Howard Marks on Inflation

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: declining and/or ultra-low rates, as I wrote in Sea Change, the private equity industry enjoyed a great tailwind for much of its existence. This was particularly true of the period 2009-21, thirteen years in which the fed funds rate was zero most of the time and averaged about half a percent. Bottom line: private equity was born and existed through 2021 in an interest rate climate that was supportive of it in the extreme. Unsurprisingly, things went great. Investors concluded that private equity was a panacea; LP capital flowed in; and GPs were able to lever it up with freely available, low-cost debt capital, especially from direct lending after its arrival on the scene. The economic climate was supportive, featuring the longest recovery in U.S. history. A 10-year bull market made it easy for PE firms to sell their portfolio companies, as did the eagerness of new PE funds to deploy capital by buying companies from old PE funds. Returns lived up to expectations, as did distributions to LPs, and this enabled PE funds to continue attracting LP capital, perpetuating the “virtuous circle.” But early in 2022, the central banks decided to fight inflation by raising rates, and the fed funds rate (for example) went from zero to 5¼-5½%.

Treasury It must be acknowledged that every one of these things is desirable in itself and a logical result of tariffs. If only it were that easy. The problem is that in the real world, and especially in economics, there are second- and third-order consequences that must be considered. If there weren’t, economics would be dependable like the physical sciences, as in “if you do A, then B happens.” As theoretical physicist Richard Feynman said, “imagine how much harder physics would be if electrons had feelings.” Well, economies and markets are made up almost entirely of people, and people do have feelings, rendering reactions unpredictable. In economics, others will react to action A, as well as to result B that action A produces, and we have to think about the effect of those reactions. Not only are repercussions often significant, but they’re also unpredictable. Further, politics plays a particularly significant and unpredictable role in the matter at hand, with a calculus all its own. What are some of the likely consequences of Trump’s tariffs? The list is long, and many are particularly serious: • retaliation by other countries • price increases and rising inflation • destruction of demand due to price increases and declining consumer confidence • recession and lost jobs, both in the U.S.order

Note that in my March 2022 memo, The Pendulum in International Affairs, I observed that between 1995 and 2020, U.S. consumer durable prices declined by 40% in real terms and total inflation averaged only 1.8% per year. Consumer durables consist mostly of vehicles, appliances, and electronics, and a big percentage of these have been imported. What would inflation have been if low-cost imports were discouraged or precluded? But let’s assume the first three goals listed above are actually achieved, causing more of the goods purchased in the U.S. to be made in the U.S.: • First, in most cases, there isn’t sufficient manufacturing capacity that can be switched on. For example, I doubt there’s a factory in the U.S. capable of producing flat screens for TVs or computers. It would take years to build enough capacity to satisfy a meaningful percentage of U.S. demand, meaning in the interim there would be shortages and/or selling prices would likely be at the old levels plus the tariffs. • Second, the new factories designed to bring back manufacturing jobs would take years to permit and build, and the cost of construction would have to be justified by an expectation of profits many years out in the future. Are CEOs likely to commit to those investments based on tariffs that might be subject to renegotiation (or discontinuation when a new administration takes office)?

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Since most Americans have little income left over after paying for necessities, the result of higher prices is likely to be declining standards of living. That’s true unless wages rise as fast as prices, but in that unlikely case we’re talking about a dangerous inflationary spiral. Higher prices are likely to result in lower unit sales, and thus in declining profit margins. My favorite economist (there’s an oxymoron for you), Conrad DeQuadros of Brean Capital, considers corporate profit margins to be the best leading indicator of recessions. When margins come under pressure, corporations engage in layoffs and other forms of cost-cutting, often leading to economic downturns. And again, there’s the complexity of economic cause and effect. It’s widely reported these days (I have no idea how reliably) that when tariffs were imposed on imported steel in 2018, 1,000 jobs were saved in the U.S. steel industry. But 75,000 jobs were lost (or potential new employees weren’t hired) in U.S. steel-using industries. Similarly, as I wrote in the memo Economic Reality in May 2016: How will the interests of the 3.2 million Americans estimated to have lost their manufacturing jobs to China be balanced against the hundreds of millions who would have to pay considerably more for imported goods? Not an easy question. Economics is the science of choices and is fraught with trade-offs.

Morgan published a graph showing that if you bought the S&P 500 index at 23 times the coming year’s earnings per share in the period 1987-2014 (the only period for which there’s data on forward-looking p/e ratios and resulting ten-year returns), your average annual return over the subsequent ten years was between plus 2% and minus 2% every time. To the extent this p/e ratio history is relevant, it bodes pretty poorly for the S&P 500. • I concluded in my January memo that this was troublesome but not threatening, again mostly because the temporary mania or “irrational exuberance” that I believe accompanies – or gives rise to – most bubbles wasn’t present. That was then. What has happened since? The U.S. stock markets saw declines of up to 10% in the first quarter of this year, with the tech-heavy Nasdaq Composite falling the most. This was primarily the result of unspectacular economic and corporate performance, moderate but still higher-than-desired inflation, and possibly worries about valuation levels and whether the U.S. would retain its position as the world’s investment destination of choice. Then, on April 2, President Trump announced tariffs on imported goods that were much higher and much more sweeping than had been anticipated. Investors promptly concluded the tariffs were likely to cause inflation to accelerate, economic growth to slow, and the U.S. to be viewed less favorably by nations and investors around the world.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: not yet having materialized. In short, the tariff picture thus far is less bad than was feared at the time of the original announcements. It’s also possible that investors are encouraged by expectations of rising earnings; the tax and spending bill that was passed, with its favorable treatment of corporations; the pledges to invest in the U.S. that a number of foreign countries have made as part of trade deals; and even the potential of artificial intelligence to add to companies’ earning power. What can we say about the price/value calculus today? • The S&P 500 was highly valued at the end of 2024 and also just before the tariff announcement. • The economic possibilities – and likely multi-year earning power for companies – are probably less positive on balance than they were before the tariff announcement, albeit not as bad as initially feared. Rising inflation is still a concern. • The threat of higher inflation has reduced the likelihood of the early, stimulative interest rate cuts investors had hoped for. • The trade and tariff agreements the administration sought are being extracted, but the U.S. seems to be viewed around the world as a less-dependable ally and partner, and some investors may conclude they should be less heavily weighted toward U.S. assets. Implementation of this view could cause net selling and/or reduce the future demand for these assets. • The U.S.

As I asked in a memo in September, is it a good idea for nations to try to repeal or resist the laws of economics in an effort to make it otherwise? The Bottom Line I consider the tariff developments thus far to be what soccer fans call an “own goal” – a goal scored for the other side when a defender accidentally puts the ball into his own team’s net. In this way, they’re highly analogous to Brexit, and we know how that turned out. Brexit cost the British mightily in terms of GDP, morale, and alliances, and it harmed their reputation for governance and stability. All of this damage was self-inflicted. I like the way things have gone during my lifetime, which conveniently spans 99% of the post-war period I’ve been discussing. Some of our government expenditures have certainly been misspent, both at home and abroad, and our national debt is nothing to celebrate. But I’ve enjoyed living in a peaceful, prosperous, and increasingly healthy world, and I’m not eager to see that change. Just a couple of months ago, the U.S. economy was performing well, the outlook was positive, the stock market was at an all-time high, and there was much talk about American exceptionalism. Now, if Trump’s tariffs are put into effect, the U.S. economy is likely to experience a recession sooner than otherwise would have been the case, higher inflation, and extensive dislocation.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Exxon Mobil Johnson & Johnson Intel Qualcomm Citigroup Bristol-Myers Squibb IBM Pfizer Oracle AT&T Home Depot Verizon At the beginning of 2024, however, only six of them were still in the top twenty: Microsoft Johnson & Johnson Walmart Procter & Gamble Exxon Mobil Home Depot Importantly, of today’s Magnificent Seven, only Microsoft was in the top twenty 24 years ago. In bubbles, investors treat the leading companies – and pay for their stocks – as though the firms are sure to remain leaders for decades. Some do and some don’t, but change seems to be more the rule than persistence. Whole Markets The greatest bubbles usually originate in connection with innovations, mostly technological or financial, and they initially affect a small group of stocks. But sometimes they extend to whole markets, as the fervor for a bubble group spreads to everything. In the 1990s, the S&P 500 was borne aloft by (a) the continuing decline of interest rates from their inflation-fighting peak in the early 1980s and (b) the return of investor enthusiasm for stocks that had been lost in the traumatic ’70s. Technological innovation and the rapid earnings growth of the high-tech companies added to the excitement. And an upswing in the popularity of stocks was reinforced by new academic research showing there had never been a long period in which the S&P 500 failed to outperform bonds, cash, and inflation.

