The Price of Success

Merkel Lands Fourth Term, But at What Cost?

By Philipp Wittrock 

German Chancellor Angela MerkelGerman Chancellor Angela Merkel

Angela Merkel will serve as Germany's chancellor for a fourth term, but Sunday's win comes at a high price. The right-wing populists are now the third-strongest party in parliament and her negotiations to create a new government are likely to be complicated.

Angela Merkel's election result four years ago was, to be sure, extraordinary. It was clear from the surveys that her conservatives wouldn't be able to repeat it. But a fall like this? Merkel's Christian Democratic Union (CDU) and its Bavarian sister party Christian Social Union (CSU) saw their joint result fall by more than eight percentage points -- their worst showing since 1949. During her first appearance after the election at her party's headquarters, the chancellor said she had, in fact, hoped for a somewhat better result. Those gathered at the headquarters dutifully chanted, "Angie, Angie."

Then things grew quiet again. Nobody waved the German flag. It was a far cry from 2013, when CDU politicians broke out into a spontaneous karaoke session after the results were announced. This time, the prominent members of Merkel's party who had gathered behind her on the stage seemed sobered by the tepid showing.

Merkel can keep her job as chancellor, the "strategic goal" has been achieved, as Merkel refers to it.

But it comes at a high price. Voters have severely punished the parties of the current governing coalition, with Merkel's conservatives losing dozens of seats in parliament. The right-wing populist Alternative for Germany (AfD) will now enter parliament with a strong, double-digit result. And it will be extremely difficult for Merkel to build a government coalition that will be stable for the next four years.

The AfD: There won't just be a sprinkling of renegades representing the AfD in parliament. The right-wing populists will be the third-largest party in the Bundestag and they have announced their intention to "chase down" the chancellor as one of the party's two leading candidates expressed it on Sunday. The election campaign already gave a taste of what might be coming, with AfD supporters loudly venting their hatred and anger at events held by Merkel's CDU.

Merkel, who isn't known for being the world's best public speaker, will now be confronted by them on a daily basis. And the conservatives will also have to ask themselves what share of the responsibility they carry for the AfD's success. What can they do to win back disappointed voters?

More than a million voters are believed to have flocked from the CDU and the CSU to the AfD. And most of them say that it was the chancellor's refugee policies that led them to vote for the right-wing competition.

It's little wonder, then, that Merkel has identified the enduring regulation of refugee flows and domestic security as the key topics for the coming years. She said on Sunday that she wants to win back voters from the AfD and described the party's move into the Bundestag as a "major new challenge."

The CSU: CSU head Horst Seehofer has a pretty clear opinion on how to succeed in diminishing the AfD's fortunes moving forward. He wants to use "clear positions" to close the "open right flank" of the CDU and CSU. But that pledge to shift the conservatives to the right could also create new fault lines between the CDU and CSU.

The CSU faces state elections in Bavaria in 2018 and support for the party collapsed on Sunday. Ahead of the election, the CSU and CDU had managed to put thin bandage on the issues that divide them -- such as the CSU demand for an upper ceiling on the number of refugees taken in by Germany. But those wounds are likely to reopen in the coming weeks.

Creating the next governing coalition: Social Democratic officials left no opportunity unused on Sunday night to declare that they are not interested in carrying on as Merkel's junior coalition partners. Mathematically, it would be possible for the parties to govern together, a visibly irritable Social Democratic chancellor candidate Martin Schulz said on Sunday. But politically it would not be.

A few CDU representatives, including Merkel herself during a television discussion between all lead candidates on Sunday evening, appealed somewhat half-heartedly to the Social Democrats' political responsibility to the state. But it appears that Merkel's sole path to a majority is a coalition with the Free Democrats (FDP) and the Greens.

At the same time, forging a government coalition comprised of four different parties -- the CDU, CSU, FDP and Greens -- will be no easy task. From refugee policies to climate protection and the common European currency, there are plenty of differences between the parties to discuss. Still, CDU leaders did express relief on election night that both the FDP and Greens had achieved solid results. That may make it easier for the two parties to accept the responsibility that comes with entering into government.

