By HENRY H. MCVEY Jul 13, 2017

As we peer around the corner today on what tomorrow might bring, our work still leads us to forecast lower overall returns. Against this backdrop, however, we see five areas that we believe can help drive both absolute and relative outperformance. First, we believe that we have entered an important period of change in global corporate structures. Driven by factors such as increased activism amidst declining returns on equity in foreign markets, we see many CEOs now striving to better simplify their global footprints. Importantly, this theme is not contained to just the corporate sector. In addition, we see our corporate ‘carve-out’ theme playing out across both the infrastructure and energy complexes. Second, we believe that investors can still deploy more capital behind the trend towards consumer experiences over things. Importantly, this theme appears to be gaining momentum across both developed and developing economies. Third, we now are more inclined to lean in on emerging market opportunities, particularly if they are linked to GDP-per-capita stories at appropriate valuations. Fourth, we still see the illiquidity premium as compelling. Finally, we continue to embrace complexity, particularly during periods of market dislocation. Right now we think certain parts of healthcare, MLPs, and low-rated corporate credit all warrant investor attention.

“He who lives by the crystal ball will eat glass.”

Ray Dalio

Founder, Bridgewater Associates

September 2017 will mark our six year anniversary at KKR heading up the Global Macro & Asset Allocation (GMAA) analysis effort. Without question, it has been a wonderful opportunity for the entire GMAA team to engage with the Firm’s deal teams across a variety of assignments, including both entries and exits. All told, during this period KKR has deployed in excess of $36 billion across its Private and Public markets; during the same period KKR has returned in excess of $53 billion to its investors.

Beyond the day-to-day deal work, having more than 200 portfolio companies in 19 cities across 16 countries staffed by local professionals has also created a unique environment for our team to derive macro insights by leveraging the strengths of our integrated business model across asset classes and capital structures.

Not surprisingly — given the tool kit the platform provides us — we have consistently shied away from using a ‘crystal ball’ approach to make bold predictions based on a ‘gut’ feel. Rather, we have concentrated our efforts on building long-term, top-down frameworks, including both fundamental and quantitative ones that identify key investment themes behind which we can form capital (or in some instances avoid forming capital). We have also tried to guide our employees and investors on where we may be in the cycle, leveraging a variety of data sets we have built out during the past two decades of macro analysis and investing.

He who lives by the crystal ball will eat glass. Ray Dalio

Founder, Bridgewater Associates

Today, almost all our work streams suggest that asset prices across most parts of the global capital markets are somewhere between fair value and expensive (Exhibit 1). From a cycle perspective, we believe that we are mid-to-later cycle in some of the more developed markets, including the United States. Consistent with this view, our base case remains that we have some form of an economic pullback in 2019. We also think it is worth noting that we are well below consensus in terms of inflation across most parts of the world, including the United States, Euro Area and Brazil (Exhibit 4).

Against this backdrop, we do feel inspired to narrow our investment focus towards fewer high conviction themes, relying less and less on macro tailwinds such as margin and multiple expansion than in the past. In particular, we are focused on potential macro disconnects, or financial arbitrages, where we can largely quantify where investor expectations appear offsides relative to the upside potential we envision. See below for full details, but our current highest conviction investment themes are as follows:

De-conglomeratization: Corporate Spin-Offs Are Creating ‘Rightsizing’ Opportunities As corporations around the world look to optimize their global footprints in a world that is increasingly turning domestically focused, we believe that this transition will create a significant opportunity for investors to buy, repair, and improve non-core assets from regional and global multinationals. We also see increased activism in the global public equity markets as a play on our thesis. Importantly, as we describe below, we see this trend towards entities hiving off non-core assets currently extending beyond traditional corporations to now include Infrastructure and Energy Assets.

As corporations around the world look to optimize their global footprints in a world that is increasingly turning domestically focused, we believe that this transition will create a significant opportunity for investors to buy, repair, and improve non-core assets from regional and global multinationals. We also see increased activism in the global public equity markets as a play on our thesis. Importantly, as we describe below, we see this trend towards entities hiving off non-core assets currently extending beyond traditional corporations to now include Infrastructure and Energy Assets. Experiences over Things We see a secular shift towards global consumers willing to spend more on experiences than on things these days. Leisure, wellness, and beauty all represent important growth categories, all of which appear to be taking share from traditional ‘things.’ Mobile shopping and online payments are only accelerating this trend, we believe, and our recent travels lead us to believe that this shift is occurring in both developed and developing countries. On the other hand, the work we lay out below shows that true core ‘goods’ inflation has actually been negative on a year-over-year basis for the past 16 consecutive quarters and negative for 50 of the last 69 quarters since 2000. Not surprisingly, we view this deflationary pressure as a secular, not cyclical, issue for corporate profitability in several important parts of the global economy.

We see a secular shift towards global consumers willing to spend more on experiences than on things these days. Leisure, wellness, and beauty all represent important growth categories, all of which appear to be taking share from traditional ‘things.’ Mobile shopping and online payments are only accelerating this trend, we believe, and our recent travels lead us to believe that this shift is occurring in both developed and developing countries. On the other hand, the work we lay out below shows that true core ‘goods’ inflation has actually been negative on a year-over-year basis for the past 16 consecutive quarters and negative for 50 of the last 69 quarters since 2000. Not surprisingly, we view this deflationary pressure as a secular, not cyclical, issue for corporate profitability in several important parts of the global economy. Emerging Markets over Developed Markets As we indicated in our 2017 Outlook Piece (see Outlook for 2017: Paradigm Shift), our five factor model has begun to inflect upwards for EM. The direction of these signals is important, because when they do collectively turn upward, EM outperformance can often last for years. Also, we are now more constructive on EM currencies, which is an important part of the EM total return equation for both equity and debt investors. If we are to be right, then commodity prices must stabilize near current levels. Details below.

As we indicated in our 2017 Outlook Piece (see Outlook for 2017: Paradigm Shift), our five factor model has begun to inflect upwards for EM. The direction of these signals is important, because when they do collectively turn upward, EM outperformance can often last for years. Also, we are now more constructive on EM currencies, which is an important part of the EM total return equation for both equity and debt investors. If we are to be right, then commodity prices must stabilize near current levels. Details below. Fixed Income Illiquidity Premium Despite the prospect of deregulation in financial services in the U.S., we still view the illiquidity premium as compelling, particularly in today’s low interest rate environment. Importantly, though, at the moment we think that there is likely more potential upside in Asset-Based Lending than in Direct Lending, which represents a shift in our previous view.

Despite the prospect of deregulation in financial services in the U.S., we still view the illiquidity premium as compelling, particularly in today’s low interest rate environment. Importantly, though, at the moment we think that there is likely more potential upside in Asset-Based Lending than in Direct Lending, which represents a shift in our previous view. Continue to Embrace Dislocation While the S&P 500 Volatility Index (VIX) has been low in recent months, ongoing periodic spikes in uncertainty – often linked to geopolitical tensions – have created attractive investment opportunities since 2011. All told, the VIX has jumped 50% or more on a year-over-year basis one out of every 11 days since April 2009. That compares to similar volatility spikes on just one out of every 20 days during the prior 2003-2007 market cycle. In our view, these types of unforeseen ‘shocks’ represent a secular, not a cyclical, pattern. See below for details, but certain Master Limited Partnerships (MLPs), CCC-rated credits, and healthcare companies currently appear interesting to us.

Exhibit 1 Our Cycle Dashboard Suggests That Many Assets Classes at the Aggregate Level Are Now Fairly to Fully Valued; As Such, More Creativity Will Be Required

Based on these macroeconomic views, we are making the following changes to our target asset allocation:

We are reducing our Global Direct Lending allocation to five percent from eight percent at the start of the year and 10% a year ago . We are still structurally bullish on this market (hence, why we retain significant exposure), but we do believe that pricing in the small end of the market has gotten competitive. Also, on the large end of the market, we think that High Yield is becoming — on the margin — more of a competitive option relative to Private Credit. So, we think right now could be a good time to allocate capital to Direct Lending at a more measured pace versus the ‘all in’ call we have been making in recent years.

. We are still structurally bullish on this market (hence, why we retain significant exposure), but we do believe that pricing in the small end of the market has gotten competitive. Also, on the large end of the market, we think that High Yield is becoming — on the margin — more of a competitive option relative to Private Credit. So, we think right now could be a good time to allocate capital to Direct Lending at a more measured pace versus the ‘all in’ call we have been making in recent years. …and using the proceeds to increase our allocation to Asset-Based Lending/Mezzanine . Meanwhile, our recent trip to Europe leads us to believe that the private credit opportunity in Asset-Based Lending/Mezzanine is actually growing quite nicely. Bank stock prices are rising, enabling financial institutions to dispose of performing assets that are priced to move. As such, we are increasing our allocation to Asset-Based Lending/Mezzanine to eight percent from five percent.