We already spend more on interest each year than on defense. And the interest bill will soar further if rates rise in the future – whether in response to inflation or deterioration of the U.S.’s creditworthiness – and maturing low-rate debt has to be replaced in a higher-rate environment. How long can we increase debt faster than GDP? No one can say when, but it makes sense to assume we’ll eventually reach a point at which our credit is no longer unlimited and our interest rates are no longer so low. As Warren Buffett said at the May 3 Berkshire Hathaway annual meeting: We’re operating at a fiscal deficit now that is unsustainable over a very long period of time. We don’t know whether that means two years or 20 years, because there’s never been a country like the United States. But you know, this is something that can’t go on forever . . . and it has the aspect to it that it gets uncontrollable at a certain point. Fixing this won’t be easy, as Buffett went on to say, because we’ve developed bad spending habits and leaders have pandered to voters by keeping taxes low. There are only two possible parts to the solution: curtail spending and/or expand revenues. No one wants to be taxed higher, and no one wants to see the programs they benefit from reduced. Because what’s required is austerity, all aspects of which are unpleasant, few people in Washington genuinely pursue a solution.

Or the threat of inflation might cause rates to stay higher, with cuts postponed. Note, however, that inflation-fighting measures such as higher rates are probably less likely to succeed against inflation caused by the addition of tariffs to selling prices than they would be against the more typical demand-driven inflation. Today’s title is particularly applicable to the Fed’s actions: certainly nobody knows. In Oaktree’s markets, fear of defaults (not unfounded) has caused risk compensation in the form of yield spreads to increase substantially, but a flight to the safety of U.S. Treasurys has caused Treasury prices to increase and thus Treasury yields to decline. The net result has been a fair-sized net increase in the available yields on credit. At the same time, we anticipate a higher incidence of distress and increased demand for bespoke capital solutions, meaning we’re likely to invest our latest opportunistic debt fund faster than otherwise would have been the case. To paraphrase Mark Twain, there are themes that rhyme throughout history. For that reason, just as I recycled the title of my post-Lehman bankruptcy memo for this one, I’ll also borrow its closing paragraph: Everyone was happy to buy 18-24-36 months ago, when the horizon was cloudless and asset prices were sky-high. Now, with heretofore unimaginable risks on the table and priced in, it’s appropriate to sniff around for bargains: the babies that are being thrown out with the bath water. We’re on the case.

Rather, I think it’s the average p/e ratio of 22 on the 493 non-Magnificent companies in the index – well above the mid-teens average historical p/e for the S&P 500 – that renders the index’s overall valuation so high and possibly worrisome. Why are asset prices so strong in the face of what I view as net negative developments? How can the S&P 500 have risen 14% in the four-plus months since April 1, the day before the tariffs were announced, given that most observers believe the tariffs will add to inflation, weigh on economic growth, and reduce the perception of the U.S. as the premiere investment destination? Here’s my explanation: • Investors are by nature optimistic. You must be an optimist to hand over your money to someone else in the hope of getting more back later. This is especially true of equity investors, and I think their optimism dies hard. • When they’re in an optimistic mood, investors have the ability to interpret ambiguous developments positively and overlook negatives. • The last sustained market correction ended in early 2009, meaning it’s been over 16 years since risk bearing was seriously punished and “buying the dips” wasn’t rewarded. That means no one under 35 or so – professional and amateur investors alike – has ever experienced a prolonged bear market. Older investors have experienced one or more, but, with the passage of such a long time, some may have been lulled into a false sense of security. • Although the U.S.

Federal Reserve cut the fed funds rate to zero to counter the effects of the Global Financial Crisis, to the end of 2021, when the Fed abandoned the idea that inflation was transitory and readied what turned out to be a rapid-fire succession of interest rate increases. The memo concentrated on the impact that this lengthy period of unusually low interest rates had on the economy, the financial markets, and investment outcomes. I followed this up with the memo Further Thoughts on Sea Change, which Oaktree released to clients in May 2023 and to the public in October. In the latter memo and subsequent conversations with clients, I’ve emphasized the significant impact of low interest rates on the behavior of participants in the economy and the markets. Easy Times In Sea Change, I likened the effect of low interest rates to the moving walkway at the airport. If you walk while on it, you move ahead faster than you would on solid ground. But you mustn’t attribute this rapid pace to your physical fitness and overlook the contribution from the walkway. In much the same way, declining and ultra-low interest rates had a huge but underrated influence on the period in question. They made it: • easy to run a business, with the stimulated economy growing unabated for more than a decade; • easy for investors to enjoy asset appreciation; © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

* * * There’s a great deal to be said about investors’ foibles, and I’ve shared much of it over the years. But the rapid market decline we saw in the first week of August – along with the rapid rebound – compels me to pull together what I’ve said previously on the subject, along with some priceless investing cartoons from my collection, and add a few new observations. To set the scene, let’s review recent events. As a result of the Covid-19 pandemic, soaring inflation, and the U.S. Federal Reserve’s rapid interest rate increases, 2022 was one of the worst years ever for the combination of stocks and bonds. Sentiment reached its low around the middle of 2022, with investors depressed by the universally negative outlook: “We have inflation, and that’s bad. And the rate increases to fight it are sure to bring on a recession, and that’s bad.” Investors could think of few positives. Then the mood lightened and, late in 2022, investors coalesced around a positive narrative: the slow economic growth would cause inflation to decline, and that would permit the Fed to start lowering rates in 2023, leading to economic vigor and market gains. A significant stock market rally began and continued nearly uninterrupted until this month. Although the rate cuts anticipated in 2022 and 2023 still haven’t materialized, optimism has been in the ascendency in the stock market. The S&P 500 stock index rose by 54% (not counting dividends) in the 21 months which ended on July 31, 2024.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: been right if only some unexpected event hadn’t transpired. But, in either case, the chance for the unexpected – and thus for forecasting error – was present. In the latter instance, the unexpected materialized, and in the former, it didn’t. But that doesn’t say anything about the likelihood of the unexpected taking place. Macro Economics In 2021, the U.S. Federal Reserve held the view that the bout of inflation then underway would prove “transitory,” which it has subsequently defined as meaning temporary, not entrenched, and likely to self- correct. I think the Fed might have been proved right, given enough time. Inflation might have retreated of its own accord in three or four years, after (a) the Covid-19 relief funds that caused the surge in consumer spending were spent down and (b) the global supply chain returned to its normal operations. (However, not slowing the economy would have brought the risk that inflationary psychology might take hold in those 3-4 years, necessitating even stronger action.) But because the Fed’s view wasn’t borne out in 2021 and waiting longer was untenable, the Fed was forced to embark on one of the fastest programs of interest rate increases in history, with profound implications. In mid-2022, there was near certainty that the Fed’s rate increases would precipitate a recession. It made sense that the dramatic increase in interest rates would shock the economy.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: reliable economic data regarding North Korea, but according to the CIA’s Worldbook, its GDP in purchasing power terms is estimated at $2,000 per person versus $50,000 in South Korea. North Korea’s citizens are described as impoverished, but at least it doesn’t have a border problem, since nobody’s trying to sneak in. There are political differences (democracy versus dictatorship) in addition to the economic ones, but I think it’s fair to say capitalism has won. In discussions of economic systems, I usually ask people what they think has been responsible for the economic preeminence the U.S. has enjoyed since the end of World War I, and thus for its citizens’ higher average standard of living. Are Americans smarter? Harder working? More deserving? None of the above. I’m confident it’s because of our historical embrace of the free-market system and capitalism. The incentives provided by free markets efficiently direct capital and other resources where they’ll be most productive. They prompt producers to make the goods people want most and workers to take the jobs where they’ll be most productive in terms of the value of their output. And they encourage hard work and risk taking. The result is a higher standard of living for society in general, but certainly not everyone benefits to the same degree.

