«The Most Important Question Is Whether We’re Going to Have Stagflation»
The benign environment of low interest rates is a bygone era, thinks Howard Marks, co-chairman of Oaktree Capital. In an in-depth interview, the legendary investor explains why he expects a fundamental shift in the market environment, what that means for your portfolio, and what he considers the worst sin in investing.
It was the best of all worlds. Since the financial crisis of 2008-09 until 2021, low inflation, low interest rates and ultra-easy monetary policy provided a friendly environment for financial assets. It was hard to make a mistake with risky investments. But that’s over, according to Howard Marks. In his view, a regime change is taking hold in the markets.
«Today, investors wonder when we are going back to ‹normal›. But I don’t think this period was normal,» says the co-founder and co-chairman of Oaktree Capital Management, a Los Angeles-based investment boutique specializing in credit markets. What he says carries weight in the investment industry. His memos, which he sends out sporadically to clients, are a must-read even for Warren Buffett.
In this in-depth interview with The Market NZZ, Mr. Marks explains why he believes the world is fundamentally changing, which strategies promise success in an environment with higher inflation and slower economic growth, and what he considers the cardinal sin in investing.
«Now is a good time to sit on your hands, read about how to be a good investor, ignore the noise, and try to get ready for the opportunities when they come»: Howard Marks.
Mr. Marks, in your latest memo entitled «Sea Change» you make the case that the market environment is fundamentally shifting. Why do you think the world is changing?
I don’t think what we’re going through right now is just a normal cycle fluctuation. For over forty years we were in an environment with declining interest rates, and for the last thirteen years we had this benign, accommodative environment. I don’t think we are going to continue under the same regime. We kind of can’t because it was all predicated on declining and low interest rates and now rates are already quite low and the Fed is unlikely in the coming years to keep them as low as they were in the past decade.
What does that mean for investors?
The decline in interest rates was very beneficial. A lot of money was made thanks to this incredible tailwind generated by the massive drop in interest rates. But that’s over. I think over the next several years the base interest rate is more likely to average 2% to 4% - not far from where it is now – rather than 0% to 2%. If that simple statement is true, then that means the outlook for the future is different from what we experienced in 2009-21. The investment strategies that worked the best over this period may not outperform in the coming period.
What are the consequences of this regime change for asset prices?
Declining interest rates created an asset boom. They subsidized borrowers and asset owners and they penalized savers and lenders. It’s kind of the story about the frog and the water: If you put a frog in a pot of boiling water, he will jump out. But if you put him in a pot of cold water and you put it on the stove, the water will get gradually hotter and he won’t jump out and die. I believe that people didn’t sufficiently notice the parameters and the complexion of the environment in the last forty and thirteen years. It just crept up on them. And today they don’t recognize how much of the money they’ve made was the result of the easy-money environment.
Who are the frogs according to this analogy?
People who bought assets with borrowed money. In the coming years it’s not going to be as easy to borrow or as cheap to borrow anymore. Let’s say you did a $10 billion buyout and you borrowed $8 billion. When that debt matures and you go to the bank to roll it over, you might find out that they are not going to lend you as much this time. Or, they are going to charge you more, or both. What’s more, your company’s profits may be down a little bit because a) we may have a recession and b) its cost of capital will be higher. The point is that using borrowed money was an absolute gift over the last forty years and it’s not going to be a comparable gift in the next five or ten years.
What does this imply for the construction of investment portfolios?
In 2015, I wrote in the memo «Risk Revisited Again» that people were moving up the risk curve because they couldn’t get the returns they needed in the safe part of the curve. Traditionally, somebody who owned a mix of cash, treasuries, some high grade bonds, some high-yield bonds and some stocks made 7% to 8% a year. But when the risk curve declines in a low return world, cash yields 0%, treasuries 1%, high-grade bonds 2%, high-yield bonds 4% and stocks are expected to make 5% or 6%. So it’s hard to get 7 or 8% in the traditional, safe part of the curve and you have to go further out on the curve to hedge funds, private equity, real estate or venture capital to get the returns you used to get safely.
And how do you think things will look in the future?
In the low-return environment of 2009-21, the mantra - perhaps unconscious - may have been that if you can’t get the desired return safely, you will pursue it unsafely - and that’s what was done. Certainly the endowments and most pension funds transformed themselves over this thirteen year period. They now have very substantial percentages in privat assets and illiquid assets such as private equity. But now, investors don’t have to do this anymore to approach the returns they need. We’re back in a place where you get a good start on the return you want or need with lower risk strategies such as debt and lending.