The successor debate: Who will succeed Merkel? Considering the weak result, this question is likely to arise even more quickly than previously anticipated. Merkel is likely to face a discussion within her party about its future direction -- and not just because of the CSU. Young and ambitious party leaders like Jens Spahn are also likely to ask what direction the party needs to take in order to bring it closer to the kind of election results it used to enjoy.

The evening that Angela Merkel secured her fourth term in the Chancellery could also mark the beginning of the debate over who will one day inherit the office from her.

Central banks are waking up to the threat of cryptocurrencies

There is growing anxiety about disruption to the payments system

by: Huw van Steenis

As cryptocurrencies grow, we should expect more central bankers to look to outlaw or crimp their use © Reuters

Few issues in central banking are more likely to provoke anxiety than the fear of losing control of one’s currency. The past few days have provided another perfect illustration of this point. On Monday the Chinese central bank banned initial coin offerings of bitcoin-type currencies, leading to a fall in the value of some cryptocurrencies of as much as 20 per cent.

Behind the scenes, there is growing uneasiness about how disruptive technology may be to the banking and payments system. Over the summer both the Basel Committee on Banking Supervision and the World Economic Forum put out lengthy papers on their concerns and the state of play.

So far, the big winners from new technology have been clients. Fintech innovators in banking appear to have been less disruptive than expected because they have largely failed to change the basis for competition in such a regulated industry, the WEF report argues. Instead, technology has led to a marked improvement in customer service and a sharp fall in the cost of payments.

But, beyond resilience to cyber attacks, there are three broad concerns.

First, will the banks, which they have spent so much time trying to make safe, be weakened by new entrants? Simply put, will banks be “Amazon-ed”? Bankers used to think regulation would make financial services less appealing for new entrants. But now the penny is dropping that non-bank rivals can target more profitable areas and skim the cream, leaving regulated banks less profitable.

Second, will banks become less important as more lending shifts beyond the regulatory perimeter? Since 2009, swaths of business have moved from banks to asset managers. More than $600bn has been raised to fund private debt, according to market data company Preqin. As a result, policymakers are spending more time analysing the non-bank sector. The growing dependence of banks on large technology firms to run their infrastructure is also giving policymakers pause for thought about who is systemically important.

Third, would central banks lose control of payments if privately issued bitcoin currencies were to take off? Issuing currencies is a lucrative business as central banks pocket the difference between the cost of issuing a coin or bank note and its face value.

Central banks also fear their ability to monitor the payment system would fall. Given the global fight against terrorism and organised crime, this is an acute concern. In an extreme scenario, central banks fear they may even lose control of the money supply.

Until recently, policymakers had not worried too much about cryptocurrencies — they provided few benefits as a currency, apart from to those simply trying to hide their tracks. They are not a “store of value”, as Monday’s move showed. They are not widely enough accepted to be a useful medium of exchange. And digital currencies have failed to be as secure as promoted — they have been successfully hacked several times in the past 12 months.

But as cryptocurrencies grow, we should expect more central bankers to look to outlaw or crimp their use. This will be most acute in markets that are worried about capital flight and organised crime. This will not stop speculators and enthusiasts, but will limit their potential to create the powerful network effects that would make them a useful parallel currency.

But perhaps these concerns should prompt central banks to make their own currencies more appealing. Clearly, more efficient protocols for electronic payments would help and there is much to learn from bitcoin technology. But more profoundly, this is another reason why the European Central Bank, Bank of Japan and others should look to exit their dangerous experiment of negative interest rates sooner than later.

The writer is global head of strategy at Schroders and a member of the World Economic Forum’s fintech group

How Much Does Trump Matter?

