INSIGHTS

GLOBAL MACRO TRENDS

VOLUME 9.3 • APRIL 2019

The Uncomfortable Truth

 The Uncomfortable Truth
As the intensifying yearn for yield by investors
increasingly bumps up against “the uncomfortable
truth” of declining interest rates amidst soaring fiscal
deficits and bulging debt loads, KKR’s Global Macro,
Balance Sheet, and Risk Analytics team has analyzed
what yield-oriented investors, especially those with
KKR GLOBAL MACRO & ASSET
large swaths of exposure to Fixed Income and Real
ALLOCATION TEAM Assets, can do to outperform without taking on undue
Henry H. McVey
Head of Global Macro & Asset Allocation risks in this environment. Our suggestion is to own
+1 (212) 519.1628
henry.mcvey@kkr.com more cash flowing assets linked to nominal GDP, build
Frances B. Lim more flexibility across mandates, and shorten duration
+61 (2) 8298.5553
frances.lim@kkr.com where appropriate. Importantly, despite our view that
Rebecca J. Ramsey inflation will remain low in the medium-term, we
+1 (212) 519.1631
rebecca.ramsey@kkr.com respect that the ‘Authorities’ are trying shrink existing
debt loads by holding nominal interest rates below
nominal GDP. As such, we believe strongly that an
overweight to modestly leveraged Infrastructure and
certain Real Estate investments with yield is prudent to
add some ballast to one’s portfolio.

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2 KKR INSIGHTS: GLOBAL MACRO TRENDS
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With central banks once again feeling inspired to hold interest rates EXHIBIT 2
low around the lion’s share of the developed world, many investors
U.S. Government and Corporate Debt Have Increased by
with whom we speak are increasingly confident that the “trifecta” of
sluggish nominal GDP growth, low rates, and paltry inflation may be
112% and 41%, Respectively, Over the Last 10 Years
back upon us. However, it is not business as usual in the capital mar- US: Debt, US$ Trillions
kets, as both debt issuance and deficits continue to soar across many
areas of the private and public sectors (Exhibits 1 and 2). In fact, Household Corporate Government GSE Financials
emboldened by the Fed’s dovish commentary through 1Q19, there is
now even talk in some circles on Wall Street as well as in academia
of such heady topics as Modern Monetary Theory (MMT), which sug- 70
gests that the global capital markets have an infinite capacity for debt
– or at least that’s the theory being put forth. 60
Government and
EXHIBIT 1 50
corporate debt have
grown by 112% and 41%
Government and Corporate Debt Has Increased 40 over the past 10 years
Meaningfully Around the Globe
30
Change in Debt % GDP: 2018 vs. 2007, ppt
20
Household Corporate
200
10
Government Total
150 0
60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08 11 14 17
100
Data as at December 31, 2018. Source: Federal Reserve Board, Haver
Analytics.
50

0 Given this unusual macro backdrop, or what we have begun to term

“the uncomfortable truth” of declining interest rates amidst rising
-50 deficits and heavy debt loads, we have been working hard as a team
within KKR’s Global Macro, Balance Sheet, and Risk Analytics (GBR)
-100
group to figure out what yield-oriented macro investors and asset
allocators, particularly those with large swaths of exposure to Fixed
Mexico
Brazil

Russia
Malaysia

Japan

Germany
Czech Rep

Indonesia

India

Italy
Hong Kong
China

South Africa

Saudi Arabia

France

Spain
Korea

Turkey

Euro Area
Thailand

Poland

Australia

UK
US

Income and Real Assets, should do to outperform without taking on

undue risks in this ‫״‬new‫ ״‬environment. See below for a more fulsome
deep dive into our various top-down frameworks, but our key conclu-
Data as at December 31, 2018. Source: Respective national statistical sions are as follows:
agencies, Haver Analytics.
1. Beyond just central bank intervention creating downward pres-
sure, we do expect aging demographics, excess capacity (e.g.,
China), and technological innovation to continue to put a lid on
interest rates. Consistent with this view, our work shows that
wealthy individuals, particularly in the U.S., are saving more, and
in doing so, are recycling more of their assets into yield-oriented
securities. Meanwhile, real yields and inflation expectations are
“ falling as we increasingly hear about price competition linked to
Beyond just central bank Asian excess capacity in sectors such as industrials and com-
modities – and this is happening at a time when global nominal
intervention creating downward GDP is structurally slowing down (Exhibit 15). Finally, as we detail
pressure, we do expect aging below, Moore’s Law is leading to – by some estimates – a 40
basis point decline in annual U.S. inflation (Exhibit 21). Our bot-
demographics (e.g., China), tom line: If we are right about all of these key drivers of current
excess capacity, and technological yield compression, then this backdrop should give us confidence
that the overall global interest rate curve will remain low relative
innovation to continue to put to historic levels.

a lid on interest rates. 2. However, from a theoretical asset allocation perspective, we

” must all respect that governments are trying to boost nominal
GDP by holding down nominal interest rates (Exhibit 35). In

KKR INSIGHTS: GLOBAL MACRO TRENDS 3

 the past, this strategy has been an important tactic for defeasing EXHIBIT 3
long-term liabilities by putting more inflation in the system.
There Is Currently $9.1 Trillion of Global Negative
Importantly, as we detail below, we do not see inflation as a
near-term threat, but we think some protection in the portfolio is
Yielding Debt, Up From a Recent Low of $5.7 Trillion in
warranted as there will continue to be occasional spikes driven
October 2018, Equating to the Highest Level Since 4Q17
by geopolitical tensions. As such, we do advocate shortening
  Select Global Bond Yields
portfolio duration and owning more collateralized assets linked
to nominal GDP. At the moment, our favorites are U.S. two-year   6 M 1 Y 2 Y 3 Y 4 Y 5 Y 6 Y 7 Y 8 Y 9 Y 10 Y 20 Y 30 Y
notes and short-term housing-related loans in the United States Switzerland   -0.79 -0.81 -0.76 -0.73 -0.69 -0.62 -0.56 -0.49 -0.44 -0.37 0.05 0.19
and Europe. We also like some of the structured product deals
Germany -0.57 -0.58 -0.61 -0.60 -0.52 -0.43 -0.38 -0.31 -0.22 -0.13 -0.03 0.40 0.62
that we are now investing behind in Asia, especially in developed
markets (e.g., Singapore and Australia). Japan -0.16 -0.17 -0.18 -0.18 -0.19 -0.19 -0.19 -0.20 -0.19 -0.14 -0.08 0.35 0.52

