Howard Marks: "I wouldn't bet the ranch (on inflation)"

Howard Marks’s latest memo on the “topic du jour” of inflation stretches to about 15 pages, around 8,000 words and graciously references the work of dozens of his contemporaries. The memo is every bit as detailed and thorough as you would expect from Marks (and you can read it in full here), so we've distilled the key takeaways below.

Arresting commentary is scattered throughout – not only from the mind of Marks himself but from Berkshire Hathaway’s superstar co-founder Warren Buffett; the late mathematical psychologist Amos Tversky and many others

The futility of forecasting is an underpinning theme, Marks asserting early on that his firm Oaktree Capital – the world’s largest investor in distressed securities – don’t employ an economist.

“Regular readers of my memos know that Oaktree and I approach macro forecasts with a high degree of skepticism,” writes Marks.

“In fact, one of the six tenets of Oaktree’s investment philosophy states flatly that we don’t base our investment decisions on macro forecasts. Oaktree doesn’t employ any economists, and we rarely invite them to our offices to share their views.”

Marks’s overt “disavowment” (his word) of economic forecasts is neatly summed up in the following line from the long-time Danny Kahneman collaborator Tversky:

“It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on."

Referencing his first memo after the pandemic struck last March, Marks writes: “I consider anything anyone says today about inflation in the coming years to be Lipsitch’s “opinion or speculation” . . . or, as I’d say, 'guesswork.'"

In this earlier article, Marks quoted Harvard epidemiologist Marc Lipsitch from 3 March 2020, when he described scientists as trying to make “informed inferences” rather than predictions about the coronavirus, but with insufficient data to turn inferences into facts.

pros and cons of the inflation debate

So, that’s what you can expect NOT to read in his memo. Instead, Marks teases out some of the macro issues that matter, discusses his outlook for them and ends with some practical advice.

Launching into the long-running debate about whether rising inflation will be transitory or not, he starts by outlining a handful of points from both sides of the aisle. From the “sustained inflation” argument, he says commentators initially fell back on economic theory to support their assertions, before moving onto more tangible indicators. Some of the notable inclusions here include skyrocketing prices of used cars, houses, and materials.

Having outlined several of the strongest arguments for rising inflation, Marks turns the tables and examines the “con” case.

Some of the key arguments here include:

• The more fleeting, artificial effect of COVID-induced supply-chain snarls in boosting (temporarily) the prices of finished goods. “Since these factors result from the restart, they may prove ephemeral,” Marks says.
• The similarly inflationary effect on consumer goods of stimulus payments combined with the lockdown-induced bubble in saving levels. Marks refers here to the ending of “enhanced unemployment benefits”, which are scheduled to wind up in September in the US and have already been stopped in Australia.

When will inflation move?

“I can’t give you an exact number or an exact time, but I would say that we do expect inflation to move down. If you look at the forecast for 2022 and 2023 among my colleagues on the Federal Open Market Committee, you’ll see that people do expect inflation to move down meaningfully toward our goal,” Marks says.

And I think that the full range of inflation projections for 2023 falls between 2% and 2.3%, which is consistent with our goals.”

Pulling together the two sides of the inflation debate, Marks makes the point that, given the stakes are so high, making a binary decision one way or the other is fraught with risk.

He also touches on some of the real-world implications of rising inflation and higher rates. 

This includes the biggest knock for those parts of the population on lower and fixed incomes – particularly the un- or underemployed and retirees.

This could also ultimately lead to a potential devaluation of the greenback, to the extent that its status as the world’s reserve currency could be at risk.

“Some hope low-interest rates can keep markets aloft forever. Some think the Treasury can issue as much debt as is needed, with the Fed willing to step in as the buyer of last resort,” says Marks.

“I’m not smart enough to prove it, but to me these assumptions seem too good to be true. I can’t tell you exactly what the catch is, but I think there has to be one. Or, perhaps better put, I wouldn’t bet the ranch on there not being a catch.”

What are the lessons for investors?

Marks casts back to another of his memos, this one from five years earlier, titled What does the market know? which addressed the question of when to buy and sell stocks. He concludes now (as he did then) that “the market has nothing useful to contribute when it comes to forecasting macro events.”

But on a more upbeat note, he refers to the title of another previous memo, You can’t predict. You can prepare to outline some of the positive actions investors might take.

Marks also alludes to the increasing volume of “bubble” calls for things like share price valuations and elevated levels of retail investing – especially speculative.

“The old me likely would have latched onto today’s high valuations and instances of risky behaviour to warn of a bubble and the subsequent correction," Marks says.

“But looking through a new lens, I’ve concluded that while those things are there, it makes little sense to significantly reduce market exposure on the basis of inflation predictions that may or may not come true, in the face of some very positive counterarguments, and when the most important rule in investing is that we should commit for the long run, remaining fully invested unless the evidence to the contrary is absolutely compelling.”

Where are the safest places to invest?

And for investors who really can’t stomach the risk of rising inflation – or whose fear of share price declines outweighs their concern about the upside they’ll forgo if they shift their exposures and inflation doesn’t rise – might consider:

• Floating-rate debt;
• Investments in businesses with largely fixed costs or the ability to pass on cost increases, or that can otherwise incorporate inflation in prices (like certain landlords); and/or
• Situations where profits have the potential to grow faster than prices rise.

Read the full memo from Howard Marks here

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