Oaktree Capital's Howard Marks recently sent out his Chairman's memo. In it, Marks admits that he is a worrywart but does raise some legitimate concerns. He writes,
the rally in financial markets has outpaced the fundamentals.
With the recent sell-off, maybe the market finally concurs. While Marks fully agrees that the government's low interest rates have prevented the economy from spiraling into depression, he is very worried about when the time comes to raise rates.
In his letter, it is very evident that Marks is most worried about inflation. His memo is entitled, 'Tell Me I'm Wrong' and he notes that
Global considerations call for higher rates, but fighting domestic economic weakness relies on low rates. Resolving this dilemma won't be easy... or painless.
Marks offers his rationale for inflation:
Reduced faith in the dollar means it would take higher interest rates to attract non-US buyers to dollar investments. And, even domestically, (a) one of these days the government will stop holding rates down and (b) higher inflation would require rates to rise to compensate for the fact that the dollars with which debts are repaid will buy less. For all these reasons, I think investors must consider the prospect of higher inflation, dollar weakness and higher interest rates.
So, how do you play inflation in your portfolio? Marks offered numerous suggestions:
- Buy TIPS.
- Buy floating rate debt.
- Buy gold (but only at the "right" price, and what's that?). Many prominent hedge funds have piled onto this play over the past few months. John Paulson's hedge fund Paulson & Co has started a gold fund and David Einhorn's Greenlight Capital has stored physical gold, just to name a few.
- Buy real assets, such as commodities, oil and real estate (ditto). John Burbank's hedge fund Passport Capital had earlier presented the case for agriculture. Commodity price inflation was also one of the major talking points seen in the piece ten investment themes for 2010.
- Buy foreign currencies.
- Make investments denominated in foreign currencies. We saw this mentioned recently by Bank of America as its analysts recommended to increase international exposure in their overweight equities, underweight bonds report.
- Buy the securities of companies that will be able to pass on increased costs.
- Buy the securities of companies that own commodities, or that own assets denominated in foreign currencies. Market Strategist Don Coxe has been a proponent of commodities and agriculture for some time now and would definitely agree with this play as it is right along the lines of his recent commentary. Well known investor Jim Rogers has long been bullish on commodities as well.
- Buy the securities of companies that earn their profits outside the U.S. We've seen a lot of hedge funds and investors scoop up shares of multinational companies which plays right into this theme. Not to mention, many funds argue that these type of blue chip names with international exposure are cheap on valuation. A few of the top stocks held by hedge funds fit this mold.
- Hold cash (to invest once interest rates have risen).
- Sell long-term bonds (and possibly go short). Marks joins the ranks of prominent investors and gurus voicing their dislike for long-term treasuries. One of the original hedgies Michael Steinhardt himself has called treasuries foolish. Legendary investor and ex-Quantum fund manager Jim Rogers shares this sentiment and dislikes treasuries. Hedge fund legend Julian Robertson is betting on higher interest rates and is doing so via constant maturity swaps (CMS). We could go on, but the point is that many prominent hedge funds have been in this play for a while now.
He follows that up with some additional thoughts writing,
These are the actions that can profit from - or that provide the flexibility to adjust to increased inflation, a decline in the dollar, and increased interest rates, all of which are interconnected. The most important one is the last one: long-term bonds could suffer worst in an inflationary, higher-rate environment, especially given today's low starting yields.
Marks also brings up a very prudent point: Most people concerned about inflation dedicate 5-15% of their portfolio to inflation protection, when in reality they should be willing to devote 30-40% of their portfolio.
Embedded below is Howard Marks' letter in its entirety. The document has had problems displaying below for some people, so if it doesn't work download the .pdf here.
Tell Me Im Wrong 01-22-10
Interesting thoughts from Oaktree's Chairman. In addition to inflation, it's clear Marks is also very skeptical when it comes to consumer spending, as he thinks a shift needs to take place where Americans don't revert to their high debt, low savings ways of the past. Additionally, he is worried about commercial real estate and joins the throngs of fund managers and market strategists that believe there are serious problems afloat there.
Specifically, Marks singles out smaller banks that that have large exposure to these loans that have a higher probability of failing. Many hedge fund managers agree, as this is something we've seen in recent hedge fund short positions.
While many hedge fund managers and prominent investors are banking on inflation, keep in mind that PIMCO's Bill Gross was out betting on deflation back in October. Given the omnipotent debate, a long time ago we outlined broad investment scenarios for inflation versus deflation. It's quite clear though that Marks falls in the inflationary camp.