. Meanwhile, our recent trip to Europe leads us to believe that the private credit opportunity in Asset-Based Lending/Mezzanine is actually growing quite nicely. Bank stock prices are rising, enabling financial institutions to dispose of performing assets that are priced to move. As such, we are increasing our allocation to Asset-Based Lending/Mezzanine to eight percent from five percent. Within Liquid Credit, we still favor Opportunistic Credit and Levered Loans. See below for details, but we retain our four hundred basis point, non-benchmark position in Bank Loans, including certain spicy parts of the CCC-credit market. We also retain our 500 basis point position in Opportunistic Credit, which has served us well, particularly during periods of notable dislocation. By comparison, the implied default rate for High Yield is now less than one percent, which inspires us to underweight the asset class. Investment Grade Debt, we believe, also looks richly priced to us, and as such, we hold a five percent underweight versus the benchmark (zero versus a five benchmark allocation).

See below for details, but we retain our four hundred basis point, non-benchmark position in Bank Loans, including certain spicy parts of the CCC-credit market. We also retain our 500 basis point position in Opportunistic Credit, which has served us well, particularly during periods of notable dislocation. By comparison, the implied default rate for High Yield is now less than one percent, which inspires us to underweight the asset class. Investment Grade Debt, we believe, also looks richly priced to us, and as such, we hold a five percent underweight versus the benchmark (zero versus a five benchmark allocation). We continue with a notable underweight to government bonds; within government bonds, we now favor EM exposure to DM exposure . Since our arrival at KKR in 2011, our base call has been that risk assets would generally outperform risk-free assets. We based this view on 1) the relative spread of risk assets using earnings yields in equities and credit spreads in fixed income versus the risk-free rate; and 2) our belief that the economic expansion cycle would be longer than normal. Today, we are running with a 14% underweight to government bonds; however, this underweight is down from the 17% underweight we had employed for the five years prior to entering 2017. Key to our thinking is that inflation remains stubbornly low, while the ongoing demographic bid for yield is likely stronger than the consensus still thinks, in our view. In terms of preferences within government bonds these days, we would have at least half of our six percent weighting in paper from Indonesia, India, and Mexico, all of which have large domestic economies, offer attractive yields, and benefit from attractive local currency ‘carry’ at current levels (Exhibit 65). By comparison, we would be notably underweight, or even short, German bunds at current levels. Details below.

. Since our arrival at KKR in 2011, our base call has been that risk assets would generally outperform risk-free assets. We based this view on 1) the relative spread of risk assets using earnings yields in equities and credit spreads in fixed income versus the risk-free rate; and 2) our belief that the economic expansion cycle would be longer than normal. Today, we are running with a 14% underweight to government bonds; however, this underweight is down from the 17% underweight we had employed for the five years prior to entering 2017. Key to our thinking is that inflation remains stubbornly low, while the ongoing demographic bid for yield is likely stronger than the consensus still thinks, in our view. In terms of preferences within government bonds these days, we would have at least half of our six percent weighting in paper from Indonesia, India, and Mexico, all of which have large domestic economies, offer attractive yields, and benefit from attractive local currency ‘carry’ at current levels (Exhibit 65). By comparison, we would be notably underweight, or even short, German bunds at current levels. Details below. We are shifting around our Public Equity allocations, including reducing our U.S. exposure to below benchmark for the first time. Specifically, we are reducing our U.S. Public Equity exposure to 19% from 21%, compared to a benchmark of 20%. Though 45% of the Russell 2000 stocks with enterprise values of $500 million to five billion are still trading below 10x EBITDA (Exhibit 43), overall indexes in the U.S., including parts of the Nasdaq, appear somewhat overheated. With the reduction in the United States, we are boosting Europe by one percent to 16% versus our current benchmark weight of 15%, and we are adding a percent to All Asia Ex-Japan to show our confidence in domestic demand stories where reforms are taking shape, India and Indonesia in particular (see our recent note Indonesia: Harnessing Its Potential dated June 2017). We retain our underweight in Latin America, which — at four percent — is two percentage points below the benchmark target. We think that corruption remains a problem in Brazil, therefore we would rather own debt than equity in Mexico at current levels.

Specifically, we are reducing our U.S. Public Equity exposure to 19% from 21%, compared to a benchmark of 20%. Though 45% of the Russell 2000 stocks with enterprise values of $500 million to five billion are still trading below 10x EBITDA (Exhibit 43), overall indexes in the U.S., including parts of the Nasdaq, appear somewhat overheated. With the reduction in the United States, we are boosting Europe by one percent to 16% versus our current benchmark weight of 15%, and we are adding a percent to All Asia Ex-Japan to show our confidence in domestic demand stories where reforms are taking shape, India and Indonesia in particular (see our recent note Indonesia: Harnessing Its Potential dated June 2017). We retain our underweight in Latin America, which — at four percent — is two percentage points below the benchmark target. We think that corruption remains a problem in Brazil, therefore we would rather own debt than equity in Mexico at current levels. Our overweight to Private Equity relative to Public Equities and Growth Investing remains unchanged . We continue to target a three hundred basis point overweight to Private Equity relative to our equal-weight in Public Equities and our five hundred basis point underweight to Growth Investing. As one can see in Exhibit 42, what we found is that low return environments for Public Equities have actually historically been decent environments for traditional Private Equity. From what we can tell, it seems single-digit return environments for Public Equities tend to be markets where fundamentals are good enough to support deleveraging and operational improvements, but not so good that it is difficult for Private Equity to keep pace with public alternatives. Also, we believe that buyout opportunities tend to increase as the forward-looking total return in public equities decreases. Within Private Equity, we are most bullish on our de-conglomeratization theme, which we describe in more detail below. On the other hand, we maintain our five percent underweight to Growth Investing (i.e., zero versus a benchmark of five percent), driven by our belief that near-term valuations appear largely full.

. We continue to target a three hundred basis point overweight to Private Equity relative to our equal-weight in Public Equities and our five hundred basis point underweight to Growth Investing. As one can see in Exhibit 42, what we found is that low return environments for Public Equities have actually historically been decent environments for traditional Private Equity. From what we can tell, it seems single-digit return environments for Public Equities tend to be markets where fundamentals are good enough to support deleveraging and operational improvements, but not so good that it is difficult for Private Equity to keep pace with public alternatives. Also, we believe that buyout opportunities tend to increase as the forward-looking total return in public equities decreases. Within Private Equity, we are most bullish on our de-conglomeratization theme, which we describe in more detail below. On the other hand, we maintain our five percent underweight to Growth Investing (i.e., zero versus a benchmark of five percent), driven by our belief that near-term valuations appear largely full. We also continue to run with a notable overweight to Energy Assets/Infrastructure in 2017, a direct play on our long-term investment thesis to buy Yield and Growth. Specifically, we hold a five percent allocation to these asset classes, compared to our benchmark of two percent. In recent months we have seen significant selling of properties from publicly traded energy companies looking to reposition their portfolios by selling non-core producing assets as well as performing mid-stream properties. Indeed, transaction volumes in this area of the ‘Oil Patch’ have increased from $20 billion in 2015 to $60 billion in 2016, and year-to-date through April 2017, volume was running at $45 billion. Meanwhile, within Infrastructure we are seeing lots of good cash flowing assets for sale. In many instances investors are getting 500-600 basis points of premium over sovereign debt returns, which is substantial in today’s low rate environment. Interestingly, similar to what we are seeing with Energy Assets, we are seeing lots of conglomerates selling off interesting infrastructure properties in sectors like towers and energy infrastructure.

Specifically, we hold a five percent allocation to these asset classes, compared to our benchmark of two percent. In recent months we have seen significant selling of properties from publicly traded energy companies looking to reposition their portfolios by selling non-core producing assets as well as performing mid-stream properties. Indeed, transaction volumes in this area of the ‘Oil Patch’ have increased from $20 billion in 2015 to $60 billion in 2016, and year-to-date through April 2017, volume was running at $45 billion. Meanwhile, within Infrastructure we are seeing lots of good cash flowing assets for sale. In many instances investors are getting 500-600 basis points of premium over sovereign debt returns, which is substantial in today’s low rate environment. Interestingly, similar to what we are seeing with Energy Assets, we are seeing lots of conglomerates selling off interesting infrastructure properties in sectors like towers and energy infrastructure. Currency: U.S. dollar bull market is now in later stages. As we describe below, the dollar has appreciated meaningfully since we joined KKR in 2011, and we now see it as somewhat extended on a real effective exchange rate basis. Moreover, given we remain in a low rate environment, we think that the value of EM currencies is again rising, particularly those countries with large domestic economies and improving macroeconomic fundamentals. We prefer carry currencies in Indonesia and India, and we even believe that the Chinese yuan may stabilize for now.

As we describe below, the dollar has appreciated meaningfully since we joined KKR in 2011, and we now see it as somewhat extended on a real effective exchange rate basis. Moreover, given we remain in a low rate environment, we think that the value of EM currencies is again rising, particularly those countries with large domestic economies and improving macroeconomic fundamentals. We prefer carry currencies in Indonesia and India, and we even believe that the Chinese yuan may stabilize for now. Cash: We reduce Cash to one percent from three percent. We use these proceeds to cover our two percent short position in Gold, which we have shorted periodically during the past few years. However, given heightened geopolitical tensions, we think that this two percent asset class ‘swap’ probably makes good sense.

