Oaktree Capital – Howard Marks: Coming into Focus

In Oaktree Capital – Howard Marks (cofounder of the $124 billion asset management firm) latest memo, “Coming Into Focus,” he provides his analysis into the current market conditions—where we are, what it means, and where we’re going.

What’s different about COVID-19

Economies are often cyclical and recessions are a normal part of the market’s onward march. However, this current situation is unlike past recessions.

For example, we saw in the early 90s ultra-high-yield bonds that “went into free-fall” due largely to bankruptcies. In other words, the markets experienced a recession caused by a financial event.

With COVID-19, things are different. The pandemic is an external variable that is draining our economy—and it won’t stop until a vaccine is developed or we’ve achieved herd immunity.

The short-term outlook is bleak—thousands of businesses will never reopen and millions of workers will never return to the jobs they once had. Furthermore, the stimulus we did receive was focused more on keeping business and people alive, rather than helping the economy grow.

 

Fixed costs remain an issue for local governments (think police, firefighters, EMTs, etc.) and low-income families continue to struggle as the gap continues to widen between white collar workers able to work safely from home and blue collar workers who have no choice but to wait for better days to come.

While the Fed has certainly been active in supporting the economy with the CARES Act, a divided government has stonewalled further stimulus relief before the election. Democrats are seeking $3 trillion but Republicans don’t want to spend more than $500 million. No compromise is in sight.

And the eviction moratorium that has kept millions from paying rent for months is set to expire in January. While we can’t predict the future, a wave of evictions at the beginning of 2021 while the coronavirus remains uncured certainly won’t do any good for the economy.

 

The impact of low interest rates

The impact of low risk-free interest rates have had a significant influence over where investors have chosen to place their bets.

On one hand, historically low interest rates means that there’s no more free lunch. Without any “safe” returns, like Treasury bonds, to fall back on, investors have had no choice but to seek higher returns elsewhere. Most of them have gone bargain hunting in the stock market, which has retraced to August 2020 levels, but which hit new highs only a few months ago.

In other words, while the stupendous 34 percent collapse we witnessed in March was a breathtaking opportunity for bargain hunters…it didn’t last very long at all. In Marks’s opinion, markets are once again where they were before the epidemic—overvalued, and probably not a great place to seek further returns (at least not until a vaccine appears or another round of stimulus is passed).

These historically low interest rates have created a climate of artificially higher valuations, meaning stock prices have risen if only because institutional investors with target returns had to seek their higher returns elsewhere. With a target goal of seven percent per annum, most asset managers won’t touch current risk-free returns with a yardstick.

Put another way, when risk-free returns are around three percent, investors feel better about betting on stocks with even higher potential returns. But when risk-free returns may as well be zero percent, investors aren’t given many options.

 

A tale of two stock markets

The gap between FAAMG stocks (Facebook, Apple, Amazon, Microsoft, and Google) and the rest of the S&P 500 is only widening. COVID-19 has shown all of us exactly how impregnable FAAMG stocks and technology stocks as a whole can be, even during a worldwide pandemic. These companies can continue scaling and cornering their respective markets.

But the exponential growth of technology giants can negatively impact other companies and sectors in the S&P 500. Companies like Amazon are bankrupting brick-and-mortars across America, and Google has all but put other search engines out of business. Unsurprisingly, Google is now facing an antitrust suit.

Marks points out that in the 1960s, the “Nifty Fifty” stocks were considered similarly unassailable. But investors were wrong. Most of the Nifty Fifty companies are a shadow of what they once were (or they’re just bankrupt). If history has taught us anything at all, it’s that there’s no such thing as “too big to fail.”

 

A new kind of crisis?

This market crisis is so dissimilar to past market crashes that it’s hard to say what the future may hold. Even market veterans like Marks concede that they aren’t sure what’s to come.

While in the past, panic selling and implosions were characteristics of downward spirals, it hasn’t been the case so far with COVID-19. Part of this was thanks to fiscal policy that resulted in historically low interest rates, which meants investors didn’t have the luxury of safely entering the bond market to wait out the pandemic.

The Federal Reserve’s unprecedented money printing and bond buying, which completely dwarfs the stimulus we received during the Great Recession, is also responsible. In fact, the Fed has already bought up 20 times as much in Treasury bonds and other bonds as it did in 2008–2009.

Embracing risk is now necessary to achieve compelling returns. The Fed and Treasury made sure of that. But…is this sustainable? Will further injections continue to help? Or will there be diminishing returns?
 

Looming issues

With near-zero percent risk-free interest rates, investors don’t have many attractive options. So, what happens if another wave of infections shuts down the country again?

Our reliance on bailouts could prove dangerous in the long term for the ethical framework of businesses and banks in America. If you know a bailout is a “sure thing” during economic hardship, it encourages riskier investments with no culpability.

Adding even more to the already gargantuan deficit could also create lasting problems, including hyper-inflation, a weakened US dollar and credit rating, more borrowing, and the loss of the dollar as the worldwide reserve currency (to name a few).

With our GDP taking the large hit it already has, low interest rates could ultimately lead to stagflation and a miserable, anemic economy that goes nowhere for years to come.

This all ends up increasing inequality. Low-income, blue-collar workers are suffering the worst right now, with many losing their jobs or placed in dangerous, compromising positions (e.g., first responders and other crisis workers).

Low-income and Black and Hispanic families are also suffering higher rates of illness and death. Working-class discontent is at an all-time high.

The big picture is blurry

Experienced investors are uncertain, and with good reason. Returns have diminished across the board, but especially in the bond markets. Stocks, which have recently reached new all-time highs, continue to be risky propositions.

Some investors are seeking returns elsewhere, in alternative assets like real estate, pre-IPOs, and private equity. In fact, more institutional money has been allocated towards alternative investments in 2020 than ever before.

But the best way forward remains anyone’s guess because so much is up in the air right now. Until conditions improve dramatically—say, if we have a vaccine and another round of stimulus—investors aren’t going to have many appealing options.

 

Please note that any investment involves risk including loss of principal. Some risks of investing directly or indirectly in real estate include declining real estate values, changing economic conditions and increasing interest rates.

This is for informational and educational purposes only and should not be construed as investment advice or an offer or solicitation of any products or services. Opinions are subject to change with market conditions. The views and strategies may not be suitable for all investors and are not intended to be relied on for legal or tax advice.

Securities offered through National Securities Corporation Member FINRA/SIPC