Netherlands -0.56   -0.60 -0.60 -0.53 -0.42 -0.32 -0.23 -0.13 -0.02 0.07 0.45 0.66
3. We believe strongly that holding nominal GDP above nominal
Finland   -0.56 -0.56 -0.54 -0.45 -0.33 -0.28 -0.13 -0.05 0.11 0.22   0.91
interest rates also argues for investors to own some form of
an overweight to longer duration Real Assets, especially those Denmark -0.65   -0.66     -0.48 -0.33   -0.15   0.03 0.37  
investments with upfront yield. As we describe in more detail Austria   -0.56 -0.55 -0.44 -0.36 -0.24 -0.15 0.00 0.07 0.17 0.28 0.73 1.08
below, we are big fans of low to modestly leveraged Infrastruc-
ture, including “last-mile” fiber assets, mid-stream energy assets, France -0.53 -0.53 -0.54 -0.44 -0.35 -0.23 -0.12 0.00 0.12 0.24 0.37 0.91 1.35
cell tower assets, renewable energy, and power, water and utility Belgium -0.54 -0.52 -0.50 -0.43 -0.27 -0.14 -0.04 0.09 0.22 0.34 0.46 1.13 1.51
assets. We also see potential in select public to private ideas that
Sweden -0.40   -0.52   -0.38 -0.26 -0.09   0.06 0.19 0.33 0.81  
we are now uncovering in Asia. Details below.
Ireland   -0.58   -0.25 -0.24 -0.09 0.07 0.20   0.44 0.59 1.19 1.41
4. On the Real Estate side of Real Assets, we also maintain an Bulgaria   -0.38 -0.21 -0.11 -0.05 0.08 0.19 0.26 0.51        
overweight position. As we detail below, our call to arms is still
Slovakia   -0.45 -0.55   -0.17 0.00   0.24 0.34 0.54 0.59   1.52
to own both Real Estate equity via Opportunistic Real Estate for
capital gains and B-piece Real Estate Credit to generate some Spain -0.37 -0.33 -0.37 -0.21 -0.09 0.07 0.43 0.65 0.84 0.96 1.14 1.75 2.29
outsized income. Given that B-piece securities are issued at a Portugal -0.37 -0.37 -0.32 -0.16 0.05 0.17 0.56 0.77 0.94 1.15 1.27 2.01 2.34
discount, we like that the risk of capital impairment is low if the
Italy -0.08 0.03 0.23 0.81 1.12 1.51 1.80 2.06 2.07 2.29 2.51 3.26 3.48
first few dividends are paid. We also like Real Estate as a compel-
ling diversifier in our portfolio as it not only provides cash flow Norway 1.13     1.27   1.34 1.37 1.40 1.46 1.51 1.57    
but also often has a distinct supply/demand cycle that is separate U.K.   0.67 0.65 0.67 0.73 0.78 0.80 0.86 0.94 0.92 1.04 1.51 1.58
from the broader economic environment. Indeed, one can see the
benefit of owning some Real Estate Credit in one of our sample U.S. 2.43 2.41 2.32 2.28   2.30   2.39     2.48   2.88
portfolios in Exhibit 7. Data as at March 31, 2019. Source: Bloomberg.

5. Finally, we continue to advocate flexibility across mandates in

the Fixed Income arena, Liquid Credit in particular. Given our
view that the shift from monetary stimulus towards fiscal stimu-
lus is likely to create periods of heightened uncertainty, we now
heavily favor increasing flexibility across all the mandates that “
we oversee. However, the most practical application of our world
view of heightened volatility is our sizeable allocation to Oppor-
With central banks once again
tunistic Credit (Exhibit 4), which has maximum ability to invest feeling inspired to hold interest
across High Yield, Loans, and Structured Products. We also think
it makes sense in the lower return, wider dispersion environment rates low around the lion’s share
that we are envisioning. of the developed world, many
investors with whom we speak
are increasingly confident that
the ‘trifecta’ of sluggish nominal
GDP growth, low rates, and
paltry inflation may be back
upon us.
”

4 KKR INSIGHTS: GLOBAL MACRO TRENDS

As we show in Exhibit 4, we are confident in our sizeable asset EXHIBIT 5
allocation bets that support our aforementioned macro views. In
With Expected Returns for Cash and Fixed Income Only
particular, we continue to run with hefty overweight positions in As-
set Based Lending, Actively Managed Opportunistic Credit, and Real
Separated by Twenty Basis Points, Long Duration U.S.
Assets. At the same time, though, we are underweight long duration
Bonds Are Now Less Appealing to Us
government bonds. Historic and Expected Returns, %

Historic Returns Next 5 Year Expected Return

However, we want to be clear: our call is not to forgo owning any
government bonds. Rather, we are advocating more of a barbell 13.5%

approach that includes shorter duration U.S. government bonds and

longer duration Real Assets. Several inputs weigh on our minds. 10.6%
10.2%
First, as we show in Exhibit 5, our forward estimate between Cash 9.4% 9.7% 9.5%
9.0%
and Fixed Income (i.e., U.S. Treasuries) is not that wide given the
duration risk and low yield now embedded in 10-year U.S. Treasur-
ies. Second, as we have worked with our clients, we are increasingly 5.9% 6.1%
5.4%
finding ways to use a variety of Real Assets as a diversifier to de-risk 4.4%
some of the volatility inherent in other parts of their portfolios, in- 3.5%
2.5% 2.3%
cluding Public and Private Equity. One can see this in Exhibit 7.

EXHIBIT 4
Listed Fixed Private Private Hedge Real Cash
Our Asset Allocation Favors Real Assets Linked to Equities Income Credit Equity Funds Assets
Nominal GDP, Flexible Mandates, and Short-Term
Government Bonds Note: Historic data from 1Q86 to 3Q18 where available and de-
emphasizing 2008 and 2009 returns at one third the weight due to the
Key Target Asset Allocation Over/Under Weights, % extreme volatility and range of performance. Proxies include MSCI AC
World Gross USD; Barclays GlobalAgg Total Return Index Unhedged
USD; Cambridge Associates Global Private Equity; HFRI Fund Weighted
Opportunistic Credit Composite Index; and Barclays GlobalAgg Total Return Index Unhedged
US Short-Duration Govt USD. Expected returns as outlined in the KKR Outlook for 2019: The Game
Has Changed.
Asset-Based Finance
Energy / Infrastructure
Distressed / Special Sit
EXHIBIT 6
Traditional PE
Stabilized Credit In Today’s Low Rate, Low Return Environment, the Need
Real Estate Cr (B-piece) for Alternatives to Deliver on Their Illiquidity Premium
Gold Has Become Even More Important
High Grade
Traditional + Alternative Assets
High Yield
Long Duration Govt Traditional Assets (Stocks + Bonds)
10%
-25 -20 -15 -10 -5 0 5 10

Data as at February 28, 2019. Source: KKR Global Macro & Asset Efficient High
Allocation analysis. 8%
Risk Portfolio
Expected Returns

Efficient Medium
6% Risk Portfolio
Illiquidity
Premium

“ 4% Efficient Low
Risk Portfolio
We are advocating more
of a barbell approach that 2%
6% 7% 8% 9% 10% 11% 12%
includes shorter duration U.S. Expected Risk

government bonds and longer Note: Expected volatility and correlations from KKR proprietary estimates
which take into account future macroeconomic expectations and
duration Real Assets. adjustments for true risks in private asset classes. Data as at January
2019. Source: Expected returns from KKR Outlook for 2019: The Game Has
” Changed.