To be sure, there are risks that warrant investor attention at this point in the cycle. As we describe in more detail below, we think that the low unemployment rate overstates the health of the consumer within the United States. In particular, credit trends within auto, student lending, and certain card categories are all areas of concern. Meanwhile, China continues to grow its nominal credit outstanding well above its nominal GDP rate. In fact, if China continues growing credit at the current pace, we believe that overall credit as a percentage of GDP could total nearly 300% by 2018, which is well ahead of many investors’ expectations (Exhibit 20). Finally, after 96 months of economic expansion, U.S. margin assumptions for 2018 appear too robust, in our view.

Maybe more important, though, is that beyond the traditional macro risks we have highlighted, it does feel to us like we have entered a new era of political uncertainty that typically occurs during important inflection points in history. Indeed, as a history major at the University of Virginia in the early 1990s, a key finding of my studies then – and one that my colleague Ken Mehlman often reminds me of today – is that industrial revolutions often produce political revolutions. At the risk of over-hyping the hype, Ken and I strongly believe that the world is currently undergoing multiple technological-driven revolutions that are disrupting key industries and transforming millions of workers from secure employment in one area to more tenuous project work across multiple careers.

Without question, the Internet has democratized access to and production of information with implications even more profound than the invention of the printing press. This empowers critics of any and all institutions; it promotes visual drama and empowers social media trolling; and it reaffirms confirmation bias as people seek information from trusted sources that reinforce their existing views. Moreover, demographic changes across the U.S. and Europe are replacing the aging Baby Boom generation with a very different workforce of Millennials.

Ken has consistently argued that these factors together are producing a generational swing towards populism, anchored by a fickle and frustrated public with sometimes whipsawing changes in political leadership and policy priorities. We’ve described this as a ‘political bull market.’ From 2008-2015, this bull market produced policies that favored more regulation, higher taxes, and heightened industry scrutiny. Many governments also promoted fiscal austerity, multilateral trade and aggressive monetary stimulus.

However, the 2016 U.K. Brexit vote and subsequent Tory losses in this year’s U.K. special election, the U.S. election of president Donald Trump, and France’s election of Emmanuel Macron (the founder of a new party who rejected the traditional center left and right factions) demonstrate that we are in a new chapter of this ‘political bull market.’ Specifically, many nations are definitely now viewing trade and foreign investment from a more nationalist perspective, fiscal austerity is being replaced by stimulus via lower taxes and infrastructure spend, while key industries such as the Energy and Financial Services sectors in certain developed markets, the U.S. in particular, are likely to be deregulated.

Importantly, given that this industrial change is just starting to accelerate and will likely last for a generation, political volatility will only increase in this environment. Indeed, as Prime Minister Theresa May learned (like Secretary Hillary Clinton before her), incumbent leaders—or those perceived as defending the status quo—will face peril among voters unless they are clearly associated with change. Traditional polling is poor at predicting how volatile publics actually vote, particularly in elections where large numbers are alienated from traditional political parties, and turnout is uneven. Companies and industries are increasingly subject to social media politicization and scrutiny.

In short, while we may be in a temporary lull after the recent political storm in Europe, we likely should expect more shocks and surprises that will impact the markets and companies in which we invest. Smart investors will need to apply societal, political, and reputational lenses to key markets, industries and companies if they are to correctly navigate the landscape that we currently envision.

Exhibit 2 KKR GMAA Target Asset Allocation Update for 2H17

Against this backdrop, we continue to subscribe to the Paradigm Shift thesis that we laid out in January. Specifically, we believe that there are several notable mega trends on which to focus. First, we see fiscal policies replacing monetary ones as incremental drivers of economic change. This viewpoint is not restricted to just the U.S. Europe too has traded in austerity for growth, while our estimates are that China is actually running an 11-15% deficit (when adjusted for supplemental spending), compared to the target of three percent of GDP. If we are right, then this trend has major implications for long-term interest rates, regional growth trajectories, and global asset allocation trends.

Second, we believe that we have entered a world where domestic agendas are being championed over global ones. In our view, this trend has important implications for global supply chains; it also means that large domestic economies with sizeable consumer markets are likely to become a destination of choice for global capital providers. Third, we see regulatory burdens easing relative to the heightened regulatory environment we have been in. The U.S. financial services industry is clearly a beneficiary, but the Energy sector too could prosper. Finally, we expect volatility to move beyond the currency market into other asset classes, including rates.

Section I: Macro Update

In the following section we provide macro updates on global GDP/inflation, global interest rates, global EPS, and the global economic cycle.

Global GDP Update/Inflation Outlook

Well, it has been a long time coming this cycle, but our recent travels across North America, Europe, and Southeast Asia finally lead us to believe that we are seeing something akin to a synchronous global recovery (Exhibit 3). China recently rebounded from its crash in nominal GDP towards a more sustainable – albeit more modest – level, while a positive outcome in the French election has helped to further boost growth in the Eurozone. The U.S. too is reaccelerating, though forecasting growth in this region remains the most difficult, as it sways between the promise of meaningful tax reform versus uncertainty surrounding the vision of the current administration.

Meanwhile, despite solid growth trends, we also see inflation moderating across many regions of the world in the second half of 2017. In fact, as we show in Exhibit 4, we believe that inflation is likely to undershoot consensus expectations in most areas of the world where KKR does business except China.

Exhibit 3 Three-Quarters of Total Global Growth Will Likely Come From EM in 2017

Exhibit 4 Brazil Is the One Country Where We Are Well Below Consensus Growth Forecasts; On Inflation, However, We Remain Below Consensus in Many Areas of the World

With these thoughts in mind, we offer the following more specific thoughts on our outlook for GDP by region as well as latest thinking on where we are in the cycle:

Europe: Despite significant political uncertainty, European GDP continues to chug along. As we detailed in our recent note (See Europe: Complexity Rules), growth in Europe remains relatively robust. In fact, we have again lifted our 2017 GDP forecast to 1.9% from 1.7% previously, driven by better than expected investment trends. Maybe more important, though, is that our quantitative GDP model is forecasting robust growth in Europe of 2.5% for 2017 (Exhibit 6). This forecast is driven largely by the powerful effects of the European Central Bank’s current monetary policy regime, partially offset by stagnant housing market concerns. However, if mortgage lending growth does accelerate, implied growth by our model could be even stronger, though we fully acknowledge an overall political risk discount of 50-75 basis points to our quantitative growth model likely makes sense in the current environment.

Also, after years of acting as a material drag on growth, government spending is now a tailwind. All told, we think that government contribution to growth has gone from an incredible 150 basis point drag on GDP at its most difficult point in 2012 to a 12 basis point tailwind in 2017 (Exhibit 5). Moreover, if President Trump does encourage more defense spending as part of his NATO agenda, then there could be even further upside to our updated estimate.

Exhibit 5 The Government Is Now a Tailwind to European Growth

Exhibit 6 Our Quantitative Model Suggests Even Better Growth Ahead in the Eurozone, Bolstered by Easier Credit, the Falling Euro, Lower Oil and Zero Interest Rate Policy

Exhibit 7 Many GDP Drivers Are Positive vs. Trend in Europe, Though We Anticipate Some Relative Weakness in Trade and Remain Conservative on Regional Exporters

Exhibit 8 The Philips Curve in Europe Appears Unresponsive, Which Means Wage Inflation Is Indifferent to the Labor Market

United States: Tweaking both our growth and inflation forecasts lower. We have lowered our 2017e GDP to 2.3% from 2.5% previously. As such, we now remain just above the consensus of 2.2%. Second quarter GDP was tracking around four percent as recently as the start of June. In recent weeks, however, 2Q17 GDP tracking has fallen to 2.7% at a seasonally adjusted annualized rate. In isolation that’s still pretty strong growth, but it means that the uplift in 2Q17 will be insufficient to fully offset the malaise in 1Q17, which is why we have taken our full-year GDP estimate down.

In terms of linking the macro to the micro, we note the following:

Vehicle sales have slowed, which is consistent with our expectations going into 2017, but the magnitude so far has been a bit greater than expected . We’ve been forecasting light vehicle sales at a 17 million seasonally adjusted annual rate (SAAR), which would represent a decline of three percent from 17.5 million in 2016. As Exhibit 12 illustrates, however, things have been even softer than anticipated so far in 2017, with the SAAR running at just 16.6 million in May. Declining used car residual values are having an important impact on new car sales.

. We’ve been forecasting light vehicle sales at a 17 million seasonally adjusted annual rate (SAAR), which would represent a decline of three percent from 17.5 million in 2016. As Exhibit 12 illustrates, however, things have been even softer than anticipated so far in 2017, with the SAAR running at just 16.6 million in May. Declining used car residual values are having an important impact on new car sales. Multifamily housing starts have fallen to a run rate of about 315,000 through the first two months of 2Q17, which is down more than 20% from around 400,000 in 1Q17. Our read of the situation is that apartment developers may be pausing in response to vacancy rates that have stopped improving nationally (the rental vacancy rate ticked up to seven percent in 1Q17 from a historic low of 6.8% in 4Q16), and to a slight inflection lower in the pace of rental appreciation (shelter CPI made a cycle peak of 3.6% Y/y in 4Q16 and has since moderated to 3.3% Y/y). Over time we think multifamily starts will revert higher, as the fundamental backdrop for rental housing remains quite strong; however the pause in the second quarter has been large enough that we may need to consider trimming our full-year U.S. total housing starts forecast of 1.25 million by 25,000 to 50,000 units.

