On Uncertain Ground (Howard Marks)

On Uncertain Ground

September 11, 2012

by Howard Marks, Chairman, Oaktree Capital

The world seems more uncertain today than at any other time in my life.  That’s a simple sentence but one with significant implications.  And it’s not just me.  Here’s what The New York Times said on August 12 in an article about John Bogle, the founder of Vanguard:

“It’s urgent that people wake up,” he says.  This is the worst time for investors that he has ever seen – and after 60 years in the business, that’s saying a lot. . . .  “The economy has clouds hovering over it,” Mr. Bogle says.  “And the financial system has been damaged.  The risk of a black-swan event – of something unlikely but apocalyptic – is small, but it’s real.”

I’m going to devote this memo to the uncertainty in the world and the investment environment and then offer my take on the appropriate strategy response.  This will require me to touch on a large number of topics, but I will try to dwell less than usual on each of them.  If after reading this memo you find yourself hungry for more, you might go back to “What Worries Me” (August 28, 2008) and “The Long View” (January 9, 2009).

The Macro-Economic Setting

It’s my belief that we’re going to see relatively sluggish economic growth in the U.S. for a prolonged period of time.  My expectations for other developed nations, given their specific issues, are even less positive.  (This is a good time for my typical reminder that I am not an economist, and far from all of my observations would be supported by that fraternity.  And please note that one of the key tenets of Oaktree’s investment philosophy dictates that our investing will not be governed by macro forecasts.  We say it’s one thing to have an opinion on the macro, but something very different to act as if it’s correct.  I urge you to consider adopting a similar attitude toward all macro forecasts, especially mine.)

Around 2008 or ’09, I had a visit from a senator looking – surprise! – for a campaign contribution.  I suppose to make conversation, he asked if I could assure him we were headed for a vigorous recovery.  “Forget vigorous,” I told him.  “I’m hoping for lackluster.”  I haven’t changed my tune.

There’s a very human tendency to think things will stay as they are, and if they change, that they’ll revert to what we’re used to.  Most people think of economic growth as the norm; after all, that’s been the general rule during our lifetimes.  In fact, the global economy has grown nicely for hundreds of years.  That’s something “everyone knows.”  But how many people think about where economic growth comes from, and whether it’s naturally occurring and inevitable?

Economic growth doesn’t just happen.  Its vigor depends on a combination of population gains, a conducive infrastructure, positive aspiration and profit motive, advances in technology and productivity, and benign exogenous developments.  In many ways and to varying degrees, I think the future for these things in the U.S. is less good than it was in the past.  The birthrate is down; our infrastructure is out of date; it’s uncertain whether technology can add as much to productivity in the future as it has in the recent past (but perhaps it always is); and mobility up the income curve has stagnated.

I think a lot about the role of deficit spending and credit.  In the forty or so years leading up to the crisis of 2008, consumers could grow their spending faster than their incomes because of the increasing availability of credit (and their increasing willingness to make use of it).  Likewise, generous capital markets greatly facilitated deficit spending on the part of governments.  Economic units around the world were able to spend money they didn’t have and thus buy things they couldn’t afford.  This made a big contribution to economic growth, but few people recognized the negative implications: increased leverage, increased dependency on the continued generosity of the capital markets, and thus increased precariousness.  In other words, unwise behavior in the short run led directly to problems in the long run.  This is a normal aspect of the economic process.

Few debtors can tap the capital markets today to the same extent they could five or ten years ago.  In a radical turn of events, lenders now appear to care about borrowers’ ability to repay, and they find some of their customers less than creditworthy.  Since almost no borrowers actually have the ability to pay off their debts, this has led to credit difficulties ranging from home foreclosures, to municipal bankruptcies in the U.S., to debt crises in peripheral Europe.

American consumers seem to have concluded that they should owe less (or have found that they can’t borrow as much).  For whatever reason, the savings rate has risen, suggesting a decline in the propensity to spend all one makes and more.  All around the world, there’s movement on the part of borrowers – sometimes voluntary and sometimes involuntary – toward austerity (reducing the excess of spending over incomes) or even delevering (spending less than you make and using the surplus to pay down debt).

These trends are healthy for individual borrowers’ balance sheets, but they imply reduced consumption and thus are negative for GDP growth.  If everyone does these things at the same time, the results can be quite contractionary.  Regardless of how you look at it, less use of consumer credit implies less economic growth.

The other specific element that gives me pause relates to confidence.  Psychology plays a huge role – perhaps a dominant and self-fulfilling one – in influencing economic growth.  In short, if people think things will be good in the future, they’ll spend and invest, and things will be good.  But if they turn pessimistic regarding the future and go into their shells, refusing to spend and invest, growth will slow down.

Consumers were traumatized by the crisis of 2008: laid off, forced out of their houses, made poorer by market declines, and denied credit.  Those who didn’t feel these influences directly were still pounded by headlines trumpeting economic weakness, the collapse of financial institutions, the need for bailouts, and malfeasance in the banking and mortgage industries.  It could require significant healing before these influences abate.

Much of an economy’s resilience comes from what economists call “animal spirits”: the bullishness that drives things upward when people’s innate optimism, acquisitiveness and tendency to forget harsh lessons are sparked by some bits of good economic news.  Right now, with animal spirits largely in hibernation, a reversal of the crisis’s trauma may not come easy.  But that doesn’t mean there won’t be one.  The U.S. consumer has a tendency to surprise on the upside.

Business investment plays a key role in economic recovery.  When managers conclude that consumers are about to resume spending after a downturn, they hire workers and invest in new equipment in order to meet the increased demand they believe is coming.  Yet the current recovery has seen little in this regard.  I think the prevailing attitude has been, “Let’s see how far we can stretch our current capacity before spending to expand it.”  Or as I heard on the radio the other day, in a report on productivity gains, “Businesses continue to do more with less.”  Thus companies have built cash hoards, not productive capacity.

Much of this has been attributed to uncertainty on the part of executives concerning the business environment.  In contrast to the preceding 28 years of pro-business and pro-free market administrations under Presidents Reagan, Bush, Clinton and Bush, today many business people detect antipathy – or, at minimum, indifference – on the part of the Obama administration, in which the private sector is little represented.  In addition, there is uncertainty and anxiety regarding the outlook for the economy, regulation and taxes.  All of these things have deterred expansion.