KKR INSIGHTS: GLOBAL MACRO TRENDS 5

EXHIBIT 7 EXHIBIT 8

We Are Increasingly Finding Ways to Use Alternatives, Rates of Return for Foreign Direct Investment (FDI)
Particularly Private Credit-Related Instruments, to Reduce Are Declining in Many Areas of the Global Economy;
Volatility and Enhance Yield We Think That This Trend Is Bullish for Our De-
Conglomeratization Thesis
Unconstrained Without Real Estate Credit
Unconstrained With Real Estate Credit Rates of Return on Foreign Direct Investment, %
24
23 US UK Germany Netherlands
22 16%
21
Expected Return (%)

20 Initial 14%
19 Commitment
18 12%
With $150
17
Million to 10%
16 Real Estate
15 Credit 8%
14
13 6%
12
8 10 12 14 16 18 20 22 4%
Expected Volatility (%)
2%
Data as at December 31, 2018. Source: Bloomberg, MSCI, Russell, BAML,
KKR. 0%
85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15

Data as at January 2017. Source: National Statistics, OECD, Haver

To be sure, we do acknowledge that there are risks to our allocation Analytics.
strategy. Most obvious is that global interest rates do not stay low
at all, as central bankers stoke inflation by holding nominal interest
rates below nominal GDP for too long. This outcome certainly could EXHIBIT 9
unfold, particularly if the dollar weakens substantially; however, given
the secular forces we see at work, a high interest rate, high inflation Few Companies Generate Top-Line Growth These
environment is definitely not our base case. In the U.S., for example, Days; As Such, We Think That Some Secular Growth Is
the Federal Reserve has missed its inflation target for 95% of the Required in One’s Portfolio
time during the last 10 years – despite several huge fiscal stimulus
programs along the way. Meanwhile, in Europe, the ECB recently de- % of MSCI World Companies With Expected Sales
Growth of Greater Than Eight Percent
cided to renew its long-term refinancing operation (LTRO) program,
which likely extends low rates in the region through at least 2021. Fi- 50%
nally, in Japan, the central bank continues to miss its inflation targets,
despite rates at essentially zero far out on the curve.

On the other hand, we could be wrong if the U.S. were to ‫״‬catch-

40%
down‫ ״‬with its global peers. In this case, it would not make sense to
investors to pay up for the illiquidity premium that we are champion-
ing across Real Estate and Infrastructure. Rather, an investor should
just buy long duration, liquid U.S. government bonds. However, we
see three important offsets to this strategy. First, long-term yields in 30%
the U.S. are already at or below short-term rates in many instances,
so there is also good convexity at the short end (where we already
have a seven percent position). Second, we firmly believe that, given
rising deficits and heavier debt loads as well as nominal rates below 23%
nominal GDP in most major economies, some collateral linked to 20%
nominal GDP is warranted at this point in the cycle. Third, from our 98 00 02 04 06 08 10 12 14 16 18
perch, we continue to see lots of interesting opportunities in the pri- Data as at December 31, 2018. Source Bloomberg, S&P.
vate markets that we believe more than justify the illiquidity premium
many investors are already counting.

6 KKR INSIGHTS: GLOBAL MACRO TRENDS

Looking at the big picture, we continue to pursue the following key- EXHIBIT 10
macro themes across all of our portfolios. First, we remain structur-
We Think the ECB’s Recent Actions Will Make
ally bullish on our deconglomeratization thesis. As we show in Exhibit
8, overall returns for many multinationals with global footprints are
Quantitative Tightening (QT) Less of a Headwind to
structurally falling. Second, we continue to want to maintain reason-
Global Financial Conditions
able exposure to secular growth stories. In a low nominal GDP return Size of ECB Balance Sheet, € Billions
environment, the value of cash flows that can grow materially more
than their peers becomes more important, we believe (Exhibit 9). GMAA Oct-18 Est GMAA Jan-19 Est
Third, as we detail in this Insights piece, we are structurally bullish
4,700
on the ‘Yearn for Yield’ by both individual and institutional investors.
Without question, we continue to see reinvestment risk as one of TLTRO-II
4,400
roll off cliff
the greatest concerns that pensions, insurers, and individual inves-
gets pushed
tors now face. The key, we believe, is accessing the right investment 4,100
out 2yrs*
vehicles that have the potential to outperform in today’s new world Dec-2018
3,800 QE ends
order of low rates and high deficits.
3,500 Forecasts
Section I: Thinking Through the Trajectory of Interest Rates
3,200

After recent trips to both Japan and Europe, many of us on the KKR 2,900 Jan-21 onwards
GBR team definitely feel like we have been to the leading global ECB QE unwind
epicenters of low rates. In Europe, the ECB has made it clear through 2,600

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

both its recent initiatives and commentary that it wants rates to stay
low through at least 2021. Consistent with this view, my colleague
Aidan Corcoran recently smoothed the slope of his ECB withdrawal
path, which one can see in Exhibit 10. As the chart shows, we have
moved from a “black diamond” type descent towards something
more akin to a “blue” or intermediate slope. Importantly, as shown
in Exhibit 11, U.S. rates have not traded on a sustained basis more
than 250 basis points above German 10-year rates for the past three
decades. We think this relationship now narrows slightly with U.S.
yields moving lower, rather than German rates moving higher.
2026
* Our October 2018 estimate assumes TLTRO rolls off according to
scheduled repayment dates (in June 2020, September 2020, December
2020 and March 2021). Our January 2019 estimate assumes that 80%
of TLTRO is extended for two years (before rolling off completely by early
2023.) Source: KKR Global Macro & Asset Allocation analysis, European
Central Bank.
EXHIBIT 11

With 10-Year German Bonds Yielding Zero, We Think

That U.S. Rates Can’t Go But So High
U.S. - Germany 10-Year Rate Spread, %
Mar-19
3.0 2.48

2.5
Apr-89
2.0 2.16 May-99 Sep-05
1.51
“ 1.5
1.0
1.18

To be sure, we do acknowledge 0.5

that there are risks to our 0.0

allocation strategy. Most -0.5

obvious is that global interest -1.0

rates do not stay low at all, as -1.5

1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017

central bankers stoke inflation Data as at March 31, 2019. Source: Bloomberg.
by holding nominal interest
rates below nominal GDP for
too long.
“

KKR INSIGHTS: GLOBAL MACRO TRENDS 7

Meanwhile, in Japan, we did not hear anything from our contacts EXHIBIT 12
that would suggest that there is any meaningful monetary tightening
In an Unusual Break from Recent History, Savings Rates
on the horizon. In fact, Governor Kuroda may yet consider further
Have Not Declined This Cycle in the U.S.
easing strategies at the long end of the interest rate curve, given the
BoJ has still been unable to achieve its two percent inflation target.  12
Recessions US Personal Savings Rate (%)
Moreover, the Japanese economy is soon entering an economically
sensitive time, with the second consumption tax expected to go into
10
effect on October 1 of this year. Against this backdrop, there is clearly
heightened sensitivity towards any domestic policy that could cause Mar-95
Jun-09
8 7.6 Dec-18
sharp appreciation of the yen just ahead of what almost inevitably 7.2
Jun-02 6.8
will lead to some form of a consumption “hiccup” in the not too dis- 6.2
tant future (i.e., even if implementation gets pushed to 2020). 6

Beyond a strong technical backdrop from the central banks, there are
4 Dec-00
several factors to consider, we believe. First, we think that there are
4.4
demographic and socioeconomic influences that are leading to lower Dec-07
rates. We note a strong ‘Yearn for Yield’ evident among U.S. consum- 2 3.4
ers, who continue to sock away savings at a heady rate relative to the
current advanced state of the economic cycle. We can quantify this 0
trend in several of the emerging markets where we invest, but our

Mar-95
Aug-96
Jan-98
Jun-99
Nov-00
Apr-02
Sep-03
Feb-05
Jul-06
Dec-07
May-09
Oct-10
Mar-12
Aug-13
Jan-15
Jun-16
Nov-17
data in the U.S. is fairly compelling. One can see this in Exhibit 12.