What does this portend for value-oriented investors like Oaktree Capital Management?
As a value investor, your goal is to buy things for less than they’re worth. The problem with that is it requires cooperation from somebody who’s willing to sell it for less than it’s worth. For that, you have to have some urgency, some fear and worry. In the last thirteen years, there was nobody in that category, because the fundamental setting was very easy. The holders of assets were complacent. They were making money and they didn’t see anything to worry about. Since they could get financing easily and cheaply, companies that burned money could still get more money. This low return world was very hard for bargain hunters like Oaktree. It was tough sledding. Now, we’re in a moderate return world, and one which may be marked by less complacency which for us is much healthier.
How will this affect the psychology of financial markets?
As I wrote in the memo «On the Couch», whereas events in the real world fluctuate between «pretty good» and «not so hot,» investor sentiment often careens from «flawless» to «hopeless». The point is, public markets don’t accurately reflect changes in reality, they exaggerate them because they incorporate too much emotionality. Sometimes people interpret everything as positive and sometimes they interpret everything as negative. For instance, you see that retail sales are weak, so you can say that’s bad because it means that the economy is weak. Or, you can say that’s good because if the economy is weak that reduces the inflationary pressure and the Fed can cut rates, which is beneficial for the economy. In our business, everything is subject to interpretation.
What is the psyche of the stock market today?
In late 2021, we were in the «flawless» phase, everyone was pretty complacent. Then, the Fed said that inflation is not «transitory» and that they are going to start raising rates. As a result, market sentiment swung in the direction of «hopeless»-ish. Today, I would say, the pendulum is slightly past the midpoint in terms of optimism/pessimism. But interestingly, it’s going back and forth. In the last six months we’ve had two mini cycles. The market was pessimistic in June, optimistic in July/August, depressed in September/October, and optimistic in December/January. It’s been fluctuating between 3700 and 4000 on the S&P 500. Sometimes the optimists are in charge and sometimes the pessimists are in charge.
At present, the markets are primarily preoccupied with the question of whether the Fed will pivot in the next few months and lower interest rates again. What do you think?
I wrote about that recently in the memo «What Really Matters» which I think is one of the most important memos I have ever written. Short-term events like that really don’t matter. In 2015 for example, everybody concluded that the Fed would start raising rates. The only thing anybody said to me was: «What month are they going to raise rates? Is it going to be January, February, March or April?» But what is the difference if the Fed starts raising rates in January or in March? What are you going to do differently? If I tell you March, you can’t do something in the meantime based on that assumption because a) it could happen sooner and b) if it happens in March, people could start incorporating that likelihood in prices in January. So it doesn’t matter, but this is what people are preoccupied by.
Nevertheless, stocks are currently reacting quite sensitively to any word coming out of the Fed.
Let me ask you a question: Do you look at your stock prices every morning? Most people do. But why? It’s highly unlikely that you’re going to change anything. If you own stock A and it’s up a dollar and you don’t own stock B and that’s down a dollar, most people aren’t going to sell A to buy B. So why waste your time on these short-term matters? It’s this illusion that you are on top of things. As I said in the memo «The Illusion of Knowledge», this preoccupation with short-term endlessly thinking about such things gives people the impression that they are doing something when they are actually not doing anything significant.
So what does really matter?
The most important question is what long-term economic growth is going to be and whether we’re going to have stagflation. Let’s back up a little. Number one, we need to think about what will be the rate of growth in GDP over the next ten years in, let’s say, the US. In the recent past, it’s been anemic. From 2009 until 2020 we had the longest economic recovery in history, but it was also the slowest. The length of the recovery kind of hid the slowness, so people didn’t think about that much. Before 2009, we had discussions of stagflation, and I think we’re likely to have them today. We need to look more deeply into the question of whether the economy is permanently growing at a lower rate than historically. Of course, this applies to the whole world, including Europe.
What do you think?
From World War II until 2000, we had the greatest period in history. Economic growth was very strong, the whole world rebuilt and the winners shared with the losers: whole countries like Germany and Japan were rebuilt. We had great advances in technology, new inventions in management techniques, globalization, and an evolution in the finance world to a risk/return mentality which was helpful to new products and new companies. Basically, for everybody who’s alive today this environment is all we know.
Why is this so important from an investment perspective?
