What was the most significant financial event of the last 40 years—the 1987 stock market crash, the 1989 S&L crisis, the collapse of Long-Term Capital Management in 1998, the Enron accounting scandal, the Great Financial Crisis of 2008 or the pandemic? According to Howard Marks, the world’s largest distressed debt investor, who posed the question at John Mauldin’s Strategic Investment Conference on May 1, it was none of the above.
Marks, the co-chairman of $164 billion Oaktree Capital Management, identified the persistent decline in interest rates starting in 1981—when the fed funds rate went from 20% to 0%—as the overriding driver of markets for four decades. This inexorable, multi-decade movement, in his view, was similar to being on a walkway in an airport where “everyone else is on the same moving walkway, so you don’t notice it.”
Marks told Mauldin he expects current interest costs “to remain roughly where they are,” but even that “changes everything in the investment world.” If the fed funds rate stays in the 2% to 4% band instead of the 0% to 2% range of the last decade, things will change more dramatically than we expect, he said.
That’s a dynamic that financial institutions are wrestling with this year. Following the aftermath of the financial crisis, near-zero interest rates had made it difficult for businesses to default or go bankrupt. Even marginal companies managed to survive.
Marks explained that between 2010 and 2019, the average default rate on high-yield bonds was 2%. “For the preceding 30 years, it was about 4%,” he continued.
Americans lulled into complacency by the airport walkway are now confronting a sharp reversal in financial conditions. As Jim Grant of Grant’s Interest Rate Observer notes, it was only three years ago, in 2020, that Fed Chairman Jay Powell argued that the central bank “needed to make up for a shortfall in inflation.” At least that mission was accomplished.
An Office Crisis?
At present, commercial real estate sits at the epicenter of the financial fear machine as Americans appear to be going everywhere but back to the office. The future of offices is now the subject of ongoing debate in numerous conversations, including Berkshire Hathaway’s recent annual meeting.
Optimists like Berkshire CEO Warren Buffett remarked that office buildings are not going away. His more skeptical vice chairman, 99-year-old Charlie Munger, who began his career in real estate, responded by saying that the owners might well be gone, however.
Munger is just one of several observers warning that office properties and property assets are likely to become an ongoing source of trouble. He recently told The Financial Times that while he doesn’t expect a replay of the financial crisis, “A lot of real estate isn’t so good anymore. There’s a lot of agony out there.”
One of the points that Marks and Munger make is that a lot of challenged businesses, not just offices, enjoyed extremely low-cost debt that needs to be refinanced in the next few years. This is also true in the opaque private equity space and the shadow banking system. It includes numerous private investors in the advisory business, for that matter.
As Grant says, it’s not just a problem for regional banks with commercial real estate loans. Interest rates depend on inflation and inflationary expectations, and a consensus is building that the 1.5% world of the last decade was an abnormality. Peter Boockvar, chief investment officer of Bleakley Financial Group, told attendees at Mauldin’s event that a 3% to 4% rate was more likely in the next decade. In early 2021, no company was factoring a 5.0% increase in interest rates into their five-year plans, Boockvar said.
Now higher cost structures arising from deglobalization are becoming a permanent part of the landscape. Boockvar pointed to the estimate of Taiwan Semiconductor’s CEO, who said it was probably five times more expensive to build the company’s new giant manufacturing facility in Arizona than on the Asian island, as an example.
Debt-dependent businesses—and governments—will have to allocate more capital to interest expense, and public markets are already reflecting this new circumstance. “The commercial real estate industry in dollars is about $20 trillion,” Boockvar said. “The public REIT part is only $1 trillion,” and public REITs, he added, already have fallen about 30% plus in value.
The remaining $19 trillion resides in private markets. “I do not believe that they have yet to acknowledge reality, with [the] Blackstone REIT being a perfect example of this new world we’re in,” Boockvar continued. “The private REIT market is more at risk here when it comes to real estate generally. Actually, some public REITs look pretty attractive after the big downdraft.”
That glass-half-full view of commercial real estate is shared by Rick Gable, the portfolio manager of a $3 billion REIT fund at MFS Investment Management. He compares today’s problem in office buildings to that of shopping malls a decade ago, when the online shopping phenomenon started to gain momentum.
Today, Gable estimates that 70% of shopping malls remain viable. The other 30% have their own issues—anchor tenants like Kmart often top the list. But most occupy decent real estate, often in suburban intersections, and the properties can be repurposed.
The "Fed Put" Exits
Another constant for the last 35 years has disappeared in the last year—and that’s the Federal Reserve Board’s tacit willingness to intervene in financial markets when stock prices swoon. This had provided an implicit floor for the equity market. It came to be called the “Fed put.”
Starting with the 1987 stock market crash, continuing through the Thai baht and Long-Term Capital Management crises in the 1990s and the housing crisis in 2008, market participants could rely on Fed Chairman Alan Greenspan and his successors riding to the rescue when equity prices started to tumble.
Based on the central bank’s behavior over the last 15 months, those days are over, said Charles Schwab & Co. chief investment strategist Liz Ann Sonders, in an interview with macro strategist Jim Bianco at Mauldin’s conference. She pointed to the stock market’s collapse last October and the Fed’s indifference to it as evidence that Jay Powell and his fellow Fed governors had other priorities. “The stock market was down 25% and there was no ‘Fed put,’ especially with inflation running hot,” Sonders said.
Bianco and Sonders agreed it was always possible that, in the event of a serious banking crisis or nasty recession, the Fed could revert to its old habits. But they also concurred that the central bank was unlikely to easily accede to the stock market’s wishes for relief in the same fashion it did in previous situations, like the 2013 taper tantrum or during 2018 when falling stock prices short-circuited efforts by Powell, then recently confirmed as chairman, to raise interest rates.
Asked by Bianco whether the Fed would change its 2% inflation target if the rate falls below 4% (which he expects by July), Sonders said it would not do so “explicitly.” She thinks inflation will continue to fall, “but getting to 2%, which is somewhat arbitrary, could take time.”
Bianco agreed. Powell “can’t change his target now” with inflation at 4% or 5% or “he would be completely discredited,” he maintained.
For her part, Sonders observed that, when it came to the disconnect between the Fed and the financial markets, which expects a reversal in monetary policy “in short order,” the Fed is likely to keep rates higher for longer than market participants are hoping.
“The Fed put has been put to bed given what we’ve seen,” she said. “Financial market weakness is not the Fed’s problem.” Structural systemic weakness would be a different story, she said.
When Bianco asked her about the strength of the labor market, Sonders said it might not be as strong as it appears. Sales of homes and autos are already experiencing recessions of their own, although the service sector is keeping the economy going.
In past slowdowns, lower-level workers were among the first to go. Sonders observed that this time, high-level executives are among the first to get pink slips.
A 40-year bull market in bonds became deeply imprinted on investors, corporate managers and policy makers and conditioned their behavior, Grant argues. The next set of problems “will be concentrated” on companies and people who borrow, he says.
What is normal depends on one’s reference point and moment in time. “The bond market is still looking over a cyclical valley,” Grant argues. America’s current set of problems were 20 years in the making and “they won’t be solved in six months.”