For our nickel, we think multiple long-tailed factors are driving the Data as at April 1, 2019. Source: Bureau of Economic Analysis, NBER,
KKR Global Macro & Asset Allocation analysis.
high U.S. savings rate, including lingering consumer caution in the
post-GFC era and the structural savings needs of an aging society
(Exhibit 13). Indeed, our research shows that the savings rate for
EXHIBIT 13
individuals aged 55 years and older is now a chunky 13%, which is
significant given that this demographic controls much of the current Aging Demographics Explain, in Part, the Surprising
wealth in the United States. There also has been a sizeable uptick in Persistence of High Savings Rates
global reserves, which one can see in Exhibit 14. These increases are
important because central banks are looking for safe homes for their U.S. Savings Rate by Age of Head of Household
assets, particularly if they feel comfortable with the local currency. 13%

6%

3%

“ -2%

Under 35 35-44 45-54 55 and Over

Indeed, our research shows that Data as at 2013. Source: Moody’s Analytics analysis of 2013 Federal
the savings rate for individuals Reserve data.

aged 55 years and older is now a

chunky 13%, which is significant
given that this demographic
controls much of the current
wealth in the United States.
“

8 KKR INSIGHTS: GLOBAL MACRO TRENDS

EXHIBIT 14 EXHIBIT 15

The War Chest of Foreign Currency Reserves Is Now Slower Nominal Growth in China Is Now Weighing
Quite High Heavily On Global Growth
FX Reserves as a % of GDP Global and China Nominal GDP (USD), 3yr Rolling CAGR
Jun-97 Current

16.8 Global, LHS China, RHS

Thailand 14% 30%
39.9
China 13.3
22.5 12%
25%
Malaysia 22.6
27.1 10%

Korea 5.5 20%

24.3 8%
Philippines 10.0
21.7 6% 15%
Russia 4.8
22.7 4%
10%
India 6.4
13.8 2%
Mexico 4.8 5%
14.3 0%
Turkey 6.2
9.6 -2% 0%
Indonesia 6.8

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

2016

2019
10.9

Data as at January 31, 2019. Source: Respective national statistical

agencies, Haver Analytics. Data as at February 28, 2019. Source: China National Bureau of
Statistics, IMFWEO, Haver Analytics.

Second, we think that we have entered a period of structurally slower

EXHIBIT 16
growth in the global nominal GDP, which theoretically means lower
nominal interest rates. Key to our thesis is that, as we show in Exhibit Tightening Liquidity Is Placing Downward Pressure on
15, China – which accounts for over one-third of global GDP growth – Nominal GDP in China
has endured a 50-75% decline in its nominal GDP growth rate since
the government shifted its business model towards more domestic China Nominal GDP and M2 Growth, %
consumption amidst structurally slower money supply growth. One Nominal GDP Growth, LHS M2 Growth, RHS
can see these trends in both Exhibits 16 and 17, respectively. 30% 35%

25% 30%

“ 20% 25%

Key to our thesis is that China 15% 20%

– which accounts for over one
third of global GDP growth – 10% 15%

has endured a 50-75% decline 5% 10%

in its nominal GDP growth rate
since the government shifted its 0% 5%
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018

business model more towards

domestic consumption amidst Data as at March 31, 2019. Source: China National Bureau of Statistics,
Haver Analytics.
structurally slower money
supply growth.
“

KKR INSIGHTS: GLOBAL MACRO TRENDS 9

EXHIBIT 17 EXHIBIT 19

China’s Consumption Economy Is Getting Bigger, While The Downshift in Labor Force Growth and Productivity
Its Fixed Asset Investment Is Poised to Slow Has Been Significant for the Overall Level of Interest
Rates
China: Consumption and Gross Capital
Formation as a % of Gross Domestic Product U.S. Productivity and Labor Force Growth
(Rolling 10-year average)
Consumption Gross Capital Formation
48 Productivity Growth Labor Force Growth
3.5%
46 2017
44.6 3.0%
44
2.5%
42

40 2.0%
39.0
38 1.5%

36 1.0%
34 2010,
35.6 0.5%
32
93 95 97 99 01 03 05 07 09 11 13 15 17 0.0%

1958

1963

1968

1973

1978

1983

1988

1993

1998

2003

2008

2013

2018
Data as at December 31, 2017. Source: China National Bureau of
Statistics, Haver Analytics.
Data as at December 31, 2018. Source: Bloomberg.

EXHIBIT 18
EXHIBIT 20
Within Trade, the Focus Is Clearly Towards the Higher
Value-Added Parts of the Global Food Chain Rates Are Highly Correlated With Nominal GDP Growth
China % of Total Exports, 12mma Nom 10yr Yld
Nom GDP y/y (3yr Avg.)
16%
Ordinary Trade (Higher Value Add)
Reexports (Lower Value Add) Dec -18 14%
60 56.7
Correl = 77%
12%
55
10%
50
8%
45
6%
40

Re-exports are now less than a 4%

35 32.0
third of exports
2%
30
02 04 06 08 10 12 14 16 18 0%
1954
1957
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1989
1992
1995
1998
2001
2004
2007
2010
2013
2016

Data as at December 31, 2018. Source: China National Bureau of

Statistics, Haver Analytics.
Data as at December 31, 2018. Source: Bloomberg,

The U.S. has not been immune to the global growth slowdown.
Indeed, as we show in Exhibit 19, both slower labor force growth
and productivity have led to declines in both the United States GDP
growth rate and the level of its interest rates. This downshift in in-
puts has been significant for the overall level of interest rates, as one
can see in Exhibit 20.

10 KKR INSIGHTS: GLOBAL MACRO TRENDS

Finally, technological improvements have put downward pressures EXHIBIT 21
on many key parts of the global economy. As a result, we have seen
Moore’s Law Is a Drag on Inflation, Particularly in the
both greater pricing transparency and lower input costs in many
instances. Without question, we think that Moore’s Law has allowed
Early Years of Innovation
for the diffusion of ever more powerful and cheaper technologies. Moore's Law Is a Drag on Inflation
As technology continues to improve (faster and more powerful
computers, lighter and bigger televisions, more productive smart- Technology drag on inflation (RHS)
phone apps, and so on), the relative price of technology continues to Production cost including technology (LHS)
Production cost excluding technology (LHS)
decline. Building off of a report by Joseph Davies, Chief Economist at

Indexes for Product ion Cost s

150 4%

Annual Inflation Rate Diff

Vanguard, we note that the lower prices for business and consumer
140
technology products have produced an average estimated drag of 3%
forty basis points per year in the official Consumer Price Index (CPI)1. 130
2%
120
Moore’s Low is certainly about more than mobile apps, video games, 110 1%
and hand-held devices. However, as technology is used more promi- 100
nently to produce more goods and services, many of the companies 0%
90
in which our clients invest are now enjoying lower production costs. -1%
80 Avg = 0.4pp
This observation is significant, as the prices charged by our portfolio
companies are just markups over marginal production costs, and as 70 -2%
such, the continued adoption of new technologies generally translates