Joseph S. Nye
. Donald Trump in Springfield

CAMBRIDGE – The United States has never had a president like Donald Trump. With a narcissistic personality and a short attention span, and lacking experience in world affairs, he tends to project slogans rather than strategy in foreign policy. Some presidents, like Richard Nixon, had similar personal insecurities and social biases, but Nixon had a strategic view of foreign policy. Others, such as Lyndon Johnson, were highly egotistical, but also had great political skill in working with Congress and other leaders.
Will future historians look back at Trump’s presidency as a temporary aberration or a major turning point in America’s role in the world? Journalists tend to focus too heavily on leaders’ personalities, because it makes good copy. In contrast, social scientists tend to offer broad structural theories about economic growth and geographic location that make history seem inevitable.
I once wrote a book that tried to test the importance of leaders by examining important turning points in the creation a century ago of the “American era” and speculating about what might have happened had the president’s most plausible contender been in his place instead. Would structural forces have brought about the same era of US global leadership under different presidents?
At the beginning of the twentieth century, Theodore Roosevelt was an activist leader, but he affected mostly timing. Economic growth and geography were the powerful determinants. Woodrow Wilson broke with America’s hemispheric traditions by sending US forces to fight in Europe; but where Wilson made a bigger difference was in the moral tone of American exceptionalism in his justification of – and, counterproductively, his stubborn insistence on – all-or-nothing involvement in the League of Nations.
As for Franklin Roosevelt, it is at least debatable whether structural forces would have brought the US into World War II under a conservative isolationist. Clearly, FDR’s framing of the threat posed by Hitler, and his preparation for taking advantage of an event like Pearl Harbor, were crucial factors.
The post-1945 structural bipolarity of the US and the Soviet Union set the framework for the Cold War. But a Henry Wallace presidency (which would have occurred if FDR had not switched him for Harry Truman as vice president in 1944) might have changed the style of the US response. Similarly, a Robert Taft or Douglas MacArthur presidency might have disrupted the relatively smooth consolidation of the containment system over which Dwight Eisenhower presided.
At the end of the century, the structural forces of global economic change caused the erosion of the Soviet superpower, and Mikhail Gorbachev’s attempts at reform accelerated the Soviet Union’s collapse. However, Ronald Reagan’s defense buildup and negotiating savvy, along with George H.W. Bush’s skill in managing the end of the Cold War, were important to the final outcome.
Is there a plausible story in which, owing to different presidential leadership, America would not have achieved global primacy by the end of the twentieth century?
Perhaps if FDR had not been president and Germany had consolidated its power, the international system in the 1940s could have realized George Orwell’s vision of a conflict-prone multipolar world. Perhaps if Truman had not been president and Stalin had made major gains in Europe and the Middle East, the Soviet empire would have been stronger, and bipolarity might have persisted longer.
Perhaps if Eisenhower or Bush had not been president and a different leader had been less successful in avoiding war, the American ascendency would have been driven off track (as it was for a time by US intervention in Vietnam).
Given its economic size and favorable geography, structural forces would likely have produced some form of American primacy in the twentieth century. Nonetheless, leaders’ decisions strongly affected the timing and type of primacy. In that sense, even when structure explains a lot, leadership within the structure can make a difference. If history is a river whose course and flow are shaped by the large structural forces of climate and topography, human agents can be portrayed as ants clinging to a log swept along by the current, or as white-water rafters steering and avoiding rocks, occasionally overturning and sometimes succeeding.
So leadership matters, but how much? There will never be a definitive answer. Scholars who have tried to measure the effects of leadership in corporations or laboratory experiments have sometimes come up with numbers in the range of 10% or 15%, depending on the context. But these are highly structured situations where change is often linear. In unstructured situations, such as post-apartheid South Africa, the transformational leadership of Nelson Mandela made a huge difference.
American foreign policy is structured by institutions and a constitution, but external crises can create a context much more susceptible to leaders’ choices, for better or worse. If Al Gore had been declared president in 2000, the US probably would have gone to war in Afghanistan, but not in Iraq.
Because foreign-policy events are what social scientists call “path dependent,” relatively small choices by leaders, even in the range of 10-15% early on a path, can lead to major divergences in outcomes over time. As Robert Frost once put it, when two roads diverge in a wood, taking the one less traveled can sometimes make all the difference.
Finally, the risks created by the personality of a leader may not be symmetrical; they may make more of a difference for a mature power than for a rising power. Striking a rock or causing a war can sink the ship. If Trump avoids a major war, and if he is not re-elected, future scholars may look back at his presidency as a curious blip on the curve of American history. But those are big “ifs.”

