The Insight: Conversations – Walking into the Unknown with Howard Marks, David Rosenberg, and Aman Kumar

0:09Hello, and welcome to the Insight by Oaktree Capital. I'm Anna Schmansky, and today I'll be having conversations with three Oak Tree thought leaders, including co-chairman Howard Marks. We'll discuss topics from Oak Tree's recently published quarterly letter roundup. We'll consider what a normal credit market is, what a recession in 2024 might mean for liquid credit, and what opportunities we're seeing in life sciences today. So for my first discussion, my guest needs no introduction. Howard, thanks so much for joining me. It's a pleasure to be here with you, Anna. In your short piece in the latest Roundup, you ask investors to consider what's normal, and specifically in relation to financial markets and interest rates.

0:52Can you explain why you think it's so important for investors to question what people perceive as normal? You have to be working in this business more than 43 years before 1980 to have ever seen anything other than declining interest rates and ultra-low interest rates. So it's only natural to conclude that declining and ultra-low interest rates are normal, but maybe they're not. You have to understand history and understand where the current period fits into history and understand how it's different from normal and what it is that shaped those differences. And only if you look into these things can you make a great decision with regard to the actions to take.

1:39Now, it gets hard because how many people were working more than 43 years ago and still are? And how many of those still have their faculties and can remember the 70s and so forth? I came up with something a couple of weeks ago that I hope will help get this across. But, you know, Einstein said that the definition of insanity is doing the same thing over and over and expecting a different result. I think another version of insanity is doing something in a new environment and expecting the same result. So if the environment is fundamentally changed, and if in the coming years we will not have interest rates which are, A, consistently declining, and be as low as they were in the 09 to 21 period when the Fed funds rate averaged a half a percent, then maybe other things will work better than the things that worked in that period.

2:27I think this is significant. Why do you think it's so challenging for investors and people in general to reset their idea of normal? Well, if you made money doing one thing over the last 43 years, it's kind of hard to say, you know what, that's out the window. And that organization that I put together, I got to get rid of those people because I need a new skill set. And everything I ever told you is no longer true to the clients. This is complicated by our human nature, if that's the right term. But I've been making reference to a book, Mistakes Were Made But Not By Me, by Carol Tavris. And it's about cognitive dissonance and self-delusion.

3:10And you have a position. You've had it for a while. you're convinced it's right it has worked and now you get some information coming in which says no you have to change your position our brain is very good at getting rid of that information but if there are real changes we have to respond to them and the great economist Paul Samuelson once said when events change I changed my mind what do you do and I think in investing there's nothing that's permanent. You can't say always, never, can, can't, will, has to. You have to be open to possibilities as things change. I mean, I've seen a lot of changes in my life.

3:52If I stuck with what I believed in 1969, I'd be in big trouble today. We're recording this in December of 2023, and you've written four memos this year. They are lessons from Silicon Valley Bank, taking the temperature, fewer losers or more winners, and further thoughts on sea change. Looking over that year of memo writing, does anything jump out at you? Well, I mean, it's kind of a microcosm because you've got short-term market-type events, Silicon Valley. I thought it was important to respond to that, mainly to A, understand the nature and risks of the banking industry, but B, to make the case that it was not systemic and did not presage a lot of contagion.

4:35Fewer losers or more winners was at the opposite end of the spectrum is what I would consider a philosophy piece. There was no advice in there that would make anybody any money in the next year. But I think that in investing, it's extremely important to be thoughtful about what you do. How do you intend to reach success? How do you define success? What are the things you're going to have to do to reach it? You can't be a superior investor without having either fewer losers than the average or more winners than the average or both. Which one will you favor? Which one is more realistic for you? So I thought that was kind of foundational.

5:11Taking the temperature was a look back at history, also foundational, but explaining that on the one hand, our investment philosophy says we don't do macro forecasts. On the other hand, I did it five times in that period and I explained how. On the third hand, all absolute rules have to go out the window sometimes. But the point is, we did it on rare occasion. If you wait for the fat pitch till the market's crazy high or crazy low, you might be able to make contact with the ball and they worked. But I think it was really important to show people that it really did come from taking the temperature of the market and not from subject matter expertise with regard to, for example, subprime mortgages that I hadn't heard of.

