By HENRY MCVEY May 14, 2015

While the recent downturn in both valuations and return on equity might suggest that now is the time to begin buying public emerging market equities en masse, we do not hold that view. Leverage remains near all-time highs, which likely means further dilution for equity holders. Also, we think currency will remain a headwind for some time, particularly as the Fed begins raising rates. Finally, EM underperformance cycles tend to run long, with an average of 91 months versus “just” 55 months this cycle. As such, it appears time is still on the side of the patient investor. To be sure, we do not think that a zero tolerance policy towards public EM equities is the “right” answer. Rather, within the asset class, our view is to remain selective as well as to consider alternative ways to gain exposure to important EM macro themes such as rising GDP-per-capita and corporate deleveraging.

Exhibit 1

EM Public Equities Have Been the Performance “Caboose” During the Last Five Years for U.S. Dollar Investors. We Now See Room for Improvement, But We Are Not Yet in the “All In” Camp

Note: Performance in U.S. dollars. Data as at December 31, 2014. Source: Bloomberg.

I was recently attending a non-profit’s investment committee meeting when our consultant pointed out how poorly the emerging markets (EM) equity asset class had performed over the past five years. Sure, I knew it had been a laggard, but as Exhibit 1 shows, for U.S. dollar-based investors, the MSCI EM index has literally been the performance “caboose” of the global capital markets, with just a 2.1% annualized return over the five years ending December 31, 2014. And if that was not bad enough, I was reminded that EM public equities’ performance was 80% correlated to the S&P 500 during this period, with an annualized volatility of 19%.

For an asset class that was supposed to help sophisticated investors gain access to the world’s fast-growing middle class amid a period of excessive leverage and demographic headwinds in the developed markets (DM), public EM equity performance results have – to say the least – been quite disappointing in recent years. This underperformance has been true even for local currency investors, as many EM large capitalization stocks, particularly in Latin America, have underperformed badly in many instances (Exhibit 3).

Exhibit 2

Asia Pacific Has Outperformed Latin America By a Wide Margin Since 2012

Data as at April 30, 2015. Source: MSCI, Bloomberg.

Exhibit 3

Damage to Large Capitalization Latin American Companies Like Petrobras Has Played a Part in the Region’s Dramatic Underperformance

Data as at April 30, 2015. Source: Bloomberg.

Against this backdrop, my KKR Global Macro & Asset Allocation colleagues and I recently spent some time addressing the question of not only what has been ailing emerging markets public equities but also where do we go from here in terms of future allocations to the asset class. Our primary conclusions about the drivers of poor performance are as follows:

  1. As we detail below, a significant portion of the underperformance of EM public equities in recent years has been linked to multiple contraction in the public markets. All told, EM equity multiples have contracted, on average, about 26% over the last five years. Interestingly, frontier markets, which represent even higher growth and less maturity than “traditional” EM markets, also experienced significant multiple contraction – an average of 31% during the same period (Exhibit 7).
  2. Another major detractor from EM public equity performance for U.S. dollar investors has been currency depreciation. See below for details, but we estimate that currency depreciation alone has reduced the five-year cumulative returns for a U.S. dollar based investor to 11% from 29%, a full 62% haircut (Exhibit 10). As such, the trailing five-year performance compound annual growth rate (CAGR) of the MSCI EM index was just 2.1% per year in U.S. dollars versus 5.2% per year in local terms. Importantly, we envision more currency headwinds ahead for EM equities, particularly as the Federal Reserve begins its tightening campaign in the months ahead.
  3. Despite GDP growth that is notably faster than in the developed markets, corporate earnings in the EM world have lagged badly. Two key issues, which we detail below, are that margin degradation and equity dilution have acted as notable impediments to growth and returns. In fact, since 2010 earnings per share in EM public equities have been flat in local currency terms and have actually been negative in U.S. dollar terms (Exhibit 14).
  4. Finally, EM country and regional indexes often have major skews that can – at times – negatively affect overall performance. As such, an investor may buy an index to gain exposure to a thoughtful macro theme like increasing consumption-per-capita or above average GDP growth, but actually end up owning a concentrated index levered to a particular product cycle, commodity, or state-owned enterprise. This issue has clearly affected Latin America’s overall performance in recent years, with the shares of a large capitalization company like Petrobras declining by 60.2% (and 77.6% in USD) during the past five years (Exhibit 3). See below for specific details on our math, but our r esearch shows “concentrated” country indexes have returned cumulatively just 12% during the past five years, compared to 44% for the remaining EM indexes we researched.

Exhibit 4

Our Rules of the Road Suggest ROE, Valuation, and Commodities Are Beginning to Look Washed Out, But Eroding FX and Lackluster Momentum Make Us Feel It Is Too Early to Call the Bottom

Data as at May 4, 2015. Source: KKR Global Macro & Asset Allocation analysis.

While the sluggish investment performance from EM public equities might – on the surface – suggest that investors just avoid the asset class in its entirety, that conclusion is not one we champion. Rather, our work suggests that EM equities can be owned in size, but generally when five key Rules of the Road are followed. They are as follows:

So what are our Rules of the Road suggesting in terms of EM equity allocations at the moment? As Exhibit 4 summarizes — and we discuss more in detail below in Section II — our key message is that, despite significant underperformance of late, our research shows that now is still not the time to make the big EM, cycle-turning equity bet, particularly given our ongoing concern about EM currencies.