China state groups enjoy profit revival amid commodity boom

Economists warn the temporary boom leaves structural problems unaddressed

by: Gabriel Wildau in Shanghái

China's buoyant property market has fuelled the country's unexpectedly strong economic growth this year and boosted construction activity © Reuters

Despite talk of a “zombie economy”, China’s state-owned enterprises have enjoyed a sharp rebound in profits this year, driven by resurgent commodity prices amid government-enforced capacity cuts.

But economists worry that the revival of groups that once relied on state-directed loans and subsidies for life-support despite persistent operating losses may be unsustainable, and threatens to breed complacency about the need to reform SOEs.

A buoyant property market has fuelled China’s unexpectedly strong economic growth this year and boosted construction activity. Heavy fiscal spending on infrastructure by Chinese local governments has likewise heightened demand for basic commodities such as coal and metals — sectors dominated by state groups.

Profits at industrial SOEs surged 42 per cent year on year in the first seven months of 2017, following a meagre 3 per cent gain for all of last year and a 21 per cent drop in 2015, according to government data. Meanwhile, among lossmaking industrial SOEs, the size of losses have declined by a quarter.

“The improvement in profits is striking, especially for upstream sectors,” said Xu Gao, chief economist at Everbright Securities in Beijing. “But this improvement reflects cyclical strength of the economy. The structural issues really haven’t been solved.”

Stronger demand has also combined with tighter supply amid state planners’ efforts to shutter excess production capacity, especially outdated factories that produce heavy pollution.

In a recent commentary, China’s official Xinhua news agency lauded the improved performance of SOEs and credited ongoing reform efforts.

“These changes not only prove that reforms are on the right track but also stiffens our determination to keep nibbling at the bone and wade into the deep water.”

But there are reasons to doubt that SOEs can maintain their strong performance. Growth of property prices and investment are slowing, indicating that construction demand will soon follow.

A top legislator warned last month that the economy was overly dependent on real estate, and big cities are tightening mortgage and purchase restrictions to control runaway prices.

Some analysts also worry that apparent success will weaken policymakers’ resolve to push ahead with politically sensitive efforts to shutter state factories, which can lead to job losses and lower tax revenues.

“I doubt the government will pre-emptively close SOEs. It’s difficult to define zombie enterprises, so if SOEs become profitable now — even if it’s just because of commodity prices — then incentives to shut them down will be much weaker,” said Shuang Ding, head of greater China economic research at Standard Chartered in Hong Kong.

But optimists say the early success of capacity and production cuts in raising prices and boosting SOE profits adds to momentum for reform. At a key policy meeting in July, President Xi Jinping said cutting SOE leverage was a top priority.

They also note that so far, capacity cuts and factory closures have not led to mass unemployment or social unrest.

Jianguang Shen, chief economist at Mizuho Securities Asia, credits the combination of a strong job market and fiscal subsidies to laid-off workers. He expects SOE reform efforts to accelerate following the Communist party’s five-yearly leadership transition next month.

“The top leadership has made it clear that financial vulnerabilities and debt accumulation is the biggest risk. I think they are at the stage where they believe it’s finally time to tackle this issue,” he said. “I think after the leadership change, next year will be the beginning of the deleveraging cycle.”

Yet Again?

By Howard Marks

Excerpted from the memo originally published here

There They Go Again . . . Again” of July 26 has generated the most response in the 28 years I’ve been writing memos, with comments coming from Oaktree clients, other readers, the print media and TV. I also understand my comments regarding digital currencies have been the subject of extensive – and critical – comments on social media, but my primitiveness in this regard has kept me from seeing them.

The responses and the time that has elapsed have given me the opportunity to listen, learn and think. Thus I’ve decided to share some of those reflections here.

Media Reaction

The cable news shows and blogposts delivered a wide range of reactions – both positive and negative. The best of the former came from a manager who, when asked on TV what he thought of the memo, said, “I’d like to photocopy it and sign it and send it out as my quarterly letter.” Love that guy.

I haven’t spent my time reveling in the praise, but rather thinking about those who took issue. (My son Andrew always reminds me about Warren Buffett’s prescription: “praise by name, criticize by category.” Thus no names.) Here’s some of what they said:

  1. “The story from Howard Marks is ‘it’s time to get out.’ ”

  1. “He’s right in the concept but wrong to execute right now.” 