5:52So I hope there was a good span of memos and that people enjoyed them. I think that's reflective of the last 34 years. And I guess further thoughts on sea change, just touching on obviously what you wrote at the end of last year. Yes, well, and that's an illustration of the fact that if you don't stop thinking, maybe you'll get some new ideas. So if you look at the memos over time, there's dare to be great one, dare to be great two. There's risk, risk revisited, and risk revisited again, and so forth. Nancy always says that all the memos are the same. But the truth is, there are only so many things to say.

6:24And my philosophy, I haven't ever counted it, but it probably has 10 or 15 key components. I can't make up new ones, and I can't stop revisiting the old ones, because I do think that they're key. I'll try to keep doing the same thing. As I said, we're recording this at the end of 2023, looking forward to 2024. What are some of the things you think investors should be monitoring as we move into the new year? Well, following on from my last answer, I don't think today's a fat pitch. The market is not crazy high and it's not crazy low. It seems a little high, not enough to make you take action. It's really important to notice that if I were to tell you, okay, Anna, stock market's 10 % overvalued, and you were to agree, that's not synonymous with going down tomorrow.

7:08And it doesn't mean you should sell because from 10 % overvalued is pretty close to fair value. And from 10 % overvalued, stocks can go up, go sideways, go down. Anything can happen. Now, the fact that it's 10 % overvalued means that there's a slightly greater tendency than usual for it to go down rather than up. But the point is not enough to take action on. I feel the same way about the economy. First of all, anybody who thinks they know what the arc of the economy in the near-term future is going to be is nutty because we're all confused and anybody's not confused doesn't understand what's going on.

7:41I didn't make that up. Somebody once said that. but it's not clear that the economy's going to boom. It's not clear that it's going to crater. So I don't think there's anything we have to do about the macro. Now, special mention to the Fed. Will the Fed have another rate increase? Will it pause? Will it start cutting rates in 24? When? How often? These things are really hard to say. The answer is different from three months ago. When people thought they had the right answer three months ago, it turned out it wasn't the right answer. What makes them think today's answer is the right answer? But the point is, we're in that middle zone, what I call the zone of reasonableness.

8:19The market is not too high or too low. The outlook for the economy is not convincingly positive or negative. Nothing smart to do today in those regards, except that given the change in interest rates and where they are and what the outlook is, and I think that when we do this two years from now, victory against inflation will have been declared, and the Fed funds rate will probably be about three and a half, maybe three. But that, I believe, is going to be the norm for the coming years. So you'll have some stability, but you won't have continuous declines. And that's important. That shapes the question of what strategies will do best.

9:01The other thing to note is still, you can potentially get equity-type returns from credit with less risk in better companies than used to be the borrowers, with less leveraged companies than used to be the borrowers. And these returns, whether they're approaching 10 for liquid credit or above 10 for private credit, these are fully competitive with equities, more than most people need, and they can be earned with greater safety than with equities. So I continue to think that the opportunity is compelling. Before we end, Do you have any other final thoughts? This has been another year like the last 54.

9:39You start the year. Sometimes you think you know what's going to happen. Sometimes you know you don't know what's going to happen. And usually it turns out that the time when you were wrong was when you thought you knew what was going to happen. We never really know what's going to happen. The great Peter Bernstein once said, essentially, we walk every day into the unknown. And it's much more profitable to acknowledge that we walk into the unknown than to have a very definite opinion of what's going to happen that heavily and take the chance of being wrong. So we will enter 24 knowing that we don't know what the future holds, but paying great attention to our individual investments.

10:18That's what we've done to date, and we think it's the way to success. Well, on that note, thank you so much for joining me. It's always a pleasure, and thank you, Anna.