Rather, we prefer increasing exposure through selectivity, a similar message we laid out in our 2015 Outlook piece (see Getting Closer to Home, January 2015). Most importantly, we retain a bias within EM for Asia over Latin America. To date in 2015, on a total return basis, EM Asia has already outperformed EM Latin America by nearly four percent (11.7% versus 7.8%) in local terms1. Since 2009, however, the gap between the two regions has been massive, with EM Asia returning nearly 150% versus 85% for EM Latin America in local terms2. Importantly, within Asia, we still favor cyclicals in India and laggard, lower beta and restructuring names in China.

Separately, we continue to advocate for interesting “one-off” EM public equity opportunities in other markets. For example, after the precipitous fall in oil prices, several Nigerian banks now look compelling at less than half of book value, while certain real estate plays in Mexico, particularly those with development skills (versus just being serial acquirers), appear compelling. Finally, with the recent pullback in India, we would be adding to positions.

In terms of our overall strategic asset allocation views, we retain the slightly more defensive bias we laid out at the beginning of 2015. Consistent with this view, our biggest position, which is 15% versus a benchmark of zero, remains Distressed/Special Situation. Our large weighting reflects our desire to migrate towards products that harness macro and geopolitical instability to their benefit. Within fixed income, we continue to overweight private credit and opportunistic liquid credit to take advantage of the illiquidity premium and periodic dislocations that have occurred from heightened regulation throughout the global banking business. Finally, within real assets we favor investments with both yield and growth, particularly those that provide some long-term inflation protection.

SECTION I: What Drove EM to Perform So Badly In Recent Years

In the following section we detail the four primary reasons why we believe that EM equities have performed so poorly in recent years for U.S. dollar-based investors.

Reason #1: P/E Contraction

My dear, here we must run as fast as we can, just to stay in place. And if you wish to go anywhere you must run twice as fast as that. -Lewis Carroll, Alice in Wonderland

For emerging market investors, we think that the aforementioned advice from the Queen of Hearts to Alice holds particular relevance. Indeed, whereas EM investors have enjoyed modest returns in nominal terms, the return profile of EM equities in real terms has been the equivalent of “just stay(ing) in place.” One can see this in Exhibit 6, which shows that the MSCI EM index has appreciated just two percent per year over the last five years on a U.S. dollar basis.

Importantly, as shown in Exhibits 5 and 6, lackluster absolute returns in EM are magnified because they come at a time of exceptional returns in developed markets, the S&P 500 in particular. All told, the S&P 500 outperformed EM equities by 10% per year on a local currency basis and 13% per year on a U.S. dollar basis, respectively, during the last five years. Besides lackluster performance, EM equities have also been a more volatile asset class, which has dented the return per unit of risk.

Exhibit 5

Emerging Market Performance Has Lagged Significantly on a Local Currency Basis…

Five-years ending December 31, 2014. Source: MSCI, Bloomberg.

Exhibit 6

…And Even More So on a U.S. Dollar Basis

Five-years ending December 31, 2014. Source: MSCI, Bloomberg.

So, what drove the massive underperformance in EM equities? We will address several factors at work in this section, but one important driver has been the significant de-rating of the price-to-earnings ratios of emerging market equities during the past few years. Specifically, as Exhibit 7 shows, the price-to-earnings ratio of emerging market equities has declined by a quarter over the last five years.

Exhibit 7

Decomposition of Total Returns Show That P/E Ratios Have Been a Drag on Equity Returns in Both Emerging and Frontier Markets; EPS Growth Too Has Also Been a Major Headwind

Data as at December 31, 2014. Source: MSCI, Bloomberg.

Interestingly (and to some degree, ironically), one of the biggest contributors to the overall P/E compression in EM was multiple compression in some of the largest and often most popular parts of the EM indexes. In particular, what the investment bank Goldman Sachs originally labeled as BRIC countries, which include Brazil, Russia, India, and China, have endured some of the greatest absolute multiple compression as investors have become disillusioned with – among other things – excessive government intervention, declining returns, weakening currencies, and unorthodox monetary policy. One can see the magnitude of the decline in PE ratios in countries like China and Russia and ROEs across all the BRICs in Exhibits 8 and 9, respectively.

Exhibit 8

BRIC P/E Ratios Have Fallen in All Countries Except India and Brazil…

Data as at March 31, 2015. Source: MSCI, Bloomberg.

Exhibit 9

…Falling Return on Equity, However, Has Been Unanimous Across the BRICs

Data as at March 31, 2015. Source:MSCI, Bloomberg.

Reason #2: EM Currencies Have Also Been a Major Headwind to the Overall Total Return of EM Equities

Another major detractor from EM equity performance in recent years has been significant currency depreciation. In fact, we estimate that currency depreciation alone has reduced the returns of EM equities for a USD based investor by nearly two thirds. Indeed, just consider that – without currency headwinds – EM equities would have returned 29% cumulatively over the last five years, versus the 11% that was actually reported in U.S. dollars. As such, the five-year performance CAGR of the MSCI EM index in local currency terms was 5.2%, while dollar-based investors earned a CAGR of just 2.1% per year.

Exhibit 10

Currency Depreciation Has Been a Major Detractor of Returns in EM Equities

Data as at December 31, 2014. Source: MSCI, Bloomberg.

Exhibit 11

In Recent Years Currency Depreciation Has More Than Offset Any Positive Contribution from EPS Growth and Dividends

Data as at December 31, 2014. Source: MSCI, Bloomberg.

