-performing), and performing Private Credit in Asia (Exhibit 19) all look interesting to us at the moment. As part of our normalization thesis, we also favor owning financial assets like mortgage servicing rights, which become even more valuable cash flow assets as rates increase (assuming unemployment does not spike during a downturn, which is our base view).
Third, we expect consumers to continue to shift towards more Experiences and away from more Goods. While this theme is not a new one for us, the pace of implementation appears to have accelerated in recent months. Importantly, we do not think the trend towards experiences is just the Amazon effect. Rather, we believe that key influences such as increased healthcare spending, heightened rental costs, and rising telecommunications budgets (e.g., iPhones) are leaving less and less discretionary income for traditional items, particularly mainstream retail goods. One can see this inExhibit 20. Recent trips to continental Europe as well as Asia lend support to our view that this trend towards experiences is global in nature and cuts across a variety of demographics. For example, in Japan and Germany, aging demographics are boosting the use of later stage healthcare offerings, while younger individuals in the U.S. are embracing more health, wellness and beautification. Our view is that mobile shopping and online payments are only accelerating this trend and our recent travels lead us to believe that this shift is occurring in both developed and developing countries. One can see this inExhibit 23. Nowhere is this shift towards e-commerce more prevalent these days than in China (Exhibit 21) with its outsized millennial population (seeChina: A Trip to the Epicenter,August 2018). By way of background, of the total 828 million millennials in Asia, Frances Lim estimates that fully 40%, or 330 million, are today in China. To put the 330 million in perspective, we would note that there are just 66 million millennials in the U.S.
Internet Users in Southeast Asia Are Incredibly Engaged, Spending Three to Four Hours per Day on Mobile Internet, More Than in Any Other Region in the World
Finally, we are structurally bullish on deconglomeratization. This theme is not new, but it is a powerful one that is accelerating the pace of corporate restructurings across the global capital markets. In our humble opinion, corporations used low-cost funding to over-expand in recent years, and with global trade now slowing at the same time domestic agendas are taking precedent, we expect more firms to hive off unprofitable subsidiaries and non-core businesses (Exhibit 25). This trend has fully gained momentum in Japan, Europe, and India, and we expect other business communities to move this way in the coming months and quarters.
We also note that we are seeing a lot of corporate streamlining occurring outside of the traditional multinational sector. Indeed, after several quarters of inactivity, we are finally seeing U.S. energy companies rightsizing their footprints, as Wall Street encourages many of these companies to shed slower growth assets in favor of hot shale basins. While this activity may not necessarily be long-term bullish for the stocks of publicly traded energy companies, it is creating significant, near term value-creation opportunities for the buyers of these properties, particularly for players with expertise in the production and midstream segments of the oil and gas markets.
Looking at the big picture, our bottom line for CIOs is that expected returns are now falling at a time when volatility is increasing. So, on a risk-adjusted basis, the next five years are likely to look dramatically different than the past five years. There are, however, important offsets to consider that can help to mitigate these challenging headwinds. First, we believe that asset allocators and macro investors can adjust their portfolios to better optimize their outcomes. One can see this inExhibits 8, 9and10, respectively. Second, we believe that a much more theme based approach will be required to take advantage not only of secular themes but also periodic, tactical mispricings in the markets. As we described above, we are recommending four themes to capitalize on this approach. Finally, we think that, with operating margins high amidst low rates and full valuations, investors need to migrate towards buying some form of complexity (Exhibits 28and29) in a market where the consensus cherishes simplicity. In our view, this approach will help to minimize the adverse effects of the historic surge in financial asset prices that we have seen unfold since the end of the GFC in 2009.
What is our view on the Private Equity vs. Public Equity debate?
While we certainly field lots of questions about the forward-looking returns, one of the most frequent questions we get is actually not one about our views on absolute levels of return for each asset class in which KKR invests. Rather, it is about relative returns. In particular, we are most often asked whether Private Equity as an asset class will outperform Public Equities during the next five to seven years (i.e., the full life cycle of a private fund). Our simple answer is yes; we do think so, but we also want to caution that it is certainly not a no brainer, particularly if you have a shorter time horizon. First, lets start with where we have been. As we showed inExhibit 1,Public Market Equities have actually outperformed Private Equity as an asset class handily over the past five years. Moreover, if one actually levers up the S&P 500 a turn or two from three to five times debt-to-EBITDA (i.e., more in line with a traditional buyout), then Public Equities have handily outperformed reported S&P 500 returns in recent years. One can see this inExhibit 30.
Both Unlevered and Levered Public Equities Actually Outperformed Private Equity in Recent Years. We Think That This Relative Outperformance Is Now Poised to Mean Revert
Private Equity Typically Outperforms Over the Cycle Relative to Public Equities. However, the Majority of the Alpha Comes When Capital Markets Conditions Are Not So Ebullient
Note: Private Equity returns as per Cambridge Associates. Data based on annual returns from 1989-2016. Source: Cambridge Associates, Bloomberg, KKR Global Macro & Asset Allocation analysis.
So, given the recent underperformance, why would we be forecasting higher returns for Private Equity than Public Equities? For starters, our historical work suggests that Public Equities often excel early in the cycle, so we are not surprised in a turbo-charged, QE-driven bull market that Public Equities have outperformed (Exhibit 30).In our humble opinion, that is to be expected, given the starting level of stocks in 2009 as well as the $16 trillion that has been amassed on the balance sheets of global central banks in recent years. However, as public markets get more mature and more expensive during the later stages of the eco