2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
into reduced unit costs of production.
Note: In the BEA’s input-output data (I-O), we identified technology-
Over time, these benefits make their way to consumers in the form related inputs as follows: computer and electronic products; broadcasting
of lower, or less rapidly increasing, final prices, even in sectors not and telecommunications; data processing, internet publishing, and
directly related to technology. As we show in Exhibit 22, Moore’s Law other information services; and computer systems design and related
in technology has had a profound effect on the prices that U.S. busi- services. We identified as closely as possible Producer Price Index
(PPI) series for each industry in the I-O, including all four technology
nesses need to charge and still make a decent profit. All told, since inputs. The weightings were multiplied by technology’s PPI to arrive at
2005, for example, the declining prices of computer and electronic the contribution to each industry’s PPI. For each industry’s PPI minus
products, computer design and services, and other technology inputs technology, we subtracted the tech contribution from PPI and divided
have trimmed 83 basis points from overall production costs and ul- it by one minus technology’s weight. Data as at 2005 through 2018.
timately from final prices in some instances. Interestingly, as Exhibit Source: KKR Global Macro & Asset Allocation calculations, Haver
Analytics, BEA, BLS, Vanguard.
21 shows, the impact of technology on inflation is typically more
pronounced in early years; thereafter, the impact becomes more
moderate as the technology costs decrease.
EXHIBIT 22

Technology’s Downward Impact on Input Prices Has Been

Pervasive Across Almost All Industries in Recent Years
Technology's Effects on PPI by Industry
(Annualized % Change in PPI, 2005-2018)
“
PPI excluding technology PPI including technology
But Moore’s Law is certainly -37bp
5.5%
about more than mobile apps, 5.0%
4.5%
-82bp

video games, and hand-held 4.0%

3.5%
-44bp -68bp

devices. As technology is used 3.0%

2.5%
-11bp
-1bp
-83bp
more prominently to produce 2.0%
1.5%
-9bp

more goods and services, many 1.0%

0%
of the companies in which our
Overall

Info Tech

Prof Svs

Manufacture

Finance

Healthcare

Retail Trade

Agriculture

clients invest are now enjoying

lower production costs.
Note: Healthcare is proxied by hospitals, retail trade by general
“ merchandise trade, finance by securities/investment. Data as at 2005
through 2018. Source: Haver Analytics, BEA input-output tables,
Vanguard, KKR Global Macro & Asset Allocation analysis.

1 Data as at 2017. Source: Vanguard Why Is Inflation So Low?

KKR INSIGHTS: GLOBAL MACRO TRENDS 11

Importantly, though, this phenomenon of lower consumer prices EXHIBIT 23
is not linked only to technology. Just consider Walgreen’s recent
The Combination of Tax Cuts and Budget Deal Is Now
announcement of lower earnings, which were driven primarily by
cheaper generic drug prices. Or Amazon’s recent decision to cut
Driving a Record Divergence Between the U.S. Budget
prices at Whole Foods, the grocery store distributor it acquired In
Balance and the U.S. Unemployment Rate
June 2017, in some major food categories by 20-50%. Without Divergence Between Unemployment and the Budget Deficit
question, these types of pricing pressures will force the hand of its
Unemployment Rate (LHS, inverted)
competitors as well as set the stage for similar top behavior patterns
Budget Balance % GDP (RHS)
in other verticals of the global economy.
Budget Bal % GDP, Apr18 CBO Baseline (RHS)
Budget Bal % GDP, Consensus (RHS)
So, our bottom line is that, when we consider all the various forces at 0% 8%
work, including strong technical flows, slowing nominal GDP growth, Korean War
Vietnam War 6%
and technological innovation, we have a hard time forecasting sig- 2%
4%
nificantly higher long-term interest rates. To be sure, with real rates
2%
having already compressed significantly in recent weeks, we are not 4%
0%
arguing for rates to go much lower. However, our basic message
is the ‘Yearn for Yield’ will continue, as almost all savers, including 6% -2%
insurance companies, individuals, and pensions, will be hard pressed -4%
8%
to find the levels of income that they need to cover their liabilities -6%
through the ownership of long-term, traditional sovereign debt instru- 10%
-8%
ments. -10%
12% -12%
Section II: Investment Considerations in a Low Rate World with 1948 1958 1968 1978 1988 1998 2008 2018
Increasing Volatility and Bigger Deficits Data as at December 31, 2018. Source: Department of Labor. Department
of Commerce, CBO, Goldman Sachs.
Given our strong view that 1) interest rates will stay low across the
United States, Europe, and Japan during the next few years; and 2)
more volatility across the global capital markets is likely, we believe EXHIBIT 24
strongly that macro investors and asset allocators should incorpo-
rate the following strategies into their asset allocation. They are as We Think That Short-Term U.S. Rates Represent Good
follows: Value, Particularly Relative to the Other Parts of the
Developed Markets
#1: Buy Shorter Duration U.S. Treasuries and Private Assets With Yield
Short-term Interest Rates, %
and Collateral. Despite the additional convexity an investor can enjoy
by extending duration, we still think that now is the time to be short- US (1999-date) Eurozone (2001-date)
ening duration in many areas of one’s portfolio. Core to our view is
Japan (1983-2006) (RHS)
that the United States government is running record deficits at a
time of record low unemployment. As Exhibit 23 shows, this policy 7% 9%
is highly unusual as it breaks with any historical pattern that we can 6% 8%
find in our macro data sets going back to the 1900s. 7%
5%
6%
4%
5%
3%
4%
2%
3%
1% 2%
0% 1%
“
-6y

-3y

+3y

+6y

+9y

+12y

+15y
0

Without question, we think Note: 0 on x-axis = peak in short-term rates; Short Term Prime
that Moore’s Law has allowed Lending Rates used as proxy for Japan; ECB Main Refinancing Rate for
Eurozone; Fed Funds Rate for U.S. Data as at February 11, 2019. Source:
for the diffusion of ever Bloomberg.

more powerful and cheaper

technologies.
“

12 KKR INSIGHTS: GLOBAL MACRO TRENDS

At the moment, we really like short-duration U.S. sovereign secu- EXHIBIT 26
rities like two-year Treasuries. Besides yielding more than most
Residential Investment as a Percentage of GDP Is Well
longer-duration sovereign debt, we like the added convexity if the
Federal Reserve is forced to ease as President Trump’s stimulus
Below Long-Term Norms, and as Such, We Think That the
package loses its punch.
Cycle Can Continue for Some Time
U.S.Residential Construction Investment
On the private side, we think that there are several interesting areas as a % of GDP
from which to choose in the shorter duration segment of the Private 7.0%
Credit markets. For example, given our bullish view on household
6.5%
formation and housing (Exhibits 25 and 26), we favor short-term
residential lending in both Europe and the United States. We also like 6.0%
owning cash flows linked to hard assets such as locomotives, storage 5.5%
assets, and short-term housing loans. Finally, we are also still finding 5.0% Median
good value in structured products, including orphaned closed-end 4.3%
4.5%
funds. While the duration of closed-end funds can be slightly longer
than some of our aforementioned suggestions in this section, their 4.0%
daily liquidity function provides us with a high additional degree of 3.5%
comfort as part of a diversified, shorter duration strategy in Fixed 3.0% 4Q18
Income. 3Q10 3.8%
2.5% 2.4%
EXHIBIT 25 2.0%

