Global private equity giant KKR has warned the technology sector is becoming outsized with technology driving 100 per cent of global earnings growth, in its mid-year global macro outlook report.
The firm says it does not expect a major crack in the digital economy, yet at the same time is concerned about tech’s huge influence on other markets such as real estate along with the recent poor performance of several IPOs.
In terms of the lacklustre IPOs, the firm says this shows that private investors may be over-paying for cash flows which may not match consensus expectations.
The report also notes that besides driving 100 per cent of global earnings growth, tech also accounts for nearly 40 per cent of leases in some areas of the real estate market.
It also notes that new issuance on credit markets is heavily skewed to levered transactions related to software companies.
“If the Technology sector were to stumble for any reason including increased regulation, the knock-on effect on the global economy could be profound,” it says.
The report adds that the poor performance of several recent IPOs in the growth arena support our view that cash flow matters.
“To be sure, we are not back to 1999, but we do believe that several recent investment rounds in the Private Growth markets have been at speculative levels. In our humble opinion, investors should avoid where possible business models that are predicated on low marginal revenue economics amidst continued high fixed costs.
“We also believe that estimates around the total addressable market have been exaggerated in certain instances. Importantly, though, we view recent disappointment in performance as a long-term opportunity, and accordingly, we do expect to shift our significant underweight in ‘Private Growth’ back to an equal weight or overweight, as leading investors in the sector are forced to acknowledge that some of their valuation metrics have gotten too robust.”
The lengthy report also includes detailed views on the global economy and its relationship to public and private market.
A modern day Cold War
It says that effectively relations between China and the US are reaching a Cold War stage.
The report adds: “Investors should make no mistake about where we are headed, given how intertwined the two countries are. Simply stated, we think that a modern day ‘cold war’ of sorts has emerged between China and the United States. Consistent with this view, we think that we are at an inflection point for global supply chains, particularly those that rely on proprietary technology.”
It uses Huawei as an important example.
It adds: “Just consider that out of $70 billion Huawei spent buying components in 2018, some $11 billion in Huawei allocations went to U.S. firms including Qualcomm, Flextronics, and Broadcom. One can see some of this dependence. Without question, these relationships are now all in play in a world where it appears U.S. national security concerns have trumped more traditional trade priorities.”
Not weak enough for a recession, not strong enough for inflation
KKR says that the majority of its research team believe the current cycle will be remembered as a series of mini and idiosyncratic economic cycles – neither strong enough to drive up inflation, nor weak enough to induce a traditional recession on a global basis.
It adds, however, that the fundamental interlinkage of supply chains means its research team holds a “growing contingency” view on a more synchronised downturn in 2020.
The firm also says that the economy and markets could be entering a phase where the nominal GDP and global profits are more aligned or where profits could lag GDP.
Rest of world could close profit gap with US
“There is the potential that profits lag GDP growth in an economic downturn. In the past decade, by comparison, global profits have reached uncharted territory, driven by unprecedented central bank resolve, lower corporate taxes in the United States, robust buybacks, and vigorous cost take-outs. Moreover, with U.S. margins now at record levels, we think that the profit gap that has existed between the U.S. and the rest of the world could also converge.”
Henry McVey, head of global macro and asset allocation, says his team still sees an attractive path forward for investors who “stick to the plan” by continuing to invest heavily behind macro themes.
He adds: “With all the geopolitical ‘noise’ swirling around these days, there is a growing propensity in the investment community to react quickly to near-term news flows, or even head to the sidelines until there is greater visibility. Our view is stick to the plan.”
McVey emphasizes that while overall portfolio risks are higher these days, low-rates, de-levered financial institutions and accommodative central banks should help to prevent a 2007-type downturn. He therefore advocates the following approach and key themes.
- Owning more cash-flowing assets linked to nominal GDP
- Favouring more Opportunistic Credit and Special Situations strategies that have the flexibility to lean into dislocations
- Embracing complexity through a variety of investment disciplines including Energy, Private Equity, Real Estate and Infrastructure
- Remaining overweight the short-end of the interest rate curve, as he sees more room for yield compression
|1.||Remain bullish on deconglomeratization, or carve-outs. |
Complexity associated with large corporate multinationals
divesting non-core subsidiaries is substantial, but carve-outs often have the potential to unlock significant value, particularly as it
relates to cash flow generation.
|2.||The ‘Yearn for Yield’ underscores the structural reinvestment risk that has emerged for income-oriented investors. |
Own more cash-flowing assets linked to nominal GDP, build
more flexibility across mandates, and shorten duration
|3.||Lean into periodic dislocations and growing dispersions. |
The capital markets are increasingly giving investors multiple
opportunities to lean into dislocation to buy mispriced assets.
The recent increase in dispersions should be an additional
tailwind to this theme.
|4.||Own secular growth stories – ‘Cash Flow Compounders’ amid slowing nominal GDP. |
With China’s nominal GDP falling, overall nominal GDP growth
has suffered mightily. In this environment we think more
investors will migrate towards secular growth stories where there is a meaningful potential for cash flow to compound.