Meanwhile, on the inflation front, we have lowered our inflation target to 1.9% from 2.25%. The consensus remains quite aggressive, in our view, at 2.3%. While we were correct to take a conservative view on healthcare and energy prices, shelter inflation – which accounts for 42.5% of CPI – has come down more than we anticipated. One can see this in Exhibits 9 and 10. Also, as we discuss later, core inflation in the ‘goods’ arena remains stubbornly problematic (Exhibit 58).

Exhibit 9 The Core CPI Basket Is Concentrated in Categories Where the Pricing Equation Is Dominated by Supply Side Rather Than Demand Side Dynamics

Exhibit 10 Rent Increases, Which Drive Shelter Inflation, Are Now Showing Signs of Moderating from Cyclically Elevated Levels

Our bottom line for the U.S: Despite the soft spots outlined above, we think the growth backdrop remains sound in 2017, both for the U.S. and globally. Our 2.3% GDP forecast for 2017e embeds mid-two percent growth in 2H17. We see a potent combination of easy credit conditions, improving household sentiment, and oil prices that are low enough to support consumer spending, but high enough to support upstream capital investment. Consistent with this view, we also think that the components that make up both core and headline inflation are likely to remain quite contained over the next several quarters and beyond.

We also think investors focused on the soft U.S. data to date in 2017 should consider taking a step back to note that earnings trends have been surprisingly strong and economic data have been surprising to the upside across much of the rest of the world (Exhibit 14). Ultimately, the data have been good enough to support an upbeat tone to most global financial markets, which is an important reason we think the Fed was willing to look past weak domestic data to hike twice so far in 2017.

Exhibit 11 Most High-Level Macro Leading Indicators in the U.S. Are Currently Quite Positive…

Exhibit 12 ...But Some Industry-Specific Factors Have Weighed on 1H17 Growth, Including Weak Auto Sales...

Exhibit 13 ...And a Dip in Multifamily Construction Starts

Exhibit 14 Recent U.S. Economic Data Have Been Weak, but Earnings and International Economic Data Have Been Considerably More Upbeat

Exhibit 15 Global Oil Inventories Are Still Quite Glutted. In Fact, Inventories Are Approximately 1.2 Billion Above Pre-4Q14 Trends

Exhibit 16 Global Oil Inventories Can Currently Supply 64 Days of Forward Demand — the Highest Level in Nine Years

China: Settling in at a lower rate of growth. As part of our mid-year update, my colleague Frances Lim, who leads our macro effort in Asia, has marginally increased her target 2017 GDP to 6.6% from 6.5%. Her upward revision is based more on 1Q17’s surge in GDP to 6.9% than her belief that growth will reaccelerate in the second half of the year. Meanwhile, we are lowering headline CPI to 2.0% from 2.3%. We make this adjustment, despite core inflation rising to 2.1% due to food price deflation in 1Q17 that brought headline inflation down, and the recent leg lower in oil prices. A stronger yuan relative to prior expectations should also help keep inflation in check.

Overall, we believe that China ‘bears’ who are calling for major downside to growth from current levels are missing the point that the country has already had its economic crash in nominal terms. One can see this in Exhibit 17, which shows that nominal GDP fell from a recent peak of 24.0% in 3Q07 to a low of 6.4% in 4Q15. In our view, too many sell-side economists have focused on China’s slowdown in real terms, which is much more subdued than in nominal terms. Specifically, at the same time that nominal GDP fell by 73%, real GDP fell a more modest 55% from 15.0% in 2Q07 to 6.7% in 1Q16. The delta between nominal GDP and real GDP is significant, however, as companies generate revenues in nominal – not in real terms; they pay their employees in nominal terms – not in real terms; and they reward shareholders in nominal terms – not real terms.

Exhibit 17 Past Its Cyclical Peak: We Think That Nominal GDP Will Now Moderate as PPI Falls Again…

Exhibit 18 …Despite Record Fiscal Stimulus

Exhibit 19 Chinese Authorities Are Using the Current GDP Strength to Tackle Deleveraging in the Financial Sector

Exhibit 20 If Current Trends Persist in China, Debt-to-GDP Ratios Could Hit 300% in Less Than 24 Months

Looking ahead, Frances believes that the government is trying to temper debt growth by being more coordinated across all its financial regulators, including the PBoC, CBRC, CSRC, CIRC, and Politburo etc. Without question, we view this coordination as a major positive. The bad news is that, even with tighter controls, China continues to grow its debt load in excess of nominal GDP. One can see the magnitude of the issue in Exhibit 20, which highlights our belief that China’s debt-to-GDP ratio could nearly reach 300% by next year if measures are not taken to slow credit growth down. Furthermore, in the near term, there is likely to be heightened volatility as implementation of new policies is subject to execution risk.

So, what’s our bottom line? Despite its surging debt burden, we believe that China’s economy will be able to maintain real GDP growth at or above its targeted 6.5% for the remainder of this year versus 6.9% in 1Q17. Key to our thinking is that President Xi Jinping will want to keep economic growth in a steady range ahead of the government transition in October. Our expectation is that as many as five of the seven Politburo Standing Committee members could be replaced, and as a result, we believe that President Xi will work with his team to ensure that economic volatility does not disrupt this transition. To be sure, it is still too early to call, but Exhibit 18 underscores how much incremental spending the Chinese government is already pursuing to ensure economic headwinds do not dominate the governmental agenda in the fall.

Brazil: Leaning towards an ‘L’ shaped recovery. The ongoing political crisis continues to weigh on economic growth, potentially more than some investors may appreciate. Indeed, while Brazil’s 1Q17 GDP growth came in strong at 4.3% (and we acknowledge fully above our expectations), a full 73% of the first quarter GDP rebound was solely due to agricultural production surging 13.4% during the same period.

So, when we pull it all together, we are now forecasting 0.3% real GDP growth for Brazil in 2017, below consensus expectations of 0.6%, but above our original forecast of 0.0% (given the cyclical surge in 1Q17). Moreover, we still see the risks to growth skewed to the downside, given the likely delays to pension reform and the general uncertainty around the direction of political leadership. Our bigger picture conclusion is that, as the country exits its longest and deepest recession on record (the economy contracted by 8.2% over the past two years), an ‘L-shaped’ recovery is the most likely scenario. Key to our thinking is that bad credit still needs to be unwound, social benefits are being cut, and business practices are being altered.

On the inflation front, large slack in the economy – with unemployment still at 13.6% – should keep inflation under control in the short term. In fact, we expect inflation to end 2017 at 3.7%, actually below the 4.5% central bank target and our prior forecast of 6.0%. As such, we believe the central bank will be able to cut rates by an additional 175 basis points, with the SELIC rate ending this year at 8.5%.

Global Interest Rates

U.S. Outlook In the face of what has been a surprisingly weak backdrop for core inflation, commodity prices, and U.S. GDP so far in 2017, the Federal Reserve in June made no material changes to its ‘dots plot’ fed funds forecasts (which continue to imply one more hike this year and three next year) and no material changes to its inflation forecasts for 2018 or beyond. Moreover, it chose to preview its balance sheet normalization plans, which we believe the central bank will roll out this September.

We clearly see the world slightly differently than the Fed, and as such, recently modified our interest rate forecasts (both short- and long-end). Specifically, we have removed one 25 basis point hike from our 2018 Fed forecast (versus our prior estimate), which means we now expect fed funds to reach 1.875% at our expected cyclical peak at the end of 2018, down from 2.125% previously (Exhibit 21). Though we respect the Fed’s seeming resolve to continue its tightening campaign, we think the drumbeat of persistently low inflation driven by weak commodity prices, demographics, and technological disruption will force it to pause at some point in coming quarters. In light of our revised Fed forecasts of one more hike in 2017 to 1.375% and two 25 basis point hikes in 2018, our 10-year yield target falls to 2.5% from 2.75% for 2017 and to 3.0% from 3.25% at our expected cycle peak in 2018 (Exhibit 22).

Exhibit 21 We Are Moving to Two Expected Hikes in 2018 from Three Previously

Exhibit 22 We Are Lowering Our U.S. 10-Year Yield Targets by 25 Basis Points to 2.5% for Year-End 2017 and 3.0% for 2018 (Estimated Cycle Peak)

By moving towards balance sheet reduction mode later this year, the Fed will also be confirming our expectation that global developed markets will move to a net issuance of government debt in 2018 (Exhibit 26), reversing the trend of what has been three consecutive years of net purchases. At the same time that the Fed starts reducing its balance sheet, other global central banks — notably the European Central Bank — may also be less aggressive in its bond buying program. Furthermore, U.S. issuance may be heightened by President Trump’s tax agenda. Collectively, these forces explain why we think 10-year yields can continue to rise a little, even as inflation remains controlled and the cycle becomes more mature.