1Q99
1Q01
1Q95
1Q97

1Q03
1Q05
1Q07
1Q09
1Q11
1Q13
1Q15
1Q17
Household Formations Has Been Lagging Structural
Demand Since 2006; We Now See More Gains Ahead
Data as at December 31, 2018. Source: Bureau of Economic Analysis,
U.S. Residential Housing Completions
Census Bureau, Haver Analytics.
as a % of Structural Demand*
130%
1986
120%
118%
#2: Embrace Credit Mandates With More Flexibility. As we discussed
2006
110% 114%
in our Outlook for 2019, as well as earlier in this piece, we believe
2023e
96% that the liquidity cycle has turned. It may not get highly restrictive
100%
relative to past cycles, but real rates are higher amidst central bank
90% 2000
balance sheet retrenchment. As a result, we generally expect finan-
99%
80% cial conditions to continue to tighten. If they don’t, then it is likely
2017
70% 70% because growth is slower than expected – which is not great either.
1994
Said differently, it feels like the capital markets might be “stuck” in
60% 81%
the medium-term. If growth is too strong, financial conditions will
50% continue to tighten. If growth is too weak, it means that margins and
2011
40% trade negotiations are under pressure.
43%
30%
1980
1984
1968
1972
1976

1988
1992
1996
2000
2004
2008
2012
2016
2020e

e = KKR GMAA estimates. Data as at November 30, 2018. Source: U.S.

Census Bureau, Haver, KKR Global Macro & Asset Allocation analysis. “
So, our bottom line is that, when
we consider all the various
forces at work, including strong
technical flows, slowing nominal
GDP growth, and technological
innovation, we have a hard time
forecasting significantly higher
long-term interest rates.
“

KKR INSIGHTS: GLOBAL MACRO TRENDS 13

 EXHIBIT 27 Equally as important, the structure of the global capital markets
has changed. For example, on the debt side of the house, the stock
Periodic Dislocations Like 4Q18 Mean That Investors
outstanding has exploded at the same time that the dealer inventory
Need to be More Nimble Than in the Past required in the United States to support this vast amount of growth
Loans Trading Above Par, % has shrunk. Without question, these technical mismatches are creat-
ing periodic distortions that accrue mightily to investors with patient
90% capital, solid underwriting skills, and – perhaps most importantly –
the ability to toggle across asset classes and securities.
80%

70% EXHIBIT 29

60% Credit Trading Strategies Are No Longer Well Supported

50%
by Wall Street. As Such, the Potential for Periodic
Dislocations Is Now Structurally Higher, We Believe
40%
U.S. Broker Dealer Inventory
30%
$300bn Oct-07
20% 285.2
10% $250bn

0% A decline of
$200bn
3/16/2018

7/19/2018

11/21/2018
12/31/2017
1/25/2018
2/19/2018

4/10/2018
5/05/2018
5/30/2018
6/24/2018

8/13/2018
9/07/2018
10/02/2018
10/27/2018

12/16/2018
1/10/2019
2/04/2019

90%

$150bn

Data as at February 28, 2019. Source: LSTA. $100bn

$50bn
EXHIBIT 28
Dec-18
When Markets Dislocate, We Think There Are a Lot of $0bn 27.8
Securities Available for Sale in What We Call ‘No Man’s 2002

2004

2006

2008
2005

2009
2003

2007
2001

2010

2012

2014

2016

2018
2015
2013

2017
2011
Land’
Data as at December 31, 2018. Source: Federal Reserve Bank of NY,
Value in ‘No Man’s Land’ by Providing Liquidity Where Others May Not Go Haver Analytics.

Market Absolute
No Man’s Land
Buyers Return Buyers
110% EXHIBIT 30

Implied Default Rates Have Spiked Periodically in

100%
Recent Years, Even When There Has Not Been an Actual
Recession
Illustrative Bond Price

90%

High Yield Implied Default Rate, %

80%
10
70%
8
60%
6
Average =
50% 4.4
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 4
Illustrative Return

Data as at December 31, 2018. Source: KKR Credit. 2

-2
2000

2002

2004

2006

2008

2010

2012

2014

2016

2018
1994

1996

1998

Data as at March 11, 2019. Source: Bloomberg.

14 KKR INSIGHTS: GLOBAL MACRO TRENDS

Given this uneven technical backdrop amidst rising geopolitical ten- EXHIBIT 31
sions, we are increasingly bullish on our theme of capital market
While the S&P GSCI Total Return Index Has the Highest
arbitrages across both Liquid and Private Credit. Indeed, if there is
one thing that became apparent during the fourth quarter of 2018, it
Correlation With U.S. CPI…
was the inconsistencies in value that appeared across capital struc- Correlation vs. U.S. CPI: 1Q04-3Q18, %
tures and asset classes. For example, Liquid Credit sold off much
more than some of the opportunities we saw in Private Credit, and 75%
as such, a significant capital structure arbitrage/opportunity emerged
that favored flexible capital that could step in and buy into poten-
tially “hung” new issue paper as well as unloved trading positions in 54% 53%
certain structured products. While many of these dislocated oppor-
tunities have been corrected in 2019, we do not think that the last 43%
39% 39%
quarter of 2018 was a “one off” situation, particularly if we are right 37% 35%
about slowing growth amidst peaking corporate margins. Moreover, 29% 28% 27%
despite the recent rally, we are still seeing some “good company, bad
19% 18%
capital structure” opportunities emerge, especially outside of the U.S.
So, consistent with this overall macro backdrop, we now hold a large 9%
overweight to Actively Managed Opportunistic Credit, and we have
again increased our position in Special Situations/Distressed this
year.

S&P 500 Energy

Priv Equity Energy

GSCI TR

Priv Infrastructure

Priv Real Estate

MLPs

HY Real Estate

CMBS IG Loan

MSCI ACWI Infra

FTSE NAREIT

S&P 500 Utilities

US TIPS Bonds

Gold

Euro Infl Linked

#3: Buy Longer Duration Real Assets Linked to Nominal GDP With Col-
lateral, Including Infrastructure. As we mentioned above, we remain
bullish on our ‘Yearn for Yield’ thesis, which we originally laid out for
investors at Morgan Stanley and then again when we joined KKR in
Data as at 1Q04-3Q18 as Cambridge Associates Infrastructure returns
2011 (See December 2011; Brave New World: The Yearning for Yield start in 1Q04 and latest available is 3Q18. Source: Cambridge Associates,
Across Asset Classes). However, there is a new twist to the plot, we Bloomberg, MSCI.
believe. Specifically, given our high conviction view that governments
are committed to driving higher nominal GDP at a time of low nomi-
nal interest rates (which has traditionally been the cure for deflation/ EXHIBIT 32
disinflation), we want to continue to increase our allocation to yield-
ing assets backed by nominal GDP. This call is a big one, we believe; …It Has One of the Lowest Return Track Records. As
we think it has legs in terms of duration, and we believe it warrants a Such, We Heavily Favor More Non-Traditional Real Assets
notable overweight position from an asset allocation perspective.
Historic Average Returns: 1Q04-3Q18, %

15.6
14.1

11.2
10.6
9.9 9.7
9.1
8.0 7.7
“ 5.9
This baton hand-off from central 5.2
4.6 4.6
4.0

bankers to politicians represents 1.4

0.8
a major change, as today’s
politicians look for innovative
Priv Equity Energy
Global Priv Equity
EME USD
FTSE NAREIT
Priv Infrastructure
S&P 500
Priv Real Estate
HY Real Estate
US HY
EMD
US Loans
Global IG
CMBS IG Loan
US TIPS Bonds
Cash
GSCI TR

ways to provide economic

relief to a growing number of
discontented voters, many of Data as at 1Q04-3Q18 as Cambridge Associates Infrastructure returns
whom have not seen their wages start in 1Q04 and latest available is 3Q18. Source: Cambridge Associates,
Bloomberg, MSCI.
increase until quite recently.
“