As one can see in Exhibit 12, the lion’s share of EM currencies have suffered sizable depreciations during the last five years, with the average spot return versus the U.S. dollar at negative 19.4%. Interestingly, the dispersion of returns among BRIC countries has been quite outsized. On the one hand, the Chinese yuan, which is largely pegged to the U.S. dollar, actually appreciated 10% from 2010 to 2014, while the much maligned Brazil real and the Russian ruble fell by more than 34% and 50%, respectively, over the same period.

Exhibit 12

Currencies With Weak Macro Fundamentals Have Lost as Much as 50% of Their Value vs. the U.S. Dollar

Data as at December 31, 2014. Source: Bloomberg.

Exhibit 13

In Many Instances EM Currency Depreciation Has Been More Powerful Than Earnings Growth and/or Multiple Expansion

Data as at December 31, 2014. Source: MSCI, Bloomberg.

As we look ahead, we see more risk that EM currencies could suffer another leg down in 2H15 and 2016. Importantly, while many EM currencies have depreciated in nominal terms, they have not actually fallen in real terms. Moreover, with commodity prices down, and global trade and investment growth slowing, many EM countries now face growth and/or deficit shortfalls that were likely unimaginable just three years ago. To this end, we have already seen an increased focus on interest rate policy by major central banks, including in India, Thailand, China, Indonesia, and Turkey.

Meanwhile, in the United States the Federal Reserve is likely to boost short-term rates by the end of the year. Without question, we believe these diverging paths of interest rate policies between the United States and the emerging markets is likely to exacerbate a key input factor in the EM total return equation that we frankly feel may still be somewhat underappreciated by the investment community at this point in the cycle.

Reason #3: EPS Growth in EM Has Lagged Badly

As we previewed earlier in Exhibit 7, EM public equity EPS have lagged badly, growing just 30% percent over the past five years. This cumulative growth by EM public equities equates to only a third of the earnings growth posted by developed market equities during the same period. If anything, however, we think this actually understates the magnitude of the recent EM earnings issues, because what modest EPS growth there has been all took place in the very early phases of this recovery when EMs were stimulating aggressively and commodity prices were snapping back fast. Indeed, since the end of 2010, earnings for EM public equities have not grown in local currency terms and have actually been in steady contraction in U.S. dollar terms (Exhibit 14).

This EM earnings shortfall in recent years might come as a surprise to some, since all else equal, one would generally expect faster corporate growth in emerging markets given the backdrop of structurally faster GDP growth. On the surface, that was true: Since 2010, MSCI EM stocks have grown revenues by 65%, which is fully 25 percentage points more than the 40% growth posted by the developed market stocks over the same period (Exhibit 15).

The problem for EM investors, however, is that beyond top-line growth, “all else” has not been equal. Margin trends, share count dilution, and FX are also key inputs to EPS growth, and as we show in Exhibit 15, all of these factors have been important detractors from emerging markets stock performance.

Exhibit 14

Since 2010 EM Earnings Have Been Stagnant in Local Currency Terms and Have Actually Fallen in U.S. Dollar Terms

Data as at March 31, 2015. Source: MSCI, Bloomberg.

Exhibit 15

Margins, Share Count Dilution, and FX Have All Been Headwinds3

Based on MSCI Index constituents as at December 31, 2014 for companies that have both full-year 2014 and full-year 2010 Earnings data. Data as at March 31, 2015. Source: MSCI, Bloomberg, KKR Global Macro & Asset Allocation analysis.

3

Reason #4: Concentration Risks Amid an Asynchronous Recovery Have Been Headwinds for EM Equity Investing

We also think that public EM equities have several “compositional considerations” that have affected performance results more than what some investors might fully appreciate. For starters, just consider that EM is not really that global of an index, according to MSCI, the source that we use for all our global and regional indexes. In fact, EM Asia accounts for nearly 70% of the total EM index, and within Asia, three countries – China, Korea, and Taiwan – collectively account for nearly 50% of the MSCI EM index. One can see this in Exhibit 16.

This concentration effect is not to be under-estimated. For example, misallocation of capital by China, Asia’s major economic force and largest single country, has directly dented overall equity returns in the region. Indeed, the cumulative five-year USD return over 2010-14 for EM Asia ex-China was 39%, versus just 19% for China (Exhibit 17).

Exhibit 16

China, Korea and Taiwan Make Up Almost 50% of the MSCI Emerging Market Index…

Data as at December 31, 2014. Source: MSCI.

Exhibit 17

…And Countries With High Company Concentration Have Underperformed

Note: Gross, local performance. Source: MSCI, Factset, Bloomberg. Data as at December 31, 2014.

Exhibit 18

A Handful of Companies Dominate Many Country Indices…

Data as at December 31, 2014. Source: MSCI.

Exhibit 19

…And Can Greatly Impact Overall Country Level Performance

Note: Highly concentrated indices comprise Egypt, Peru, Czech Republic and Hungary. On average the largest company in these indices represents 56% of the index. Gross return is calculated in local currency. See Exhibit 17 for further detail. Data as at December 31, 2014. Source: MSCI, Factset, Bloomberg.

In addition to country concentration complexities, certain public EM equity markets have heavy company weightings in many instances. In Taiwan, for example, Taiwan Semiconductor accounts for 23% of the index, while Samsung represents 24% of the Korean equity market. Meanwhile, in Mexico, telecommunications player America Movil is a sizeable 20% of the index. In the U.S., by comparison, the largest weighting in the S&P 500 is Apple at just 3.5%.

