KKR writes in their Global perspectives https://www.kkr.com/global-perspectives/publications/hot-spots
So, what should investors know about what we learned during our journey to key “hot spots” around the globe in 2019, and what does it mean for our asset allocation framework?
- As one might expect, trade was the topic du jour across both continents. Our key takeaway was that there may or may not be a headline win around trade eventually, but the global competitive landscape has shifted permanently, in our view. From what we can tell, there is a growing nationalist movement amongst politicians to usher in a collective disarmament of the World Trade Organization. In many instances supporting national champions is now more important than sourcing the lowest cost supply chains. It is one of the reasons that we have always believed that President Trump would threaten to implement Round IV of tariffs (see mid-year outlook Stay the Course for full details). Consistent with this view, we see a Berlin Wall-type scenario now unfolding across global technology standards – one that flies in the face of what the WTO and other organizations that promote open standards have attempted to achieve for nearly three decades. Already, Western players such as Google, Facebook, Twitter, and WhatsApp have had difficulty in China, and in their places, Baidu, Ren Ren, Weibo, and WeChat are now thriving. Not surprisingly, we see 5G as the next chapter in this global bifurcation of technology standards/providers. Meanwhile, several foreign firms with whom we spoke during our time in Beijing indicated some sort of an acceleration in supply chain diversification away from China in order to reduce operating risks. Thailand, Vietnam, Mexico, and even the United States and Europe, were all mentioned during our visits as key beneficiaries of this rerouting, a migration pattern my colleague Frances Lim has been arguing for some time. At the same time, the trend towards insourcing within China is now a very viable one for investors to consider backing with their capital. The decision-makers with whom we spoke in Beijing confirmed that the trend towards insourcing is broad-based, spanning the industrial, technology, and healthcare sectors. So, our bottom line is that, even if there is positive headline news around trade negotiations (e.g., China buying more oil or soybeans) in the coming months, rule of law and national security concerns represent longer-term issues that are not easily fixable, particularly as the geopolitical and strategic importance of technological prowess across industries increases. If we are right, then a different investment playbook than what worked for the last 25 years is now required.
- In terms of the global inflation outlook, our travels lead us to believe that we are stuck somewhere between disinflation and deflation. As a team at KKR, we are firmly in the camp that demographics, technological change, and excess capacity are likely to keep a lid on inflationary trends for the near future. Consistent with this view, we now estimate that the Federal Reserve needs to engineer 40-50 basis points of inflation annually just to keep inflation stable, given that deflation is actually playing out in many key sectors such as Autos, Technology, and Consumer Goods. Hence, as we describe below in more detail, we remain of the view that rates are likely to stay lower for longer, which has huge investment implications for both individual and institutional savers. In the world we envision, upfront yield becomes more important to credit allocators, while pricing power becomes more important to investors in equity securities. Importantly, China’s recent decision to let its currency weaken only strengthens our conviction in our thesis.
- China continues to be the most innovative technology market that we visit each year, while Europe is trying to close the gap. Driven by 330 million millennials that are coming of age, the opportunity around Big Data, Artificial Intelligence, and 5G remains outsized within both the consumer and corporate segments of China. From our vantage point, it is hard to overstate how important getting up to speed on Chinese technological innovation is to any global investor who allocates capital to the Technology and/or Consumer sectors. This knowledge base is also critical to a better understanding of the current U.S.-China trade debate, and why we believe this debate is much more significant than just the world’s two largest economies arguing about terms of trade. Meanwhile, in Europe we think that Berlin has clearly emerged as the Continent’s Silicon Valley, and the significant opportunity set that we see across private Technology investments in the region make us even more bullish that European Private Equity can handily outperform European Public Markets. Further details below.
- We expect more geopolitical volatility ahead, and we now assign a 50% probability to a Hard Brexit. The potential temporary dysfunction from a disorderly departure, particularly as it relates to business uncertainty in the private sector, likely deserves more attention than it is getting from investors. Therefore, we are of the mindset that U.K. investments should demand one of the highest risk premium of any developed economy today, and as such, we are encouraging hedging the majority of one’s positions in the currency market.
- Given the uncertainty, we think that the opportunity to buy complexity at a discount remains outsized. Interestingly, though, Asia seems to be gaining on Europe in terms of the ability to transact. Beyond just acquiring positions through the public markets (which is becoming a more relevant opportunity set for PE firms), our conversations in Beijing with senior executives now lead us to believe that there is a forthcoming wave of deconglomeratization in China that could soon rival what we are seeing in Europe these days. Simply stated, multinationals are increasingly of the mindset that doing business in China as a foreigner is getting tougher, not easier. If we are even partially right, this opportunity could be quite meaningful to Private Equity, Real Estate, Credit, and Infrastructure over the next five to seven years, we believe Looking at the bigger picture, our asset allocation tilts towards investments that are linked to nominal GDP, have collateral against them, and generate upfront cash flow. As a result, we remain overweight Real Assets, Global Infrastructure in particular. We also remain constructive on more flexible mandates across both liquid and illiquid investments, and as such, maintain our increased allocations to both Actively Managed Opportunistic Credit and Special Situations. Finally, we continue to overweight Private Equity in size (300 basis points), as our work shows that the value of private investments grows more important later in the cycle.