Memo Date
December 13, 2022
Topics Touched
Credit InvestingParadigm ShiftMacro Forecasts
- Perceived quality, it turned out, wasn’t synonymous with safety or with successful investment.
- The ability to issue high yield bonds, smaller firms could now acquire larger ones by using heavy leverage, since there was no longer a need to possess or maintain an investment grade rating. This change permitted, in particular, the growth of leveraged buyouts and what’s now called the private equity industry.
- New investor mentality. Now risk wasn’t necessarily avoided, but rather considered relative to return and hopefully borne intelligently.
- It took the appointment of Paul Volcker as Fed chairman in 1979 and the determination he showed in raising the fed funds rate to 20% in 1980 to get inflation under control and extinguish inflationary psychology. As a result, inflation was back down to 3.2% by the end of 1983.
- Ushered in a declining-interest-rate environment that prevailed for four decades (much more on this in the section that follows). I consider this the second sea change I’ve seen in my career.
- We saw major contributions from (a) the economic growth and preeminence of the U.S.; (b) the incredible performance of our greatest companies; (c) gains in technology, productivity and management techniques; and (d) the benefits of globalization. However, I’d be surprised if 40 years of declining interest rates didn’t play the greatest role of all.
- Effects of declining interest rates:
- Accelerate the growth of the economy, cheaper for consumers to buy on credit and for companies to invest in facilities, equipment, and inventory
- Reduce businesses’ cost of capital
- Increase the fair value of assets
- It seems to me that a significant portion of all the money investors made over this period resulted from the tailwind generated by the massive drop in interest rates. I consider it nearly impossible to overstate the influence of declining rates over the last four decades.
- The massive increase in interest rates had its usual depressing effect on bond prices.
- Falling stock and bond prices caused FOMO to dry up and fear of loss to replace it
- Now, with high-yield bond prices up to ~8%, high-yield bonds are likely to deliver equity-like returns
- Globalization is slowing or reversing. If this trend continues, we will lose its significant deflationary influence.
- Fed appears likely to slow the pace of its interest rate increases, it’s unlikely to return to stimulative policies any time soon.
- Fed has to maintain credibility, can’t appear to be inconstant by becoming stimulative too soon
- Fed would probably like to see normal interest rates high enough to provide it with room to cut
- These (the above) are the reasons why I believe that the base interest rate over the next several years is more likely to average 2-4% (i.e., not far from where it is now) than 0-2%
- Recession in the next 12-18 months likely to coincide with deteriorate of corporate earnings and investor psychology
- We’ve gone from the low-return world of 2009-21 to a full-return world, and it may become more so in the near term. 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 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.