Economy
Easy Money - Howard Marks (하워드 막스)
Memo to: Oaktree Clients
From: Howard Marks (하워드 막스)
Re: Easy Money
The backstory: I began writing these memos in 1990 and continued to do so for ten years despite never receiving a single response. Then, on the first business day of 2000, I published bubble.com, a memo with warnings about excesses in the tech sector that turned out to be timely. The inspiration for the memo came from a book I’d read the preceding autumn: Devil Take the Hindmost: A History of Financial Speculation, by Edward Chancellor, an account of speculative excesses starting with the South Sea Bubble of the early 1700s. The book’s description of behavior surrounding the mania for the South Sea Company jibed with what I was seeing in the tech/media/telecom bubble that was underway. I received excellent feedback on the memo from clients – encouragement that prompted the many memos that have followed.
I consider it highly coincidental that 24 years later, I devoted another autumn to reading another Chancellor book, The Price of Time: The Real Story of Interest, his history of interest rates and central bank behavior. I thank Zach Kessler, a regular memo reader, for sending it. The relevance of The Price of Time to the trends I’ve been discussing for the last year occasions this memo.
* * *
In December 2022, I published Sea Change, a memo that primarily discussed the 13-year period from the end of 2008, when the U.S. Federal Reserve cut the fed funds rate to zero to counter the effects of the Global Financial Crisis, to the end of 2021, when the Fed abandoned the idea that inflation was transitory and readied what turned out to be a rapid-fire succession of interest rate increases. The memo concentrated on the impact that this lengthy period of unusually low interest rates had on the economy, the financial markets, and investment outcomes. I followed this up with the memo Further Thoughts on Sea Change, which Oaktree released to clients in May 2023 and to the public in October. In the latter memo and subsequent conversations with clients, I’ve emphasized the significant impact of low interest rates on the behavior of participants in the economy and the markets.
Easy Times
In Sea Change, I likened the effect of low interest rates to the moving walkway at the airport. If you walk while on it, you move ahead faster than you would on solid ground. But you mustn’t attribute this rapid pace to your physical fitness and overlook the contribution from the walkway. In much the same way, declining and ultra-low interest rates had a huge but underrated influence on the period in question. They made it:- easy to run a business, with the stimulated economy growing unabated for more than a decade;
- easy for investors to enjoy asset appreciation;
- easy and cheap to lever investments;
- easy and cheap for businesses to obtain financing; and
- easy to avoid default and bankruptcy.
1. Low interest rates stimulate the economy
Everyone knows that when central banks want to stimulate their countries’ economies, they cut interest rates. Lower rates reduce costs for businesses and put money into the hands of consumers. For example, since most people buy cars on credit or lease them, lower interest rates make cars more affordable, increasing demand. The result is typically good for automakers, their suppliers, and their workers, and thus for the economy in general. It’s important to realize that easy money keeps the economy aloft, at least temporarily. But low interest rates can make the economy grow too fast, bringing on higher inflation and increasing the probability that rates will have to be raised to fight it, discouraging further economic activity. This oscillation of interest rates between extremes can have effects and encourage behavior that natural/neutral rates (see p. 13) would be less likely to induce.2. Low interest rates reduce perceived opportunity costs
Opportunity cost is a major consideration in most financial decisions. But in low-interest-rate environments, the rate earned on cash balances is minimal. Thus, you don’t forgo much interest by withdrawing money from the bank to buy a house or boat (or make an investment), which makes doing so seem painless. For example, if someone’s thinking about taking $1 million out of savings for a purchase at a time when savings accounts pay 5% interest, they’re likely to understand that doing so will cost them $50,000 per year in forgone income. But when the rate is zero, there is no opportunity cost. This makes the transaction more likely to occur.3. Low interest rates lift asset prices