KKR INSIGHTS: GLOBAL MACRO TRENDS 15

EXHIBIT 33 EXHIBIT 34

We Think That There Are Multiple Ways to Own We Think That Governments Are Now Focused on
Infrastructure in One’s Portfolio Driving Better Returns in the Real Economy Relative to
the Financial Economy
Infrastructure Investments by Type: Weighted Average Net IRR, %
Financial and Real Economy Prices Total Return
Performance in Local Currency Since January 2009, %
12.5-20
10-20 250%
5-17.5 10-15 Asset prices Real Economy Prices
200%

5-12.5 5-12.5 5-12.5 150%

100%

50%

0%
Open Infra Core Infra Value Green- Opportu-
-50%
End Debt Brown- Separate Added field nistic

Commodity
S&P 500
European HY
US HY
MSCI World
SXXP
MSCI EM
Topix
US IG
Germ. Bond
European IG
Gold
US Bond
Japan Bond
US Nominal GDP
EU Nominal GDP
US House Price
US wages
European wages
US CPI
European CPI
EA House Price
field A/c

Data as at 2017. Source: Probitas Partners’ Infrastructure Institutional

Investor Trends for 2017 Survey.

Data as at December 31, 2018. Source: Goldman Sachs Investment

Research.
This baton hand-off from central bankers to politicians represents
a major change, as today’s politicians look for innovative ways to
provide economic relief to a growing number of discontented vot-
EXHIBIT 35
ers, many of whom have not seen their wages increase until quite
recently. It also reflects a decision by governments to control more of By Holding Nominal Interest Rates Below GDP, the U.S.
their own economic destiny via a more nationalistic approach versus Is Trying to Stoke Both Growth and Inflation
being too reliant on global connectivity to succeed. In our view, this
new reality is likely to periodically unsettle the global capital markets U.S. Fed Funds Rate, % Points Above/(Below)
U.S.Nominal GDP Growth
for some time. So, in this environment, our bottom line is that the in-
3yr Moving Avg.
vestment “playbook” feels all but certain: capture upfront yield, own
Tight Monetary Policy

more hard assets, shorten duration, lock in low cost liabilities, and
6% 1982
avoid countries with large current account deficits. 5.7%
4%

2009
2%
0.8%

0%
Loose Monetary Policy

2019e
-2% -2.6%

-4%
2005 2012
1978 -3.7%
-4.1%
-6%
“ -5.6%
2002
2008
2005

2014
1960

1990

2017
1984
1966
1969

1996
1963

1999
1993
1972
1978

1987
1975

2011
1981

Though not as well known as Data as at December 31, 2018. Source: Bloomberg, KKR Global Macro &
traditional illiquid investments Asset Allocation analysis.

like Direct Lending or Distressed

Credit, we think the B-piece
segment of the CMBS market
warrants investor attention.
“

16 KKR INSIGHTS: GLOBAL MACRO TRENDS

In terms of specific ideas, we favor the following areas of opportunity EXHIBIT 37
with Real Assets. First, we have been impressed with the opportuni-
We Now See Lower Leverage in the B-Piece Market
ties we have seen in “last-mile” optical fiber financing as well as
in pipeline build-outs. In many instances investors can enjoy some Loan-to-Value (LTV) % of Pool w/ LTV > 70%
significant cost of capital compression by taking final stage construc-
tion risk, or helping to spin assets out that are considered non-core. 80%
70%
Similarly, within the energy arena, there are what appear to be “bro- 70%
70%
ken” MLP stories where the underlying mid-stream and processing
assets appear to be trading cheaply relative to the overall enterprise. 65% 60%
65%
Finally, in regions like Asia, we are seeing several emerging public 60% 50%
to private opportunities where infrastructure assets shuttled within 40%
60% 58%
large conglomerates are now finally being divested.
37% 30%
EXHIBIT 36 20%
55% 10%
The Surge in Global Mobile Traffic Has Created an 10%
Almost Insatiable Demand for Fiber-Related Infrastructure 50% 0%
2007 2014 2018
Global Mobile Data Traffic, Exabytes per Month Usage
80 Data as at January 31, 2019. Source: Commercial Real Estate Direct,
Morgan Stanley.
70
60
45% CAGR 2017-2022
50 EXHIBIT 38
40 The Pool Size in the B-Piece Market Has Shrunk
30 Meaningfully as Well
20
Loan Count Pool Size
10
0 250 $3,250 $3,500
2017 2018 2019 2020 2021 2022
$3,000
Note: 2019-2022 are estimates. Data as at March 1, 2019. Source: Cisco, 200 215

Pool Size ($ in millions)

Credit Suisse. $2,500
Loan Count

150 $2,000
$1,160

#4: Own B-Piece Commercial Real Estate Credit as well as Cash Flow-
ing Opportunistic Real Estate Equity.  Though not as well known as tra-
ditional illiquid investments like Direct Lending or Distressed Credit,
we think the B-piece segment of the CMBS market warrants inves-
tor attention. Consistent with this view, we originally added CMBS
B-piece to our asset allocation mix back in June 2018 based on a va-
riety of factors that we uncovered. For starters, given our long-held
view on structurally lower interest rates this cycle, we have admired
the outsized yield that this asset class provides. All told, even with
the latest dip in interest rates, we still expect an approximate 10%
current return with the possibility of a total return of 11-13%.  Third, unlike the CLO and Leverage Loan market where regula-
Second, we like that CMBS is secured by senior, first mortgage loans
on stabilized commercial properties. These properties have signifi-
cant existing cash flow and cover their mortgage payments by over
two times, on average, which provides a strong base for any down-
turn in the economic environment.  longer dated capital, which helps explain part of the outsized yield
100 $1,500
$896
$1,000
50 72
51 $500
0 $0
2007 2014 2018
Data as at January 31, 2019. Source: Commercial Real Estate Direct,
Morgan Stanley.
tions are becoming more accommodative, the risk retention laws that
were enacted after the Global Financial Crisis remain fully intact. This
“skin in the game” requirement has positively impacted the invest-
ing environment. Without question, it has created a moat around the
B-piece opportunity and limited participation to more fundamental,
premium embedded in these securities. Moreover, as prescribed,
it has created a more conservative lending environment leading to
lower leverage and higher coverage mortgage loans. One can see the
level of improvement in Exhibits 39 and 40.  Fourth, given our thesis
about owning collateral that is linked to nominal GDP, B-piece securi-
ties certainly check the box in this area given the exposure to a broad
segment of the U.S. commercial property market. 

