Update after the jump.
From: Memos from Howard Marks, October 11:
Further Thoughts on Sea Change
In May, I wrote a follow-up memo to Sea Change (December 2022) that was shared exclusively with Oaktree clients. In Further Thoughts on Sea Change, I argued that the trends I had highlighted in the original memo collectively represented a sweeping alteration of the investment environment that called for significant capital reallocation. This memo was originally sent to Oaktree clients on May 30, 2023.1
This Time It Really Might Be Different
On October 11, 1987, I first came across the saying “this time it’s different.” According to an article in The New York Times by Anise C. Wallace, Sir John Templeton had warned that when investors say times are different, it’s usually in an effort to rationalize valuations that appear high relative to history – and it’s usually done to investors’ ultimate detriment. In 1987, it was high equity prices in general; the article I cite was written just eight days before Black Monday, when the Dow Jones Industrial Average declined by 22.6% in a single day. A dozen years later, the new thing people were excited about was the prospect that the Internet would change the world. This belief served to justify ultra-high prices (and p/e ratios of infinity) for digital and e-commerce stocks, many of which went on to lose more than 90% of their value over the next year or so.
Importantly, however, Templeton allowed that things might really be different 20% of the time. On rare occasions, something fundamental does change, with significant implications for investing. Given the pace of developments these days – especially in technology – I imagine things might genuinely be different more often than they were in Templeton’s day.
Anyway, that’s all preamble. My reason for writing this memo is that, while most people I speak with seem to agree with many of my individual observations in Sea Change, few have expressly agreed with my overall conclusion and said, “I think you’re right: We might be seeing a significant and possibly lasting change in the investment environment.” This memo’s main message is that the changes I described in Sea Change aren’t just usual cyclical fluctuations; rather, taken together, they represent a sweeping alteration of the investment environment, calling for significant capital reallocation.
The Backdrop
I’ll start off by recapping my basic arguments from Sea Change:
In late 2008, the Federal Reserve took the fed funds rate to zero for the first time ever in order to rescue the economy from the effects of the Global Financial Crisis.
Since that didn’t cause inflation to rise from its sub-2% level, the Fed felt comfortable maintaining accommodative policies – low interest rates and quantitative easing – for essentially all of the next 13 years.
As a result, we had the longest economic recovery on record – exceeding ten years – and “easy times” for businesses seeking to earn profits and secure financing. Even money-losing businesses had little trouble going public, obtaining loans, and avoiding default and bankruptcy.
The low interest rates that prevailed in 2009-21 made it a great time for asset owners – lower discount rates make future cash flows more valuable – and for borrowers. This in turn made asset owners complacent and potential buyers eager. And FOMO became most people’s main concern. The period was correspondingly challenging for bargain hunters and lenders.
The massive Covid-19 relief measures – combined with supply-chain snags – resulted in too much money chasing too few goods, the classic condition for rising inflation.
The higher inflation that arose in 2021 persisted into 2022, forcing the Fed to discontinue its accommodative stance. Thus, the Fed raised interest rates dramatically – its fastest tightening cycle in four decades – and ended QE.
For a number of reasons, ultra-low or declining interest rates are unlikely to be the norm in the decade ahead.
Thus, we’re likely to see tougher times for corporate profits, for asset appreciation, for borrowing, and for avoiding default.
Bottom line: If this really is a sea change – meaning the investment environment has been fundamentally altered – you shouldn’t assume the investment strategies that have served you best since 2009 will do so in the years ahead.
Having supplied this summary, I’m going to put flesh on these bones and share some additional insights.
A Momentous Development
To promote discussion these days, I often start by asking people, “What do you consider to have been the most important event in the financial world in recent decades?” Some suggest the Global Financial Crisis and bankruptcy of Lehman Brothers, some the bursting of the tech bubble, and some the Fed/government response to the pandemic-related woes. No one cites my candidate: the 2,000-basis-point decline in interest rates between 1980 and 2020. And yet, as I wrote in Sea Change, that decline was probably responsible for the lion’s share of investment profits made over that period. How could it be overlooked?
First, I suggest the metaphor of boiling a frog. It’s said that if you put a frog in a pot of boiling water, it’ll jump out. But if you put it in cool water and turn on the stove, it’ll just sit there, oblivious, until it boils to death. The frog doesn’t detect the danger – just as people fail to perceive the significance of the interest rate decline – because of its gradual, long-term nature. It’s not an abrupt development, but rather a drawn out, highly influential trend.
Second, in Sea Change, I compared the 40-year interest rate decline to the moving walkway at an airport. If you stand still on the walkway, you’ll move effortlessly; but, if you walk at your normal pace, you’ll move ahead rapidly – perhaps without being fully conscious of why. In fact, if everyone’s walking on the moving walkway, doing so can easily go unnoted, and the walkers might conclude that their rapid progress is “normal.” ....
....MUCH MORE
Also at Oaktree, November 2:Howard Marks (Co-Chairman) and Armen Panossian (Head of Performing Credit) discuss topics related to Howard’s latest memo, Further Thoughts on Sea Change, and Oaktree’s recently published Performing Credit Quarterly 3Q2023 in this crossover episode of The Insight: Conversations and Behind the Memo. They consider the implications of the potential sea change reshaping the investment environment, the tail risks building in today’s markets, and what it means to be in a full return world.Podcast and transcript:
https://www.oaktreecapital.com/insights/insight-podcast/market-commentary/full-return-world-with-howard-marks-and-armen-panossian
