Expected returns ‘lowest they’ve ever been’
Leading global ‘distressed debt’ manager Howard Marks and his Oaktree Capital firm are well-known for their sometimes combative and private equity approach to investment. The firm has increased its work in Australia in recent years after achieving some success buying-out and breaking-up the Blue Sky Alternative Asset Management empire, and more recent involvements with Virgin Australia and the beleaguered Freedom Foods.
Yet the group also offers some of the more unique and useful insights into the operation of financial markets. It is easy as investors to rely on the most accessible information, be that from domestic stockbrokers, bank-led economists or high-profile journalists, but few understand the nature of markets like the owners of debt in distressed companies.
Oaktree Capital’s latest Memo, titled Coming into focus, has offered a different take on the position in which most of the developed world now finds itself. The 17-page missive, which is released intermittently throughout the year, focuses primarily on the outlook for returns in what has become a zero-rate world.
Marks offered great detail into the ‘power of interest rates’ and highlights the seven most important impacts that the current policies have (and will continue to have) on investor and market behaviour. It highlights the important ‘stimulative effect’ of lower interest rates, being that all financing, consumer, business and government, is immediately made more attractive; exactly what is needed in the middle of a pandemic.
It then highlights the point most often quoted by “growth” investors, being that lower interest rates increase the “discounted present value of future cash flows,” affording substantially higher valuations for assets ranging from residential property to stocks and bonds. However, lower rates also bring down the returns demanded by the ‘capital market line’ to warrant future investment. For instance, if term deposit rates are under one per cent, then by comparison a dividend yield of three per cent is far more attractive.
The cause-effect relationship then results in these “lower demanded” returns leading directly to higher valuations, as many “value” managers, including Australia’s own Platinum Asset Management, have warned. Oaktree goes on to suggest that low rates and the resultant low prospective returns “encourage risk tolerance and reaching for return,” something defined for some time as the “search for yield” and, perhaps more recently, in the plaintive question, “is growth the new yield?” Ultimately, the aim of lower rates and yields is to force capital markets like shares, initial public offerings (IPOs) etc. to re-open appropriately as investors are forced to “put more money to work.”
According to Oaktree, the result is that “prospective returns on everything are about the lowest they’ve ever been.” The potential solutions are varied and ultimately depend on a series of factors including investors’ risk tolerance, timeframe, patience and the amount of capital they are able to put at risk. As I have personally highlighted on many occasions, the investment approaches that worked over the last decade will not work in the next decade, as conditions have evolved; our investment approaches must evolve with them.
Oaktree highlights a series of options for investors, ranging from investing in the same way and simply expecting historic returns to continue regardless of the message markets are providing; or to invest the same way and settle for the prospective low returns they forecast. Alternatively, investors could consider reducing risk in light of higher uncertainty, accept zero returns by going to cash, or even increase risk in this difficult pursuit; many have clearly decided on the latter.
Ultimately, it seems the best risk-adjusted solution has already been identified by Australia’s leading financial advisers and investors, being to seek more “alternative,” niche and specialist investment strategies that have less correlation and reliance on ever-lower interest rates.