Overall, we think the Fed has moved from being ‘data dependent’ to now being somewhat ‘data defiant.’ Put another way, we think market participants should appreciate that a flat Phillips Curve today (i.e., low unemployment, low inflation) will not necessarily act as a brake on Fed tightening. In fact, if the Fed becomes convinced that its rate decisions now have relatively less importance for the path of inflation, it could become more focused on its role as a regulator of financial market excesses, including high risk-asset valuations and rising credit balances globally.

Looking at the big picture, our view is that the Federal Reserve is using its public commentary to signal three important messages. First, the neutral rate is likely to be much lower this cycle. Specifically, we believe that the neutral rate, which is the interest rate that neither stimulates nor cools down the economy, could be closer to 2.5%, compared to a historical average of closer to 4.0%. We link this downshift to demographics (note the participation rate is now at 62.7% versus 67.1% twenty years ago), disruptive technologies (e.g., the traditional retail sector has lost 51,000 jobs during the last three months ending May 31, 2017 at a time when overall employment grew by 362,000 during the same period), and uncertainty around China and its excess capacity in industries such as steel.

Second, the Fed will likely be extremely conservative around the unwinding of its balance sheet. Said differently, it learned an important lesson during the 2013 Taper Tantrum. Given that the maturing of the balance sheet is non-linear, we think that this approach makes sense. Also, given that quantitative easing is actually a novel concept, there is little to no precedent about how shrinking a $4.3 trillion balance sheet might affect market liquidity, volatility, etc.

Exhibit 23 European Bonds Appear Overpriced Relative to Treasuries, Particularly if One Adjusts for Inflation Differentials

Exhibit 24 While China’s Economy Is Just $11.2 Trillion vs. $18.6 Trillion for the U.S., It Has 1.6x the Amount of U.S. Savings

Third, barring a surge in wage growth to north of 3.5%, we believe that the Federal Reserve will remain measured. There are just too many unusual forces for them to consider, including a potential change in leadership, tax reform, and China. Also, the Federal Reserve will likely have to wrestle with the reality that the repeal of the Affordable Care Act could dent consumer spending more than markets now think. Indeed, low income consumers have a higher marginal propensity to spend than the average American, and as such, incremental spending on healthcare costs could offset the benefits of lower taxes to the upper-middle and high-end earners of the U.S. working population.

Exhibit 25 With the ECB in Full QE Mode, European Rates Are Helping to Suppress U.S. Rates, Even as the Federal Reserve Becomes More Conservative

Exhibit 26 G4 Sovereign Issuance Less Central Bank Purchases Shows that Net Issuance Is Now Actually Negative. However, This Trend Will Change in 2018

International Rate Outlook After discussing the outlook with my colleague Aidan Corcoran, we envision German yields backing up towards one percent at some point during the next twelve months versus just 30 basis points today. Key to our thinking is that monetary conditions in Germany are at their most accommodative in recent history (Exhibit 27). All told, German nominal GDP growth is now more than 300 basis points above the 10-year bund rate, further fueling an economy that is already performing well. Also, the spread between U.S. and German rates has gotten quite wide, a trend we expect to self-correct by German bunds resetting higher versus U.S. bonds rallying heavily.

In terms of market implications, we do view this readjustment as potentially disruptive for holders of long duration assets in Europe (i.e., bond prices are too high), though there could also be beneficiaries (notably in the Financial Services sector). Maybe more important, though, is that we believe the Eurozone economy can handle a bund sell-off of this magnitude, given that it is actually an expression of stronger growth versus a major shift in monetary policy.

Meanwhile, in Asia our colleague Frances Lim sees a more stable interest rate outlook for Japan than what we are forecasting for Europe in the second half of 2017. True, the BoJ has shifted from growing its balance sheet to yield curve control, but it has largely been inconsequential. In fact, long rates remain essentially unchanged since the announcement in late 2016. Maybe more important to the rate outlook – and the BoJ’s thinking – is that the country is likely to miss its inflation target again, supporting her strong view that the policy rate will stay at -0.1% and a 10-year yield will continue to hover around zero percent for the foreseeable future.

Looking at the bigger picture, we think it is worth mentioning that in nominal dollar terms both the ECB and BoJ balance sheets are now on pace to finally eclipse the Fed. One can see this in Exhibit 28. While we normally focus on central bank balance sheet size relative to GDP, the absolute value is also important, as it drives very large sums of money into and out of the key sovereign bonds across the world. Given this important baton hand-off at a time when the global QE cycle is getting mature, our view is that investors should begin to prepare for interest rate volatility to finally increase, as the investment community begins to parse every new piece of information on the health of the economy, inflation, and central bank balance sheet management.

Exhibit 27 German Monetary Conditions Are at Historically Accommodative Levels in Europe. In Our View, This Growth Trajectory Makes Bunds Vulnerable

Exhibit 28 We Expect Greater International Rates Volatility as Both the ECB and BoJ Balance Sheets Eclipse the Fed In USD Terms

Global Earnings: Rebound Still Under Way

After a multiple year hiatus, global earnings are growing again. Interestingly, though, while the U.S. growth has been solid, Europe and EM actually represent the lion’s share of the upward thrust in earnings momentum. As we detail below, we expect these trends to continue. To this end, we note the following:

2017 S&P 500 EPS Update We have revised upwards our 2017 EPS forecast for the S&P 500 to $128, compared to our prior forecast of $127 (now implying 7.1% growth versus 2016 actual EPS of $119). Driving the increase is 4.7% of top-line growth coupled with modest margin expansion of 30 basis points. Previously, we assumed 6.1% revenue growth with no margin expansion. Consistent with this more conservative view, we remain below the consensus of $132 (which is down from $133 at the beginning of the year).

Exhibit 29 For the S&P 500 in 2017, We Look for Revenue Growth of 4.7% and EPS Growth of 7.1%

Exhibit 30 Our 2017 EPS Estimate Is $128, Which Is 3.4% Below Consensus Estimates

Why then the lower number relative to consensus? Our more conservative outlook for 2017 is predicated on two factors. They are as follows:

Point #1: Energy earnings for publicly traded companies appear too optimistic, in our view. As we show in Exhibit 32, we estimate that the consensus estimates for 2017 embed a $64 year-end oil price versus its current level of $45 on June 30, 2017. This optimistic assumption is significant, as a full 27% of EPS growth in 2017 is expected to come from the Energy sector (Exhibit 31). As such, we have baked in a 30% haircut to Energy earnings, which reduces our S&P 500 EPS by $1.50 in 2017. Overall, while we remain bullish on the ability to buy attractively priced properties from energy companies, including producing wells and midstream assets (hence, our overweight to Energy Assets), we hold a more cautious view of many of the publicly traded stocks within the S&P 500 Energy sector.

Exhibit 31 Consensus Expectations Are for 72% of the 2017 U.S. EPS to Come From Just Three Sectors: Energy, Financials and Technology

Exhibit 32 In Our View, the Energy Sector Contribution Is Just Too Optimistic, Embedding What We Believe Is an Oil Price of $64 for End-2017

Point #2: Margin assumptions across many sectors of the S&P 500 are too optimistic, in our view. As the investment bank Goldman Sachs has pointed out, around 50% of the total margin expansion since 2009 has come from just the Technology sector, with Apple accounting for a full 20% of total margin expansion during this same period. Otherwise, our work shows that corporate margins have already peaked, something that many economists have already seen for nine quarters in the U.S. government’s Bureau of Economic Analysis National Income and Products Account (NIPA).

So, when we look at forward margin estimates, we conclude that sell-side forecasts in sectors such as Consumer Discretionary and Industrials are just too optimistic. These sectors are less equipped to absorb higher labor costs while maintaining profitability at this point in the cycle (Exhibit 33). Hence, we assume a conservative margin expansion of 30 basis points in 2017, which is now about 40 to 50 basis points lower than consensus expectations (Exhibit 34).

Exhibit 33 Consumer Discretionary and Industrials Margins Have the Unfortunate Combination of Being High Relative to History but Low in Absolute Terms

Exhibit 34 Despite the Bullish Shift Towards Higher Margin Technology Stocks Within the S&P 500, Overall Margin Assumptions Still Look Aggressive to Us

2018 S&P 500 EPS Update As we think about 2018, we have also taken some additional time to adjust for potential tax reform legislation that we think might be put forward and passed. At the risk of stating the obvious, we continue to think that any benefit to EPS will likely remain a 2018, not a 2017, event. We also see a Border Adjustment Tax (BAT) as a non-starter.

On the other hand, we do still expect some corporate tax reform in 2018. Specifically, we are assuming a lower statutory corporate tax rate of 25%, mandatory repatriation of overseas profits, partial loss of interest deductibility, and a softening dollar. To this end, we note the following assumptions we have made:

Lower Corporate Tax Rate: Consistent with what we detailed in our January outlook, we still assume the statutory tax rate falls to 25% from 35% today, with the effective tax rate dropping to 22% from 28% during the same period. To calculate the impact on S&P 500 earnings, we divide the change in effective tax rate by (1 – the current effective tax rate), which theoretically provides a full $11.10 boost to EPS. However, we believe this likely overstates the actual impact on profits, as a portion of these benefits would likely be passed on to consumers via lower prices or be competed away. As such, we take a 20% haircut and assume just $8.90 of the EPS boost (or 80% of the $11.10) falls to the bottom line.

