It’s hard to get really depressed until your dreams come true. Once your dreams come true and you realize you feel the same way you did before then you get a feeling of hopelessness.

Like travelers on the moving walkway, it was easy for businesspeople and investors to think they were doing a great job all on their own.  In particular, market participants got a lot of help in this period as they rode the 10-year-plus bull market, the longest in U.S. history.  Many disregarded the benefits that ensued from low interest rates.  But as one of the oldest investment adages says, we should never confuse brains with a bull market. 

I love Hayek’s word “malinvestment,” because of the validity of the idea behind it: in low-return times, investments are made that shouldn’t be made; buildings are built that shouldn’t be built; and risks are borne that shouldn’t be borne.  People with money feel they must put it to work, since cash yields little or nothing.  They drop their risk aversion and, as discussed below, compete spiritedly for lending or investing opportunities with higher potential returns.  The investment process becomes all about flexibility and aggressiveness, rather than thorough diligence, high standards, and appropriate risk aversion.

Providers of capital vie to be the one who gets the deal.  To compete for deals, the “winner” must be willing to accept low returns from possibly questionable projects and reduced safety, including weaker documentation.  For this reason, it’s often said that “the worst of loans are made at the best of times.” 

The availability of capital fluctuates radically.  Whereas in times of stringency, capital may not be available even to quality borrowers for valid purposes, in periods of easy money, capital typically becomes available to weaker borrowers, in large amounts, for almost any purpose.  Things that couldn’t be financed in tighter times are deemed acceptable.

But it must be noted that cheap leverage doesn’t make investments better; it merely amplifies the results.

This is one of the foremost reasons for the adage “never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average.”  Heavy leverage can render companies fragile and make it hard for them to get through the proverbial low spots in the stream. 

It’s common for people to conclude that the environment they’ve lived through for a while is “normal,” and that the future will entail more of the same.  For this reason, people who have gotten used to low interest rates may think rates will always be low and make decisions based on that assumption.  As a result, investor due diligence or corporate planning may assume that the cost of capital will remain low.  This can become a source of trouble if rates are higher when financing is actually sought. 

However, investors learned a lesson that has been repeated throughout financial history: catalysts for interest rate increases inevitably pop up, and thus perpetual prosperity and “the end of cycles” turn out to be nothing but wishful thinking.

Elevated risk taking, underestimating future financing costs, and increased use of leverage often lie behind investments that fail when tested in subsequent periods of stringency, bringing on the next crisis and perhaps the need for the next rescue. 

Cycles don’t have an obvious beginning and end.  The only requirement for something to correctly be considered a full cycle is that it must include four components: (1) a movement from a norm to a high, (2) a move away from that high back toward the norm, (3) a move from the norm to a corresponding low, and (4) a movement from that low back toward the norm.  Any of these can be labeled the start of a cycle, providing it goes on to include all four.

When money is easy, few people opt to sit out the dance, even though the adverse results described above can reasonably be anticipated. When faced with the choice between (a) maintaining high standards and missing deals and (b) making risky investments, most people will choose the latter.  Professional investment managers especially may fear the consequences of idiosyncratic behavior that’s bound to look wrong for a while. Abstaining demands uncommon strength when doing so means departing from herd behavior.

Finally, what will we see moving forward?  It now appears that sometime in 2024, the Fed will declare victory against inflation and begin to reduce the fed funds rate from today’s somewhat restrictive 5.25-5.50%.  The current “dot plot,” which summarizes the views of Fed officials, shows three 25-bps rate cuts in 2024, bringing the rate to 4.60%, and then more cuts in 2025, taking it to the mid-3s.  However, today’s consensus thinking among investors seems to be considerably more optimistic than that, anticipating more/earlier/bigger rate cuts. 

At present, I believe the consensus is as follows:

• Inflation is moving in the right direction and will soon reach the Fed’s target of roughly 2%.

• As a consequence, additional rate increases won’t be necessary.

• As a further consequence, we’ll have a soft landing marked by a minor recession or none at all.

• Thus, the Fed will be able to take rates back down.

• This will be good for the economy and the stock market.

Before going further, I want to note that, to me, these five bullet points smack of “Goldilocks thinking”: the economy won’t be hot enough to raise inflation or cold enough to bring on an economic slowdown.  I’ve seen Goldilocks thinking in play a few times over the course of my career, and it rarely holds for long.  Something usually fails to operate as hoped, and the economy moves away from perfection.  One important effect of Goldilocks thinking is that it creates high expectations among investors and thus room for potential disappointment (and losses). 

I don’t have an opinion as to whether the consensus described above is correct.  However, even granting that it is, I’ll still stick with my guess that rates will be around 2-4%, not 0-2%, over the next few years.  Do you want more specificity?  My guess – and that’s all it is – is that the fed funds rate will average between 3.0% and 3.5% over the next 5-10 years.  If you think I’m wrong, ask yourself whether you’d put your money on a different half-point range.  (Before readers protest my uncharacteristic descent into forecasting, I’ll point out that, at Oaktree, we say it’s okay to have opinions on the macro; it’s just not okay to bet clients’ money on them.  We invest with an awareness of current macro conditions, but our investment decisions are always based on bottom-up analysis of companies and securities, not macro forecasts.)