The effects of low interest rates are multi-faceted and ubiquitous, yet frequently overlooked. I became more conscious of them as I read The Price of Time, and I want to catalog them here: i. Low interest rates stimulate the economy Everyone knows that when central banks want to stimulate their countries’ economies, they cut interest rates. Lower rates reduce costs for businesses and put money into the hands of consumers. For example, since most people buy cars on credit or lease them, lower interest rates make cars more affordable, increasing demand. The result is typically good for automakers, their suppliers, and their workers, and thus for the economy in general. It’s important to realize that easy money keeps the economy aloft, at least temporarily. But low interest rates can make the economy grow too fast, bringing on higher inflation and increasing the probability that rates will have to be raised to fight it, discouraging further economic activity. This oscillation of interest rates between extremes can have effects and encourage behavior that natural/neutral rates (see p. 13) would be less likely to induce. ii. Low interest rates reduce perceived opportunity costs Opportunity cost is a major consideration in most financial decisions. But in low-interest-rate environments, the rate earned on cash balances is minimal.

Further, history clearly showed that major central bank tightening has almost always led to economic contraction rather than a “soft landing.” And yet, no recession has materialized. Instead, late in 2022, the consensus among market observers shifted to the view that (a) inflation was easing, and this would permit the Fed to start cutting interest rates, and (b) rate cuts would enable the economy to avoid recession or ensure that any contraction would be mild and short-lived. This optimism ignited a stock market rally in late 2022 that persists today. And yet, the anticipated rate reductions in 2023 that undergirded the rally didn’t transpire. Then, in December 2023, when the “dot plot” of Fed officials’ views called for three interest rate cuts in 2024, the optimists driving the market doubled down, pricing in an expectation of six. Inflation’s stubbornness has precluded any rate cuts thus far, with 2024 more than half over. Now the consensus has coalesced around the idea of a first cut in September. And the stock market keeps hitting new highs. The optimists today would likely say, “We were right. Look at those gains!” But, regarding interest rate cuts, they were simply wrong. For me, all this does is serve as another reminder that we don’t know what’s going to happen or how markets will react to what does happen. Conrad DeQuadros of Brean Capital, my favorite economist (how’s that for an oxymoron?)

Thanks to the way incentives interact with people’s different abilities, some people do considerably better than others. Some also prosper thanks to good luck and/or inherited advantage, rather than innate ability. The free-market system doesn’t necessarily produce “fair” outcomes in all circumstances, but economic systems designed to do so generally don’t provide the incentives needed to encourage economic productivity for the collective good. That’s what accounts for their record of failure. On August 15, the media reported that the next day, Vice President Harris would announce her economic policies. The bulk of the attention went to her promise to ban price gouging in the grocery industry. “Grocery prices … have jumped 26 percent since 2019, according to Elizabeth Pancotti, director of special initiatives at the Roosevelt Institute, a left-leaning think tank” (The Washington Post, August 15), and many voters say inflation is their greatest concern. For this combination of reasons, Harris’s targeting of grocery prices is entirely predictable. (Ironically, August 15 was also the day U.S. inflation was reported to have fallen below 3% for the first time since March 2021.) I’m certain, however, that this falls under the heading of simplistic economic solutions that are designed to appeal to voters but are unsoundly based and likely to fail. What Is Price Gouging?

Price gouging is generally defined as sellers taking advantage of market power or temporary supply/demand imbalances to raise prices to levels that otherwise wouldn’t prevail. And food prices did rise significantly in 2021 and 2022, leading to suspicion of food retailers. But might there be reasons for the price increases other than a malevolent decision to gouge on the part of sellers? Here are a few possibilities: • When the pandemic began in March 2020, most people stayed home and cooked their own meals, significantly increasing the demand for groceries and depleting inventories. • The production system was disrupted, with inputs in short supply or in the wrong places relative to the needs. This led to the much-discussed “supply-chain problems.” Too few goods – when coupled with too much money chasing them – constitute the classic reason for inflation. • The federal government sent taxpayers massive amounts of Covid-19 relief. Many more people received benefits than had been hurt financially by the pandemic. Those people came out ahead, capturing trillions of dollars for future spending. © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

” Some Argentine loans paid as little as 5 percent – low in absolute terms or relative to their risk but still a couple of points above the measly yield on [consols, or perpetual British government debt] . . . (TPOT, emphasis added) When bond yields decline, bonds present less competition for riskier assets. Thus, low yields on bonds lead to lower demanded returns – and higher valuations – on other asset classes, such as equities, real estate, and private equity. For these reasons, low interest rates lead to asset inflation and sometimes asset bubbles like those we saw in late 2020 and throughout 2021. iv. Low interest rates encourage risk taking, leading to potentially unwise investments Low interest rates create a “low-return world” marked by paltry prospective returns on safe investments. At the same time, investors’ required returns or desired returns typically don’t decline (or they decline by much less), meaning investors face a shortfall. The ultra-low returns on safe assets cause some investors to take additional risks to access higher returns. Thus, these investors become what my late father-in-law called “handcuff volunteers” – they move further out on the risk curve not because they want to, but because they believe it’s the only way to achieve the returns they seek. In this way, capital moves out of low-return, safe assets and in the direction of riskier opportunities, resulting in strong demand for the latter and rising asset prices.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Another classic cartoon sums up this ambiguity in fewer words. It’s highly applicable to the market tremor that inspired this memo. One more source of miscalculation is investors’ tendency toward optimism and wishful thinking. Investors in general – and equity investors in particular – must, by definition, be optimists. Who other than people with positive expectations (and/or a strong desire for increased wealth) would be willing to part with money today based on the possibility of getting back more in the future? Charlie Munger, Warren Buffett’s late partner, routinely quoted the ancient Greek statesman Demosthenes, who said, “Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.” One great example is “Goldilocks thinking”: the belief that the economy will be neither strong enough to bring on inflation nor weak enough to lapse into recession. Things sometimes work out that way – as may be the case right now – but not nearly as often as investors posit. Expectations that incline toward the positive encourage aggressive behavior on the part of investors. And if this behavior is rewarded in good times, still more aggressiveness usually ensues. Rarely do investors realize that (a) there can be a limit to the run of good news or (b) an upswing can be so strong as to be excessive, rendering a downswing inevitable.

