This time is different: Learnings from a shifting global regime

With a whirlwind of recent developments — post-U.S. election tax debates, ‘Liberation Day’, and travels both abroad and at home in early May—we think it makes sense to update what we have been learning, especially as it relates to our Regime Change thesis. 

One learning involves the role of international bonds, including investors’ increased desire to own more non-U.S. fixed income, alongside more private market alternatives, that can help to further diversify a portfolio. 

Another key area where we have increased our knowledge involves the U.S. dollar’s valuation relative to history. With a weakening dollar, local currency liabilities have the potential to become a more severe drag on performance than we and many investors were expecting prior to April 2nd.

Meanwhile, on tariffs, we’ve updated our ‘post-bargaining plausible case’ by incorporating what we’ve learned from the recent China and U.K. negotiations. Our new baseline suggests a 15% effective tariff rate (down from 18%), which we see as the most likely steady state. This new steady state also improves our GDP growth outlooks for the United States, Europe and China. 

Finally, another area we are now watching more closely as part of the tariffs conversation is the relative importance of goods vs. services to the U.S. economy. Our estimates actually suggest that the gross profitability of U.S. services exports currently surpasses the ‘lost profits’ on goods that the U.S. imports instead of manufacturing domestically. 

This learning, coupled with the potential for further dollar weakness, has impacted the way we are thinking about the ‘America First’ agenda.

When Ken Mehlman and I wrote about the outcome of the U.S. election last November (see 2024 Election: Focus on the Forest, Not the Trees), we noted that from a macro and asset allocation perspective the 2024 ‘Red Sweep’ only added further fuel to KKR’s Regime Change thesis, first laid out to investors as we exited COVID. 

To review, the thesis underscores our view that this time is different, including the way investors need to think about asset allocation, including the role of bonds. Specifically, we think that government bonds will not be able to fulfill their role as portfolio ‘shock absorbers’ this cycle. 

As a reminder, our top-down Regime Change thesis framework is driven by four factors: heightened geopolitical competition, bigger fiscal deficits (which is consistent with the latest U.S. debt downgrade by Moody’s to Aa1 from Aaa on May 16th), a messy energy transition, and stickier inflation. 

Importantly, the world we are describing represents a major shift from the low growth, low inflation, tight fiscal and loose monetary policy framework that dominated much of the last two decades, especially the 2010-2016 period. (One can see this in Exhibit 2 below).

Of the factors mentioned above, the geopolitical factor has been the most amplified of late. As my colleagues General (Retired) David Petraeus and Vance Serchuk remind me often, we have moved from an era of benign globalisation to one of great power competition. 

Increasingly in this world, politics is driving economics, and there is a blurring of capital markets policy and national security policy as cross border barriers to the flow of capital, data, technology, and people rise. 

Seen through this lens, key milestones such as Brexit and now ‘Liberation Day’ represent just the latest ‘textbook’ examples of the convergence that the KKR Global Institute has been suggesting for some time.

However, there is a new variable affecting our Regime Change thesis that we believe warrants investor attention. It centres on the introduction of a potentially structurally weaker dollar, alongside our longstanding view that the correlation between stocks and bonds is moving from negative to positive this cycle. 

Indeed, as we saw upon the April 2nd ‘Liberation Day’ announcement and then again when President Trump sparred with Federal Reserve head Jerome Powell later that month, the unsettling triumvirate of 1) the U.S. dollar depreciating; 2) equities selling off; and 3) bond prices declining all at the same time, wreaked havoc on markets, challenging two fundamental underpinnings of modern-day asset allocation theory. 

The picture is as follows:

1. During risk off days, government bonds are no longer fulfilling their role as the ‘shock-absorbers’ in a traditional portfolio. 

As such, there is now an ongoing clear and present danger for global allocators who bought into the idea that when stocks sell off, bonds will always rally. Importantly, this significant break down in asset allocation theory is occurring not only in the U.S. but also across most other global developed markets. One can see this in Exhibit 1.

2. While bonds and stocks were selling off together, the U.S. dollar was also weakening. 

As a result, there has been a growing fear that, because of dollar weakness, local currency liabilities have the potential to become a more severe drag on performance than expected, especially during turbulent days in the market. 

CIOs and their boards are seeing their offensive assets such as stocks and defensive assets such as government bonds both decline in value at the same time that their local currency liabilities, which they traditionally have not hedged, increase in value too. This unsettling outcome is occurring at a time when most global retirement plans are overweight U.S. assets relative to their benchmarks.

EXHIBIT 1: With the U.S. Leading the Pack, Long-Term Correlation Levels Between Stocks and Bonds Have Increased Across Most Countries

Exhibit 2: Regime Change: We Continue to Argue That This Time Is Different

There is also the consideration that the government is trying to narrow the goods segment of the trade deficit without first narrowing the fiscal deficit. The associated slowdown that we are also seeing in the large and notably more profitable services sector surplus, which we discuss below in more detail (Exhibit 14), is likely a contributing influence as well. 

