Howard Marks, Oaktree Capital — 2024-01-09
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Memos from Howard Marks 2024-01-09T08:00:00.0000000Z" pubdate title="Time posted: >1/9/2024 8:00:00 AM (UTC)">Jan 9, 2024
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The backstory: I began writing these memos in 1990 and continued to do so for ten years despite never receiving a single response. Then, on the first business day of 2000, I published bubble.com , a memo with warnings about excesses in the tech sector that turned out to be timely. The inspiration for the memo came from a book I'd read the preceding autumn: Devil Take the Hindmost: A History of Financial Speculation , by Edward Chancellor, an account of speculative excesses starting with the South Sea Bubble of the early 1700s. The book's description of behavior surrounding the mania for the South Sea Company jibed with what I was seeing in the tech/media/telecom bubble that was underway. I received excellent feedback on the memo from clients – encouragement that prompted the many memos that have followed.
I consider it highly coincidental that 24 years later, I devoted another autumn to reading another Chancellor book, The Price of Time: The Real Story of Interest , his history of interest rates and central bank behavior. I thank Zach Kessler, a regular memo reader, for sending it. The relevance of The Price of Time to the trends I've been discussing for the last year occasions this memo.
In December 2022, I published Sea Change , a memo that primarily discussed the 13-year period from the end of 2008, when the U.S. Federal Reserve cut the fed funds rate to zero to counter the effects of the Global Financial Crisis, to the end of 2021, when the Fed abandoned the idea that inflation was transitory and readied what turned out to be a rapid-fire succession of interest rate increases. The memo concentrated on the impact that this lengthy period of unusually low interest rates had on the economy, the financial markets, and investment outcomes. I followed this up with the memo Further Thoughts on Sea Change , which Oaktree released to clients in May 2023 and to the public in October. In the latter memo and subsequent conversations with clients, I've emphasized the significant impact of low interest rates on the behavior of participants in the economy and the markets.
Easy Times
In Sea Change , I likened the effect of low interest rates to the moving walkway at the airport. If you walk while on it, you move ahead faster than you would on solid ground. But you mustn't attribute this rapid pace to your physical fitness and overlook the contribution from the walkway.
In much the same way, declining and ultra-low interest rates had a huge but underrated influence on the period in question. They made it:
easy to run a business, with the stimulated economy growing unabated for more than a decade;
easy for investors to enjoy asset appreciation;
easy and cheap to lever investments;
easy and cheap for businesses to obtain financing; and
easy to avoid default and bankruptcy.
In short, these were easy times, fueled by easy money. Like travelers on the moving walkway, it was easy for businesspeople and investors to think they were doing a great job all on their own. In particular, market participants got a lot of help in this period as they rode the 10-year-plus bull market, the longest in U.S. history. Many disregarded the benefits that ensued from low interest rates. But as one of the oldest investment adages says, we should never confuse brains with a bull market.
As I've continued to think and talk about the switch from declining and/or ultra-low interest rates to more normal, stable ones, I've emphasized the fact that low rates alter investor behavior, distorting it in ways that have serious consequences.
Thinking about the change in interest rates sensitized me to media mentions of low rates, and I've noticed many. This was particularly true following Silicon Valley Bank's meltdown last March, which many articles attributed to faulty managerial decisions made "during the preceding period of easy money." More recently, there's been much discussion of the less-favorable outlook for private equity, usually related to expectations that interest rates aren't going to return to the low levels of the recent past.
The effects of low interest rates are multi-faceted and ubiquitous, yet frequently overlooked. I became more conscious of them as I read The Price of Time , and I want to catalog them here:
Everyone knows that when central banks want to stimulate their countries' economies, they cut interest rates. Lower rates reduce costs for businesses and put money into the hands of consumers. For example, since most people buy cars on credit or lease them, lower interest rates make cars more affordable, increasing demand. The result is typically good for automakers, their suppliers, and their workers, and thus for the economy in general.
It's important to realize that easy money keeps the economy aloft, at least temporarily. But low interest rates can make the economy grow too fast, bringing on higher inflation and increasing the probability that rates will have to be raised to fight it, discouraging further economic activity. This oscillation of interest rates between extremes can have effects and encourage behavior that natural/neutral rates (see p. 13) would be less likely to induce.
Opportunity cost is a major consideration in most financial decisions. But in low-interest-rate environments, the rate earned on cash balances is minimal. Thus, you don't forgo much interest by withdrawing money from the bank to buy a house or boat (or make an investment), which makes doing so seem painless. For example, if someone's thinking about taking $1 million out of savings for a purchase at a time when savings accounts pay 5% interest, they're likely to understand that doing so will cost them $50,000 per year in forgone income. But when the rate is zero, there is no opportunity cost. This makes the transaction more likely to occur.
In finance theory, the value of an asset is defined as the discounted present value of its future cash flows. We discount future cash flows when calculating present value because we must wait to receive them, so they're less valuable than cash flows received today. The lower the rate at which future cash flows are discounted, the higher the present value, as investors have noted for centuries:
In the [18th] century, Adam Smith described how the price of land depended on the market rate of interest. In The Wealth of Nations (published in 1776) Smith noted that land prices had risen in recent decades, as interest rates declined. ( The Price of Time, or "TPOT" )
By placing too low a discount on the future earnings of companies, investors [in the 1920s] ended up paying too much. ( TPOT )
In real life, investments are evaluated primarily on a relative basis. The return demanded on each investment is largely a function of the prospective returns on other investments and differences in these investments' respective levels of risk. Low interest rates lower the "relative bar," making the higher returns offered on riskier assets appear relatively attractive even if they're low in the absolute.
In this vein, The Price of Time describes the thought process that made "iffy" loans to the government of Argentina acceptable in the low-rate environment of the late 1880s:
Buenos Aire