  1. “The market is a little expensive, but you should continue to ride it until there are a couple of big down days.”

  1. “There are stocks that are past my sell points, and I’m letting them continue to burble higher.”

  1. “I appreciate Howard Marks’s message but I think now is no more a time to be cautious than at any other time. We should always invest as if the best is yet to come but the worst could be right around the corner. This means durable portfolios, hedges, cash reserves . . . etc. There is no better or worse time for any of these things that we can foresee in advance.”

I take issue with all these statements, especially the last, and I want to respond – not just in the sense of “dispute,” but rather to clarify where I stand. In doing so, I’ll incorporate some of what I said during my appearances on TV following the memo’s publication.

Numbers one and two are easy. As I explained on CNBC, there are two things I would never say when referring to the market: “get out” and “it’s time.” I’m not that smart, and I’m never that sure. The media like to hear people say “get in” or “get out,” but most of the time the correct action is somewhere in between. 

I told Bloomberg, “Investing is not black or white, in or out, risky or safe.” The key word is “calibrate.” The amount you have invested, your allocation of capital among the various possibilities, and the riskiness of the things you own all should be calibrated along a continuum that runs from aggressive to defensive. 

And as I told CNBC, what matters is “the level that securities are trading at and the emotion that is embodied in prices.” Investors’ actions should be governed by the relationship between each asset’s price and its intrinsic value. “It’s not what’s going on; it’s how it’s priced. . . . When we’re getting value cheap, we should be aggressive; when we’re getting value expensive, we should pull back.” 

Here’s how I summed up on Bloomberg: 

It’s all about investors’ willingness to take risk as opposed to insisting on safety. And when people are highly willing to take risk, and not concerned about safety, that’s when I get worried.

If it’s true, as I believe, that (a) the easy money in this cycle has been made, (b) the world is a risky place, and (c) securities are priced high, then people should probably be taking less risk today than they did three, five or seven years ago. Not “out,” but “less risk” and “more caution.”

And from my visit to CNBC:

All I’m saying is that prices are elevated; prospective returns are low; risks are high; people are engaging in risky behavior. Now nobody disagrees with any of the four of those, and if not, then it seems to me that this is a time for increased caution. . . . It’s maybe “in, but maybe a little less than you used to be in.” Or maybe “in as much as you used to be in, but with less-risky securities.”

Numbers three and four – arguing that it’s too early to sell even if the market is expensive or holdings are past their sell point – are interesting. They’re either (a) absolutely illogical or (b) signs of the investor error and lack of discipline that are typical in bull markets.

  • If the market is expensive, why wouldn’t you lighten up?

  • Why would you prefer to sell after a few big down days, rather than today? (What if the big down days are the start of a slide so big that you can’t get out at anything close to fair value? What if there’s a big down day followed by a big up day that gets you right back where you started? Does the process re-set? And is it three big down days in a row, or four?)

  • And if you continue to hold past your sell points, what does “sell point” mean?

Bottom line: I think these things translate into “I want to think of myself as disciplined and analytical, but even more I want to make sure I don’t miss out on further gains.” In other words, fear of missing out has taken over from value discipline, a development that is a sure sign of a bull market. 

The fifth and final comment – that one should exercise the same degree of care and risk aversion at all times – gives me a lot to talk about. In working on my new book, I divided the things an investor can do to achieve above average performance into two general categories:

  • selection: trying to hold more of the things that will do better and less of the things that will do worse, and

  • cycle adjustment: trying to have more risk exposure when markets rise and less when they fall.

Accepting that “there is no better or worse time” simply means giving up on the latter. Whereas Buffett tells us to “be fearful when others are greedy and greedy when others are fearful” – and he’s got a pretty good track record – this commentator seems to be saying we should be equally greedy (and equally fearful) all the time.

I feel strongly that it’s possible to improve investment results by adjusting your positioning to fit the market, and Oaktree was able to do so by turning highly cautious in 2005-06 and highly aggressive in 1990-91, 2001-02 and immediately after the Lehman bankruptcy filing in 2008. This was done on the basis of reasoned judgments concerning:

  • how markets have been acting,

  • the level of valuations,

  • the ease of executing risky financings,

  • the status of investor psychology and behavior,

  • the presence of greed versus fear, and

  • where the markets stand in their usual cycle.