Beyond the aforementioned portfolio construction questions that have come up in our discussions with global CIOs, boards, politicians, and investors, recent trips to the United Kingdom and to Los Angeles to participate in Michael Milken’s annual conference, elicited a slew of other questions from business executives and investors seeking guidance. 

Further, partial tariff relief has arrived faster than we anticipated post April 2nd in the form of preliminary China and U.K. trade deals.

To this end, we are using this latest Insights note to not only flag some of the most topical questions but also to detail our views (given the points highlighted above) on the way we are approaching asset allocation in the current environment. 

See below for details, but our summary views on the most asked questions are as follows:

1. While not a game changer, partial tariff relief has arrived a little faster than anticipated. What has changed in your thinking? 

Dave McNellis, Brian Leung, and Miguel Montoya have updated their ‘post bargaining plausible case’ for tariffs to incorporate learnings from the China and U.K. deals. Overall, we now think a 15% post-bargaining effective tariff rate (ETR), down from our previous assumption of 18%, seems the most likely steady state. 

A few key observations: the decline in China tariffs is certainly helpful, although perhaps not the needle mover for our base case as one might initially think. Keep in mind that President Trump had already carved out exemptions for major categories like computers, electronics, and smartphones, so reducing the assumed tariff rate on other items doesn’t have as much impact as it might seem. 

That said, the post-bargaining ETR for China now decreases to 30%, compared to our prior estimate of 37%. The U.K. deal also brought some positive news, introducing the possibility of flexibility on 232 sector tariffs. We had previously assumed no exemptions to the 25% tariffs on autos and steel/aluminium aside from USMCA exemptions. 

Now we assume that roughly 50% of auto import volumes and 10% of steel and aluminium volumes might eventually be exempted down to the 10% 'base' tariff rate. The lowering of our post-bargaining ETR to 15% from 18%, combined with the earlier-than anticipated arrival of partial tariff relief, both support an improved outlook for GDP. 

As a result, we are moving our U.S. Real GDP growth estimate for 2025 up to a 1-2% range from the previous 0.5-1.5%. Meanwhile, in Europe, we are awaiting the outcome of negotiations with the European Union. That said, Aidan Corcoran suggests that a positive outcome, similar to what happened with the U.K. and China, could impact growth slightly. 

As such, he is increasing his European GDP estimate to 0.7% from 0.6% in 2025. Finally, Changchun Hua suggests that if the situation holds, the impact on China’s GDP falls from negative 240 basis points to ‘just’ negative 90 basis points. 

The need for rate cuts and RMB depreciation also will be less urgent than we initially thought, and as such, our China Real GDP growth outlook for 2025 increases to 4.8% from 4.3%.

2. Why are you not more bearish on earnings growth, given the magnitude of the supply shock? 

Unlike the downturn in 2007, which was driven by both bank and consumer deleveraging, surging oil prices, and sharply wider credit spreads, this potential downturn is a policy-induced one, which does not share those same attributes. 

In fact, oil prices are going down, credit spreads are only modestly wider (and remember credit spreads have been the most coincident indicator in our long-standing Earnings Growth Leading Indicator or EGLI model). 

One can see this in Exhibit 8. 

Further, banks are flush with cash, and global policy rates are heading lower. So, as we detail below, we do think that corporate earnings growth will moderate sharply, but our EGLI (Exhibit 9) will not turn negative the way it did during other major periods of uncertainty, unless there is an unanticipated policy mistake around the deficit widening further and/or the independence of the Fed becoming impaired. 

That’s the good news. 

The potentially bad news for investors is that the initial communication of the ‘Liberation Day’ game plan as well as the recent introduction of DeepSeek by Chinese entrepreneurs, has increased uncertainty – uncertainty that will likely dent the premium valuation that U.S. Equities and U.S. credit spreads enjoyed prior to April 2nd, especially as we see

1.  Further blurring between economics and national security amongst governments around the world; and
2. Global allocators repositioning their portfolios to gain more diversification outside of the United States. Finally, as we show below, the desire to reduce America’s goods deficit actually may come at the expense of its sizeable and profitable services surplus. 

See Exhibit 14 for details, but some insightful work done by my colleague Dave McNellis shows that services have a higher return on capital and are likely a better way to harness the U.S.’s comparative advantage on a sustainable basis.

EXHIBIT 3: Unlike in the Past, Consumers and Corporations Are Not Overleveraged

EXHIBIT 4: Since the Inauguration, Both Oil and the 10-Year Yield Have Declined, With Oil Providing Meaningful Tailwinds

3. Could currency policy ultimately be a more effective vehicle for improving U.S. competitiveness, especially relative to reciprocal tariffs on goods? 

As history has shown, following the Plaza Accord in 1985 and the Dot. com bust in 2000, one of the most potent levers used to increase American competitiveness was allowing for a renormalisation of the U.S. dollar’s trading level. 