KKR INSIGHTS: GLOBAL MACRO TRENDS 17

 EXHIBIT 39 Section III: Conclusion
Higher Coverage Ratios Are Helping Performance in the
As we have detailed in this report, we think that rates are likely to re-
B-Segment of the CMBS Market main lower for longer across many developed markets of the world.
Debt Service Coverage Ratio ("DSCR") This viewpoint is significant because it likely means that macro
2.4x investors and asset allocators may need to reposition their portfolio
to minimize the mounting reinvestment risks we now see unfold-
2.2x 2.1x ing. Indeed, given the recent policy changes in Europe around its
new LTRO program as well as the Fed’s more modest balance sheet
2.0x withdrawal program, we have high conviction that rates are likely to
1.7x remain extremely low through the end of at least 2021 – and most
1.8x
likely well beyond this timeframe.
1.6x
1.4x However, it is not business as usual when it comes to boosting yield
1.4x in one’s portfolio. Specifically, given the surge in government and
corporate leverage that we are seeing, our message is certainly not
1.2x for investors to just go out and massively extend their duration by
2007 2014 2018 buying a large swath of government bonds. Rather, we think some
Data as at January 31, 2019. Source: Commercial Real Estate Direct, combination of yielding short-duration and long-duration assets,
Morgan Stanley. especially those tied to nominal GDP and collateralized with attrac-
tive cash flowing properties, is likely to be the winning formula in the
macroeconomic environment we are envisioning. Rates are low for a
EXHIBIT 40 reason: Global nominal GDP growth is not what it used to be.
Thicker B-Piece Tranches Are Beneficial as Well
B-Piece Thickness Horizontal Structure Thicknesss
12%
~10.0%
10%

2.60%
“
8%
7.6% 7.4%
Meanwhile, within Real Estate
6%
equity, we are bullish on several
4%
areas of the opportunistic and
2% 3.1%
value-added parts of the market.
0%
2007 2014 2018
First, we are structurally bullish
Data as at January 31, 2019. Source: Commercial Real Estate Direct, on opportunities in second tier
Morgan Stanley.
innovation cities regarding
U.S. multifamily, logistics and
Finally, we like that this asset class initially starts at a substantial
discount (approximately 40-50% of face value) which creates a more distribution centers. In addition,
stable return profile and downside protection2 in stress scenarios.  with supply tightening up in the
The high current return combined with the discount decreases the
chance of capital impairments as coupons are received.  United States, we are constructive
Meanwhile, within Real Estate equity, we are bullish on several areas
on senior living and healthcare
of the opportunistic and value-added parts of the market. First, we facilities. Finally, we like the rising
are structurally bullish on opportunities in second tier innovation cities
regarding U.S. multifamily and logistics and distribution centers.
demand that we are seeing for
In addition, with supply tightening up in the United States, we are affordable housing and student
constructive on senior living and healthcare facilities. Finally, we like
the rising demand that we are seeing for affordable housing and for housing in both developed and
student housing in both developed and developing markets. developing markets.
“
2 Note that downside protection is no guarantee against future losses.

18 KKR INSIGHTS: GLOBAL MACRO TRENDS

In terms of specific areas where to lean in with one’s portfolio, our EXHIBIT 42
advice is as follows:
Inflation Remains Well Anchored as China,
1. We still like the short-end of the U.S. Treasury curve. In fact, we
Demographics, and Technology Continue to Keep
think its current yield is mispriced relative to other sovereign debt
Downward Pressure on Input Costs
we see in developed market economies. U.S. 10-Year Inflation Expectations, PCE, %
8
2. We also favor shorter duration collateralized private investments,
particularly in areas such as housing in Europe and the United 7
States.
6

3. We also want to lean into Actively Managed Opportunistic Credit, 5

given our view that we are entering a period of increasing peri-
odic dislocations (e.g., 1Q16, 4Q18, etc.). 4

3
4. On the long-end of the curve, we are in favor of more illiquid
investments relative to sovereign debt, particularly for those 2
investors who are constrained by near-term obligations. Without
question, the value of the illiquidity premium is worth more in a 1
low interest environment. Infrastructure is most appealing to us,
but we also like the B-piece segment of the CMBS market in the 0
United States. 1965 1975 1985 1995 2005 2015

Data as at December 31, 2018. Source: Consensus Economics, Goldman

As we mentioned earlier, we do not see inflation as an immediate Sachs Global Investment Research
threat, but — to be prudent — we have altered our portfolio to create
some inflation hedges. We have done so because we respect that the
‘Authorities’ are clearly holding nominal interest rates below nominal
GDP for a reason. Specifically, this loose monetary policy is aimed at
stoking a little inflation to boost both wages and defease heavy debt
loads, though the impact of demographics, excess capacity, and tech-
nology are likely to make it less effective than in the past, we believe.

EXHIBIT 41

We Believe That Slowing Growth Amidst Higher Wages

Will Become a Headwind to Margins in 2019
S&P 500 Revenue Less Wage Growth Scenario Analysis, %

Revenue Growth less Wage Growth “

Base
Bear However, it is not business
Bull
4Q18e as usual when it comes to
10% 5.3%
boosting yield in one’s portfolio.
5%
4Q19e Specifically, given the surge
0%
0.7%
in government and corporate
-5% leverage that we are seeing,
-10% our message is certainly not
-15% for investors to just go out and
-20% massively extend their duration
by buying a large swath of
2002

2020
2008
2005

2014

2017
1996

1999

2011

Data as at December 31, 2018. Source: Bloomberg, Haver Analytics, KKR

Global Macro & Asset Allocation analysis.
government bonds.
“

KKR INSIGHTS: GLOBAL MACRO TRENDS 19

EXHIBIT 43

The Cash Flow Component of the Asset Is the Key Driver of Total Return
Current Yields Across Asset Classes, %
8–12 10.0
Private Credit
Liquid Credit 9–11
6–10
Real Assets 6–8 7.0
6.5
6.0 6–7
3–9
5–6
4.0
3.1
2.4

0.0

-0.1 -0.1
Japan Germany Gold US Govt China Gov US Europe Private Special US Bank Real US High US Direct EM High Energy Real Mezzanine
Govt Bond Govt Bond Bond 10 10 Yr Investment Bank Infrastruc- Situations Loans Estate Yield Lending Yield Income Estate (Unlev)
10 Yr 10 Yr Yr Grade Loans ture Stabilized Unlevered B-Piece
Credit

Data as at March 31, 2019. Source: Bloomberg, KKR Global Macro & Asset Allocation analysis.

If we are wrong in our approach, it will likely be because rates are

poised to move higher after global central banks have been too lax for
too long. This outcome could occur, particularly if the dollar fell out
of bed. However, given our aforementioned views around excess ca-
pacity, technological change, and demographics, we think a squeeze
in corporate margins – more than a surge in inflation – is a more
likely outcome (Exhibit 42) than a higher inflation, robust nominal
GDP environment. Also, if inflation and rates do increase materially,
we think that our overweight to Real Assets with yield should add
some ballast to the portfolio.

So, our bottom line is that reinvestment risks are rising, and now is
the time to reposition one’s portfolio for the ongoing ‘Yearn for Yield’
that we see unfolding across many different parts of the global capi-
tal markets. Importantly, though, given where we are in the cycle and
where monetary and fiscal policies are directed, we think that owning
more assets backed by nominal GDP and hard assets, versus just
traditional fixed income products, makes sense in the macroeconomic
environment we envision for the coming five to seven years.

20 KKR INSIGHTS: GLOBAL MACRO TRENDS

KKR INSIGHTS: GLOBAL MACRO TRENDS 21
22 KKR INSIGHTS: GLOBAL MACRO TRENDS
Important Information
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context requires, and not of KKR. The views expressed
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