10:31For our next conversation, we'll be discussing liquid credit markets, where we are today and where we might be going in the future. For this discussion, I'm thrilled to be joined by David Rosenberg, co-portfolio manager of Oak Tree's Global Credit, U.S. High Yield Bond, and Global High Yield Bond Strategies. David, thanks so much for joining me. Thanks for having me. In the liquid credit piece that appears in the recent roundup, You and your co-authors argue that if we do finally enter into a recession, below investment grade credit may not behave the same as it has in previous dislocations. So just to begin, can you explain what you mean by this?

11:11Yeah, so if you think about recession and what that means, usually recession is a surprise. Something really bad happens. There's either excess going on in a sector or maybe a commodity price moves in an unexpected direction, something that catches everybody flat-footed and everyone has to react and handle it. And often, frankly, a lot of the defaults are driven by the fact that people were planning to go and refinance and now the recession surprises everyone and shuts the market down and now they can't and they have to restructure. What I think is going to be different this go-around is the fact that this recession by no means is any form of a surprise.

11:48A strategist told me the other day, this is the most predicted recession in history. So everybody's talking about this potential recession, which means, by the way, that people are preparing for it. So if you think about portfolio managers like myself, I've been stress testing our portfolios for well over a year, saying, hey, if a recession hits, what do we think is going to happen? How are these credits going to make it through? Which means the odds of a panic selling from the investment community is much, much lower than you typically see because people are prepared. But it also means CEOs and CFOs have been stress testing their companies.

12:22So it's more common when you talk to them about earnings and guidance, you hear things about reducing advertising spend, cutting back on CapEx, redeploying that money into the balance sheet to shore up liquidity, to pay off near-term maturities. This is not behavior that usually results in really bad things. And so I think that the market is somewhat uniquely positioned to weather through the potential storm much better this go-around than we've seen in previous recessions. And also in 2020, we had the pandemic, which was obviously a surprise, and there was a little bit of a spike in default rates in both high yield bonds and leveraged loans.

13:03Do you think that might also impact what we see now? I think it's really important. So I tell people all the time is that you don't usually have a cleansing event before recession. Usually the recession is the cleansing event, but we had COVID. And so when COVID hit in a high yield market, you had around a 6 % default rate. In the loan market, you had around a 4 % default rate. All these companies, if COVID hadn't happened, would have stumbled along until the next recession, and then they would have defaulted. So you've had this pull forward of defaults, which I think really does impact the way the market reacts to this event.

13:34Because frankly, when people think recession, most people are thinking you're going to have at least one year of double digit defaults, if not two years back to back of double digit defaults. And I actually did go check in all previous recessions that that is true. You have at least one year of double digit defaults and that creates concern and fear and creates the way that things behave. But it's very different to have 10 % default rate in 2024, for example, versus having 5 % in 2024 and 5 % in 2020. That changes the way the market reacts to all this. So I think that the smoothing of the default impact is going to be a very big driver of how things behave this go-round.

14:11And what about recovery rates? How might they be different in this cycle? Well, that's very important. And I think that one will be to the negative, which is when you think about recovery, I think for bonds, recovery rates likely be very similar as they've been historically. And so for history, for us, if you recall, around 50 cents on the dollar, for the market, maybe a little bit lower on recoveries. But the story, which I think is going to be unique this go around, is going to be in the broadly syndicated loan market. In the loan market, recoveries have generally been very good. Call it north of 60 cents on the dollar because you have a first lien.

14:43And that first lien is supposed to matter when it comes to recovery. But the other thing that you have is in the old version, you think about leveraged buyouts, which is generally where the riskiest deals come in the markets. And your typical leveraged buyout years past would be you'd have some loans. Below those loans, you'd have some bonds. Below the bonds, you'd have some equity. And you'd take the company private. And the recovery from the loans in those scenarios was buffered by the fact that the loan did not see a dollar of loss until the bond below it was totally wiped out. So you have this cushion.

