Ultra-low interest rates look likely to endure – does this diminish the attractiveness of bonds?
I agree that enduring low interest rates are a safe assumption. However, low interest rates are likely to have a depressing effect on all asset classes, not just bonds. All prospective returns emanate from interest rates. So, future returns from fixed income are at a low ebb today, but I believe the same applies to everything.
As the coronavirus crisis has taken a grip, have you been surprised at the way credit markets have reacted?
No, it hasn’t been a surprise. We are students of the market cycle. We believe it is appropriate to calibrate our investment activities according to where we believe we are in the cycle.
For a while now, we have believed that our current position in the cycle is rather high. It has been a very long upswing, from the aftermath of the global financial crisis in 2009 until the coronavirus appeared in early 2020. That is an abnormally long upswing and a lot of money has been made. Interest rates have been low throughout, encouraging many market participants to take excessive risks in order to achieve a higher return.
In recognition of that, our mantra has been: “move forward, but with caution”. We are not afraid to invest – we have to invest in order to deliver a return. But during this time, we chose to invest with even more caution than usual.
And yet you recently started talking about reversing this cautious stance. Isn’t it a risky time to do that?
You should see this in the context of what I call the “twin risks”. The first is the risk of losing money and the second is the risk of missing opportunity – and nobody wants to do either of those. So, the obvious solution is to balance these two risks, and we can adjust that balance as we move through the market cycle.
Today, as a result of the virus, people have stopped engaging in the same risky behaviour as before and, with prices down, prospective returns have improved. Pulling all this together, our investment world feels less precarious now. We can start to worry less about losing money and worry a bit more about missing opportunities. We therefore feel emboldened to move to a more neutral balance between the two risks.
Were the radical measures introduced by the US government and the Federal Reserve to support the US economy a good idea?
The key word here is “economy”. I fully subscribe to the idea that the Fed should be supporting the economy at the moment. A matter of weeks ago, the economy was going into free fall – we were staring into the abyss of a potential depression. If we hadn’t seen the Fed and other central banks coming to the rescue with massive injections of cash and liquidity, that would have been the outcome.
I get more worried, however, when I think about the idea of the Fed supporting the US stock market. It is not the role of a central bank to be supporting the market – that is beyond its remit.
Clearly it is difficult to strike the right balance here. If the government gave every company enough money to survive until next year, inevitably a proportion of the support would go to the wrong sort of business – the living dead of the corporate world – and I don’t think it is healthy to try to keep them alive. Unhealthy companies should be weeded out during the challenging stages of the cycle – that is a natural feature of the capitalist system. It is Darwinism: survival of the fittest. Now is not the time for pure Darwinism, of course. That would likely mean the depression that, thankfully, we appear to have avoided. So, some support is necessary, but it would be easy to take it too far.
Are there policy and market parallels here with the global financial crisis?
In the financial crisis, it took a long time to develop the policy responses and they were small in comparison. Policymakers appear to have learnt lessons, however. This time round, they have implemented – in a matter of weeks – policies that took months to think through in the financial crisis. And they have implemented them on a massive scale.
The policy response has been both rapid and substantial, and brought some joy back into the market. When the virus hit, markets very quickly went into full-on panic mode. The price movements – in equity and bond markets alike – were dramatic and disturbing. The Fed’s main policy response announcement on 23 March marked the low point in markets, and the recovery since then has been almost as remarkable.
Despite the policy response, though, there will inevitably be plenty of situations in which companies default on their debt obligations. I started investing in high yield bonds in 1978, and Bruce Karsh and I have been investing together in this market since 1985. During this time, we’ve seen three major crises in our investment universe: the collapse of the leveraged buyout boom in 1991, the dot com bubble bursting in 2001 and the global financial crisis in 2008. Each time, we have seen a lot of defaults. But on each occasion, we have managed to avoid most of the defaults. Our default rate has been roughly one-third of that seen in the wider market. So, we will likely see some defaults in our portfolio this time round, but we are confident they will be less numerous than those seen across the market.
Is there a risk of contagion from the energy sector now the oil price has collapsed?
I am not so worried about the risk of contagion. Some market commentators are suggesting that the collapse of the oil price is a terrible problem for the economy. I don’t see it that way. If you think about it, it’s a zero-sum game, with winners and losers – the lower price oil is great news for consumers of oil.
So, I don’t see the problems in the energy sector spreading elsewhere. Among financial institutions, I expect there are some regional banks that have lent excessively to energy companies, but the extent of leverage within the US banking system is much lower now than it was in the financial crisis. Generally-speaking, the US banks are capitalised well enough to absorb losses.
Have passive and quantitative strategies exacerbated the sharp moves we’ve seen in bond spreads?
Passive strategies manage money on autopilot. There is no thought process, no weighing of the merits of investing in a particular company on a particular day – they are mandated to replicate a particular index or theme.
Nowadays, more than 95% of all trading on the US stock exchange is automated (source: Oaktree as at 22 April 2020) – there are no people involved whatsoever. It follows, therefore, that no human thought is applied to the vast majority of investment activity and it is obvious to me that, when markets swing in an extreme direction, this automated trading must exaggerate those swings. I don’t know the extent of that influence – it is impossible to determine – but I do believe that they play a role in amplifying market moves.
How do you describe your investment approach?
Most of what we do for you and for other investors is asset selection. Once we’ve identified a suitable asset, we buy it, collect the interest, and wait to be repaid. Put simply, that is what a bond investor does: put money to work, receive interest and then get the money back.
The art is in identifying companies that can deliver that. We need to figure out which companies will come through when times get tough. I sometimes talk about it in terms of crossing a stream that is, on average, five feet deep. At that depth, most of us can cross it safely but if it gets deeper, some of us may struggle to make it to the other side. When we think about the market cycle, it helps us to understand just how deep that stream may become in difficult times. And when we think about companies, we then know how strong they need to be to make it through. Those are the companies that we choose to invest in, while we avoid the ones that look like they might not be able to make it.
Looking further out, do you foresee any unintended consequences of the massive policy response we’ve seen?
Some people are worried about inflation because of the stimulus. Many other people are worried about deflation. The only thing I’m certain about is that we won’t have both at the same time.
Basically, we don’t really know anything about the future. We never do! We all have the same information about the present and the same ignorance about the future. There is widespread applause for the very strong action that we’ve seen from the Fed and the Treasury, but nobody knows what it means for the future.
We can look to history for some help, but the combination of things we’re dealing with now has no obvious precedent. It’s the biggest pandemic in a century; the biggest economic decline outside of wartime in nearly as long; the biggest ever oil price collapse; and the biggest ever stimulus package.
We are in uncharted waters. I am a firm believer that the best thing we can do in these uncharted waters, is find dependable companies that our analysis suggests are strong enough to see them safely across the depths.
Oaktree Capital is a fund manager for St. James’s Place.
The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested. An investment in equities does not provide the security of capital associated with a deposit account with a bank or building society.
The opinions expressed are those of the fund managers listed above and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.