I feel the best way to understand today’s investment environment is to realise that the financial crisis and economic contraction are behind us, but so is a good deal of the market recovery. Here are the most important macro considerations.
First, the economy is showing gradual improvement and the capital markets have stabilised and turned generous. We believe the economic recovery in the U.S. is genuine. It may well not be dynamic, steady as to pace or uniform across all sectors – and thus it’s unlikely to feel like a rerun of the prosperous 1990s– but the recovery seems to be underway and likely to remain so.
Second, low yields on short-term Treasurys continue to make it impossible for investors to enjoy both decent returns and complete safety. Instead, they generally must choose between return and safety, and since few investors can dispense with return, it usually gets the nod. This phenomenon has forced investors out on the risk curve, and most securities to be at least fairly priced.
Third, however, I think today’s investors are largely what my late father-in-law used to call “handcuff volunteers” – participating, but often somewhat less than thrilled to be doing so. I do not sense the euphoria and blindness to risk of 2005-07, particularly as to leveraged, illiquid and innovative strategies. Investors are pursuing return, but often with reservations. And their worries are not unfounded, given the existence of a long list of macro uncertainties that will not be resolved quickly, easily or painlessly. These include:
the low level of industrial competitiveness in the developed economies,
the risk of structurally high unemployment
the problem of government deficits and debt, and the likely depressing impact of austerity and higher tax rates,
the need to revamp the U.S. healthcare and education systems,
the burden of underfunded public pension plans,
the impact on economic activity of allowing interest rates to rise from today’s artificially low levels,
the outlook for inflation,
the superior cost-competitiveness of the developing nations, and
the issues of protectionism, capital controls and non-market exchange rates.
Given the two-year recovery of the markets, the at-least-adequate pricing of most major asset classes and the existence of the uncertainties listed above, we consider this a time to proceed with caution. It’s important that we acknowledge we’re living in a low-return world, and also important that we accommodate and adapt to that reality.
I want to reiterate what I wrote in “Open and Shut” in December: in order to enjoy the benefits of the financial recovery in 2009-10, all you really needed was capital to spend in late 2008 and the nerve to spend it. Today, the combination of capital and nerve is more likely to be a recipe for disaster. Instead,we think investing in today’s low-return world requires caution, risk control, scepticism, discipline, discernment and selectivity . . . the same elements that were required in 2004-07 if one were to avoid the full brunt of the financial crisis.
As you know, the latter are the things that come most naturally to Oaktree. We’ve never found it difficult to limit losses in tough times; that’s what our company was built to do. We’ve done it in the past, and we don’t think there’s any reason why we shouldn’t be able to keep doing so in the future. The greater challenge for cautious investors like us is to participate when markets do well, but we’ve generally done that, too. Thus our long-term record shows both outstanding protection in bad times and healthy(although not necessarily maximal) gains in good times.
A good portion of our ability to keep up despite insisting on risk control is attributable to my colleagues’ skillful implementation of Oaktree’s investment philosophy. But I want to highlight another source: while we may lean in the direction of defence when we’re concerned about what lies ahead, we never “bet the ranch” on bearish macro forecasts and give up on return.
Everyone at Oaktree has opinions on these things, but we’re very conscious of their limitations. We know full well that it’s one thing to have an opinion regarding the macro-future but something very different to behave as if it’s correct. The bottom line is that we’ll bring caution to the task of investing in the low-return world I describe, but that caution will never consign us to the sidelines.