But if the government puts its thumb on the scale in favor of one party or the other, it distorts the workings of the free market and keeps it from functioning efficiently on behalf of society overall. More on this later. There are forms of seller behavior that are clearly wrong. These include collusion, price fixing, and predatory pricing designed to drive competitors out of the market. But laws prohibiting these behaviors are already on the books. Additional laws designed to prohibit and punish price increases that someone views as unfair, excessive or exorbitant – as opposed to being the result of improper conduct – are sure to prove difficult to enforce and counter-productive. Would a Law Against Price Gouging Work? Just as history is full of failed command economies, it also shows the ineffectiveness of attempts to regulate prices. In 1974, when the OPEC oil embargo set off inflation that made life difficult for millions, the U.S. government countered by distributing “WIN” buttons, standing for Whip Inflation Now. I still have mine, but neither it nor the voluntary consumer actions that were supposed to follow were enough to keep inflation from reaching 13.5% in 1980. The buttons were derided, with some skeptics wearing them upside down, according to Wikipedia. “Worn that way, ‘NIM’ stood for ‘No Immediate Miracles,’ ‘Nonstop Inflation Merry-go-round,’ or ‘Need Immediate Money.’ ’’ © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: There’s more recent experience with price controls, in Venezuela. Here’s what I said about it in Economic Reality: A case in point is the price controls, which have expanded to apply to more and more goods: food and vital medicines, yes, but also car batteries, essential medical services, deodorant, diapers, and, of course, toilet paper. The ostensible goal was to check inflation and keep goods affordable for the poor, but anyone with a basic grasp of economics could have foreseen the consequences: When prices are set below production costs, sellers can’t afford to keep the shelves stocked. Official prices are low, but it’s a mirage: The products have disappeared. (Atlantic Monthly, May 12, 2016, emphasis added) Here’s a shocker: you can set prices for goods, but you can’t make people produce them. That sounds a lot like economic reality. This is an example of the fact that officials may believe they can control economic developments with a stroke of the pen, but they’ll be thwarted by second-order consequences that complicate the effort. There’s nothing wrong with trying to bring down the cost of necessities. However, the best way to do this is to encourage additions to supply. Another way is to not overstimulate demand by injecting excessive liquidity into the economy. Mandating lower prices is generally the least effective way to get them.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Another component of Harris’s economic program is a plan to give first-time homebuyers $25,000 to help with down payments. Certainly, it’s hard these days for young people to come up with the cash needed to become homeowners. The problem here is that giving a million would-be buyers $25,000 each, or $25 billion in all, would almost certainly result in an immediate increase in home prices, eliminating much of the hoped-for benefit from the program. Easy: that can be prevented by passing a law that prohibits current sellers from raising home prices in response to enactment of the program. But what about homes that will come onto the market in the future? Simple: enact another law that says you can’t ask more for your home than you would have if the program didn’t exist. Try enforcing that one. • When he was president, Donald Trump enacted tariffs on goods from China to counter trade practices he considered unfair. Now, he promises a 10% across-the-board tariff on imports. Those tariffs might discourage imports, stimulate domestic production, and reduce the U.S.’s chronic trade deficit. But they’d likely be paid by consumers of imported goods, as manufacturers and exporters are unlikely to absorb a tariff if they can pass it on. For many years low-cost imports have held down inflation in the U.S. and enabled Americans to enjoy an attractive standard of living.

In this context, we should note what President Biden said at the Democratic National Convention in August: “I’m proud to have been the first president to walk a picket line and be labeled the most pro-union president in history.” Are employees per se more deserving of protection than employers? Without employers, where would people get jobs? Regardless, they do serve as convenient targets for politicians. • The rhetoric surrounding these matters is often alarmingly classist and divisive. Here’s part of a typical note I received from a candidate last month: “Even with inflation lowering [sic], food prices still seem sky-high. It’s another sign of corporate greed hurting . . . consumers. CEOs shouldn’t be lining their pockets with record profits while families struggle to put food on the table or pay for medications.” In this kind of environment, “profit” is a dirty word, and “greedy corporations” are ripe for suspicion and regulation. • Finally, elected officials have a habit of exempting themselves from impact. Thus, it’s interesting to observe that California’s minimum fast-food wage doesn’t apply to restaurants in government facilities. What official wants to suffer the wrath of an employee forced to pay more for lunch? One of the most important characteristics of the laws of economics is that they apply to everyone. On the other hand, attempts to negate those laws are usually designed to affect some parties differently from others.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Between 1990 and 2000, which I would consider the last roughly normal period for rates, the fed funds rate ranged from 3% to 8%, suggesting a median equal to today’s 5.25-5.50%. So no, today’s interest rates aren’t high. Having disposed of that question, I’ll move to the subject of this section: the outlook for rates. Many of my reasons for believing we’re not going back to ultra-low rates are rooted in my thoughts on how the Fed should think about the issue. But the Fed could decide to lower rates to stimulate economic growth or reduce the cost of servicing the national debt, even if doing so might be deemed imprudent. Thus, I have no idea what the Fed will do. But I’m sticking with the thinking that follows. In my original Sea Change memo, I listed a number of reasons why we weren’t likely to go back to ultra- low interest rates anytime soon. The most salient are these: • Globalization has been a strong disinflationary influence, and it’s likely on the decline. For this reason – and because the bargaining power of labor seems to be on the rise – I believe inflation may tend to be higher in the near future than it was pre-2021. If true, this will, all else being equal, mean interest rates will be kept higher to prevent inflation from accelerating. • Rather than be in a perpetually stimulative posture, the Fed may want to maintain the neutral rate most of the time.

This rate, which is neither stimulative nor restrictive, has most recently been estimated to be 2.5%. • The Fed might want to get out of the business of controlling rates and let supply and demand set the price of money, which hasn’t been the case for a quarter century. • Having had a taste of inflation for the first time in decades, the Fed might keep the fed funds rate high enough to avoid encouraging another bout. To control inflation, one would think the rate would need to be kept positive in real terms. If inflation will be, say, 2.5%, the fed funds rate would by definition have to be above that. • Perhaps most importantly, one of the Fed’s essential jobs is to enact stimulative monetary policy if the economy falls into recession, largely by cutting rates. It can’t do that effectively if the rate is already zero or 1%. To this list, I would add a few more reasons for not returning to ultra-low interest rates, including the tendency of easy money to (a) induce risk taking and “malinvestment”; (b) encourage increased use of leverage; (c) produce asset bubbles; and (d) create economic winners and losers. Finally, cutting rates to stimulative territory as soon as inflation hits 2% could cause it to reaccelerate. Instead, the plan should be to get inflation to 2% and then keep rates at a level that is neither stimulative nor restrictive.

(TPOT) Even though it cannot be known with certainty, it is useful to hold in mind how the world would look if the natural rate held sway; . . . a rate that accurately reflects society’s time preference; which ensures that we neither borrow too much nor save too little; which ensures capital is used efficiently, and puts an accurate value on land and other assets; a rate which provides savers with a fair return and is not so low as to subsidize bankers and their financial friends, nor so high as to bite borrowers. (TPOT) Or as the central bank head of Germany said in 1927, a time when his counterparts in the U.S. and Great Britain were arguing for easy money, “Don’t give me a low rate, give me a true rate, and then I shall know how to keep my house in order.” (TPOT) Natural rates seem to me to be related to but not quite the same thing as “neutral rates,” which are rates that are neither stimulative nor restrictive. Neutral rates are less likely than administered rates to be super-high or super-low, and thus less likely to encourage extreme behavior. As Swedish economist Knut Wicksell said in 1936: . . . if the rate of interest was too low, credit would expand rapidly, and inflation would appear. On the other hand, if the rate was kept too high, credit would contract and prices would decline.