Today, investors wonder when we are going back to «normal». But I don’t think this period was normal. The rising tide raised all boats, everybody was prosperous, some more than others. The US did great, China did quite well, Europe and Japan did OK, and the emerging markets did very well from a low base. But if this is going to be less true in the coming decades, we’d like to know that. It will affect the value of assets, growth of earnings, demand for capital and many more things. So what macro growth will look like in the years ahead is the first question.
And what is the next question?
If we have slow growth, might we have stagflation? In other words, low growth and high inflation. That’s the worst of all worlds. This is what matters, not if we are going to have a recession in the second quarter or the third quarter and not whether it’s going to last three months or four months. But that’s what most people think about. They’re literally wasting their time thinking about short-term events and worrying about all the daily noise in the media.
Accordingly, how should one proceed as a prudent investor?
In the memo «I beg to Differ» I make the point that you have to do something different from others if you want to outperform. So when everybody else is a short-term investor, you should become a long-term investor. You can get a big advantage that way. When you think long-term, volatility doesn’t matter. Let’s say you come into a bunch of money and you go out and buy Sixt, the car rental company. You are not going to look in the newspaper every morning to see what it’s worth. You are going to operate it, rent cars and make money. The fact that stocks are public causes people to be concerned with daily prices. So if you’re convinced a company is a good company, you should buy the stock, put it into the drawer and only look every year end at the prices.
In other words, patience is key to success?
Yes. What you need is sitzfleisch: The stamina to resist the temptation of responding to these short-term influences. Of course, that’s easier said than done, but if you want to do a great job as an investor, you have to do things that are easier said than done. Look at Warren Buffett. He treats shares of a stock not as speculative objects, but as a piece of a corporation that you are going to own for years because you believe in it. If that’s true, then why look at the price every morning?
So how should you align your portfolio to today’s market environment?
As I mentioned earlier, market psychology is neither euphoric nor depressed today. So you should behave as normal. In contrast, for the last thirteen years you had to do something abnormal which is you had to reduce the ownership of debt in your portfolio because it yielded so little. Now, you can go back to the portfolio you held 25 years ago, before all this craziness, before the tech bubble, the global financial crisis, and the boom of private equity and hedge funds. For everybody who came into this business in the last thirteen years this easy period is all they’ve ever seen. But that wasn’t normal, any period with zero interest rates is not a normal time. Zero interest rates distort all kinds of behavior and distort investment results.
Is there a specific advice you would give against this background?
Every reader should sit down and think hard about what her or his portfolio should look like in terms of aggressiveness and defensiveness. But most people don’t take a methodical approach to investing and especially to setting their risk parameters. They think: «Oh, I heard on TV this stock is going up, I’m going to buy it.» Or: «My friend bought this stock and it doubled, so I’m going to buy it.» Well, it already doubled so maybe you shouldn’t buy it.
What else is important when it comes to the right calibration of a portfolio?
Today, a traditional portfolio of stocks and bonds of varying types and qualities makes perfect sense. Some risky ones, some safe ones, all depending on your risk tolerance, your aspirations and your intestinal fortitude. You have to decide whether you’re okay with volatility or not because the cardinal sin of all is to sell at the bottom. So if you have a weak stomach, no sitzfleisch, you shouldn’t subject yourself to big downward fluctuations.
That’s all?
Let me add one more thing. When you think about what your risk posture is in terms of aggressiveness vs defensiveness, the next question is: Will you change it from time to time, as the conditions in the market change? Most people probably don’t have the ability to change their risk posture appropriately. They will lose money because of trading costs, so they should just strap in and hold on. In my 50 years in this business, I only made about five, six or seven market calls; once or twice a decade, when the market was either ridiculously overpriced or ridiculously underpriced. In these rare moments, you could reach a firm conclusion and you were probably correct. If I had tried to do this 50 times, or 500 times it would have been a disaster. It’s just not a good idea to think you can regularly gain success through what’s called market timing.
If you can stomach a fair amount of volatility, where are the best opportunities for bargain hunters today?
Since market psychology is moderate, bargains are not pronounced. We’re in transition from «flawless» to «hopeless». We saw great excesses to the upside when people thought it was «flawless», we will see great excesses to the downside when people think it’s «hopeless». But in between, where we are now, there’s nothing clever to do. One of the most important things is patient opportunism: Try to avoid mistakes, and when there is nothing clever to do, the mistake lies in trying to be clever. So now is a good time to sit on your hands, read about how to be a good investor, ignore the noise, and try to get ready for the opportunities when they come.
Howard Marks
