Oaktree Capital (OAK, Financial), the private equity firm co-founded by guru Howard Marks (Trades, Portfolio), just reported earnings. On its quarterly earnings call, held Oct. 25, the firm talked about market conditions.
Note that Marks just released a new book called "Mastering the Market Cycle." I read it and think it is very insightful as far as how to deal with the ebb and flows in capital markets. If I find the time, I’ll make sure to review it in depth.
But first let’s dive into Oaktree’s latest commentary on the market. I’ve put highlights from the earnings call transcript into quotations and will follow them up with charts and or my personal interpretation (any emphasis is also mine).
"So, where are we seeing opportunity in Oaktree? As Bruce Karsh mentioned last quarter, our bargain hunting has continued to uncover opportunities to put capital to work in non-US credit markets. Many emerging markets now exhibit the characteristics of late-cycle behavior, namely large and excessive debt loads after a period of easy money, GDP contractions, balance of payment problems, the loss of confidence in local currencies because fiscal deficits are perceived as no longer supportable, and in some cases inflationary price spikes."
The Bank of America Merrill Lynch Emerging Markets Corporate Plus Index tracks the performance of U.S. dollar and euro-denominated emerging markets non-sovereign debt issued in the U.S. and Eurobond markets. It hasn't been pretty this year and, as always, that's where Oaktree likes to look first.
"We also remain cognizant of the macroeconomic risks on the horizon in Europe with the threat of a global trade war, uncertainties in Italy, Brexit, and the near-term potential for a slowdown in economic growth. And were these conditions not tricky enough, central banks in developed market countries led by the Federal Reserve here in the U.S. are tightening monetary policy and reversing the quantitative easing programs, which in the past had supplied abundant liquidity to borrowers."
The highlighted part of Oaktree's commentary is the main reason we are experiencing very different market behavior compared to the years before. It started with a bout of volatility in February. Things calmed down but after the recent rate hike, and surprising hawkish stance by the Fed, markets are starting to realize this is a serious change.
Traders know that volatility begets volatility. Currently this may be even more true as volatility in line with historical levels is a break with recent history. No doubt some market participants have been exploiting the Fed, and these will now have to reconsider their strategy of buying any dips.
"And as far as your comment on central banks, that's one of the clear-cut headwinds in the market. You see it most directly impacting investment grade debt strategies which – that is not Oaktree's business. We haven't seen a lot of that carryover into the non-investment grade debt strategies. Question obviously is how far and how fast, and as we've spoken again about in the past, the amount of debt outstanding around the globe issued by corporations is essentially at record highs and so, higher rates as a general matter probably have an impact, but it's really a question of how far, how fast. So, we monitor that closely."
Oaktree pointed out that corporate debt (which it is one of the premier experts on) is at record highs. It is not the kind of firm to make firm predictions, but obviously if the Fed continues on its rate hike path (historically the path is rarely changed before several years have passed) there will be casualties. Low interest rates have allowed many weaker companies to survive. Instead of using this opportunity to reorganize, innovate or strenghten balance sheets, apparently corporate debt is at record highs.
"Having said all that, we remain concerned about a lot of things, not just the volatility in the equity markets. There's a lot of headwinds for us and, as I mentioned, the hardest thing is finding good investment opportunities. So, asset prices still remain pretty high, prospective returns pretty low, rates are going up as you mentioned, debt levels are very high, debt service costs are rising, and there's still a lot of complacency in our view in the market."
I agree its hard to find good investment opportunities. There are still many investments that are worth owning. I even have some wonderful investments, but five years ago it was much easier to buy really great values. Of course, you never know whether we are returning to an environment like that or we'll just have a very choppy or flat market for the next five years.
"Having said that, we continue to deploy capital, I want to emphasize that. In fact, our deployment in the quarter is up about 50% over the prior quarter and the prior quarter last year. We're finding a lot of opportunities outside of the United States. We continue to work our way through our existing roster of funds and that's why I mentioned a number of the funds that we're looking forward to raising the next generation next year. So, there are opportunities, but our mode is to be pretty patient, pretty disciplined and have a lot of dry powder and a lot of liquidity at Oaktree corporate to take advantage of opportunities going forward."
Even through Oaktree identifies plenty of risks and believes opportunities are generally poor, it continues to invest. Likely this is in part a hedge against being wrong. The firm is being extra careful and try to allocate intelligently. For example, it is buying outside of the U.S. Even though Oaktree built its foundation on cautious investing, it is currently extra careful with the credits it selects.
Disclosure: Author is long Oaktree.