As we detail in Exhibit 19, history shows that there can be a notable penalty for owning a concentrated index. Too often a concentrated EM index ends being a “closet bet” on a product, a cycle, and/or a government policy that goes awry versus giving an investor exposure to a broad-based rising GDP per capita story in a specific country of choice.

Importantly, these sorts of compositional risks have been, we believe, actually amplified during the current economic cycle, given the asynchronous nature of the recovery. Specifically, the traditional relationship between the DM consumer and the EM producer has broken down versus past cycles. What do we mean? As Exhibit 20 shows, DM consumers in areas like the United States and Europe are saving, not spending, the way they did in the past. As a result, EM countries have not been able to export their way to prosperity as in past cycles, which has clearly affected growth, incomes, and – ultimately – stock market returns versus prior cycles in the 1990s and 2000s.

Exhibit 20

DM Belt-Tightening and Increased Savings Have Become Headwinds to Traditional Trade-Driven EM Exports

Data as at April 8, 2014. Source: IMF, Haver Analytics.

Exhibit 21

The World’s Biggest Shoppers Still Reside in the U.S. and Europe

Data as at April 14, 2015. Source: World Bank, Haver Analytics.

SECTION II: Our Rules of the Road and Where Do We Go From Here?

As someone who spends a lot of time traveling between KKR’s 21 global offices in 15 countries, I have come to value on-the-ground insights, especially in the emerging markets. Without question, talking with local businessmen, politicians, and central bankers adds an important subjective input that is hard to replicate from my office in midtown Manhattan.

But it is not enough. Over time and through multiple hard lessons along the way, we have learned that it is easy for an investor to get lost – or at least become misguided – amid various, often conflicting, anecdotes across multiple EM jurisdictions with differing macro stories and sensitivities. As such, we find it is helpful to supplement the local “color” with a more objective framework that helps one keep an eye on the big picture. To this end, we have reviewed our latest outlook for each one of our Rules of the Road, which collectively help to cement our near-term bias towards increasing exposure selectively versus an outright overweight to the entire asset class.

Rule #1: Favor EM When ROE Is Stable or, Preferably, Rising; Current Outlook: Neutral

When I transitioned from a micro, or a bottom-up, company analyst role to a top-down macro one in 2003, there were many important analytical processes that I took with me. However, one in particular, continues to standout: the Dupont analysis. In my humble opinion, the Dupont analysis is one of the “must have” tools for both macro and micro investors. Why? Because it simply and effectively decomposes return on equity – whether it is for a company, sector, or country – into its three key components: margins, asset turns, and financial leverage. If an investor can understand the marginal change in return on equity using these three inputs, then he or she has a high probability of getting the investment story correct, in our view.

Within our emerging markets research effort, the Dupont analysis has been hugely critical for assessing top-down trends. In fact, it is the lens through which we developed our first Rule of the Road for analyzing EM equities as an asset class. Specifically, what we have found is that, as long as the return on equity in emerging markets is not falling on an absolute basis, EM equities generally outperform DM equities. However, if it is falling, then the message is to stay clear of the asset class. One can see the visual of Rule of the Road #1 in Exhibit 22.

Exhibit 22

As Long As EM ROE Isn’t Falling on an Absolute Basis, EM Generally Outperforms DM

Note: Total return is gross dividends calculated in U.S. dollars. Data as at February 27, 2015. Source: MSCI, Bloomberg.

Importantly, despite a global economy that began its healing process in 2009, return on equity in EM has plummeted in recent years. One can see the magnitude of the decline in Exhibit 23, which shows that there has been a full 21% decline in EM return on equity. This decline occurred at a time when the rest of the world has largely enjoyed flat to higher returns on equity.

So what happened? Well, as Exhibit 23 also shows, the primary headwind to EM ROE has been margins, which have declined fully 22% to 8.0% at year-end 2014 versus 10.3% in 2010. In addition, declining asset turns have been a further 7% tailwind. Finally, our work also shows that returns would have actually have been worse had EM companies not levered up during this period. One can see this in Exhibit 23, which shows that while the S&P 500 and the MSCI World delevered by 11%, EM public equities actually levered a full 10%. Without this additional incremental leverage, we estimate that aggregate ROE would have been 1.1 percentage points lower (10.5% versus 11.6% actual).

Exhibit 23

Increased Leverage Throughout EM Has Somewhat Softened the Blow that Declining Margins and Slower Asset Turns Have Had Upon Overall Return on Equity. However, We Now See Deleveraging Ahead for Public EM Equities

Data as at December 31, 2014. Source: MSCI, Bloomberg.

Exhibit 24

The ROE Slowdown Has Been Fairly Uniform Across EM Regions

Data as at December 31, 2014. Source: MSCI, Bloomberg.

Exhibit 25

Slowing GDP Growth Is Weighing on Companies’ Ability to Turn Assets

e = KKR Global Macro & Asset Allocation estimates. Data as at March 20, 2015. Source: IMF, Haver Analytics, Bloomberg, MSCI, KKR Global Macro & Asset Allocation analysis.