Is this effort in conflict with the tenet of Oaktree’s investment philosophy that says macro-forecasting isn’t key to our investing? My answer is an emphatic “no.” Importantly, assessing these things only requires observations regarding the present, not a single forecast. 

As I say regularly, “We may not know where we’re going, but we sure as heck ought to know where we stand.” Observations regarding valuation and investor behavior can’t tell you what’ll happen tomorrow, but they say a lot about where we stand today, and thus about the odds that will govern the intermediate term. They can tell you whether to be more aggressive or more defensive; they just can’t be expected to always be correct, and certainly not correct right away.

The person who said “there is no better or worse time” was on TV with me, giving me a chance to push back. What he meant, he said, was that the vast majority of people lack the ability to discern where we stand in this regard, so they might as well not try. 

I agree that it’s hard. Up-and-down cycles are usually triggered by changes in fundamentals and pushed to their extremes by swings in emotion. Everyone is exposed to the same fundamental information and emotional influences, and if you respond to them in a typical fashion, your behavior will be typical: pro-cyclical and painfully wrong at the extremes. To do better – to succeed at being contrarian and anti-cyclical – you have to (a) have an understanding of cycles, which can be gained through either experience or studying history, and (b) be able to control your emotional reaction to external stimuli. Clearly this isn’t easy, and if average investors (i.e., the people who drive cycles to extremes) could do it, the extremes wouldn’t be as high and low as they are. But investors should still try. If they can’t be explicitly contrarian – doing the opposite at the extremes (which admittedly is hard) – how about just refusing to go along with the herd?

Here’s what I wrote with respect to the difficulty of doing this in “On the Couch” (January 2016):

I want to make it abundantly clear that when I call for caution in 2006-07, or active buying in late 2008, or renewed caution in 2012, or a somewhat more aggressive stance here in early 2016, I do it with considerable uncertainty. My conclusions are the result of my reasoning, applied with the benefit of my experience (and collaboration with my Oaktree colleagues), but I never consider them 100% likely to be correct, or even 80%. I think they’re right, of course, but I always make my recommendations with trepidation.

When widespread euphoria and optimism cause asset prices to meaningfully exceed intrinsic values and normal valuation metrics, at some point we must take note and increase caution. And yet, invariably, the market will continue to march upward for a while to even greater excesses, making us look wrong. This is an inescapable consequence of trying to know where we stand and take appropriate action. But it’s still worthwhile. Even though no one can ascertain when we’re at the exact top or bottom, a key to successful investing lies in selling – or lightening up – when we’re closer to the top, and buying – or, hopefully, loading up – when we’re closer to the bottom.

There’s been a lot of discussion regarding my comments on the FAANGs – Facebook, Amazon, Apple, Netflix and Google – and whether they’re a “sell.” Some of them are trading at p/e ratios that are just on the high side of average, while others, sporting triple-digit p/e’s, are clearly being valued more on hoped-for growth than on their current performance.

But whether these stocks should be sold, held or bought was never my concern. As I said on Bloomberg:

My point about the FAANGs was not that they are bad investments individually, or that they are overvalued. It was that the anointment of one group of super-stocks is indicative of a bull market. You can’t have a group treated like the FAANGs have been treated in a cautious, pessimistic, sober market. So that should not be read as a complaint about that group, but rather indicative [of the state of the market].

That’s everything I have to say on the subject.
Passive Investing

Passive investing can be thought of as a low-risk, low-cost and non-opinionated way to participate in “the market,” and that view is making it more and more popular. But I continue to think about the impact of passive investing on the market.

One of the most important things to always bear in mind is George Soros’s “theory of reflexivity,” which I paraphrase as saying that the efforts of investors to master the market affect the market they’re trying to master. In other words, how would golf be if the course played back: if the efforts of golfers to put their shot in the right place caused the right place to become the wrong place? That’s certainly the case with investing.

It’s tempting to think of the investment environment as an unchanging backdrop, that is, an independent variable. Then all you have to do is figure out the right course of action and take it. But what if the environment is a dependent variable? Does the behavior of investors alter the environment in which they work? Of course it does.

