As published in Conseiller on 20 November 2023 (in French)
In his recent memo for Oaktree Capital Management, Howard Marks opines that to achieve a superior long-term record, an investor should strive to do “a little better than average every year” and “through discipline to have highly superior relative results in bad times.” He argues that this approach is more likely to avoid extreme volatility and large losses. And, he adds, “the best foundation for above-average, long-term performance is an absence of disasters.”
So far this year, investors have enjoyed very robust returns for risk assets. But how likely is it that the good times will persist?
I believe we are in the later stages of the economic cycle and that corporate and economic fundamentals will likely weaken in the coming quarters. There are several warning signs present in markets today. One is risk assets are responding positively to both good and bad economic news, which suggests a relatively high level of complacency about macroeconomic risks. Secondly, we have seen some high profile “perma bears” turn bullish which can be a sign of capitulation, and which tends to happen close to market peaks.
Fixed income has effectively been forced to be repriced based on what is happening with government yields, while other asset classes, which are not as directly connected to interest rates, are living in a world where they haven’t adjusted to what, I believe, is the appropriate cost of capital and risk premium. The late August rally was reminiscent of 2021, when the market had taken an optimistic view that inflation would prove to be transitory. The S&P 500 closed August at almost the exact same level as it did two years ago, 4,508 in 2023 compared to 4,523 in 2021. In some ways, risk markets could be even further ahead of themselves now than they were two years ago.
While inflation turned out not to be transitory, to support asset prices now, both a soft landing and lower rates are required. It seems unlikely that both will be achieved, with the possibility that neither a soft landing nor lower rates is also a realistic scenario. Have valuations in large-cap public equities, private markets and real estate appropriately adjusted to a higher interest rate regime? Ultimately, risk premiums will revert to where they should be. This repricing is likely to choppy.
Having a flexible mandate can be very useful during these times. As the economic cycle winds down, I expect more opportunities to arise. Because of that our short book which a couple of years ago would have held mostly Treasury bonds is now mostly risk assets at the index level, comprising of equity index (think: S&P500, Russell 2000, and NASDAQ), credit index, and individual credit positions. There are still some duration hedges in place, but I don’t expect that to be the biggest source of risk going forward. We are decently net-long corporate bonds, net-long government securities (e.g. 6-month T-bills in Canada and the U.S.) and short 10-year Treasuries.
Bottom line: This is an excellent time to add value through active trading to protect capital, minimize drawdowns and create the foundation for above-average, long-term returns—and, most importantly, avoid disasters.