Think like a bargain hunter
In his latest memo, Oaktree’s Howard Marks wrote “In my 53 years in the investment world, I’ve seen a number of economic cycles, pendulum swings, manias and panics, bubbles and crashes, but I remember only two sea changes. I think we may be in the midst of a third one today.”
The first sea change, according to Howard, came in the 1970s with the adoption of a new investor mentality where “risk wasn’t necessarily avoided, but rather considered relative to return and hopefully borne intelligently.”
The second sea change came after U.S. Federal Reserve Chairman, Paul Volcker, set out to crush inflation soon after his appointment in 1979. U.S. CPI hit 11.0 per cent in 1974, receded to a range of 6 per cent to 9 per cent in the period 1975 to 1978, and then rebounded to 11.4 per cent in 1979 and 13.5 per cent in 1980. Volker was determined to get inflation under control, and he increased the U.S. Federal Funds rate to a record high of 20 per cent.
The Federal Funds rate subsequently declined to high single digits over the balance of the 1980s and mid-single digits in the 1990s, and a declining interest rate environment prevailed for four decades.
This four-decade interest rate bull market, whereby U.S. ten-year bonds declined from around 16 per cent to 0.5 per cent, accelerated economic growth, subsidised borrowers, boosted valuations, increased asset prices, created a “wealth effect” and encouraged leverage.
Today, we have a very different environment with inflation and interest rates hitting a 40-year high and 14-year high, respectively. Interest rates will more likely average 2 per cent to 5 per cent1 rather than zero to 2 per cent, meaning the easy “investment fruit” coming from declining interest rates has been well and truly been picked.
As investors, we need to grasp whether this is a third sea change Howard Marks is referring to and, if so, what are the ramifications.
The first thing we need to understand is that higher interest rates typically imply slower economic growth, an improved playing field for savers relative to borrowers, added pressure on valuations and asset prices, reduced leverage and slow down to the “wealth effect”.
Well publicised zombie companies will see reduced funding. Start-ups will also have greater trouble getting funding. Strong companies will have the opportunity to acquire weaker competitors at more reasonable prices. Household wealth will grow at a slower rate. And many workers intending to retire in the foreseeable future will likely delay their plans as their relative wealth comes under pressure. Exceptionally high debt levels will be reined in, where possible, in response to higher interest or mortgage repayments. Non-core assets will be sold. And buyers will be more discerning in parting with their cash.
1 Howard Marks mentions an average of 2 per cent to 4 per cent, but I am mindful that the Central Banks of Canada, New Zealand and the US are likely to tighten their official cash rate further from the current 4.25 per cent.
Chief Executive Officer of Montgomery Investment Management, David Buckland has over 30 years of industry experience. David is a deeply knowledgeable and highly experienced financial services executive. Prior to joining Montgomery in 2012, David was CEO and Executive Director of Hunter Hall for 11 years, as well as a Director at JP Morgan in Sydney and London for eight years.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