According to our models, one of which we show in Exhibit 15, the USD is likely around +15% rich relative to its theoretical fair value, making it the third most expensive level since the 1980s. 

In this context, we think a change in the trading level of the U.S. dollar — likely driven by a strategic asset allocation repositioning by global investors, or even by some foreign governments allowing gradual appreciation of their currencies as a tacit condition of tariff relief — could actually bolster competitiveness far more effectively than imposing heavy reciprocal tariffs on the U.S.’s closest trading partners and military allies. Importantly, we are not arguing for an uncontrolled devaluation. 

Rather, we believe that if the dollar were just to relinquish some of the elevated valuation it has accrued since the onset of COVID in a ‘mean reversion’ trade, it could stabilize at a level that would significantly enhance U.S. competitiveness in the global export arena. 

Bottom line: Over time we favour more market-based forces to create competitive export advantages relative to imposing fluctuating reciprocal tariffs which we think can dent capital investment/productivity by creating more uncertainty.

4. For investors who are considering selling down their overweight in U.S. financial assets, what should they know? 

Many CIOs are considering moving assets out of the United States towards other parts of the world. While the theory behind this shift is understandable, the practicality of the execution is difficult. The U.S. equity market, for example, is nearly twice the size of Europe, Japan, and India, combined. 

Moreover, many U.S. companies are large, liquid names that have low leverage and solid earnings growth. Their returns on capital are often higher too. 

However, on the fixed income side, we do see some room for improvement through greater diversification. Key to our thinking is that, if our Regime Change thesis continues to play out the way we think it will, the traditional role of U.S. government bonds in many global portfolios will become more diminished. 

The reality is that the U.S. government is burdened with a large fiscal deficit and high leverage, and its bonds are likely over-owned by many global investors who have benefitted from both positive interest rate differentials and a strong U.S. dollar. 

Recall that many portfolios have relied heavily on the 60/40 model, comprising 60% Equities and 40% bonds, with a significant portion allocated to U.S. Treasuries. See below for more detail, but we asked our colleague Rachel Li for an analysis that explored the impact of adding international bonds into the traditional 60/40. 

Her findings indicated that local bonds could indeed provide the additional diversification that, these days, U.S. government bonds might struggle to deliver. 

Moreover, when combined with private assets such as Private Equity as well as Infrastructure- and Asset-based Finance, the potential benefits to returns and to risk management were substantial. One can see this in Exhibit 19.

5. Are strong, positive market technical forces helping to offset shaky economic trends? 

Investing is more than just understanding the fundamentals. The technical picture matters too. Our punchline remains that tariffs represent a supply shock that has dampened demand, prompting us to consider more limited growth prospects of 1-2% U.S. GDP growth in 2025 versus our quantitative model’s projection of 2.9% (ex-tariffs). 

That’s the bad news. 

The good news is that the technical backdrop is still quite compelling and becoming more optimistic. The S&P 500 is poised to buy back over $1 trillion of stock, money market balances are high, and net issuance, as we describe below, is near historic lows (Exhibits 28 and 29). 

Looking at the big picture, we think that today’s market is one where we will need to ‘make our own luck.’ 

On the positive side of the ledger, we do believe that the fat left tail risk, which includes a falling dollar, rising interest rates, and a weakening equity market (i.e., what investors experienced in the aftermath of ‘Liberation Day’) has been – through trial and error – mitigated.

That said, as we mentioned above, the introduction of DeepSeek by Chinese innovators and the abrupt roll-out of ‘Liberation Day’, suggest that valuations are now likely capped relative to the prior period of U.S. exceptionalism. 

Moreover, as we signalled earlier (and we detail below), we think the role of U.S. bonds in many portfolios will come under question, especially in a world where the U.S. overtly pursues an ‘America First’ agenda. Importantly, this transition towards more regional and country emphasis is happening at a time when current accounts are beginning to normalise faster than fiscal accounts are being shrunk, a backdrop which makes us want to think differently about “risk free” rates.

From an asset allocation perspective, we like control positions in Private Equity, especially those with operational improvement stories. 

Meanwhile, in Credit, we favour focusing on market dispersions and securities higher up the capital structure, and we think Real Estate Credit and growth Infra in the Real Assets space are attractive. 

From a country perspective, we favour Japan, India, and Germany, alongside an equal-weighted approach to the S&P 500 (versus the market capitalisation weighted approach in the past). 

From a thematic perspective, we remain bullish on our major investment themes, including the Security of Everything, Capital Light to Capital Heavy, Productivity/Worker Retraining, Collateral-Based Cash Flows, and Intra-Asia Trade.

Acknowledgements: Aidan Corcoran, Kris Novell, Brian Leung, Rebecca Ramsey, Ezra Max, Bola Okunade, Miguel Montoya, Allen Liu

This is an excerpt from our KKR Global Macro Trends, May 2025 - 'The Art of Learning'. Access the full paper here.