If there is good news about the future, we feel that it is related to the fact that margins are approaching trough levels. Indeed, as Exhibit 26 illustrates, margins are now one standard deviation below normal. The bad news, as my colleague Dave McNellis recently pointed out to me, is that high unit labor costs remain a headwind for EM margins (Exhibit 27). Nowhere is this issue more acute than in Brazil, where real wage growth has run persistently above the rate of productivity improvements. In fact, since 2003, real wages have grown 27%, while labor productivity has actually declined by 8% (Exhibit 28). However, Brazil is not alone as we continue to hear about upward pressure on wages in countries such as Indonesia, China, and even parts of India.

Also, as we look ahead, we believe that asset turns, or revenues as a percentage of assets, are not likely to improve meaningfully overnight. Key to our thinking is that, as we show in Exhibit 29, unproductive use of credit in large EM countries like China has led to an excessive build out of property, plant, and equipment (PPE). The other issue is that, given the high level of leverage at the corporate level, companies can no longer raise debt to boost return on equity. In fact, as companies begin to normalize their leverage, overall ROE could likely face additional downward pressure below its current level of 11.6%, we believe.

Exhibit 26

Margins Are Near Trough Levels…

Data from September 2001 - April 2015. Analysis excludes recession-impacted periods of April - November 2002 and January 09 - January 10. Source: MSCI, Bloomberg, KKR Global Macro & Asset Allocation analysis.

Exhibit 27

…But It’s Difficult to Call an Outright Bottom When Unit Labor Costs Remain Quite Elevated

*Average of top 10 MSCI EM and MSCI DM countries, weighted by market cap contribution. Collectively these countries account for 88% and 94% of total index weight, respectively. Data as at March 2015. Source: OECD, Haver Analytics, KKR Global Macro & Asset Allocation analysis.

Exhibit 28

There’s a Huge Gap Between Real Wage and Productivity Growth in Brazil

Data as at 2013. Source: Haver Analytics, Morgan Stanley Research.

Exhibit 29

Credit per Unit of GDP in China Has Increased Meaningfully, Leading to Excessive Levels of Total Fixed Investment

Data as at December 31, 2014. Source: People’s Bank of China, China National Bureau of Statistics, Haver Analytics.

Our bottom line: Given high leverage levels and excessive capital expenditures on unproductive assets, we do not see return on equity in EM snapping back quickly. Leverage still needs to come down, while asset turns are likely to remain weak, in our view. As such, we think waiting for some of these factors to mean revert before expecting the benefit of any improvement of margins on overall ROE probably makes the most sense at this point in the cycle.

Rule #2: Valuation…It’s Almost Never Different This Time; Current Outlook: Neutral

“The four most dangerous words in investing are: ‘this time is different.’” Sir John Templeton, legendary investor and philanthropist

If I was asked to make a case for a long-term re-rating of EM stocks, at least two things would need to occur. First, it would need to be at a time when domestic consumption is so robust and consistent in EM countries that their economic cycles become independent and self-sustaining. Second, EM government and central banks would stop meddling in the private and quasi-private sectors, which would allow for better pricing of credit and better returns on equity for shareholders, we believe.

In the near-term, however, such a “nirvana-like” macroeconomic backdrop in EM is unlikely to occur, and as such, we likely need to abide by the wise words of EM’s legendary investor, Sir John Templeton, that it is not different this time. Specifically, when EM public equities rally to the point that they’re trading close to parity with DM equities on P/E valuations, our research leads us to Rule of the Road #2 that an investor should certainly consider reducing the size of his or her overweight EM equity positions. Indeed, as one can see in Exhibit 30, in all three cases (1995, 2007, and 2010), the best thing an investor could do was to aggressively reduce public EM exposure relative to DM exposure. Why? Because each time it was not – in fact – different. In all three cases, EM began a notable and important period of underperformance because – at such elevated valuation levels – EM markets were not properly pricing in the required risk premium, including geo-political threats, difficulties associated with ease of doing business, and corruption practices, that are often associated with these markets.

Exhibit 30

We Have Seen a Fairly Consistent Pattern of EM Relative Valuation Peaks and Troughs

Note: Total return is gross dividends, U.S dollar. PE data from November ‘98 thru May ‘00 omitted due to consistency issue. Data as at April 30, 2015. Source: MSCI, Bloomberg.

Exhibit 31

Business Conditions in EM and DM Markets Are Not the Same….

Data as at November 7, 2014. Source: World Bank, Haver Analytics.

So what guidance, if any, does EM valuation offer us today? We note the following. At the end of April 2015, the MSCI EM traded at 14.8 times trailing earnings, or roughly 3.8 multiple points below the MSCI developed market P/E of 18.6. While that certainly sounds like an attractive spread, folks should appreciate that, as we show in Exhibit 30, the historical underperformance cycles have not ended until EM stocks have traded at even deeper discounts. In fact, the minimum previous spread at the relative trough was 6.4 multiple points in December 2008, when EM traded at 9.4 times trailing earnings versus DM at 15.9 times4.

So, our bottom line is that EM valuations do look reasonably attractive; however, based on history, they are not so cheap that an investor can gain confidence that the current underperformance cycle definitely has to be close to an end, particularly in light of some of the other macro factors we track. As such, we still rate valuation a neutral in our Rule of the Road #2.