In finance theory, the value of an asset is defined as the discounted present value of its future cash flows. We discount future cash flows when calculating present value because we must wait to receive them, so they’re less valuable than cash flows received today. The lower the rate at which future cash flows are discounted, the higher the present value, as investors have noted for centuries: In the [18th] century, Adam Smith described how the price of land depended on the market rate of interest. In The Wealth of Nations (published in 1776) Smith noted that land prices had risen in recent decades, as interest rates declined. (The Price of Time, or “TPOT”) By placing too low a discount on the future earnings of companies, investors [in the 1920s] ended up paying too much. (TPOT) In real life, investments are evaluated primarily on a relative basis. The return demanded on each investment is largely a function of the prospective returns on other investments and differences in these investments’ respective levels of risk. Low interest rates lower the “relative bar,” making the higher returns offered on riskier assets appear relatively attractive even if they’re low in the absolute. In this vein, The Price of Time describes the thought process that made “iffy” loans to the government of Argentina acceptable in the low-rate environment of the late 1880s: Buenos Aires “took advantage of the low rate of interest and the abundance of money in Europe to contract as many loans as possible, new loans often being made in order to pay the interest on former ones.” Some Argentine loans paid as little as 5 percent – low in absolute terms or relative to their risk but still a couple of points above the measly yield on [consols, or perpetual British government debt] . . . (TPOT, emphasis added) When bond yields decline, bonds present less competition for riskier assets. Thus, low yields on bonds lead to lower demanded returns – and higher valuations – on other asset classes, such as equities, real estate, and private equity. For these reasons, low interest rates lead to asset inflation and sometimes asset bubbles like those we saw in late 2020 and throughout 2021.4. Low interest rates encourage risk taking, leading to potentially unwise investments
Low interest rates create a “low-return world” marked by paltry prospective returns on safe investments. At the same time, investors’ required returns or desired returns typically don’t decline (or they decline by much less), meaning investors face a shortfall. The ultra-low returns on safe assets cause some investors to take additional risks to access higher returns. Thus, these investors become what my late father-in-law called “handcuff volunteers” – they move further out on the risk curve not because they want to, but because they believe it’s the only way to achieve the returns they seek. In this way, capital moves out of low-return, safe assets and in the direction of riskier opportunities, resulting in strong demand for the latter and rising asset prices. Riskier investments perform well for a while under these conditions, encouraging further risk taking and speculation: In his 1844 book On the Regulation of Currencies [banker John Fullarton] observed that at times of low interest, “everything in the nature of value puts on an aspect of bloated magnitude,” and every article becomes an object of speculation. Long periods of easy money, wrote Fullarton, engender “a wild spirit of speculation and adventure.” Fullarton noted that financial euphoria occurred after a period of falling interest rates: “From the Bubble year [i.e., the South Sea Bubble of 1720] downwards, I question much if an instance could be shown of any great or concurrent speculative movement on the part of capitalists, which had not been preceded by a marked decline of the current rate of interest.” (TPOT) The risk-free rate is the point of origin, or jumping-off point, for returns and risk premia. When a central bank cuts the risk-free rate:- the rest of the yield curve usually follows;
- the capital market line governing asset-class returns also shifts downward, especially if the desire for higher returns in the low-return environment causes riskier investments to be aggressively pursued as described above;
- in addition to moving lower, the capital market line also can flatten, reducing risk premia, if investors are paying little heed to fundamental/credit risk; and
- the liquidity premium – the increment in expected return for owning illiquid rather than readily saleable assets – can also shrink, as return-seeking investors embrace illiquid investments.
- In the low-return environment of 2017, Argentina once again became the poster child for questionable investment opportunities, when it offered 100- year bonds. As I asked at the time in my memo There They Go Again . . . Again (July 2017), “Is Argentina, a country that defaulted five times in the last hundred years (and once in the last five), likely to get through the next hundred without a rerun?” Argentina’s checkered history as a borrower was ignored in the low-return environment, and the bonds were versubscribed thanks to their having a yield of 7.85% at a time when 30-year Treasurys offered only 2.77%. It took less than a year for Argentina to request a loan from the International Monetary Fund and less than three years for it to default on the bonds. When the 100-year bonds were restructured in 2020, holders received new bonds with an expected recovery value of roughly 54.5 cents on the dollar, according to The Wall Street Journal of August 31, 2020. Aptly, that same Journal article quoted Piotr Matys of Rabobank Group NV, as saying, “Treasury yields are so low, it’s forcing investors into risk. That’s why people are buying crazy stuff.”