The early foundation for passive or index investing lay in the belief that the efforts of active investors cause stocks to be priced fairly, so that they offer a fair risk-adjusted return. This “efficiency” makes it hard for mispricings to exist and for investors to identify them. “The average investor does average before fees,” I was taught, “and thus below average after fees. You might as well throw darts.”

There’s less talk of dart-throwing these days, but much more money is being invested passively. If you want an index’s performance and believe active managers can’t deliver it (or beat it) after their high fees, why not just buy a little of every stock in the index? That way you’ll invest in the stocks in the index in proportion to their representation, which is presumed to be “right” since it is set by investors assessing their fundamentals. (Of course there’s a contradiction in this. Active managers have been judged to be unable to beat the market but competent to set appropriate market weightings for the passive investors to rely on. But why quibble?)

The trend toward passive investing has made great strides. Roughly 35% of all U.S. equity investing is estimated to be done on a passive basis today, leaving 65% for active management. However, Raj Mahajan of Goldman Sachs estimates that already a substantial majority of daily trading is originated by quantitative and systematic strategies including passive vehicles, quantitative/algorithmic funds and electronic market makers. In other words, just a fraction of trades have what Raj calls “originating decision makers” that are human beings making fundamental value judgments regarding companies and their stocks, and performing “price discovery” (that is, implementing their views of what something’s worth through discretionary purchases and sales). 

What percentage of assets has to be actively managed by investors driven by fundamentals and value for stocks to be priced “right,” market weightings to be reasonable and passive investing to be sensible? I don’t think there’s a way to know, but people say it can be as little as 20%. If that’s true, active, fundamentally driven investing will determine stock prices for a long time to come. But what if it takes more?

Passive investing is done in vehicles that make no judgments about the soundness of companies and the fairness of prices. More than $1 billion is flowing daily to “passive managers” (there’s an oxymoron for you) who buy regardless of price. I’ve always viewed index funds as “freeloaders” who make use of the consensus decisions of active investors for free. How comfortable can investors be these days, now that fewer and fewer active decisions are being made?

Certainly the process described above can introduce distortions. At the simplest level, if all equity capital flows into index funds for their dependability and low cost, then the stocks in the indices will be expensive relative to those outside them. That will create widespread opportunities for active managers to find bargains among the latter. Today, with the proliferation of ETFs and their emphasis on the scalable market leaders, the FAANGs are a good example of insiders that are flying high, at least partially on the strength of non-discretionary buying.

I’m not saying the passive investing process is faulty, just that it deserves more scrutiny than it’s getting today.
The State of the Market

There has been a lot of discussion about how elevated I think the market is. I’ve pushed back strongly against people who describe me as “super-bearish.” In short, as I wrote in the memo, I believe the market is “not a nonsensical bubble – just high and therefore risky.”

I wouldn’t use the word “bubble” to describe today’s general investment environment. It happens that our last two experiences were bubble-crash (1998-2002) and bubble-crash (2005-09). But that doesn’t mean every advance will become a bubble, or that by definition it will be followed by a crash.

  • Current psychology cannot be described as “euphoric” or “over-the-moon.” Most people seem to be aware of the uncertainties that are present and of the fact that the good times won’t roll on forever.

  • Since there hasn’t been an economic boom in this recovery, there doesn’t have to be a major bust.

  • Leverage at the banks is a fraction of the levels reached in 2007, and it was those levels that gave rise to the meltdowns we witnessed.

  • Importantly, sub-prime mortgages and sub-prime-based mortgage backed securities were the key ingredient whose failure directly caused the Global Financial Crisis, and I see no analog to them today, either in magnitude or degree of dubiousness.

It’s time for caution, as I wrote in the memo, not a full-scale exodus. There is absolutely no reason to expect a crash. There may be a painful correction, or in theory the markets could simply drift down to more reasonable levels – or stay flat as earnings increase – over a long period (although most of the time, as my partner Sheldon Stone says, “the air goes out of the balloon much faster than it went in”). 
Investing in a Low-Return World

A lot of the questions I’ve gotten on the memo are one form or another of “So what should I do?” Thus I’ve realized the memo was diagnostic but not sufficiently prescriptive. I should have spent more time on the subject of what behavior is right for the environment I think we’re in.