Rule #3: EM Equities Have Reliably Foreshadowed EM FX; Current Outlook: Negative

In investing, as in sports, card games, and other forms of competitive endeavor, one of the key things participants look for is a “tell,” or some fairly reliable signal of when the nature of the game may be about to shift. One interesting “tell” we have uncovered about emerging markets investing is that the performance of public EM stocks has reliably foreshadowed the inflation-adjusted performance of EM currencies. See Exhibit 33 for details, but since 1987 when our dataset begins, emerging markets stock performance has foreshadowed the real trade-weighted performance of emerging markets currencies versus the U.S. dollar by fully 17-33 months. In our view, this insight is a big deal, because as we showed earlier, currency depreciation in certain years can more than offset any positive benefits from earnings growth and/or multiple expansion.

Exhibit 32

…And As Such, Different Risk Premiums Are Warranted, Particularly Across EM Countries

Data as at April 30, 2015. Source: Bloomberg, KKR Global Macro & Asset Allocation analysis.

Why should such a lagged relationship exist? While we can’t say with certainty, our gut is that underperformance of publicly traded equities in a country may act as a signal that the backdrop for other forms of investment – including foreign direct investment and other portfolio investments – is becoming less attractive. Over time, such heightened caution diminishes investment inflows, thereby pressuring the currency. Another factor at work, we think, is that slower EM investment inflows also serves to cool inflation, which also influences the real value of the currency.

Exhibit 33

EM Public Equities Tend to Lead Their Currencies by One to Three Years

OITP = Other Important Trading Partners, which is a weighted average index calculated by the U.S. Federal Reserve, based on the foreign exchange values of the U.S. dollar against a subset of currencies in the broad index that do not circulate widely outside the country of issue. Data as at March 10, 2015. Total return is gross dividends in USD for both EM and DM. Source: MSCI, Federal Reserve, Haver Analtyics, Bloomberg.

Granted, the relationship above tells us nothing about the future direction of EM equities, since equities are the leading component of the relationship. What the relationship does tell us, however, is that – given the significant underperformance of EM equities of late – emerging market currencies are likely to remain under pressure in coming quarters. This outcome would be consistent with the view we articulated in our 2015 Insights note Getting Closer to Home, which suggested that the USD rally is still only about half way done (Exhibit 34). If we are right, then any acceleration in earnings and/or expansion of trading multiples in EM public equities in the short-term could likely be dented by further currency headwinds, and as such, we retain a negative outlook at the moment for our Rule of the Road #3.

Exhibit 34

We Think USD Rally Is Only About Halfway Done, Both in Terms of Time and Value

Data as at March 31, 2015. Source: Bloomberg.

Exhibit 35

EM FX Valuation Has Cheapened, But Is Not What We Would Call Washed Out

*Weighted average of top 10 MSCI EM countries by market cap contribution, which collectively account for 88% of total index weight. Data as at April 30, 2015. Source: IMF World Economic Outlook, Haver Analytics, KKR Globl Macro & Asset Allocation analysis.

Rule #4: EM and Commodities Remain a “Trade of One;” Current Outlook: Neutral

As we perform due diligence alongside our colleagues in regions like emerging Asia and Latin America, many of our conversations with local officials and businessmen often center around things like improving infrastructure, expanding access to credit, and a developing middle class. Rarely do these “Authorities” with whom we speak wish to spend much time focusing on their countries’ dependence on commodity exports.

In our view, this approach is a mistake. Indeed, the fact remains that EM stocks remain quite closely bound with commodity markets. How much? All told, since 1997 EM equity relative performance has been fully 86% correlated with the spot price of the GSCI commodity index (Exhibit 36).

Exhibit 36

EM/DM Relative Performance and the GSCI Have Been Highly Correlated (86% Since 1997)…

Note: Total return is gross dividends, U.S. dollar. Data as at April 30, 2015. Source: MSCI, Bloomberg.

Exhibit 37

…Even Though EM Public Equities Are Not Heavily Overweight Commodity Sector Companies

Data as at April 30, 2015. Source: MSCI, Factset.

At first blush, this tight EM-commodity relationship might seem surprising, given that weighting of commodity sectors is actually not that different between emerging and developed market equities (Exhibit 37). In fact, today Energy—the single most important global commodity in our view—accounts for around eight to nine percent of both indexes.

However, a lot has changed in recent quarters. In particular, global commodity prices and related equities, particularly in EM, have suffered mightily. One can see the magnitude of the damage at sector and company level in Exhibits 38 and 39. Not surprisingly, given all the carnage, we feel much better about the current level of commodity prices and commodity equities in EM (and DM for that matter), but we still do not envision a major sustained commodity price rebound in the near-term that could lead to sustained EM public equity outperformance.

Exhibit 38

Energy and Materials Have Been Hard Hit, Particularly in EM Public Equities

Data as at April 30, 2015. Source: MSCI, Factset.

Exhibit 39

Many Large Capitalization Names in EM Public Equities Have Experienced Significant Declines

Period from March 2011 thru April 2015. The companies listed above represent the MSCI Emerging Markets Index constituents in each of the Materials and Energy sectors having the largest value decline during the period of March 2011 through April 2015. Data as at April 30, 2015. Source: MSCI, Factset.

Against this backdrop, an investor is left to wonder why commodities are still so important for emerging market equity performance, even in countries that actually benefit from lower prices? First, we think the heavy commodity influence is less linked to commodity weights in an equity index per se — and more to the total economies of EM countries. This nuance is a small but important one, as commodity-related activities account for more than five percent of the GDP of the key countries for EM investors, versus just over one percent of GDP for the key DM countries. One can see this in Exhibit 40.