- In the 2010s, investors eagerly snapped up leveraged buyout loans bearing historically low yields of around 6%. The buyers included CLOs, which are structured to give relatively high yields to the investors in their lower-rated tranches, as well as private credit lenders that levered up the prospective returns to roughly 9%.
- While “zombie” companies that burn cash haven’t historically been considered creditworthy, many were able to borrow easily in the pro-risk times through 2021. But as financial conditions have tightened, these companies have seen their cost to borrow rise and/or the amounts they can borrow shrink.
- The craving for good returns in low-return times can enable scams. Theranos (the medical technology company) and FTX (the cryptocurrency exchange) were the most prominent examples in recent years. Such scandals are less likely to happen in times of economic and capital market stringency, when investors are less eager and more careful.
5. Low rates enable deals to be financed readily and cheaply
Related to the above, low rates make people more willing to lend for risky propositions. Providers of capital vie to be the one who gets the deal. To compete for deals, the “winner” must be willing to accept low returns from possibly questionable projects and reduced safety, including weaker documentation. For this reason, it’s often said that “the worst of loans are made at the best of times.” The availability of capital fluctuates radically. Whereas in times of stringency, capital may not be available even to quality borrowers for valid purposes, in periods of easy money, capital typically becomes available to weaker borrowers, in large amounts, for almost any purpose. Things that couldn’t be financed in tighter times are deemed acceptable. For one example, consider the shifting perception of high-tech companies. Prior to roughly 2005, they were usually considered too undependable to be creditworthy, since outcomes for tech investments are generally asymmetric. If the company succeeds, the equity owners get rich. If it fails, there’s little asset value for creditors to recover. But in the years following the tech/media/telecom meltdown of 2000-02, when interest in public equities declined and large sums flooded into private equity funds, tech companies began to be bought out, often with financing from the newly popular field of private credit.6. Low interest rates encourage greater use of leverage, increasing fragility
Borrowed money – leverage – is the mother’s milk of rapid expansion and speculation. In my memo It’s All Good (July 2007), I compared leverage to ketchup: “I was a picky eater when I was a kid, but I loved ketchup, and my pickiness could be overcome with ketchup.” Ketchup got me to eat food I otherwise would have considered inedible. In much the same way, leverage can make otherwise unattractive investments investible. Let’s say you’re offered a low-rated loan yielding 6%. “No way,” you say, “I’d never buy a security that risky at such a low yield.” But what if you’re told you can borrow the money to buy it at 4%? “Oh, that’s a different story. I’ll take all I can get.” But it must be noted that cheap leverage doesn’t make investments better; it merely amplifies the results. In times of low interest rates, absolute prospective returns are low and leverage is cheap. Why not use a lot of leverage to increase expected returns? In the late 2010s, money flowed to both private equity, given its emphasis on leveraged returns from company ownership, and private credit, which primarily provides debt capital to private equity deals. These trends complemented each other and led to a significant upswing in levered investing. But in the last decade, some companies acquired by private equity funds were saddled with capital structures that failed to anticipate the increase in interest rates of 400-500 basis- points. Having to pay interest at higher rates has reduced these companies’ cash flows and interest coverage ratios. Thus, companies that took on as much debt as possible – based on their former levels of earnings and the prevailing low interest rates – may now be unable to service their debt or roll it over in a higher-rate environment. Finally, all else being equal, the more leverage that’s piled on a company, the lower the probability it’ll be able to survive a rough patch. This is one of the foremost reasons for the adage “never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average.” Heavy leverage can render companies fragile and make it hard for them to get through the proverbial low spots in the stream. Take, for example, Signa, a large privately owned property company in Europe, which announced in November of last year that it was beginning insolvency proceedings: The decision to go all-out during the era of cheap money left Signa dangerously exposed to the sharp rise of interest rates this year.......................... And rising interest rates have hammered commercial property values across the market, reducing the value of the assets used to secure Signa’s loans. (FT Asset Management Newsletter, December 11, 2023, emphasis added)7. Low interest rates can lead to financial mismatches