Repatriation/ Buybacks: Given that the repatriation tax is likely to be mandatory, we assume that all of the approximately $1.2 trillion of accumulated overseas profits will be brought back onshore at a one-time tax rate of 10%. We then assume that 50% of the after-tax proceeds are used for share buybacks in the first year. If we are right, then this addition could add three to four dollars to EPS, we believe.

Potential Partial Loss of Interest Deductibility: We estimate that S&P 500 non-financial companies had roughly $2.8 trillion of net debt and roughly $150 billion of interest expense for fiscal year 2016. So, at a 25% corporate rate, the loss of all interest expense deductions would cost the S&P 500 roughly $4.40 per share in earnings. In our view, a shift towards immediate 100% expensing of interest costs is highly unlikely. So, for our base case we assume 50% of this number (or $2.20 in EPS), which handicaps the probability that there is some ‘grandfathering’ provision on existing debt.

U.S. Dollar: See our commentary below in the ‘where are we in the cycle section,’ but we now assume that the dollar bull market has largely run its course. Case in point, the dollar has already depreciated five percent year-to-date. Even so, the average dollar price in 2017 year-to-date remains three percent above the average price for full year 2016. Assuming no further appreciation or depreciation from current levels, 2018 EPS would be adversely affected by two dollars per share in our base case.

When we bring it all together, our 2018 EPS forecast for the S&P 500 is now $141, compared to our prior forecast of $143 and a current consensus of $148. One can see a breakdown of our forecast in Exhibit 35. Included in our base case for 2018 is 4.1% top-line growth and flat margins, both forecasts slightly more conservative than the consensus (Exhibit 36). Overall, our message is that the earnings cycle is likely to remain solid through the first half of 2018, which influences the way we think about both equity and credit assets at this point in the cycle.

Exhibit 35 We Look for 2018e EPS to Reach $141, Which Is 4.6% Below Consensus Estimates

Exhibit 36 We Have More Conservative Revenue Growth and Margin Assumptions Relative to Consensus

International EPS For the first time in years, we are seeing international EPS outshining U.S. estimates. In rough terms, we expect both Europe and Asia to grow EPS by 20% in 2017, versus mid-single digits for the United States. Moreover, earnings revisions for Europe and the Emerging Markets appear quite favorable relative to the United States. One can see this in Exhibit 37.

In terms of what to look for, our message is pretty clear. Specifically, work done by my colleague Brian Leung shows that earnings are increasingly being driven by just a few sectors. For example, Financials are supposed to account for a full 38% of total European earnings growth in 2017, while Technology is supposed to account for 37% of total EPS growth in EM in 2017.

Exhibit 37 EPS in EM and Europe Are Expected to Grow Approximately 20% in 2017, Outpacing Growth in the US

Exhibit 38 Europe EPS Growth Driven by Financials, EM Driven by Technology and U.S. Growth Driven by Energy

Our bigger picture comment, which we think is bullish for EM, is that Technology has now become become bigger than Financials, measured as a percentage of MSCI market capitalization (Exhibit 39). In our humble opinion, this baton hand-off points to not only an important maturing of emerging market economies but also that public investors are now able to own securities and indexes that are more directly levered to EM’s rising GDP per capita stories. In the past, this was clearly not the case, as many EM indexes were heavily tilted towards just commodity and financial companies.

Exhibit 39 The Technology Sector Has Taken Over as the Largest Driver of EM Returns

Where Are We in the Cycle?

Since we arrived at KKR in 2011, we have been arguing for a longer cycle. Several factors have influenced our thinking over the years. First, given how bad the environment was for jobs and growth in 2008/2009, it would only make sense that it would take longer than normal to create a sustainable economic recovery. Second, as the world transitions away from manufacturing towards more of a services-based economy, our research leads us to believe that the cycles have – on average – gotten more extended. Third, the level of monetary stimulus this cycle has been unprecedented, and as such, it will likely take much more time for central banks to unwind what is now a $14.5 trillion global QE experiment.

Though it may not feel this way to some, we are actually now 96 months into an economic expansion in the United States (Exhibit 40). Our base view is that the expansion continues through 2018, and then we run into a soft patch of economic growth thereafter. While economic expansions do not die of old age, they are affected by issues like peaking margins, heightened leverage, and deteriorating credit. For our nickel, we see all three as potential concerns being issues by 2019.

Exhibit 40 We Are Quite Long in the Tooth in Terms of Pure Cycle Duration at 96 Months

Exhibit 41 Eight Years of Consecutive Positive Performance for the S&P 500 Is Highly Unusual; We Are Now at Eight and One-Half Years Through June 30th, 2017

Exhibit 42 Private Equity Typically Outperforms in Lower Return Environments

Exhibit 43 Despite the Strong Bull Run, 45% of Private Equity Core Addressable Market As Measured by the Russell 2000 Still Has EV/EBITDA of Less than 10x

Importantly, though, we just do not see the leverage in the system to argue for a major, broad-based recession in the U.S. (Exhibits 44 and 45). Rather, we think that we are entering peak margin season for corporations at a time when low-end consumers appear to be struggling, despite robust employment growth. We are not sure, but lack of productivity may have driven corporations to employ more but pay less, a backdrop that we think is not ideal when profits are historically high this late in the cycle.

Another important part of the where are we in the cycle story revolves around the currency, the U.S. dollar in particular. Our base view continues to be that the U.S. dollar is in a near-term lull before its last rally, likely driven by a U.S. recession in 2019. From a valuation perspective, the U.S. dollar now appears overvalued on a real effective exchange rate basis while most other currencies are either undervalued or close to fair value, suggesting the longer-term trend is in favor of a weaker U.S. dollar (Exhibits 46 and 47).

Exhibit 44 We Envision an Economic Drawdown Closer to 2001 Than 2009 in Terms of an Overall Growth Slowdown

Exhibit 45 We Forecast a Mild U.S. Recession in 2019, With Attributes More Similar to 2001 Than 2007

Second, with the bulk of the political headwinds in Europe passed, the euro is likely to remain reasonably strong against the U.S. dollar, in our view. This viewpoint could be significant for markets, as the euro makes up approximately 20-60% of most trade weighted currency indexes that many investors follow. Third, from a cyclical perspective, the U.S. is late cycle and growth is likely to lose momentum. By comparison, developing markets are just emerging from the bottom of the cycle, and Europe still has more to go in the current economic cycle, which would suggest funds flowing away from the U.S. Finally, the Federal Reserve now seems more cautious about unwinding its balance sheet at a time when the current Republican administration is less likely to able to pursue as ambitious of an agenda in areas like Border Tax adjustability.

Exhibit 46 Global Imbalances Have Narrowed, Which Suggests Less Misalignment of Global Currencies

Exhibit 47 In Addition, the U.S. Dollar No Longer Appears Undervalued on a Real Effective Exchange Rate Basis

Section II: Key Themes/Trends Update

In the following section we detail several key investment themes that we think can create differentiated alpha for long-term investors. They are as follows:

De-conglomeratization: Corporates Shedding Assets Is Yielding Results Across Energy, Infrastructure, and Private Equity, we are seeing a notable acceleration in divestitures and carve-outs from the multinational community. In our view, this idea is a big one; it is global, and it has duration. It also reflects a push by more activist investors for management teams to optimize their global footprints, particularly as domestic agendas take precedence over global ones. Central to this story is that, as we show in Exhibits 48 and 49, respectively, returns are falling for many multinational companies.

Exhibit 48 Rate of Returns for FDI Are Declining in Many Areas of the Global Economy

Exhibit 49 Local and Regional Competitors Are Increasingly Challenging the Returns of Multinational Firms

Exhibit 50 Investors Can Now Look to the More Mature Economies as Funding Sources, Particularly in Today’s Slower Growth World

Exhibit 51 Complex Corporate Structures Amidst Compelling Valuations Make Japan an Interesting Play on Our Corporate ‘Carve-Out’ Thesis

At the moment, Japan has emerged as one of the most compelling pure play examples on our thesis about corporations shedding non-core assets and subsidiaries. Without question, the macro backdrop is compelling for at least three reasons. First, many of Japan’s largest companies have literally hundreds of subsidiaries that could be deemed non-core, and as corporate governance and shareholder activism gain momentum, they are increasingly being identified as potential sources of value creation. Second, the deposit to GDP ratio is 135.5% (Exhibit 50), underscoring that banks are hungry to lend to acquirers of these subsidiaries. In many instances, a private equity firm can get at least 7x leverage, with an all-in cost of funds that is below two percent. Finally, as we show in Exhibit 51, enterprise value to EBITDA multiples in Japan are still below historical averages, a setup that we can’t find in many other markets around the world.

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 the companies to shed slower growth assets in favor ‘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 (Exhibit 52), particularly for players with expertise in the production and midstream segments of the oil and gas markets. Also, within the Infrastructure sector, we have seen a notable number of divestitures of hard assets 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 in Infrastructure is in addition to the some of the structural increases in infrastructure investment that we think will occur as governments rely more on fiscal spending than monetary spending to bolster growth in the years ahead.