Second, it’s also worth remembering that emerging markets are connected to each other via investment and trade linkages, such that even resource-poor countries such as Turkey often actually exhibit strong positive correlations with commodity prices (Exhibit 41). In the case of Turkey, we think this is due to its dependence on global investors’ appetites for EM as an asset class, given its need to finance its substantial current account deficit. Trade linkages with oil heavyweights like Russia and the Middle East likely also play a part in the positive correlation.

Exhibit 40

Commodity Extraction Remains an Integral Activity for Many EM Economies

Average of top 10 MSCI EM and MSCI DM countries, weighted by market cap contribution. Collectively these countries account for 88% and 94% of total index weight, respectively. Data as at March 2015. Source: World Bank, Haver Analytics, KKR Global Macro & Asset Alloccation analysis.

Exhibit 41

Even Turkey Has Exhibited a Positive Correlation With Commodity Prices (88%) Since 1998

Note: Total return is gross dividends, U.S. dollar. Data as at March 5, 2015. Source: U.S. Energy Information Administration, Energy Intelligence Group, Haver Analytics, Bloomberg, KKR Global Macro & Asset Allocation analysis.

Importantly, our macro research still points towards a backdrop where it is still not yet the time to be aggressively bullish on commodities for three reasons. First, we still see slowing growth in China, which is an anchor consumer of many commodities. Second, as we showed earlier in Exhibit 34, we think that the U.S. dollar is only halfway through its bull market. Finally, as Exhibit 42 shows, there is excess capacity overhang in many areas, including oil inventories.

So given this backdrop, we maintain a neutral outlook for this Rule of the Road. The good news is that many commodities have been significantly de-rated, which leads us to a neutral outlook versus our prior negative stance. However, with no clear catalyst for broad-based, sustained appreciation for the commodity complex, we feel comfortable adhering to what this Rule of Road suggests about the near-term future of public EM equity performance.

Exhibit 42

U.S. Crude Oil Inventories Now Sit at Over 30 Days, Which Is Very High by Historical Levels

Data as at March 31, 2015. Source: U.S. Energy Information Administration, Energy Intelligence Group, Haver Analytics, Bloomberg, KKR Global Macro & Asset Allocation analysis.

Rule #5: Respect That EM/DM Moves in Protracted Cycles, So It’s Usually Better to Wait for Clear Turning Points; Current Outlook: Slightly Negative

A strategic inflection point is a time…when its fundamentals are about to change. That change can mean an opportunity to rise to new heights. But it may just as likely signal the beginning of the end. -Andrew S. Grove

After more than a decade of doing top-down strategy and implementation, we’ve learned that investors love a good debate over how to interpret real-time macro data to further an investment cause. In many instances folks are looking to leverage insights from data to call what Andy Grove terms an important “strategic inflection point,” so that they can allocate more capital to a company, sector, country, region, and/or asset class.

We certainly strive in our profession to generate alpha by preemptively calling a turn in the performance of an asset class that might not be readily apparent to the masses. However, in the EM versus DM debate, both our research and experience have taught us that patience – and more so than in other asset classes, we believe – is required when calling a major inflection point. Why? Because mean reversion, one of the most powerful concepts in investing, actually does not work that well within the EM versus DM debate, particularly for investors with a shorter time frame. In fact, since the inception of the MSCI EM Index in December 1987, relative performance cycles have run, on average, for 7.6 years (91 months). One can see this in Exhibit 43. Moreover, none of the past three major cycles has been less than 81 months. This historical point on duration is particularly important because the most current EM underperformance cycle that started in September 2010 has – so far – run for only 4.4 years (55 months).

Exhibit 43

EM/DM Has Moved in Long Secular Bull and Bear Markets

Note: Total return is gross dividends, U.S. dollar. Data as at April 30, 2015. Source: MSCI, Bloomberg.

Exhibit 44

Historically, a Simple Momentum-Based EM/DM Investment Strategy Would Have Been Quite Effective

Note: Total return is gross dividends, U.S. dollar. Illustrated returns do not include fees or trading costs or investment fees. Past results are not necessarily indicative of future performance. Data as at April 30, 2015. Source: MSCI, Bloomberg.

To be sure, the starting points of bull and bear markets are only obvious in hindsight, which often makes cyclically-driven investment strategies difficult to implement in practice. In this case, however, we think the cycles are sufficiently long and steady enough that it really does pay to wait for a trend to form. To this end, I asked my colleague David McNellis to come up with a “simple” investing discipline to which an investor could adhere. His advice: On a monthly rebalance, go long EM relative to DM only when the three-month moving average of the relative total return index is positive on a year-over-year basis. One can see the potency of this strategy in Exhibit 44.

We also find it impressive that, unlike many systematically driven investment strategies, this one actually would have had relatively low turnover. In fact, over the past 26 years for which we have data, the signal would have toggled between “buy” and “sell” only nine times.

So, what’s it saying at the moment? Again, it suggests that, while an important turn may be coming (with China now leading the pack), we have not gotten the full signal that an inflection point in EM equities relative to DM equities has occurred. So, while we are watching overall EM momentum closely these days, we are still retaining a slightly negative bias at the moment for this final Rule of the Road.

Exhibit 45

China’s Equity Market Is Exhibiting Positive Momentum, Unlike Brazil and India

Data as at April 30, 2015. Source: Bloomberg.

