A sea change is under way in markets
The writer is co-founder and co-chair of Oaktree Capital Management and author of ‘Mastering the Market Cycle: Getting the Odds on Your Side’
In my 53 years in the investment world, I’ve seen a number of economic cycles, pendulum swings, bubbles and crashes, but I remember only two real sea changes. I think we may be in the midst of a third one today.
The first occurred in the 1970s with the creation of high-yield bonds. Prudent bond investing had previously consisted of buying only presumedly safe investment grade bonds. But investment managers could now prudently buy bonds of almost any quality as long as they were adequately compensated for the attendant risk.
This reflected a new investor mentality. Now risk wasn’t necessarily avoided, but rather considered relative to return and hopefully borne intelligently. This new risk/return mindset was critical in the development of many new types of investment, such as private equity, 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.
The next big change was the long-term decline in interest rates. This trend began just a few years after the advent of risk/return thinking and I believe the combination of the two largely gave rise to the incredible four decades of stock market performance that began in the early 1980s. The S&P 500 index rose from a low of 102 in August 1982 to 4,796 at the beginning of 2022, for a compound annual return of 10.3 per cent per year.
Obviously, multiple factors gave rise to investors’ success over this period, including economic growth in the US; the strong performance of the country’s 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.
This era perhaps reached its apex in the period from 2009 to 2021 (with the exception of a few months in 2020). This was an asset owner’s market and a borrower’s market. With the risk-free rate near zero and people eager to make risky investments, it was a frustrating period for lenders and bargain hunters.
Of course, all of the above flipped in the last year. Most importantly, inflation, which began to rear its head in early 2021, caused the Federal Reserve to kick off one of the quickest rate-hiking cycles on record in 2022. As a result, the market characterised by easy money and optimistic borrowers and asset owners disappeared; suddenly, lenders and buyers held better cards. Credit investors like Oaktree became better positioned to demand higher returns and stronger creditor protections. The list of loans and bonds trading at distressed levels grew from dozens to hundreds.
In short, it looked like a complete reversal of the conditions that prevailed for much of the last 40 years.
In my view, the buyers who’ve driven the S&P 500’s recent 10 per cent rally from the October low have been motivated by a belief that the economy and markets will return to the halcyon days of this previous era. They appear to think that inflation is easing, the Fed will soon pivot and reduce interest rates and a recession will be averted, or be modest and brief. But are these beliefs justified?
As I’ve written many times about the economy and markets, we never know where we’re going, but we ought to know where we are. The bottom line for me is that, in many ways, conditions at this moment are overwhelmingly different from — and mostly less favourable than — those of the post-financial crisis climate. These changes may be long-lasting, or they may wear off over time. But in my view, we’re unlikely to see a quick return of the same optimism and ease that marked the period after 2009.
We’ve gone from the low-return world of 2009-21 to a full-return world. Investors can now potentially get solid returns from credit instruments, meaning they no longer have to rely as heavily on riskier investments to achieve their overall return targets.
Lenders and bargain hunters face much better prospects in this changed environment than they did in 2009-21. And, importantly, if you grant that the environment is and may continue to be very different from what it was over the past 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.