Howard Marks: What lies ahead for inflation, interest rates – and why it's a sea change

The US Federal Reserve’s expected, but still shocking, 50 basis point rate hike on Wednesday night makes Howard Marks’ latest memo, “Sea Change,” all the more poignant.

The move was an easing of the previous 75 basis point hike, but Fed Chairman Jerome Powell has projected rates might hit 5.1% next year, beyond the previous 4.6% forecast. It has also cut 2023 economic growth forecast to 0.5%, form 1.2% in September.

Much of the Oaktree Capital co-founder’s latest letter to investors – which stretches to almost 5,000 words – addresses the biggest shifts (sea changes, if you like) Marks has seen in his long career so far.

Sea change #1

Starting at his earliest days as a bond investor, in 1978, he recalls how high-yield bonds first became investable. “I was making money steadily and safely…investment managers could now prudently buy bonds of almost any quality, as long as they were adequately compensated for the attendant risk,” writes Marks.

Around this time, the high yield bond universe was valued at around US$2 billion but now sits at around US$2 trillion.

This, in turn, led to the advent of other types of investment vehicles in areas such as:

• Distressed debt
• Mortgage-backed securities
• Structured credit, and
• Private lending.

“It’s no exaggeration to say today’s investment world bears almost no resemblance to that of 50 years ago,” writes Marks.
“Young people joining the industry today would likely be shocked to learn that, back then, investors didn’t think in risk/return terms. Now that’s all we do.”

Marks also touches on the big macroeconomic shift underpinned by the OPEC oil embargo of the early 1970s. In particular, he summarises how circumstances and events then led to one of the inflation-linked fears uttered in recent times – a wage-price spiral. As Marks explains, this was in part due to the highly unionised workforce of the 1970s US. The strong culture of collective bargaining meant cost-of-living provisions commonly featured in contracts – provisions that were triggered when inflation ticked up, which in turn further exacerbated inflation.

Sea change #2

The Consumer Price Index ballooned to 11% in 1974, from 3.2% in 1972 before receding to the 6-9% range for four years and then rebounding to more than 11% in 1979. This see-sawing continued into the early ‘80s, only settling down to 3.2% by the end of 1983 after Fed chairman Paul Volcker lifted the Fed Fund rate to 20%.

Volcker’s actions presaged a 40-year period of declining interest rates.

Marks also details four broad factors that drove investor success during these decades:

• the economic growth and pre-eminence of the US,
• the strong performance of “our greatest companies”,
• gains in technology, productivity, and management techniques; and
• the benefits of globalisation.

“However, I’d be surprised if 40 years of declining interest rates didn’t play the greatest role of all,” writes Marks.

Throwing back to the ‘70s briefly, one example he provides places in sharp relief the situation in which many find themselves today as cash rates, and therefore mortgage rates, rise in most developed markets.

“I received a notice from the bank each time my rate changed, and I framed the one that marked the high point in December 1980: It told me the interest rate on my loan had risen to 22.25%,” Marks writes.
“Four decades later, I was able to borrow at just 2.25%, fixed for 10 years. This represented a decline of 2,000 basis points. Miraculous!”

“The moving walkway”

Marks also discusses the effect this long-term period of interest rate falls had on financial markets and investors. One of these is “a bonanza for those who buy assets using leverage,” courtesy of the combination of rising asset values and reduced borrowing costs.

He employs the analogy of a moving walkway – the conveyor belts found in the long corridors of many airports around the world.

“If rather than stand still on it, you walk at your normal pace, you move ahead rapidly,” Marks says.

“That’s what I think happened to investors over the last 40 years. They enjoyed the growth of the economy and the companies they invested in, as well as the resulting increase in the value of their ownership stakes. But in addition, they were on a moving walkway, carried along by declining interest rates.”

Throughout his latest update, Marks spills a lot of ink explaining the more recent period spanning the aftermath of the GFC – 2009 – up to pre-pandemic 2020. He writes about the dramatic effects that followed the Fed’s move to rates of “approximately zero” in late 2008.

“Stocks increased non-stop for more than 10 years, except for a handful of downdrafts that each lasted a few months. From a low of 667 in March 2009, the S&P 500 reached a high of 3,386 in February 2020, for a compound return of 16% per year,” says Marks.

“In this period, the US enjoyed its longest economic recovery in history (albeit also one of its slowest) and its longest bull market, exceeding 10 years in both cases.”

He describes the years between 2009 and 2021 as broadly dominated by investor optimism and minimal worry.

“These were golden times for corporations and asset owners thanks to good economic growth, cheap and easily accessible capital, and freedom from distress. This was an asset owner’s market and a borrower’s market.”

That was then. This is now

Starting from the early stirrings of inflation in early 2021, Marks reviews the Fed’s initial view this was transitory. This inflation was fed by a combination of pent-up demand, savings amassed during lockdowns, and government COVID stimulus.

“These policies further stimulated demand when it didn’t need stimulating,” writes Marks.

Jumping further toward the present day, he then gives a blow-by-blow account of what happened between March 2022 and now (his memo was published on 13 December).

What lies ahead - Sea change #3

While typically shying away from macro forecasting, Marks provides a brief overview in response to the many questions about his outlook for inflation and interest rates.

“No one can predict inflation, but it seems likely to remain higher than what we became used to after the GFC, at least for a while,” he says.

“The course of interest rates will largely be determined by the Fed’s progress in bringing inflation under control. If rates go much higher in that process, they’re likely to come back down afterward, but no one can predict the timing or the extent of the decrease.”

The (mis)beliefs that drove the recent S&P rally

Marks says the recent 10% equity market rally was driven by investors with the following beliefs:

• inflation is easing
• the Fed will soon pivot (a view that’s been largely quashed by Powell’s latest speech)
• interest rates will trend back down
• recession will be averted, or only short-lived and modest
• “the economy will return to halcyon days.”

What Marks believes

Among some of the standout points here (there are 12 of them in the full document) are:

• His view that before the Fed even thinks about “declaring victory on inflation,” it will first need to be assured that inflation has settled near its 2% target (it’s currently above 7%).
• Globalisation is slowing or reversing
• The Fed might want a neutral interest rate – one that’s neither stimulative nor restrictive.

On the first of these points, Marks writes: “While the Fed appears likely to slow the pace of its interest rate increases, it’s unlikely to return to stimulative policies any time soon.”

On globalisation, he notes the deflationary influence this had on prices of things such as consumer durables, which saw prices decline by 40% between 1995-2020. He argues that if the shift away from globalisation continues, we’ll lose this downward price pressure.

And what about interest rates? 

Marks believes the cash rate will hover between 2% and 4% for the next several years, above the 0% to 2% range its occupied in the last decade.

“And importantly, if you grant that the environment is and may continue to be very different from what it was over the last 13 years – and most of the last 40 years – it should follow that the investment strategies that worked best over those periods may not be the ones that outperform in the years ahead. That’s the sea change I’m talking about,” writes Marks.

To read the latest Howard Marks memo in full, you can find it on the Oaktree Capital website.

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