15:13Now, what we've seen is this shift of what we call loan-only capital structures are very clever in how we name things. And so loan-only capital structures, basically the private equity sponsors looking at the loan market. When the loan market moved to Covenant Light, which is another big driver of recoveries we'll talk about in a second. When the loan market moved to Covenant Light, private equity sponsors looked and said, well, if I can finance my leveraged buyout with just loans and I have no call protection on my loans, that gives me all this optionality. If I want to refinance my capital structure and pay myself a dividend, sell the company early, whatever it may be.

15:45And that's valuable. Optionality always occurs to the value of the equity. And so you started to see more and more leveraged buyouts finance with only loans. And I had this conversation with Howard Marks the other day where I said, well, what does it mean when you have a first lien in a structure where the whole structure is first lien? And he laughed and said, yeah, you're senior, but senior to what? Because if you're senior to the equity, what does that really mean? And I think that's what the market's going to have to realize this go around is that when you have a loan-only capital structure, the recovery should be no different than the bond in the previous years when there was a bond below you because there's nothing to cushion you.

16:16The other reality is with Covenant Light, back when you used to have covenants, you had the ability to pull the rug out early. If things were going wrong, the lenders were able to stop the music and say, I'm hoarding all this cash. You can no longer pay coupons to your bondholders or dividends to your equity holders because I'm hoarding all this cash for my recovery. And that was a very powerful tool to improve recoveries for loans. With Covenant Light, you can't do that. The lenders have to sit on their hands until eventually the company has a maturity or runs out of cash. And when that happens, that means that as all that time is playing out, more money is being paid out in coupons to bondholders, if there is bondholders or potentially the company.

16:53leaking to equity holders, and that dilutes your recovery. So the combination of those two, I think you're going to see a much lower recovery rate in the defaults that you do see in the loan market this go around. You've touched on a few really important trends. Another trend that we've obviously seen over the last decade has just been the dramatic growth in credit markets overall. What impact do you think this increase in scale could have on the opportunity set that credit investors see if there is a recession? Yeah, I think it has a big impact, and I think opportunity said is the right way to put it, Anna, which is I'm a performing credit guy.

17:25And so I go around the world talking to people about performing credit. And I get the question all the time, how can you talk about performing credit when you also have this other side of Oak Tree that's all excited about distressed credit? And the answer, quite frankly, is the market is so much bigger that we can all look at it from different angles, but yet be very happy, which is I'm very happy to look at a potential recession where you can say, hey, the default rate, it's around 2 % today. Could it go to 4 % for bonds, maybe 5 % for loans? Somewhere in that zip code seems reasonable. But the 30-year average default rate for bonds is four.

17:56So that's nothing dramatic, as we said. It's not the 10. So for me, I've got 96 % of the market that I think is going to perform, and there's a lot for me to do. For a distressed investor, that 4 % is a small sliver of a much larger pie. So there's plenty for them to look and do, and there's a target-rich environment for them as well. And so as the market grows, it allows us all to be a lot more thoughtful about how we want to deploy our capital. There's a lot more to pick from. So let's switch topics now a little bit. We are recording this in early December, and we recently saw a pretty meaningful rally in a number of asset classes, especially high-yield bonds.

18:35What would you say has been the primary cause of this, and how durable do you think this rally might be? Yeah, I'm always a pessimist or cynic. I like to say professional pessimist, but people call me cynic when it comes to these kind of things. But there has been a dramatic rally. And I think there's two things driving this rally. One is this concept of a no landing, as everybody's been talking about. It's funny, early in my career, soft landing, I always thought it meant no recession. Now soft landing means benign recession, so they've made up no landing, have no recession. So the market always has to have its terms.

19:06And so that no landing camp is getting louder and louder, that this might be the first time ever that the Fed in the U.S., for example, is fighting inflation to this degree without pushing the economy into recession. And I suppose there's a first time for everything, but I'm not a believer that this is going to be that case. But as the market thinks about that possibility, risk assets rally as everyone's looking for risk and ways to benefit from the fact that this may play out. The other part of the rally, I think, is driven by this narrative of a pivot. Everyone's waiting for rates to go back down.

