Howard Marks: The easy times are over

Sir John Templeton wrote to clients during the 1954 recession that the four most dangerous words in investing are “this time it’s different.” 

According to Templeton, the phrase is often misappropriated by investors to wrongly rationalise valuations that appear high by historical standards. 

While this argument bears truth, Oaktree's Howard Marks points out that Templeton gave a 20% chance that things may actually be different.  

In his latest note, Marks argues that, due to fundamental structural shifts, today's reality fits within that 20%. 

What is that structural shift, I hear you ask?

Some may suggest the Global Financial Crisis and bankruptcy of Lehman Brothers, the tech bubble, or the monetary and fiscal response to COVID-19. But Marks proffers another candidate: the 2,000-basis-point decline in interest rates between 1980 and 2020.

This wire summarises Marks' note, including the asset class he believes is best placed to perform after years of free money and easy wins. 

Free money lifted all boats, with little required effort from investors

Marks compares 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.'"

That automated walkway was defined by the following:

• two rescues from financial crises, 
• a generally favourable macro environment, 
• aggressively accommodative central bank policies, 
• a lack of inflation worries, 
• ultra-low and declining interest rates, and 
• generally uninterrupted investment gains. 

It was one thing for the Fed to slash rates in response to a global credit crisis. It is another thing entirely for it to keep rates so low in the years since. 

"I was shocked when I looked at the data and saw that the Fed kept the rate near zero for nearly seven years. Setting interest rates at zero is an emergency measure, and we certainly didn’t have a continuous emergency through late 2015. To me, those sustained low rates stand out as a mistake not to be repeated," Marks says.

Not only did these conditions lift all boats, they also broke down the market's capital allocation mechanism.  

"It causes things to be built that otherwise wouldn’t have been built, investments to be made that otherwise wouldn’t have been made, and risks to be borne that otherwise wouldn’t have been accepted."

Will this state of play continue? Marks believes it's both unlikely and misadvised. 

"I don’t think the Fed should return us to an environment that has been distorted to encourage universal optimism, belief in the existence of a Fed put, and thus a dearth of prudence."

Reality is set to bite

Assuming the central bank-fuelled good times won't continue, Marks identifies 7 realities investors will have to grapple with:

• economic growth may be slower;

• profit margins may erode;

• default rates may head higher;

• asset appreciation may not be as reliable;

• the cost of borrowing won’t trend downward consistently (though interest rates raised to fight inflation likely will be permitted to recede somewhat once inflation eases);

• investor psychology may not be as uniformly positive; and

• businesses may not find it as easy to obtain financing.

What strategies will rise to the moment?

Marks notes that "if certain strategies were the best performers in a period with a given set of characteristics, it must be true that a starkly different environment will produce a dramatically altered list of winners."

Against the seven points mentioned above, Marks believes lending, credit, or fixed-income investing should be better off.

In contrast to a year ago, investors today can get equity-like returns from investments in credit. Whereas in early 2022, high-yield bonds (for example) yielded in the 4% range, today they yield more than 8%, "meaning these bonds have the potential to make a great contribution to portfolio results."

Crucially too, credit investments aren't dependent on the market for returns. If the market shuts down or becomes illiquid, the return for the long-term holder is unaffected.

If the developments I describe really constitute a sea change as I believe – fundamental, significant, and potentially long-lasting – credit instruments should probably represent a substantial portion of portfolios . . . perhaps the majority.