This Time It May Really Be Different
Anytime I hear these words the hairs on my neck stand up (notice I didn't say head!) and I become highly suspicious. However, a couple of investment icons that I have followed for decades and highly respect recently echoed those sentiments. Since neither of these strategists leans towards hyperbole, it caught my attention. Below I will walk you through their comments and the implications for financial markets.
Howard Marks:
The first strategist I will cover is Howard Marks. Howard is the founder of Oaktree Capital Management and is one of the most successful investors you may never have heard of. A strong case can be made that if there was a Mount Rushmore for investors, he would be on it!
In a recent memo to clients, Howard made the case that the changes he sees in the market are not just the typical cyclical fluctuations that we see in the markets, but rather it represents a Sea Change in the investment environment, which requires a change in how to invest. Here is a summary of why he believes we are experiencing a Sea Change in the investment environment:
- 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 (fear of missing out) became most people's main concern. The period was correspondingly challenging for bargain hunters (value investors) 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.
In summary, he believes we went through unusually easy times largely due to highly accommodative monetary policy for a very long time, but that time is over. According to Marks, the positive forces that shaped the 2009-21 period began to change about 18 months ago, and the extended period of extremely low inflation and interest rates has transitioned to a period of moderately higher inflation and interest rates. In this new environment of higher interest rates, he believes the opportunity to generate competitive returns from fixed income has increased substantially. Once this sinks in, assets will begin to shift from the most overvalued parts of the stock market towards the higher and more reliable returns available in parts of the bond market.
Martin Barnes:
Martin Barnes was the chief economist at BCA Research and the long-term editor of The Bank Credit Analyst, a top-notch investment research service I have subscribed to since the mid-1990s. In a recent research report, Martin makes the case that most investors have too short of an investment perspective and only focus on the next three to twelve months. While the major secular forces that drive economic activity and financial markets tend to last for years at a time, investors who understand these trends will reap the biggest rewards. He argues the most important trends of the past 50 or so years have been the dramatic swings in inflation. In general, the steep rise of inflation from the late 1960s to the early 1980s was dreadful for financial assets. While the subsequent multi-decade period (1982 to 2019) of disinflation (lower inflation) contributed to the greatest financial bull market in history. According to Barnes, we are again entering a new era for inflation, and the implications for financial markets are significant.
He believes we are currently in a transition phase to a new era of moderately higher inflation. Not a return to the destructively high inflation of the 1970s but rather a move from the underlying base of 2% we have experienced over the past couple of decades to a higher zone of 3-4%. That may not sound like a significant move higher, however, the implications for the financial markets may be substantial. First, it suggests that barring new deflationary shocks, the era of unusually low interest rates is over. The second impact may be on stock valuations. In the chart below, Barnes illustrates the positive impact lower inflation and interest rates had on valuations from 1982 to 2019, he estimates two-thirds of the gains in the S&P 500 over that time frame came simply from higher valuations on the index. He argues that valuation will not be a tailwind to investors in the future, due to: higher inflation and interest rates; the inability to cut corporate tax rates further; a higher percentage of profits going to workers in the future; and lower profit margins. In summary, Barnes believes short-term bonds offer competitive returns to stocks in the current environment, and advocates overweighting them in portfolios as we undergo the transition to a new era of inflation and economic risks subside.
In our experience, understanding the secular trends and environment is a key element of successful long-term investing. We have great respect for Howard Marks and Martin Barnes, and always value their perspective and willingness to think beyond the very short-term investment horizon. We agree with much of their thinking and are seeing attractive risk versus reward opportunities in the bond market for the first time in years. We also agree it is a good time to focus on quality investments, reasonable valuations, and the highly speculative and overvalued parts of the financial markets.
If you have any questions regarding this commentary or your investment strategy, please give us a call.
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