(TPOT) In my view we haven’t had a free market in money since the late 1990s, when I believe the Fed became “activist,” eager to head off problems real and imagined by injecting liquidity. Given that activism, investors have become preoccupied with central bank actions and their consequences. For years, that’s all investors have talked about. If I ran the Fed (to be clear, I don’t expect to be offered the job), I think I would (a) lower rates to stimulate the economy when it’s growing too slowly to produce needed jobs; (b) raise rates to cool off the economy when it’s overheating, to head off rising inflation; and (c) keep my hands off rates the rest of time, allowing market forces to determine their level. Under this construct, we certainly wouldn’t see rates perpetually near zero, as we did much of the time from 2009 to 2021. (I estimate the fed funds rate averaged roughly 0.5% over that stretch). © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: 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. While on the subject of consensus thinking, I’ll point out the following: • Eighteen months ago, it was near-universally accepted that the Fed’s aggressive program of rate increases would result in a recession in 2023. That was wrong. • Twelve months ago, the optimists who launched the current stock market rally were motivated by their belief that the Fed would pivot to dovishness and start cutting rates in 2023. That was wrong. • Six months ago, there was a consensus that there would be one more rate increase in late 2023. That was wrong. I find it interesting that the current stock market rally began as a result of optimism powered by consensus thinking that was generally off target. (See the second bullet point just above.)

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). FT Unhedged recently expressed a similar view: Yesterday’s letter suggested that we think the market’s current expectation of solid growth and six rate cuts seemed likely to be wrong in one direction or the other: either strong growth will limit the Fed to close to the three rate cuts it currently forecasts, or growth will be weak and there will be as many cuts as the market expects. In this sense, the market does look to be pricing in too much good news.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: * * * The upshot of my sea change thesis is simple: 1. The period from 1980 through 2021 was generally one of declining and/or ultra-low interest rates. 2. This had profound ramifications in many areas, including determining which investment strategies would be the winners and losers. 3. That changed in 2022, when the Fed was forced to begin raising interest rates to combat inflation. 4. We’re unlikely to go back to such easy money conditions, other than temporarily in response to recessions. 5. Therefore, the investment environment in the coming years will feature higher interest rates than those we saw in 2009-21. Different strategies will outperform in the period ahead, and thus a different asset allocation is called for. Bullet points one through three above are statements of fact and not controvertible. Consequently, the conclusion – number five – depends exclusively on whether number four is correct. The question is simple: do you agree with it or don’t you? If you agree, we have a host of solutions to propose. January 9, 2024 © 2024 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Since that didn’t cause inflation to rise from its sub-2% level, the Fed felt comfortable maintaining accommodative policies – low interest rates and quantitative easing – for essentially all of the next 13 years. • As a result, we had the longest economic recovery on record – exceeding ten years – and “easy times” for businesses seeking to earn profits and secure financing. Even money-losing businesses had little trouble going public, obtaining loans, and avoiding default and bankruptcy. • The low interest rates that prevailed in 2009-21 made it a great time for asset owners – lower discount rates make future cash flows more valuable – and for borrowers. This in turn made asset owners complacent and potential buyers eager. And FOMO became most people’s main concern. The period was correspondingly challenging for bargain hunters and lenders. • The massive Covid-19 relief measures – combined with supply-chain snags – resulted in too much money chasing too few goods, the classic condition for rising inflation. • The higher inflation that arose in 2021 persisted into 2022, forcing the Fed to discontinue its accommodative stance. Thus, the Fed raised interest rates dramatically – its fastest tightening cycle in four decades – and ended QE. • For a number of reasons, ultra-low or declining interest rates are unlikely to be the norm in the decade ahead.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: investors – has, with relatively few exceptions, only seen interest rates that were either declining or ultra-low (or both). You have to have been working for more than 43 years, and thus be over 65, to have seen a prolonged period that was otherwise. And since market conditions made it tough to find employment in our industry in the 1970s, you probably had to get your first job in the 1960s (like me) to have seen interest rates that were either higher and stable or rising. I believe the scarcity of veterans from the ’70s has made it easy for people to conclude that the interest rate trends of 2009-21 were normal. The Relevance of History The 13-year period from the beginning of 2009 through the end of 2021 saw two rescues from financial crises, a generally favorable macro environment, aggressively accommodative central bank policies, a lack of inflation worries, ultra-low and declining interest rates, and generally uninterrupted investment gains. The question, of course, is whether investors should expect a continuation of those trends. • Recent events have shown that the risk of rising inflation can’t be ignored in perpetuity. Moreover, the reawakening of inflationary psychology will probably make central banks less likely to conclude that they can engage in continuous monetary stimulation without consequences.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: been made, and risks to be borne that otherwise wouldn’t have been accepted. There’s no doubt that this is true in general, and I’m convinced it accurately describes the period in question. Many articles about the problems at Silicon Valley Bank and First Republic Bank cite errors that were made in the preceding “easy-money” period. Rapid growth, unwise inducements to customers, and lax financial management were all encouraged in a climate with accommodative Fed policy, uniformly positive expectations, and low levels of risk aversion. This is just one example of a time-worn adage in action: “The worst of loans are made in the best of times.” I don’t think the Fed should return us to an environment that has been distorted to encourage universal optimism, belief in the existence of a Fed put, and thus a dearth of prudence. If the declining and/or ultra-low interest rates of the easy-money period aren’t going to be the rule in the years ahead, numerous consequences seem probable: • economic growth may be slower; • profit margins may erode; • default rates may head higher; • asset appreciation may not be as reliable; • the cost of borrowing won’t trend downward consistently (though interest rates raised to fight inflation likely will be permitted to recede somewhat once inflation eases); • investor psychology may not be as uniformly positive; and • businesses may not find it as easy to obtain financing.

However, when the Fed and Treasury flooded the economy with cash in 2020 and inflation began to rise in 2021, the one thing that should have been obvious was that there was no good reason to hold long-dated bonds at pitifully low yields, which presented profound risk and miniscule potential for return. Comparisons to the GFC SVB’s failure – along with the collapse of Signature Bank, the rescue of First Republic Bank, and Credit Suisse’s forced sale to UBS – roiled markets in March. This resulted from fear of bank failure contagion along the lines of what we saw during the Global Financial Crisis of 2007-08, when Bear Stearns, Merrill Lynch, Lehman Brothers, Wachovia Bank, Washington Mutual, and AIG either melted down or required rescues. There were times in that span, particularly in the last four months of 2008, when investors were forced to contemplate the possibility of an unstoppable series of failures that could have endangered the entire financial system. Nobody wants to face that again. © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

It had appeared in Businessweek on August 13, 1979, following years of raging inflation, dreary economic news, and poor stock market performance. In short, the article’s theme was that no one would ever invest in stocks again because they had done so badly for so long. Here are a few of the article’s observations: Whatever caused it, the institutionalization of inflation – along with structural changes in communications and psychology – have killed the U.S. equity market for millions of investors. . . . For investors . . . low stock prices remain a disincentive to buy. . . . For better or for worse, then, the U.S. economy probably has to regard the death of equities as a near-permanent condition – reversible some day, but not soon. . . . It would take a sustained bull market for a couple of years to attract broad-based investor interest and restore confidence. © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

If inflation isn’t brought under control, those nominal returns could lose significant value when they’re converted into real returns, which are what some investors care about most. Of course, real returns on other investments could suffer as well. Many people think of stocks and real estate as potentially providing inflation protection, but my recollection from the 1970s is that the protection typically takes hold only after prices have declined so as to provide higher prospective returns. • Finally, the sea change could end up being less long-lasting than I expect, meaning the Fed takes the fed funds rate back down to zero or 1% and the yields on credit recede accordingly. Fortunately, by buying multi-year credit instruments, an investor can tie up the promised return for a meaningful period (assuming the investment provides some degree of call protection). Reinvesting will have to be dealt with upon maturity or call, but once you’ve made the credit investments I’m suggesting, you will at least have secured the promised yield – perhaps minus losses on defaults – for the term of the instruments. * * * The overarching theme of my sea-change thinking is that, largely thanks to highly accommodative monetary policy, we went through unusually easy times in a number of important regards over a prolonged period, but that time is over.