19:37It's funny. I think over the last year, the most common question I've gotten from investors is, when's the Fed going to pivot? Talk about fundamentals, you talk about markets, all people want to talk about is, oh, that's all well and good, but when's the Fed going to pivot? And I joke and tell people, the Fed doesn't know when the Fed's going to pivot, so how am I supposed to know? But what I've really come around to tell people is, look, I can't tell you when the Fed's going to pivot, I can't tell you how the Fed's going to pivot, but I can tell you why. And I find it fascinating that the market is lost sight of why.

20:05Because the Fed doesn't pivot to prop up the stock market. As much as everybody wants that to be the mandate, it's not actually the mandate of the Fed. The Fed's supposed to prop up the economy and those aren't always the same thing. And so I tell people, the Fed will pivot when something bad happens, when there's a crisis. We have a global pandemic and the world is shutting down. They will aggressively pivot in order to keep things operating and keep the economy from shutting down. Which means, if you think about this narrative that's driving the rally in the market, the narrative is simply this.

20:34We're going to have a recession, but it's going to be benign. Nothing really serious to worry about, as we talked about defaults pick up, but not to any really scary levels. And in spite of this benign recession, we're going to see interest rates go down 100 basis points before halfway through the year 2024. And I understand why everyone wants that to be true. It would be amazing. Benign recession, 100 basis points drop in rates, all risk assets would rally. Debt would trade up, equities would trade up. We can all high five and talk about how smart we are and count all the money that we've made.

21:02It just doesn't make any sense because if we do truly go through what is a benign recession, there is no reason for interest rates to go down 100 basis points. Everything's fine. The recession was benign. And conversely, if you have 100 basis points drop in rates before we get to the summer of 24, then there was no soft landing. Something really bad happened. And so I think that's the part that the market is seizing on is the market's gone through this schizophrenia of the pivot is going to happen, the pivot is not going to happen. It is squarely back in the camp of the pivot is going to happen.

21:32And that is a big driver of the rally. But to me, part of what may make this rally sputter out or even go the other way is the reality that the Fed may very well not pivot. it. What I remind people is the goal of the Fed isn't to touch 2 % inflation, claim victory, and then bring rates back down, which, by the way, is inflationary. The goal of the Fed was to stay at 2 % inflation, which may require them to keep rates where they are for a little while. And if that happens, it's going to change the calculus of what risk people are willing to take. And I think that's what the market's going to need to absorb in 2024.

22:07So as we look to 2024, outside of interest rates, what's another risk or trend that you're monitoring closely? I monitor the consumer a lot. I think if you look at really what's been driving so much of the strength in the economy is the consumer's ability and willingness to just keep grinding ahead and spending money. And it's really been quite fascinating to me how resilient the consumer has been and its ability to spend money. That's the one thing I watch the most. My concern is, in reality, if you think about inflation and the need to fight inflation, you're effectively need people to stop spending money.

22:44People keep spending money on higher and higher price goods, you can have more inflation. And so you have central banks that want people to stop spending money. And as that focus continues and the consumer continues to fall under pressure, there is some risk. And we're seeing some cracks in the veneer already that may hint to the fact that we're getting to the end of this spending cycle. And if that's true, then you have to start to think about sectors that are very consumer dependent, discretionary spending dependent, specialty retail sectors, luxury goods sectors, automotive, things where discretionary spending is the key.

23:17And I think that if we find ourselves in a period where that spending just cannot maintain its pace, then those sectors are going to weaken. And that's something we watch very closely. So to end, do you have any final thoughts about what we've seen in 2023 or what we might see in 2024? The biggest theme, I think, of this year, and the thing that I think people are going to look back on a year or so from now and talk about how amazing it was, I'll steal the theme from Howard's C-Change memo, but really, you have the ability to buy debt with an equity-like prospective return. And I think we're going to look back at the end of 2024 and talk about how amazing that was, that you could buy debt with an equity-like return and the opportunity investors have going into 24 when you have a potential recession.