Easy-money episodes make it particularly attractive to borrow short at low rates in order to make long-term investments or loans with higher prospective returns. This is the other classic reason why, in the investment world, proverbial six-footers often drown. (Investors with liability maturities that match the duration of their assets make it across the river much more regularly.) In tougher times, if lenders demand their money back or decline to roll over existing debt when it comes due, debtors can find themselves holding discounted or illiquid assets – just when cash is needed. This is a familiar theme that frequently marks the turn of the cycle from benign to nasty. Chancellor provides an example from 1866 in connection with the failure of Overend Gurney, a London broker: Lending against long dated and illiquid collateral was not a suitable business for Overend, which normally discounted three-month commercial paper financed with daily cash calls on the money market. The Times [of London] described how Overend had erred: A Discount Company which had forsaken the business of discount brokers for that of “financing”, which had locked up its assets in securities promising to repay a high rate of interest, but incapable of conversion into cash on an emergency, had found its resources too limited to meet the calls upon them except at a ruinous sacrifice of its property, and had, therefore, suspended payment. (TPOT)8. Low interest rates give rise to expectations of continued low rates
It’s common for people to conclude that the environment they’ve lived through for a while is “normal,” and that the future will entail more of the same. For this reason, people who have gotten used to low interest rates may think rates will always be low and make decisions based on that assumption. As a result, investor due diligence or corporate planning may assume that the cost of capital will remain low. This can become a source of trouble if rates are higher when financing is actually sought. For example, in recent months, I’ve noted a number of lots in midtown Manhattan that have been cleared for the construction of new buildings. Given the lengthy planning and approval process involved with such projects, these buildings were undoubtedly greenlit in the low-interest-rate environment that preceded 2022. Will they be built if the actual financing costs are higher than those that were assumed? Or will they be abandoned at significant cost? When the pandemic year of 2020 came to a close, the recovering economy, rallying stock market, and low interest rates put investors in a good mood, and there was widespread belief that the Fed would keep rates “lower for longer,” supporting the economy and stock market for years to come. However, investors learned a lesson that has been repeated throughout financial history: catalysts for interest rate increases inevitably pop up, and thus perpetual prosperity and “the end of cycles” turn out to be nothing but wishful thinking. Consider another example from Chancellor: One of the aims of U.S. monetary policy in the 1920s was to dampen the seasonal fluctuations of interest rates caused by the agricultural cycle, which led to money being tight at certain times of the year. The Fed was so successful at this that Treasury Secretary Andrew Mellon went so far as to hail an end to the cycle of boom and bust. “We are no longer the victim of the vagaries of business cycles As economist Perry Mehring writes [in The New Lombard Street]: “Intervention to stabilize seasonal and cyclical fluctuations produced low and stable money rates of interest, which supported the investment boom that fueled the Roaring Twenties but also produced an unstable asset price bubble.” (TPOT, emphasis added)9. Low interest rates bestow benefits and penalties, creating winners and losers
Importantly, low interest rates subsidize borrowers at the expense of savers and lenders. Does it make sense to reduce the revenues of lenders so that investors can lever their investments cheaply? [In the mid-17th century,] Thomas Manley added that lowering the rate of interest would involve robbing Peter (the creditor) to pay Paul (the borrower). (TPOT) Doing so is a policy decision, or more likely the consequence of a decision to stimulate the economy. But it can have many other effects. When the rate of interest on savings is 4%, a retiree fortunate enough to have saved up $500,000 will earn $20,000 per year on her bank balance. But when the interest rate on a savings account is near zero, as we saw for much of the last 14 years, she gets essentially nothing. Is