There clearly isn’t much room for interest rate declines from today’s levels, and I don’t think short-term interest rates will be as low in the coming years as in the recent past. For these and other reasons, I believe the years ahead won’t be as easy. But while my expectations may prove correct, there’s no evidence yet on which I can hang my hat. Why not? My answer is that the economy and markets are in the early stages of a transition that’s far from complete. Asset prices are established through a tug-of-war between buyers who think prices will rise and sellers who think they’ll fall. There’s been an active one over the last year or so as sentiment has waxed and waned regarding the outlook for inflation, recession, corporate profits, geopolitics, and especially a Fed pivot back to accommodation. The tug-of-war is ongoing, and, as a result, the S&P 500 is within a half percent of where it was a year ago. I’ve been thinking lately about the fact that being an investor requires a person to be somewhat of an optimist. Investors have to believe things will work out and that their skill will enable them to wisely © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: position capital for the future. Equity investors have to be particularly optimistic, as they have to believe someone will come along who’ll buy their shares for more than they paid. My point here is that optimists surrender their optimism only grudgingly, and phenomena such as cognitive dissonance and self-delusion permit opinions to be held long after information to the contrary has arrived. This is among the reasons why they say of the stock market: “Things can take longer to happen than you thought they would, but then they happen faster than you thought they could.” Today’s sideways or “range-bound” market tells me investors possess a good amount of optimism despite the worries that have arisen. In the coming months, we’ll find out if the optimism was warranted. The positive forces that shaped the 2009-21 period began to change around 18 months ago. The higher inflation turned out not to be transitory. This brought on interest rate increases, concern that a recession would result, some resurrection of worry over the possibility of loss, and thus insistence on greater compensation for bearing risk. But while most people no longer see an outlook that’s flawless, few think it’s hopeless either. Just as optimism abetted a positive cycle in those 13 years, I believe a lessening of optimism will throw some sand into the financial gears in a variety of ways, some of which may be unforeseeable.

As a result, it seems inescapable that some financial institutions will reduce the amount of credit they make available, causing some borrowers to be left out. In particular, SVB’s failure could mean the startup world will have a tougher time getting financing in the months ahead. Regional and community banks are likely to undergo increased scrutiny and experience deposit flight as cash flows to money market funds and larger banks perceived to be safer. Their importance as the main financers of real estate makes it likely that the going will get tougher for property owners and developers, just as office buildings, brick-and-mortar retail, and perhaps even multifamily are coming under pressure in many regions. Combine developments like these with the reality that (a) interest rates are no longer declining or near zero; (b) the Fed can’t be as accommodative as it was in the last few crises, because of today’s elevated inflation; and (c) negative developments are popping up in portfolios, and I think the case made in my previous memo, Sea Change (December 2022), has been bolstered. The easy-money environment of the last few years has been blamed for – among other things – the difficulties at SVB and its peers. Their failure is likely to bring stricter scrutiny to banking, meaning things are unlikely to be as easy in the period ahead. And to paraphrase Warren Buffett, now that the tide has gone out a bit, we’ve caught a glimpse of some who were swimming naked near shore.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: The Illusion of Knowledge I’ve been expressing my disregard for forecasts for almost as long as I’ve been writing my memos, starting with The Value of Predictions, or Where’d All This Rain Come From in February 1993. Over the years since then, I’ve explained at length why I’m not interested in forecasts – a few of my favorite quotes echoing my disdain head the sections below – but I’ve never devoted a memo to explaining why making helpful macro forecasts is so difficult. So here it is. Food for Thought There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know. – John Kenneth Galbraith Shortly after putting the finishing touches on I Beg to Differ in July, I attended a lunch with a number of experienced investors, plus a few people from outside the investment industry. It wasn’t organized as a social occasion but rather an opportunity for those present to exchange views regarding the investment environment. At one point, the host posed a series of questions: What’s your expectation regarding inflation? Will there be a recession, and if so, how bad? How will the war in Ukraine end? What do you think is going to happen in Taiwan? What’s likely to be the impact of the 2022 and ’24 U.S. elections? I listened as a variety of opinions were expressed.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: What Really Matters? I’ve gathered a few ideas from several of my memos this year – plus some recent musings and conversations – to form the subject of this memo: what really matters or should matter for investors. I’ll start by examining a number of things that I think don’t matter. What Doesn’t Matter: Short-Term Events In The Illusion of Knowledge (September 2022), I railed against macro forecasting, which in our profession mostly concerns the next year or two. And in I Beg to Differ (July 2022), I discussed the questions I was asked most frequently at Oaktree’s June 21 conference in London: How bad will inflation get? How much will the Fed raise interest rates to fight it? Will those increases cause a recession? How bad and for how long? The bottom line, I told the attendees, was that these things all relate to the short term, and this is what I know about the short term: • Most investors can’t do a superior job of predicting short-term phenomena like these. • Thus, they shouldn’t put much stock in opinions on these subjects (theirs or those of others). • They’re unlikely to make major changes in their portfolios in response to these opinions. • The changes they do make are unlikely to be consistently right. • Thus, these aren’t the things that matter. Consider an example.

Bullish behavior came out of the pandemic-related bottom of March 2020; since then, significant problems have developed inside the economy (inflation) and outside (Ukraine); and there’s been a significant correction. No one, including me, knows what the sum of those things implies for the future. I’m writing only to place recent events in the context of history and point out a few implied lessons. This is important, because we have to go back 22 years – to before the bursting of the tech-media-telecom bubble in 2000 – to see what I consider a real bull market and the ending of the resultant bear market, and I imagine many of my readers entered the investment world too late to have experienced that event. You may ask, “What about the market gains that preceded the Global Financial Crisis of 2008-09 and the pandemic-related collapse of 2020?” In my view, in both cases, the preceding appreciation was gradual, not parabolic; it wasn’t driven by overheated psychology; and it didn’t take stock prices to crazy heights. Moreover, high stock prices weren’t the cause of either crisis. The excesses in the former lay in the housing market and the creation of securities backed by sub-prime mortgages, and the latter collapse was a consequence of the arrival of Covid-19 and the government’s decision to shut down the economy to limit the spread of the disease.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: this supply would be difficult at any time, but particularly so at this time of year, when people need to heat their homes. That means Russia’s biggest export – and largest source of hard currency ($20 billion a month is the figure I see) – is the hardest one to sanction, as doing so would cause serious hardship for our allies. Thus, the sanctions on Russia include an exception for sales of energy commodities. This greatly complicates the process of bringing economic and social pressure to bear on Vladimir Putin. In effect, we’re determined to influence Russia through sanctions . . . just not the potentially most effective one, because it would require substantial sacrifice in Europe. More on this later. The other subject I focused on, offshoring, is quite different from Europe’s energy dependence. One of the major trends impacting the U.S. economy over the last year or so – and a factor receiving much of the blame for today’s inflation – relates to our global supply chains, the weaknesses of which have recently been on display. Thus, many companies are seeking to shorten their supply lines and make them more dependable, primarily by bringing production back on shore. Over recent decades, as we all know, many industries moved a significant percentage of their production offshore – primarily to Asia – bringing down costs by utilizing cheaper labor.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: However, the most important aspect of this change didn’t relate to high yield bonds, or to private equity, but rather to the adoption of a new investor mentality. Now risk wasn’t necessarily avoided, but rather considered relative to return and hopefully borne intelligently. This new risk/return mindset was critical in the development of many new types of investment, such as distressed debt, mortgage backed securities, structured credit, and private lending. It’s no exaggeration to say today’s investment world bears almost no resemblance to that of 50 years ago. Young people joining the industry today would likely be shocked to learn that, back then, investors didn’t think in risk/return terms. Now that’s all we do. Ergo, a sea change. At roughly the same time, big changes were underway in the macroeconomic world. I think it all started with the OPEC oil embargo of 1973-74, which caused the price of a barrel of oil to jump from roughly $24 to almost $65 in less than a year. This spike raised the cost of many goods and ignited rapid inflation. Because the U.S. private sector in the 1970s was much more unionized than it is now and many collective bargaining agreements contained automatic cost-of-living adjustments, rising inflation triggered wage increases, which exacerbated inflation and led to yet more wage increases.