In the low-return world I described in the memo, the options are limited:

  1. Invest as you always have and expect your historic returns.

  1. Invest as you always have and settle for today’s low returns.

  1. Reduce risk to prepare for a correction and accept still-lower returns.

  1. Go to cash at a near-zero return and wait for a better environment.

  1. Increase risk in pursuit of higher returns.

  1. Put more into special niches and special investment managers.

It would be sheer folly to expect to earn traditional returns today from investing like you’ve done traditionally (#1). With the risk-free rate of interest near zero and the returns on all other investments scaled based on that, I dare say few if any asset classes will return in the next few years what they’ve delivered historically.

Thus one of the sensible courses of action is to invest as you did in the past but accept that returns will be lower. Sensible, but not highly satisfactory. No one wants to make less than they used to, and the return needs of institutions such as pension funds and endowments are little changed. Thus #2 is difficult.

If you believe what I said in the memo about the presence of risk today, you might want to opt for #3. In the future people may demand higher prospective returns or increased prospective risk compensation, and the way investments would provide them would be through a correction that lowers their prices. If you think a correction is coming, reducing your risk makes sense. But what if it takes years for it to arrive? Since Treasurys currently offer 1-2% and high yield bonds offer 5-6%, for example, fleeing to the safety of Treasurys would cost you about 4% per year. What if it takes years to be proved right?

Going to cash (#4) is the extreme example of risk reduction. Are you willing to accept a return of zero as the price for being assured of avoiding a possible correction? Most investors can’t or won’t voluntarily sign on for zero returns.

All the above leads to #5: increasing risk as the way to earn high returns in a low-return world. But if the presence of elevated risk in the environment truly means a correction lies ahead at some point, risk should be increased only with care. As I said in the memo, every investment decision can be implemented in high-risk or low-risk ways, and in risk-conscious or risk-oblivious ways. High risk does not assure higher returns. It means accepting greater uncertainty with the goal of higher returns and the possibility of substantially lower (or negative) returns. I’m convinced that at this juncture it should be done with great care, if at all.

And that leaves #6. “Special niches and special people,” if they can be identified, can deliver higher returns without proportionally more risk. That’s what “special” means to me, and it seems like the ideal solution. But it’s not easy. Pursuing this tack has to be based on the belief that (a) there are inefficient markets and (b) you or your managers have the exceptional skill needed to exploit them. Simply put, this can’t be done without risk, as one’s choice of market or manager can easily backfire.

As I mentioned above, none of these possibilities is attractive or a sure thing. But there are no others. What would I do? For me the answer lies in a combination of numbers 2, 3 and 6.

Expecting normal returns from normal activities (#1) is out in my book, as are settling for zero in cash (#4) and amping up risk in the hope of draws from the favorable part of the probability distribution (#5) (our current position in the elevated part of the cycle decreases the likelihood that outcomes will be favorable). 

Thus I would mostly do the things I always have done and accept that returns will be lower than they traditionally have been (#2). While doing the usual, I would increase the caution with which I do it (#3), even at the cost of a reduction in expected return. And I would emphasize “alpha markets” where hard work and skill might add to returns (#6), since there are no “beta markets” that offer generous returns today.

These things are all embodied in our implementation of the mantra that has guided Oaktree in recent years: “move forward, but with caution.” 

Since the U.S. economy continues to bump along, growing moderately, there’s no reason to expect a recession anytime soon. As a consequence, it’s inappropriate to bet that a correction of high prices and pro-risk behavior will occur in the immediate future (but also, of course, that it won’t). 

Thus Oaktree is investing today wherever good investment opportunities arise, and we’re not afraid to be fully invested where there are enough of them. But we are employing caution, and since we’re a firm that thinks of itself as always being cautious, that means more caution than usual. 

This posture has served us extremely well in recent years. Our underlying conservatism has given us the confidence needed to be largely fully invested, and this has permitted us to participate when the markets performed better than expected, as they did in 2016 and several of the last six years. Thus we’ll continue to follow our mantra, as we think it positions us well for the uncertain environment that lies ahead.