it good for society to make her settle for zero? Or would it be better if she put the money into the stock market in an effort to make more? While discussing the ramifications of policy decisions, let’s consider the impact of low rates on the distribution of income and wealth. . . . because assets like stocks and real estate are disproportionately held by the rich, ZIRP [the “zero interest-rate policy” that was introduced in December 2008] helped produce the largest spike in wealth inequality in postwar American history. From 2007 to 2019, . . . the wealthiest 1 percent of Americans saw their net worth increase by 46 percent, while the bottom half saw only an 8 percent increase. A report from McKinsey Global Institute, not exactly known as a bastion of economic populism, calculated that from 2007 to 2012, the Fed’s policies created a benefit for corporate borrowers worth about $310 billion, whereas households that tried to save money were penalized by about $360 billion. (The Atlantic, December 11, 2023, emphasis added) The yawning economic gap is one of the biggest problems the U.S. faces, and it’s probably responsible for a fair bit of the extreme divisiveness we see every day in the media and in politics. A central bank’s decision to set rates that subsidize some and penalize others clearly has consequences.10. Low rates induce optimistic behavior that lays the groundwork for the next crisis
Elevated risk taking, underestimating future financing costs, and increased use of leverage often lie behind investments that fail when tested in subsequent periods of stringency, bringing on the next crisis and perhaps the need for the next rescue. In this way, excesses in one direction typically precede excesses in the other direction. In October 1889, the Governor of the Bank of England, William Lidderdale, delivered a stern warning to the City: The present tendency of finance . . . is distinctly in the direction of danger, too much capital is being forced into industrial developments, financiers are taking larger & larger risks in securities which require prosperity & easy money to carry without becoming a burden, & an increased number of investments have been driven up in price by the combined efforts of a long period of cheap money & depression in trade . . . we have most of the elements of a Crisis. (TPOT)The Never-Ending Story
One of the quotes I return to most frequently is Mark Twain’s purported observation that “history doesn’t repeat itself, but it often rhymes.” For investors, cycles, along with their causes and effects, are among the influential matters that invariably rhyme from one period to the next. Roughly 30 years ago – largely thanks to my involvement with my partner Bruce Karsh and his distressed debt funds – I became much more conscious of the importance of fluctuations in the availability and cost of money. Thus, I wrote as follows in my memo You Can’t Predict. You Can Prepare. (November 2002): The longer I’m involved in investing, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself. I reused that paragraph in my 2018 book Mastering the Market Cycle: Getting the Odds on Your Side, adding this: . . . the credit cycle can be easily understood through the metaphor of a window. In short, sometimes it’s open and sometimes it’s closed. And, in fact, people in the financial world make frequent reference to just that: “the credit window,” as in “the place you go to borrow money.” When the window is open, financing is plentiful and easily obtained, and when it’s closed, financing is scarce and hard to get. . . . In the book I made three foundational observations about cycles in general:- The events that make up each cyclical progression don’t merely follow each other. Much more importantly, each event in the progression is caused by those that went before. This causality must be appreciated if one is to fully understand cycles and navigate them successfully.
- Cyclical oscillation isn’t best thought of as consisting merely of “ups and downs,” but rather as
- Cycles don’t have an obvious beginning and end. The only requirement for something to correctly be considered a full cycle is that it must include four components: (1) a movement from a norm to a high, (2) a move away from that high back toward the norm, (3) a move from the norm to a corresponding low, and (4) a movement from that low back toward the norm. Any of these can be labeled the start of a cycle, providing it goes on to include all four.
- First, stimulative rate cuts bring on easy money and positive market developments;
- which reduce prospective returns;
- which leads to willingness to bear increased risk;
- which results in unwise decisions and, eventually, investment losses;
- which bring on a period of fear, stringency, tight money, and economic contraction;
- which leads to stimulative rate cuts, easy money, and positive market developments.
