Sea Change

Oaktree Capital Memo, December 2022

What I Mean by "Sea Change"

In the memo I wrote in 2012 titled "Ditto," I said: "In my career, I've seen a number of economic cycles, pendulum swings, manias and panics, bubbles and crashes, but there have only been a few truly momentous sea changes. I think we may be in the midst of one."

Today, I'm more confident: We are in a sea change.

For the last 40 years—since 1980—we have been in a declining interest rate environment. The Federal Funds Rate peaked at roughly 20% in 1980–1981. By 2020, it was essentially zero. This four-decade decline provided an extraordinary tailwind for asset prices of all kinds.

Why This Matters

Consider the effect of declining rates on asset values:

• Bonds rise when rates fall
• Stocks rise because future cash flows are discounted at lower rates
• Real estate rises because financing costs drop
• Leveraged buyouts succeed because debt service becomes cheaper with each refinancing

When money is free, almost everything works. That was the defining feature of the 2009–2021 era. Low rates, quantitative easing, and abundant liquidity made the investment world seem easy.

But here's the thing: most of the investors practicing today have only known this environment. They learned their craft in a world of declining rates, easy money, and central bank bailouts. This is all they know.

The New World

I believe we're now in the early innings of a new period that will look very different:

1. Interest rates will be higher on average than in the 2009–2021 period
2. Credit will be less freely available and more discerning
3. Leverage will be less rewarding and potentially more dangerous
4. The "Fed put" will be less reliable as inflation constrains central bank action

In the new environment, alpha—not beta—will separate winners from losers. When rates were falling, you didn't need to be good. You just needed to be in. Going forward, selectivity, skill, and discipline will matter enormously.

Bottom Line

The big question isn't whether rates will go higher from here (they may or may not). It's whether the ultra-low-rate environment of 2009–2021 was normal or the aberration. I believe it was the aberration. And if that's right, the investment strategies, risk tolerances, and return expectations built during that period need to be reconsidered.

Those who understand this sea change will have a significant advantage. Those who don't will wonder why the strategies that always worked suddenly stopped working.