Kohlberg Kravis Roberts & Co (KKR) has engaged in a number of discussions among insurers around leveraged credit. These discussions highlight the macroeconomic and political uncertainty taking place across markets and dislocations around the globe. KKR believes these dislocations will likely continue, resulting in heightened volatility and incremental buying opportunities. Moreover, we believe that being nimble, having conviction and dynamically allocating across asset classes by identifying the strongest relative value opportunities can generate alpha in these periods. Thus, we expect performance strategy and manager selection to be even more important in the coming years as the combination of greater volatility and lower liquidity take hold.
WE BELIEVE THE KEY PHRASE THAT YOU WILL HEAR MORE OF IN 2019 IS THAT OF ‘DISPERSION’.
In 1852, Charles MacKay published “Memoirs of Extraordinary Popular Delusions and the Madness of Crowds”. In the book he discusses, among other things, three examples of economic bubbles – The Mississippi Company, Tulip Mania and The South Sea Company. One quote in the book regarding these examples came to mind at the end of last year.
“But it was a long time before public credit was thoroughly restored. Enterprise, like Icarus, had soared too high, and melted the wax of her wings; like Icarus, she had fallen into a sea, and learned, while floundering in its waves, that her proper element was the solid ground.”
Since the end of last year, we have seen a significant uptick in investors seeking to change how they are allocating capital in the leveraged credit market. We believe many investors – that have seen strong market driven returns over the last 10 years – are now seeking to mitigate beta risk and focus more on idiosyncratic risk. The market returns in Q4 2018 acted as a jolt to many. The credit markets, and specifically the leveraged loan and high yield bond markets, witnessed the dangers of daily liquidity funds. Strong outflows in December created significant volatility, represented a tipping point, and most investors retreated. Many market participants who were drawn in by attractive market driven returns found themselves flying too close to the sun. The returns in sub-investment grade credit in Q4 2018 were not just remarkable for their sharply negative trend but also for their correlation across asset classes (bonds, loans and equities). We now look at the drivers of this trend: 1) FUNDAMENTALS – SCRATCH BENEATH THE SURFACE The charts below show the broad strength in Revenue and Earnings growth across KKR’s Global Credit portfolio.Exhibit 1: Sector Momentum (KKR Global Credit)
Source: KKR Credit Analysis as of December 31, 2018
Exhibit 2: Sector Momentum (KKR Global Credit)
Source: KKR Credit Analysis as of December 31, 2018
If we look at a sector analysis of EBITDA growth, we can see broadly positive momentum here. Exhibit 3 below shows last 3 month growth on the vertical axis and last 12 month growth on the horizontal. The size of the circles represents our exposure:
Exhibit 3: Sector Momentum (KKR Global Credit)
Source: KKR Credit Analysis as of December 31, 2018
However, look at how dispersion increases as we move from broad industry groups to sub-sectors:
Exhibit 4: Sub-Sector Momentum (KKR Global Credit)
Source: KKR Credit Analysis as of December 31, 2018
The chart highlights the dangers than can lurk in areas such as Household Products and Marine.
In truth, wider markets are already showing dispersion in performance. For example, Exhibit 5 shows EBITDA year- on-year growth in selected S&P 500 sectors and shows remarkably different earnings growth in IT and Materials versus Consumer and Utilities sectors:
Exhibit 5: S&P Sector EBITDA Y-o-Y Growth
Source: KKR GMAA, Federal Reserve, European Central Bank as of December 31, 2018
An index-linked portfolio will – by its nature – focus on all these sectors and generate index-like returns. To put this in context in terms of Sub-Investment Grade credit, we have summarized the forecast from most of the investment banks below of what they believe the different indices will return in 2019:
Overall, these forecast returns are lower than historic norms and are relatively uncertain (as demonstrated by a wide dispersion of forecasts).
2) LOWER LIQUIDITY AND HIGHER VOLATILITY
We believe the lack of a consensus on forecast returns can be partly attributed to the fact that the 10 year quantitative easing cycle is coming to an end.