SECTION III: Conclusion

Patience is bitter, but its fruit is sweet. - Jean-Jacques Rousseau

While the recent performance of EM equities has certainly put a lot of folks in a bad mood, we still advocate a little more patience before the final part of the storm passes. The good news is that both valuations and return on equity now should provide investors with some reasonable margin of safety. However, excluding more dollar-linked markets like China, we think currency will remain a headwind in EM public equities for some time, particularly as the Fed begins raising rates. Finally, while momentum could be in the early stages of turning, we do not believe it has given us the “all-in” signal.

So, in the interim, what is an asset allocator to do? We certainly do not think that a zero tolerance policy towards public EM equities is the right answer. Rather, within the asset class, our advice is to begin scaling up but with a bias towards selectivity. To this end, we break down our “Do’s” and “Don’ts” into three buckets that we think are worth pursuing at this point in the cycle. They are as follows:

  1. We continue to focus on reform-minded stories with not only strong leaders but also strong central bankers. In our view, both Mexico and India fit this billing. To be sure, these are expensive markets, but we like the potential upside if earnings come through and inflation remains in check. Specifically, we like Mexican midcap companies, particularly in real estate and consumer-related areas, while in India we think cyclical companies with upside to 2016 EPS estimates now look attractive. By comparison, we retain a more cautious outlook in a country like Indonesia until we have greater clarity around new Prime Minister Joko Widodo’s business and political agenda.
  2. Find stories where central bank policy is accommodative against a backdrop of low/falling inflation. At the moment, we still favor China (Exhibit 49). Importantly, we think that slower growth is actually better for Chinese stocks because it signals fewer excesses as well as the ability for the government to be more accommodative. However, we fully appreciate that the the tech and growth sectors in China now look expensive, and as such, we are focusing more on lower beta names and restructuring stories. Consistent with this view, we also expect the HSCEI market in Hong Kong to perform well.
  3. On the other hand, we want to avoid markets that have benefited mightily from the China Growth Miracle during the prior decade, particularly if inflation is high. Ironically, we think that many of the countries that benefitted from China’s growth, particularly commodity players, are now likely to underperform. Key to our thinking is that excess profits were not invested back into infrastructure. Now with loose credit conditions in many instances, high inflation and low productivity are denting currency valuations. Hence, countries like Brazil, Russia, and Malaysia all still represent near-term areas of caution, in our view.

Exhibit 47

The Key for Investors Is to Focus on the Best Risk-Adjusted Return Profile Across the Various EM Asset Classes. In Our View, EM Public Equities Are Just One Option Amid a Growing List of Alternatives

Data as at May 12, 2015. Source: KKR India internal analysis, Bloomberg. Note: The above reflects the current market views, opinions and expectations of KKR based on its historic experience. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment or any KKR fund, vehicle or account which, may differ materially, and are not to be relied upon as such. There can be no assurance that investors in any KKR fund, vehicle or account will receive a return of capital.

Overall, our bigger picture message is that harnessing the attractive component of rising GDP-per-capita in the emerging markets is more complicated than it seems. It requires that an investor work hard to truly identify the right themes – and equally the appropriate vehicles – to deliver on key macro tailwinds. In too many instances investors fail to appreciate how levered a country or regional index is to one company, sector, and/or local trend. As a result, the risk premium associated with the investment can be vastly understated.

In addition to advocating selectivity within the public EM equity universe, we also recommend that folks consider some non-traditional EM structures, including distressed, Asian PE, real estate, and parts of EM credit. Our experience has taught us that these vehicles may be more elegant ways to take advantage of the current dislocation occurring across EM, particularly as China slows. Importantly, in the case of credit and real estate, high nominal rates in many EM countries often allow investors to earn ongoing coupons that dwarf what is available in the public equity markets – and still be higher up in the capital structure. Using the Indian market as a proxy, one can see the potential disparity of returns in Exhibit 47. Overall, our strong conviction about using both more targeted vehicles as well as non-traditional approaches is not new for us. However, it has served us well during our time as a global asset allocator during a highly unusual time across the global capital markets, and as such, we continue to advocate it, particularly for institutional accounts with a heavy international focus.

Exhibit 48

We Continue to Avoid EM Stories With High Inflation

Data as at April 15, 2015. Source: IMFWEO, Macrobond.

Exhibit 49

China Has Significant Capacity to Ease Against a Backdrop of Low Inflation/Disinflation

Data as at April 15, 2015. Source: IMFWEO, Macrobond.

Longer term, though, as the EM consumer becomes stronger, EM producer nations become less dependent on the developed markets for exports, and the public EM equity markets become more closely linked to rising GDP-per-capita (versus the current overweight in many markets towards state-owned enterprises), we think that many countries in the public equity EM universe that we track will become more idiosyncratic in nature. As they do, we think that our Rules of the Road will suggest a more structurally positive outcome for the entire asset class than they do today. Until then, however, we still think that the case for selectivity remains, particularly until EM currencies stabilize.

1 Data as at April 30, 2015. Source: MSCI, Bloomberg.

2 Ibid.1.

3 Please note that this analysis is on a “static constituents” basis, based on index members as of December 31, 2014 and full-year 2010 data. This is necessary to measure share count dilution over time on an “apples to apples” basis. The result is that some statistics are slightly different from those one would see on a headline index basis. Importantly, the margin change shown here is slightly different from what is shown in Exhibit 26.

4 Data as at February 28, 2015. Source: MSCI, Bloomberg.