Exhibit 52 We Believe That Private Energy Assets Often Offer Less Beta and More Alpha Than Pure Commodity Assets

Exhibit 53 The Lion’s Share of Rig Count Growth by Basin Over the Past Year Has Been All Permian

Exhibit 54 U.S. Upstream Activity Has Focused on Streamlining, With Many Energy Companies Selling Assets to Reposition Their Portfolios for Faster Growth

Exhibit 55 Interest by European Investors Towards Infrastructure Has Generally Increased in Recent Years

Experiences over Things While this theme is not a new one for us, the pace of implementation appears to have accelerated in recent months. Importantly, as we describe below, we do not think that 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. One can see this trend in Exhibit 56.

Exhibit 56 Disposable Income Available for Traditional ‘Things’ Is Waning At a Time of Significant Change in Consumer Spending

Exhibit 57 The Trend Towards Greater Spending on Experiences Is Accelerating in Europe Too

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. Meanwhile, in the emerging markets we continue to see demand for basic healthcare offerings, including private insurance and specialized surgery care, especially in fast-growing consumer markets such as Brazil, China, Indonesia, and India.

Importantly, the trend towards services extends well beyond just the Healthcare sector. Recreation, travel, and leisure all appear to be market share gainers versus basic ‘things’ that consumers traditionally bought with their disposable income. Moreover, consumers are more willing to use the Internet to price shop, making them more fickle in some instances.

Exhibit 58 ‘Core Core’ Goods Are in a State of Secular Deflation…

Exhibit 59 ...Driven by Negative Pricing Across Many Traditional Goods

The downside of the environment we are describing is that many traditional retailers, malls, and product providers are likely to see waning demand for their offerings. Moreover, pricing power in many areas of the ‘goods’ market is negative. All told, goods inflation has been negative on a year-over-year basis for the past 16 consecutive quarters and negative for 50 of the last 69 quarters since 2000 (Exhibit 58). These trends are noteworthy, because – as we show in Exhibit 61, a lot of infrastructure has already been built to support consumer expenditures. As a result, if we are right that the shift towards experiences over things is more secular than cyclical (which we believe it is), many companies across the global supply chain may need to reconsider their existing footprints to better accommodate the preferential shifts that we are highlighting.

Exhibit 60 Chinese Millennials Not Only Save Less But Also Allocate Three Times More of Their Income to Leisure

Exhibit 61 The Trend of Experiences Over Things May Force Tough Decisions in the U.S. Brick and Mortar Community

Emerging Markets over Developed Markets As we indicated in our 2017 outlook, our quantitative model is turning more positive on Public Equity Emerging Markets. Higher real rates, smaller deficits, less institutional sponsorship, and more stable currencies all lead us to believe that Emerging Markets as an asset class are bottoming. This viewpoint is consistent with what we laid out in our October 2016 Insights Asia: Pivot Required. This insight is significant, as periods of emerging market outperformance tend to extend for multiple quarters (Exhibit 62).

Importantly, when we do a simple Dupont analysis to decompose return on equity, our work shows that operating margins are finally improving across all of EM, which is now boosting return on equity. While the margin increase is broad-based by region, commodity related companies are driving the lion’s share of the increase, reinforcing our earlier point that commodity prices must at least stabilize at current levels for our EM dashboard to remain positive. Meanwhile, financial leverage across EM is declining, while asset turnover remains essentially unchanged in recent quarters.

To our surprise, one area that has actually turned down since our last ‘check-in’ in August 2016 is momentum. Our belief is that the momentum pullback is more of a temporary blip around the Brazil political situation, but we will be watching the situation closely. In the past, the momentum pullback has helped to boost flows from non-dedicated EM managers, which is often critical to boosting returns over the cycle. Given the strength of our model and the importance of this input, we think that it will be critical for this variable to turn up again if we are to be right on our call that we are on the cusp of experiencing a secular turn in relative performance of EM.

In addition to the more positive attitude we have been sharing about certain EM Public Equities, we are also more constructive on local debt, including both sovereign (as reflected by our earlier shift out of 100% developed market sovereign debt towards areas like Mexico, Indonesia, and India) and corporate fixed income securities. Indeed, with the U.S. dollar now above what we believe is fair value, EM currencies are likely to perform better. Moreover, many EM governments and companies have pared back some of their excessive spending, which – all else being equal – increases the potential for debt repayment. One can see the magnitude of the improvement in corporate behavior of late in Exhibit 64.

Exhibit 62 It Has Been a Long, Hard Road in EM…

Exhibit 63 …But Our Work Shows That EM Is Bottoming

Exhibit 64 Free Cash Flow Is Up Across EM

Exhibit 65 Within EM Debt, We Generally Favor Local Currency Across Both Sovereign and Corporate

Fixed Income Illiquidity Premium In today’s low rate environment we continue to migrate towards securities that harness the 2.5-3.5% illiquidity premium that we now believe is available across many parts of Private Credit. Without question, in a world where risk free rates are still close to zero in many instances, we think that this additional cushion is important for overcoming the mounting liabilities that many pensions and insurance companies face today. As a result, Private Credit as an asset class remains one of our largest non-benchmark weightings.

Exhibit 66 The Illiquidity Premium Has Remained Fairly Constant Across a Variety of Environments…

Exhibit 67 …and a Variety of Private Credit Markets

However, we do continue to shift our portfolio within Private Credit. Specifically, similar to what we did at the beginning of the year, we are again dropping our Global Direct Lending allocation to a 500 basis point position, down from 800 basis points in January and 1000 basis points last year. Strong technicals amidst sluggish supply are driving a wider array of yield hungry allocators of capital towards Private Credit products, often rendering terms less attractive than they were 12-18 months ago. Meanwhile, a flood of new capital in the low end of the market is compressing spreads somewhat.

Exhibit 68 Foreign Banks Have Pulled Back from Indonesia, Creating Opportunities in Certain Instances for Private Credit

Exhibit 69 Banks’ Assets in Europe Have Decreased by 22% from 2.9x GDP to 2.3x Since the Great Financial Crisis

On the other hand, we see a growing opportunity within the Asset-Based Lending part of the market. Central bankers in Europe now understand that yield curve steepness is of paramount importance, and with rising stock prices, we have seen a flurry of performing assets coming off bank balance sheets (Exhibit 69). We have also seen more opportunities – either through platforms or joint ventures – to partner alongside local banks in countries such as Ireland, Italy, and Spain. Given this view, we are topping up our Asset-Based Lending/Mezzanine exposure to 800 basis points from 500 basis points in January and 300 basis points in 2016.

Separately, we also see an emerging trend – no pun intended – in many of the emerging markets that we have visited in recent quarters. Indeed, as we show in Exhibit 70, more and more corporates in places like India and Indonesia are shifting from traditional financial intermediaries in favor of complex solutions that can be underwritten by leading private credit players.

Exhibit 70 Emerging Market Private Credit Is Increasingly Another Interesting Play on Our Illiquidity Premium Thesis

Finally, given our 300 basis point overweight to Energy Assets/Infrastructure, we did want to highlight that we view this cash flowing sector as a back-door play on both our Illiquidity Premium and Yield and Growth thesis. Importantly, for those concerned about where we are in the economic cycle, Infrastructure credit performed notably better than many traditional credit products, both public and private, during the last economic downturn.

Embrace Complexity/Dislocation Simply stated, we want to buy capital markets dislocations that are increasingly occurring around – amongst other things – geopolitical tensions and/or perceived changes in monetary policy. It might not feel this way right now, but since 2011 the VIX has increased by 50% or more over eight percent of the trading days, compared to an historical average of around 4.9% during the pre-crisis period.

Exhibit 71 Post the Global Financial Crisis, Volatility Spikes Have Become the Norm

Exhibit 72 Global QE Has Been Significant. We See a Shift From Monetary Stimulus Towards More Fiscal Stimulus Ahead

Given that global central bank balance sheets have expanded by $14 trillion in recent years, we continue to find examples around the world in both equities and debt where investors appear to be over-paying for quality assets but are not willing to pay fair price for assets that may have stumbled and/or require some fixing to achieve their potential. Within public equities, we currently think that certain MLPs appear attractive (Exhibit 75). Our work shows that this asset class is one of the few high yielding asset classes that have not compressed with the dramatic decline in interest rates that we have seen in recent years. To be sure, there are some broken business models in the sector (particularly roll-up stories), but we have also been able to find some cheap cash-flowing assets that we believe will create substantial long-term value for shareholders.

Exhibit 73 The Wide Range of Equity Performance Has Created Significant Opportunities to Both Buy and Sell

Exhibit 74 Given the Flight to Quality, Individual Credit Picking and Understanding Relative Value Across All Spread Assets in a More Concentrated Way Can Add Material Alpha

Exhibit 75 There Are Very Few Asset Classes Offering Above Average Yields. MLPs Are Currently One of Them

On the debt side, we note that many areas of the traditional liquid markets appear expensive. One can see this in Exhibit 74, which shows that many parts of the credit markets, high yield in particular, are trading well inside of their historical norms (e.g., BB spreads less BBB spreads, B spreads less BB spreads). By comparison, parts of the CCC universe for loans actually look quite interesting relative to the B sub-segment of the market. To be sure, not every CCC credit is worthy of investor attention, but we do believe that looking for these types of anomalies does make sense in a market that generally does not offer that much relative value, in our view.