This seemingly unstoppable upward spiral kindled strong inflationary expectations, which in many cases became self- fulfilling, as is their nature. The year-over-year increase in the Consumer Price Index, which was 3.2% in 1972, rose to 11.0% by 1974, receded to the range of 6-9% for four years, and then rebounded to 11.4% in 1979 and 13.5% in 1980. There was great despair, as no relief was forthcoming from inflation-fighting tools ranging from WIN (“Whip Inflation Now”) buttons to price controls to a federal funds rate that reached 13% in 1974. It took the appointment of Paul Volcker as Fed chairman in 1979 and the determination he showed in raising the fed funds rate to 20% in 1980 to get inflation under control and extinguish inflationary psychology. As a result, inflation was back down to 3.2% by the end of 1983. Volcker’s success in bringing inflation under control allowed the Fed to reduce the fed funds rate to the high single digits and keep it there over the rest of the 1980s, before dropping it to the mid-single digits in the ’90s. His actions ushered in a declining-interest-rate environment that prevailed for four decades (much more on this in the section that follows). I consider this the second sea change I’ve seen in my career.

Investors can become expert regarding a few companies and their securities, but no one is likely to know enough about macro events to (a) be able to understand the macro expectations that underlie the prices of securities, (b) anticipate the broad events, and (c) predict how those securities will react. Where can a prospective buyer look to find out what the investors who set securities prices already anticipate in terms of inflation, GDP, or unemployment? Inferences regarding expectations can sometimes be drawn from asset prices, but the inferred levels often aren’t proved correct when the actual results come in. Further, in the short term, security prices are highly susceptible to random and exogenous events that can swamp the impact of fundamental events. Macro events and the ups and downs of companies’ near- term fortunes are unpredictable and not necessarily indicative of – or relevant to – companies’ long-term prospects. So little attention should be paid to them. For example, companies often deliberately reduce current earnings by investing in the future of their businesses; thus, low reported earnings can imply high future earnings, not continued low earnings. To know the difference, you have to have an in-depth understanding of the company. No one should be fooled into thinking security pricing is a dependable process that accurately follows a set of rules.

If you want to know how tall to build a levee, look at the last 100 years of flood data and assume the next 100 years will be the same. Stationarity is a wonderful, science-based concept that works right up until the moment it doesn’t. It’s a major driver of what matters in economics and politics. [But in our world,] “Things that have never happened before happen all the time,” says Stanford professor Scott Sagan. Cromwell’s rule: Never say something cannot occur . . . . If something has a one-in-a- billion chance of being true, and you interact with billions of things during your lifetime, you are nearly assured to experience some astounding surprises, and should always leave open the possibility of the unthinkable coming true. Stationarity might be fairly assumed in the realm of the physical sciences. For example, thanks to the law of universal gravitation, under given atmospheric conditions, the speed at which an object falls can always be counted on to accelerate at the same rate. It always has, and it always will. But few processes can be counted on to be stationary in our world, especially given the role played by psychology, emotion, and human behavior, and their propensity to vary over time. Take, for example, the relationship between unemployment and inflation.

For roughly the last 60 years, economists relied on the Phillips curve, which holds that wage inflation will rise as the unemployment rate declines, because when there are fewer idle workers on the sidelines, employees gain bargaining power and can successfully negotiate for higher wages. It was also believed for decades that an unemployment rate around 5.5% indicated “full employment.” But unemployment fell below 5.5% in March 2015 (and reached a 50-year low of 3.5% in September 2019), yet there was no significant increase in inflation (in wages or otherwise) until 2021. So the Phillips curve described an important relationship that was built into economic models for decades but, seemingly, didn’t apply over much of the last decade. Cromwell’s rule is also relevant. Unlike in the physical sciences, in markets and economies there’s very little that absolutely has to happen or definitely can’t happen. Thus, in my book Mastering the Market Cycle, I listed seven terms that investors should purge from their vocabularies: “never,” “always,” “forever,” “can’t,” “won’t,” “will,” and “has to.” But if it’s true that those words have to be discarded, then so too must the idea that one can build a model that can dependably predict the macro future. In other words, very little is immutable in our world. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Here’s what Niall Ferguson wrote in Bloomberg Opinion on July 17: Consider for a moment what we are implicitly asking when we pose the question: Has inflation peaked? We are not only asking about the supply of and demand for 94,000 different commodities, manufactures and services. We are also asking about the future path of interest rates set by the Fed, which – despite the much-vaunted policy of “forward guidance” – is far from certain. We are asking about how long the strength of the dollar will be sustained, as it is currently holding down the price of U.S. imports. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: But there’s more. We are at the same time implicitly asking how long the war in Ukraine will last, as the disruption caused since February by the Russian invasion has significantly exacerbated energy and food price inflation. We are asking whether oil- producing countries such as Saudi Arabia will respond to pleas from Western governments to pump more crude. . . . We should probably also ask ourselves what the impact on Western labor markets will be of the latest Covid omicron sub-variant, BA.5. UK data indicate that BA.5 is 35% more transmissible than its predecessor BA.2, which in turn was over 20% more transmissible than the original omicron. Good luck adding all those variables to your model. It is in fact just as impossible to be sure about the future path of inflation as it is to be sure about the future path of the war in Ukraine and the future path of the Covid pandemic. I found Ferguson’s article so relevant to the subject of this memo that I’m including a link to it here. It makes a lot of important points, although I beg to differ in one regard. Ferguson says above, “It is in fact just as impossible to be sure about the future path of inflation as it is to be sure about the future path of the war in Ukraine and the future path of the Covid pandemic.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: poor labor conditions that wouldn’t be tolerated in the U.S. The result was more jobs for non-U.S. workers, economic growth for the countries where the manufacturing was done, increased competitiveness for U.S. importers, and bargain-priced goods for American consumers. In addition, offshoring undoubtedly contributed substantially to the low level of inflation experienced in the U.S. over the last 40 years. One popular gauge of inflation, the Personal Consumption Expenditures (PCE) deflator, rose by only 1.8% per year from 1995 (importantly, the blast- off point for Chinese exports to the U.S.) through 2020. Inflation was considered tame at that level, and, in fact, many in business and government wished it were a bit higher. But a look inside the numbers is instructive: Personal Consumption Expenditures Annual Inflation Share of PCE All 1.8% Non-Durables 1.6 25-30% Durables (2.0) 10-15 Services 2.6 55-60 Source: Federal Reserve Bank of St. Louis FRED database; AmosWEB It’s startling to note that the prices of durables fell by almost 40% over the 25 years in question. The availability of ever-cheaper goods like cars, appliances and furniture produced abroad was a major contributor to the benign U.S. inflation picture in this quarter-century. Likewise, although prices of non- durables didn’t actually come down, cheap imports of items like clothing helped keep the lid on prices overall.

” I think accurately predicting inflation is “more impossible” (if there is such a thing) than predicting the outcomes of the other two, since doing so requires being right about both of those outcomes and a thousand other things. How can anyone possibly get all these things right? Here’s my rough description of the forecasting process from The Value of Predictions: I imagine that for most money managers, the process goes like this: “I predict the economy will do A. If A happens, interest rates should do B. With interest rates of B, the stock market should do C. Under that environment, the best performing sector should be D, and stock E should rise the most.” The portfolio expected to do best under that scenario is then assembled. But how likely is E anyway? Remember that E is conditioned on A, B, C and D. Being right two-thirds of the time would be a great accomplishment in the world of forecasting. But if each of the five predictions has a 67% chance of being right, then there is a 13% probability that all five will be correct and that the stock will perform as expected. Predicting event E on the basis of assumptions concerning A, B, C and D is what I call single- scenario forecasting. In other words, if what was assumed regarding A, B, C or D turns out to have been erroneous, the forecasted outcome for E is unlikely to materialize. All of the underlying forecasts have to be right in order for E to turn out as predicted, and that’s highly improbable.

