Memo to: Oaktree ClientsFrom: Howard MarksRe: Tell Me I’m WrongMy readers treat me well. They indulge my penchant for dissecting the past, and they send kindmessages of encouragement. To repay their generosity, I’m going to venture into something Iusually avoid: the future of the U.S. economy.This memo won’t be about the future in general, just the elements I find worrisome. As I see it,every investor is either predominantly a worrier or predominantly a dreamer. I’ve come cleanmany times: I’m a worrier. By saying that, I absolve myself of having to describe the wholefuture. I’m going to cover the negatives, starting with the immediate and ending with thesystemic (some of the latter repeats themes from “What Worries Me,” August 28, 2008). Forthe other side of the story, I’d suggest you consult the optimists who seem to be in charge of themarkets these days.The Near Term
One thing is indisputable: the rally in financial markets worldwide has outpaced thefundamentals
. At the beginning of 2009, most onlookers expected a generally weak economyand were concerned that the behavior of consumers and banks would remain conservative.They were 100% right, and fundamentals are still tenuous. And yet, the rally has exceeded allexpectations of which I’m aware.Market participants have grasped at slender “green shoots”: things that are declining but at aslower rate, or that have stopped getting worse, or that have begun to improve, albeit anemically(e.g., “At some of the nation’s largest lenders, the number of consumer loans that are going badis starting to level off.”
The New York Times
, January 21). Most of the good news falls intothose categories; little or nothing has blown anyone’s socks off. We haven’t seen mucheconomic news that’s overwhelmingly positive, despite the fact that (a) today’s comparisons areagainst very weak periods a year ago, (b) our exports have been made cheaper by a dollar that’s10-20% lower, and (c) there’s been an enormous amount of government stimulus. The gainsbeing reported are often in tenths of a percent, and the other day my drive-time radiocommentator said, “Hirings are almost equal to firings.” That doesn’t tell me we’re in the midstof a strong recovery, or on track for one.In particular, most companies’ sales remain quite weak. The economy is generating very littlegrowth at the so-called “top line” on which Gross Domestic Product is based. Rather, the profitgains being reported have been aided in large part by cost cutting. But “cost cutting” and“productivity gains” are nice-sounding ways of saying companies are getting by with less labor.Thus the employer’s productivity gain can be the employee’s job loss. It doesn’t bode well for
2the general welfare, consumer spending or GDP growth if the level of business activity, as seenin revenues, isn’t rising; GDP doesn’t benefit from profit margin expansion.Reliance on Government StimulusA year or so ago, the government came to the rescue of the economy with massive stimulus.With the Great Depression as a reference point, Bernanke et al. were determined to limit thecontraction in liquidity, support financial institutions and encourage economic activity. Somesay too much has been spent, the resulting deficits are worrisome, and the program’s a flop,since the economy’s still languishing and unemployment remains high.But the fact that growth is sluggish doesn’t mean the stimulus has failed. The relevant questionisn’t how the economy is doing, but how growth compares against what it would have beenwithout the stimulus. “What if” questions like that are largely unanswerable, but I’m sure we’remuch better off than we would have been without the government’s help.Home sales are weak, but what would they be if the federal government wasn’t directly orindirectly backing 80-85% of all new mortgages and providing $8,000 tax credits to first-timehome buyers? What would 2009 auto sales have been without the “cash for clunkers” program?GDP growth is insubstantial, but what would it be if government spending hadn’t risen bydouble digits?Although not all the money has been well spent – “a blunt and messy solution” according toWilliam Dudley, president of the New York Federal Reserve (
The New York Times
, January 21)– it seems clear the stimulus program has prevented a much more dire outcome. Regardless,the economy’s response is tepid, and I wonder whether the slow growth reflects negativeunderlying secular trends. This makes me tend toward an expectation that the recovery will belackluster, and that it will take years before we get back to anything approaching the vibrancy of the period preceding the crisis.I fall back on the analogy of a stalled car (the economy) being pulled by a tow truck (government stimulus). The tow truck will want to let the car down one of these days and go onits way. Will the car be able to move on its own? We can only wait and see. I think it’s morelikely to sputter along than it is to move forward energetically. But at least we don’t have toworry any longer about the analogy of fifteen months ago: an airplane whose engine has flamedout. A powerless plane in mid-flight presents a far more troubling image than a stalled car.The Role of Interest RatesInterest rate reduction has played an extremely important part in the government’s efforts to endthe crisis and bring the economy back to life.
By reducing short-term interest rates (in this case to near-zero), the government makes itmore attractive to spend and invest, stimulating the economy. This is the most direct effect.
3
Lower rates also provide a direct subsidy to financial institutions, which can borrow cheaplyand lend at higher rates. (If a bank can borrow $100 from the government at 1% and lend itout at 6%, it’s as if the government wrote the bank a check for $5 – but more subtle andperhaps less vexing to Main Street, and with potentially positive multiplier effects.) Giventhe state of financial institutions in 2008, it’s clear this element was essential.
There’s a third, less direct effect. Rock-bottom rates on Treasurys push people to chase highreturns by undertaking riskier investments. A year ago, the pensioner living on interestopened his year-end mutual fund statement and saw that the return on his T-bill or moneymarket fund was close to zero. He grabbed the phone and called the company to say, “Getme out of that fund and into the one that’s paying 15%” . . . and so became a high yieldbond investor.It’s clear from the behavior of the markets that something has been goosing investmentperformance, since the best gains have been seen in the fundamentally riskiest assets. Part of itis general easing of the excessive risk aversion and fear of a year ago, and part is a justifiedrebound from too-low prices. But certainly near-zero interest rates have played a major part.As with most remedies – economic and otherwise – ultra-low interest rates raise questions:
Will economic recovery continue if rates go to market levels?
Will financial institutions remain viable without the subsidy of low rates?
Can the residential real estate market recover without support from cheap mortgages?But what if rates remain low?
Will foreigners continue to lend the U.S. the money it needs to cover its deficits?
Can the dollar hold its value against other currencies if international demand weakens fordollars with which to invest in the low-yielding U.S.?
Most market participants tend to extrapolate currency movements (rather than project theirreversal). So if low rates cause the dollar to weaken, will non-U.S. investors shy furtherfrom our currency to avoid continued weakness, exacerbating these issues?
Global considerations call for higher rates, but fighting domestic economic weakness relieson low rates. Resolving this dilemma won’t be easy . . . or painless.
The Importance of Consumer SpendingAt two-thirds of GDP, consumer spending was the linchpin of U.S. economic growth in thedecade-plus leading up to the credit crisis. And the foundation for the rapid growth in thatspending was the availability of consumer credit and the willingness to use it.The innovation and explosion of consumer credit, which I view as having begun in the 1970s,enabled Americans to spend money they didn’t have to buy things they couldn’t afford. Thiswas compounded in the current decade by vastly lowered credit standards for first mortgagesand by radical expansion of what used to be called second mortgages but were re-labeled “home
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Howard Marks Fourth Quarter 2009 Memo
Howard S. Marks, chairman of Oaktree Capital Management, shares his thoughts on the economic recovery, or lack thereof, in his latest memo to clients.
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