Section III: Risks to Consider

In terms of risk on which to focus, we think the following considerations are worthy of investor attention.

Potential U.S. Consumer Disconnect While aggregate statistics by the government for the U.S. consumer are reporting record low unemployment amidst surging household net worth, we have come to an increasingly more conservative outlook for the U.S. consumer, particularly at the low end of the market. Key to our thinking is that, as we show in Exhibit 76, basic household expenses continue to increase faster than overall wages, which is a growing issue for the large segment of the U.S. market that has not built net worth in recent years. Moreover, debt loads in areas such as student lending and autos has crept up to what we view as concerning levels. Sub-prime credit cards too should be an area of investor focus, in our view. How else can one explain rising auto defaults that now approximate 2007 levels with unemployment below the natural rate of employment?

Exhibit 76 Healthcare and Shelter Inflation Have Largely More Than Offset Any Acceleration in U.S. Wage Growth

Exhibit 77 21-34 Year Olds Likely Make Up the Greatest Share of U.S. Consumer Default Risk Over the Next 12 Months

Exhibit 78 We Believe U.S. Auto Companies Have Moved Down the Credit Quality Ladder to Sustain Growth

Exhibit 79 60-Day Plus Delinquencies in the U.S. Are Up Across Prime and Subprime, With the Latter Approaching Global Financial Crisis Peak Levels

Exhibit 80 Americans Under the Age of 35 Now Hold the Largest Percentage of Non-Mortgage Debt

Exhibit 81 The Unemployment Rate and Education Levels Go Hand-in-Hand

To be sure, we do not see the leverage in the system that brought about the mortgage crisis in 2007. However, we do wonder whether any slowdown in employment could portend a notable slowdown in not only consumer spending but also meaningfully impact consumer delinquency trends. As we mentioned earlier, corporate margins appear full at time when employment is below its natural rate of unemployment (Exhibit 82). At the same time, productivity has been lagging. Said differently, productivity is now growing slower than wage growth, so that the marginal benefit of adding employees to growth has essentially disappeared (Exhibit 83).

Exhibit 82 Unemployment Has Dipped Slightly Below Its Natural Rate (NAIRU)

Exhibit 83 Real Unit Labor Costs May Already Have Peaked This Cycle

A more ominous conclusion is that, because this cycle has been defined by adding employees and not boosting productivity in recent years, we now have an excess of employees in the workforce relative to long-term growth potential. This insight is significant because it could lead to a potentially surprising number of layoffs if corporate earnings growth does slow in the coming quarters. We are watching this inter-relationship quite closely, as consumer defaults in areas like autos and cards are increasing in what many view as an attractive backdrop for U.S. consumers.

Market Flows/Leverage Warrant Investor Attention As has been well documented in recent years, active management has had a woeful performance run. According to my colleague Brian Leung’s work, 85% of large cap active managers have underperformed their benchmark during the last 10 years, while 91% of small cap managers have suffered a similar fate. Not surprisingly, money has gushed out of active funds and into passive funds.

Exhibit 84 Since 2009, Investors Have Poured $1.8 Trillion Into Passive Funds and Redeemed $600 Billion from Active U.S. Equity Funds

Exhibit 85 Volatility Is Now at Its Lows While Equity Long/Short Hedge Fund Gross Leverage Is Near Its Highs

At the same time, robust global Quantitative Easing has reduced overall sustained volatility. This development is important because it means that many hedge fund managers are being forced to lever up to maintain the volatility metrics that they have promised their investors (Exhibit 85).

In our view, the combination of high leverage and low volatility is not a good one, particularly at a time in the cycle when index flows are luring performance chasers into an increasingly select number of stocks. If history is any guide, any material and sustained increase in volatility could force the growing number of levered managers to reduce their gross exposures by selling over-owned index names at potentially an inopportune time.

Credit Spreads Are Tight From almost any vantage point, credit spreads appear tight. Our favorite measure for quantifying potential over-optimism in the credit markets is to assess the implied default rate that the liquid high yield market appears to be discounting. As we show in Exhibit 86, the model is currently suggesting an implied default rate of 0.9%, well below the historical average and a far cry from levels seen as recently as 1Q16. In terms of absolute yield levels, high yield spreads too feel compressed, trading now at 369 basis points above the risk-free rate. In the past, this spread has averaged closer to 580 basis points.

Exhibit 86 Early Last Year, the Implied Default Rate Increased to 8.7%. Today, by Comparison, It Is Just 0.9%

Exhibit 87 High Yield Spreads Have Tightened Significantly, and As Such, Are Now Well Below Average

Relative value within and across the high yield asset class also feels somewhat disconnected with reality. For example, despite being lower down in the capital structure, high yield spreads are now trading 41 basis points tighter, on average, than bank loans (Exhibit 88). Also, when we look at high yield debt relative to equities in volatile sectors like energy, credit appears expensive. One can see this potential ‘disconnect’ in Exhibit 89.

Exhibit 88 High Yield Spreads Appear Mispriced Relative to Those of Bank Loans at This Point in the Cycle

Exhibit 89 High Yield Energy Credit Looks Expensive Relative to Equities at Current Oil Prices

Leverage in China If there was one take-away from the Global Financial Crisis, it was to ‘follow the leverage.’ In 2007, for example, U.S. banks levered up their balance sheets to hold billions of dollars of mortgages from highly levered U.S. consumers – not a great combination. Today, by comparison, U.S. banks run with about one-third of the leverage they did at the peak, (10x versus 30x), and consumers have not levered up their single biggest asset – their house – to the same degree.

Exhibit 90 China’s Current Account Surplus and Its Capital Account Have Diverged

Exhibit 91 China’s Banks Are Levering Up Similar to U.S. Banks Before the Global Financial Crisis

On the other hand, China has added an enormous amount of leverage in recent years (Exhibit 91). What some folks may not appreciate is that China became the world’s growth engine after the 2007 downturn by extending credit the same way the United States did with mortgage credit after the tragic events of 2001. As we showed earlier in Exhibit 20, credit as a percentage of GDP spiked to 180% from 140% during the financial crisis, and it is now on track to reach 300% possibly as early as 2019.

To be sure, while China can maintain strict capital controls in the short-term, it can’t do it forever. Moreover, if the country continues to run nominal credit growth above nominal GDP for an extended period of time, we believe that the currency will be forced to adjust.

Section IV: Conclusion

As we peer around the corner today on what tomorrow might bring, our work leads us to forecast lower overall returns. Key to our thinking for the next five years is that margins and multiples are high, while interest rates are low. Also, we potentially expect an increase in companies’ cost of capital, as interest rate volatility increases. Moreover, as we indicated earlier, we have entered a period of heightened social and geopolitical tensions, tensions that are not likely to abate during what our colleague Ken Mehlman refers to as a global ‘political bull market.’

Against this backdrop, however, we still see some attractive opportunities. Our base view is that investors must focus on those select areas where a manager can gain what is believed to be an advantage in sourcing, operations, strategy, and/or execution. He or she must also be looking for investments in the right ‘ponds’ of opportunity.

As we have detailed in this piece, we see five areas of focus that we believe can help drive both absolute and relative outperformance. First, we believe that we have entered an important period of change in global corporate structures. Driven by factors such as increased activism amidst declining returns on equity in foreign markets, we see many CEOs now striving to better simplify their global footprints. Importantly, this theme is not contained to just the corporate sector. In addition, we see our corporate ‘carve-out’ theme playing out across both the infrastructure and energy complexes.

Second, we believe that investors can still deploy more capital behind the trend towards consumer experiences over things. Importantly, this theme appears to be gaining momentum across both developed and developing economies. Third, we now are more inclined to lean in on emerging market opportunities, particularly if they are linked to GDP-per-capita stories at appropriate valuations. Fourth, we still see the illiquidity premium as compelling. Given our base view that rates remain low in historical context, the opportunity to earn 200-400 basis points of excess spread in fixed income (and not necessarily be extending duration) makes a lot of sense to us. Finally, we continue to embrace complexity, particularly during periods of market dislocation. Right now we think parts of healthcare, MLPs, and low-rated credit all warrant investor attention.

Our strong view is that now is not the time to overpay for growth and/or to over rely on margin expansion for growth. As indicated earlier, we are now 96 months into an economic expansion, and we now expect a shift in both global monetary policy and net issuance by 2018. Also, consumer trends are likely not as positive as the headline data suggests in the United States, while increasing debt growth in China relative to nominal GDP is unsustainable at current levels, in our view.

As such, we continue to run with an asset allocation portfolio that is lower risk than it was two to three years ago. However, given the strong growth that we are forecasting in earnings amidst low inflation and low rates, we do not believe that the bull market in risk assets has – at this point – fully run its course.