Memo from Howard Marks: Sea Change

Whilst the markets celebrated the last two US inflation prints in anticipation of a pause in rate hikes or even a more accommodative monetary policy, earlier this week, the Fed took another 50bps hike (though less than 75bps of the previous instances) and remarked that it will continue to ‘squeeze the economy in 2023’. As investors accept that higher interest rates are here to stay, a timely memo from the great Howard Marks landed in our inbox, reminding us about the effects of the declining interest rate environment we all enjoyed over the last few decades.

“What are the effects of declining interest rates?

• They accelerate the growth of the economy by making it cheaper for consumers to buy on credit and for companies to invest in facilities, equipment, and inventory.
• They provide a subsidy to borrowers (at the expense of lenders and savers). 
• They reduce businesses’ cost of capital and thus increase their profitability.
• They increase the fair value of assets.  (The theoretical value of an asset is defined as the discounted present value of its future cash flows.  The lower the discount rate, the higher the present value.)  Thus, as interest rates fall, valuation parameters such as p/e ratios and enterprise values rise, and cap rates on real estate decline.
• They reduce the prospective returns investors demand from investments they’re considering, thereby increasing the prices they’ll pay.  This can be seen most directly in the bond market – everyone knows it’s “rates down; prices up” – but it works throughout the investment world.
• By lifting asset prices, they create a “wealth effect” that makes people feel richer and thus more willing to spend.
• Finally, by simultaneously increasing asset values and reducing borrowing costs, they produce a bonanza for those who buy assets using leverage.

…Is it any wonder then that private equity and other levered strategies enjoyed great success over the last 40 years?

In a recent visit with clients, I came up with a bit of imagery to convey my view of the effect of the prolonged decline in interest rates: At some airports, there’s a moving walkway, and standing on it makes life easier for the weary traveller.  But if rather than stand still on it, you walk at your normal pace, you move ahead rapidly.  That’s because your rate of travel over the ground is the sum of the speed at which you’re walking plus the speed at which the walkway is moving.

That’s what I think happened to investors over the last 40 years.  They enjoyed the growth of the economy and the companies they invested in, as well as the resulting increase in the value of their ownership stakes.  But in addition, they were on a moving walkway, carried along by declining interest rates.  The results have been great, but I doubt many people fully understand where they came from.  It seems to me that a significant portion of all the money investors made over this period resulted from the tailwind generated by the massive drop in interest rates.  I consider it nearly impossible to overstate the influence of declining rates over the last four decades.”

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