Easy Money Observed
The behavior brought on by low rates takes place in plain sight. Some people take note of it, and a subset of them talk about it rather than let it pass unremarked. Fewer still understand its real implications. And almost no one alters their investment approach to take them into account. The low-rate period that immediately preceded the Global Financial Crisis of 2008-09 was marked by the kind of spirited competition to make investments and provide financing described above. It was in this climate that Chuck Prince, then CEO of Citi, made the statement for which he is remembered: When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. (July 14, 2007) When money is easy, few people opt to sit out the dance, even though the adverse results described above can reasonably be anticipated. When faced with the choice between (a) maintaining high standards and missing deals and (b) making risky investments, most people will choose the latter. Professional investment managers especially may fear the consequences of idiosyncratic behavior that’s bound to look wrong for a while. Abstaining demands uncommon strength when doing so means departing from herd behavior. And this gives me a great opportunity to reference one of my favorite quotations from John Kenneth Galbraith’s wonderful book on market excesses: Contributing to and supporting this euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten......................................... There can be few fields of human endeavor in which history counts for so little as in the world of finance. (A Short History of Financial Euphoria) The lessons from past periods of easy money usually fall on deaf ears since they come up against (a) ignorance of history, (b) the dream of profit, (c) the fear of missing out, and (d) the ability of cognitive dissonance to make people dismiss information that is inconsistent with their beliefs or perceived self-interest. These things are invariably enough to discourage prudence in times of low interest rates, despite the likely consequences. As you no doubt know, Charlie Munger passed away on November 28 at the age of 99. I want to pay a small tribute to Charlie’s life and wisdom by sharing something he wrote me in 2001: “Maybe we have a new version of Lord Acton’s law: easy money corrupts, and really easy money corrupts absolutely.”Will We Go Back to Easy Money?
Before I turn to the above question, I want to answer the one I’m asked most often these days: “Are you saying interest rates are going to be higher for longer?” My answer is that today’s rates aren’t high. They’re higher than we’ve seen in 20 years, but they’re not high in the absolute or relative to history. Rather, I consider them normal or even on the low side.- In 1969, the year I started work, the fed funds rate averaged 8.2%.
- Over the next 20 years, it ranged from 4% to 20%. Given this range, I certainly wouldn’t describe 5.25-5.50% as high.
- Between 1990 and 2000, which I would consider the last roughly normal period for rates, the fed funds rate ranged from 3% to 8%, suggesting a median equal to today’s 5.25-5.50%.
- Globalization has been a strong disinflationary influence, and it’s likely on the decline. For this reason – and because the bargaining power of labor seems to be on the rise – I believe inflation may tend to be higher in the near future than it was pre-2021. If true, this will, all else being equal, mean interest rates will be kept higher to prevent inflation from accelerating.
- Rather than be in a perpetually stimulative posture, the Fed may want to maintain the neutral rate most of the time. This rate, which is neither stimulative nor restrictive, has most recently been estimated to be 2.5%.
- The Fed might want to get out of the business of controlling rates and let supply and demand set the price of money, which hasn’t been the case for a quarter century.
- Having had a taste of inflation for the first time in decades, the Fed might keep the fed funds rate high enough to avoid encouraging another bout. To control inflation, one would think the rate would need to be kept positive in real terms. If inflation will be, say, 2.5%, the fed funds rate would by definition have to be above that.
- Perhaps most importantly, one of the Fed’s essential jobs is to enact stimulative monetary policy if the economy falls into recession, largely by cutting rates. It can’t do that effectively if the rate is already zero or 1%.
- Eighteen months ago, it was near-universally accepted that the Fed’s aggressive program of rate increases would result in a recession in 2023. That was wrong.
- Twelve months ago, the optimists who launched the current stock market rally were motivated by their belief that the Fed would pivot to dovishness and start cutting rates in 2023. That was wrong.
- Six months ago, there was a consensus that there would be one more rate increase in late 2023. That was wrong.
- Inflation is moving in the right direction and will soon reach the Fed’s target of roughly 2%.
- As a consequence, additional rate increases won’t be necessary.
- As a further consequence, we’ll have a soft landing marked by a minor recession or none at all.
- Thus, the Fed will be able to take rates back down.
- This will be good for the economy and the stock market.
- The period from 1980 through 2021 was generally one of declining and/or ultra-low interest rates.
- This had profound ramifications in many areas, including determining which investment strategies would be the winners and losers.
- That changed in 2022, when the Fed was forced to begin raising interest rates to combat inflation.
- We’re unlikely to go back to such easy money conditions, other than temporarily in response to recessions.
- Therefore, the investment environment in the coming years will feature higher interest rates than those we saw in 2009-21. Different strategies will outperform in the period ahead, and thus a different asset allocation is called for.