To put this in context, central banks in developed countries have purchased ~$16 trillion in assets and this is now reversing rapidly. As shown in Exhibit 6, the overall money supply is shrinking. However, our concern extends beyond the economy in general and into the financial markets, especially Sub Investment Grade credit markets.
Exhibit 6: Monthly Changes in Balance Sheet ($bn)
Note: * We assume that 80% of TLTRO is extended for two years (before rolling off completely by early 2023. Source: KKR GMAA, Federal Reserve, European Central Bank
Overall broker-dealer inventories have reduced by ~75% since the financial crisis. We believe the growth in daily liquidity mutual funds alongside a shortage of overall market liquidity is likely to exacerbate market volatility. Since 2011, we have seen numerous periods of heightening price movements and we expect this trend to continue.
Exhibit 7: Trailing 90 Day Volatility
Source: Credit Suisse as of December 31, 2018
3) DISPERSION OF COMPANY PERFORMANCE AND INVESTMENT APPROACHES
With thanks to our KKR Global Macro & Asset Allocation team, they have highlighted some areas where we expect a slowdown in 2019. Most notably, they believe there is likely to be a weakening of US Fixed Income Investment.
This trend is partly due to normalizing inventories as businesses had been building stocks ahead of potential tariffs. We expect to see slowing housing starts and auto sales in the US, declining upstream energy investment and potentially some deferrals of business capex.
However, we believe consumption growth is likely to remain strong. Looking at real personal consumption expenditures (PCE), we expect this to remain solid given lower overall unemployment levels.
For readers who would like to read more about our thoughts on these trends, please see our KKR Global Macro & Asset Allocation Team’s 2019 Outlook called “The Game Has Changed” at the following link: http://www.KKR.com/global-perspectives/ publications/outlook-2019-game-has-changed
So we expect a diversion of business results depending on the primary drivers. Against this backdrop, one would expect divergence in the performance of managers depending on style. However, we would caution investors that we expect overall dispersion to be significantly higher than normal given more bouts of volatility.
For example, in Exhibit 8 we look at the dispersion of performance across ~250 managers on eVestment. Dispersion is measured as the absolute difference in return of 1st quartile and 4th quartile managers. For example, if the average 1st quartile manager returned 8% and the 4th quartile return was 1%, this ‘Manager Dispersion’ measures 7%. We have overlaid this with annualized volatility in High Yield returns since 2013 to show the strong correlation. The more volatile the period, the more likely there to be significant dispersion in performance.
Exhibit 8: Dispersion of Performance versus Return Vol.
Source: KKR Credit Analysis, eVestment as of as of December 31, 2018
In summary, we believe that investors will have vastly different experiences depending on the investment approach they take and credit risk they hold. For investors that heed risks and avoid flying to close to the sun in index-linked products, we believe there are attractive opportunities to select risk. For those that don’t, we suspect it will be a bumpy ride in the medium term. We can summarize our views as follows:
- At a high level, fundamental performance is good. This may continue to drive broad bouts of risk taking, but underneath the surface there are areas of weakness;
- These areas of weakness mean that an index-linked approach to investing is likely to yield lower returns than historical norms;
- The global shift from monetary stimulus to fiscal stimulus may result in lower overall market liquidity;
- Lower overall liquidity levels will exacerbate volatility when areas of weakness are recognized by the market;
- The move to fiscal stimulus may also result in dispersion of returns, especially as we suspect spending patterns will change;
- With dispersion of company performance and a new realization of market norms and volatility, we believe that manager performance will also be heavily dispersed and it will be difficult for many to beat the index; and
- Better performance has (and may continue to) come from those that know credits’ intrinsic value well, have the ability to be (and are incentivized to be nimble and can invest with conviction.
By Kohlberg Kravis Roberts Chris Sheldon, Member & Head of KKR Leveraged Credit Jeremiah Lane, Member, KKR Leveraged Credit Mitch Lee, Co-Head, KKR Insurance Relationship Management John Morrison, Co-Head, KKR Insurance Relationship Management