2009 to 2021 Fed behavior Highly stimulative Inflation Dormant Economic outlook Positive Likelihood of distress Minimal Mood Optimistic Buyers Eager Holders Complacent Key worry FOMO Risk aversion Absent Credit window Wide open Financing Plentiful Interest rates Lowest ever Yield spreads Modest Prospective returns Lowest ever The overall period from 2009 through 2021 (with the exception of a few months in 2020) was one in which optimism prevailed among investors and worry was minimal. Low inflation allowed central bankers to maintain generous monetary policies. These were golden times for corporations and asset © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Most importantly, inflation began to rear its head in early 2021, when our emergence from isolation permitted too much money (savings amassed by people shut in at home, including distributions from massive Covid-19 relief programs) to chase too few goods and services (with supply hampered by the uneven restart of manufacturing and transportation). Because the Fed deemed the inflation “transitory,” it continued its policies of low interest rates and quantitative easing, keeping money loose. These policies further stimulated demand (especially for homes) at a time when it didn’t need stimulating. Inflation worsened as 2021 wore on, and late in the year, the Fed acknowledged that it wasn’t likely to be short-lived. Thus, the Fed started reducing its purchases of bonds in November and began raising interest rates in March 2022, kicking off one of the quickest rate-hiking cycles on record. The stock market, which had ignored inflation and rising interest rates for most of 2021, began to fall around year-end. From there, events followed a predictable course. As I wrote in the memo On the Couch (January 2016), whereas events in the real world fluctuate between “pretty good” and “not so hot,” investor sentiment often careens from “flawless” to “hopeless” as events that were previously viewed as benign come to be interpreted as catastrophic. • Higher interest rates led to higher demanded returns.

Thus, stocks that had seemed fairly valued when interest rates were minimal fell to lower p/e ratios that were commensurate with higher rates. • Likewise, the massive increase in interest rates had its usual depressing effect on bond prices. • Falling stock and bond prices caused FOMO to dry up and fear of loss to replace it. • The markets’ decline gathered steam, and the things that had done best in 2020 and 2021 (tech, software, SPACs, and cryptocurrency) now did the worst, further dampening psychology. • Exogenous events have the ability to undercut the market’s mood, especially in tougher times, and in 2022 the biggest such event was Russia’s invasion of Ukraine. • The Ukraine conflict reduced supplies of grain and oil & gas, adding to inflationary pressures. • Since the tighter monetary policies were designed to slow the economy, investors focused on the difficulty the Fed would likely have achieving a soft landing, and thus the strong likelihood of a recession. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Here’s how the change in the environment looks to me: 2009 to 2021 Today Fed behavior Highly stimulative Tightening Inflation Dormant 40-year high Economic outlook Positive Recession likely Likelihood of distress Minimal Rising Mood Optimistic Guarded Buyers Eager Hesitant Holders Complacent Uncertain Key worry FOMO Investment losses Risk aversion Absent Rising Credit window Wide open Constricted Financing Plentiful Scarce Interest rates Lowest ever More normal Yield spreads Modest Normal Prospective returns Lowest ever More than ample If the right-hand column accurately describes the new environment, as I believe it does, then we’re witnessing a complete reversal of the conditions in the middle column, which prevailed in 2021 and late 2020, throughout the 2009-19 period, and for much of the last 40 years. How has this change manifested itself in investment options? Here’s one example: In the low-return world of just one year ago, high yield bonds offered yields of 4-5%. A lot of issuance was at yields in the 3s, and at least one new bond came to the market with a “handle” of 2. The usefulness of these bonds for institutions needing returns of 6 or 7% was quite limited. Today these securities yield roughly 8%, © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: meaning even after allowing for some defaults, they’re likely to deliver equity-like returns, sourced from contractual cash flows on public securities. Credit instruments of all kinds are potentially poised to deliver performance that can help investors accomplish their goals. The Outlook Inflation and interest rates are highly likely to remain the dominant considerations influencing the investment environment for the next several years. While history shows that no one can predict inflation, it seems likely to remain higher than what we became used to after the GFC, at least for a while. The course of interest rates will largely be determined by the Fed’s progress in bringing inflation under control. If rates go much higher in that process, they’re likely to come back down afterward, but no one can predict the timing or the extent of the decrease. While everyone knows how little I think of macro forecasts, a number of clients have asked recently about my views regarding the future of interest rates. Thus, I’ll provide a brief overview. (Oaktree’s investment philosophy doesn’t prohibit having opinions, just acting as if they’re right.)

In my view, the buyers who’ve driven the S&P 500’s recent 10% rally from the October low have been motivated by their beliefs that (a) inflation is easing, (b) the Fed will soon pivot from restrictive policy back toward stimulative, (c) interest rates will return to lower levels, (d) a recession will be averted, or it will be modest and brief, and (e) the economy and markets will return to halcyon days. In contrast, here’s what I think: • The underlying causes of today’s inflation will probably abate as relief-swollen savings are spent and as supply catches up with demand. • While some recent inflation readings have been encouraging in this regard, the labor market is still very tight, wages are rising, and the economy is growing strongly. • Globalization is slowing or reversing. If this trend continues, we will lose its significant deflationary influence. (Importantly, consumer durables prices declined by 40% over the years 1995-2020, no doubt thanks to less-expensive imports. I estimate that this took 0.6% per year off the rate of inflation.) • Before declaring victory on inflation, the Fed will need to be convinced not only that inflation has settled near the 2% target, but also that inflationary psychology has been extinguished. To accomplish this, the Fed will likely want to see a positive real fed funds rate – at present it’s minus 2.2%.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: HFRI Hedge Fund Index* HFRI Macro (Total) Index S&P 500 Index 5-year annualized return* 5.2% 5.0% 12.8% 10-year annualized return* 5.1 2.8 13.8 * Performance through July 31, 2022. The broad hedge fund index shown is the Fund Weighted Composite Index. What the table above shows is that, according to HFR, the average hedge fund woefully underperformed the S&P 500 in the period under study, and the average macro fund did considerably worse (especially in the period from 2012 to 2017). Given that investors continue to entrust roughly $4.5 trillion of capital to hedge funds, they must deliver some benefit other than returns, but it’s not obvious what that could be. This seems to be especially true for the macro funds. To support my opinion regarding forecasts, I’ll cite a rare example of self-assessment: a seven-page feature that appeared in the Sunday Opinion section of The New York Times on July 24 titled “I Was Wrong.” In it, eight Times opinion writers opened up about incorrect predictions they made and flawed advice they had given. The most relevant here is Paul Krugman, who wrote a confession titled “I Was Wrong About Inflation.” I’ll string together some excerpts: In early 2021, there was an intense debate among economists about the likely consequences of the American Rescue Plan . . . . I was on [the side that was less concerned about the impact on inflation].

• Thus, while the Fed appears likely to slow the pace of its interest rate increases, it’s unlikely to return to stimulative policies any time soon. • The Fed has to maintain credibility (or regain it after having claimed for too long that inflation was “transitory”). It can’t appear to be inconstant by becoming stimulative too soon after having turned restrictive. • The Fed faces the question of what to do about its balance sheet, which grew from $4 trillion to almost $9 trillion due to its purchases of bonds. Allowing its holdings of bonds to mature and roll off (or, somewhat less likely, making sales) would withdraw significant liquidity from the economy, restricting growth. • Rather than be in a stimulative posture on a perpetual basis, one might imagine the Fed would prefer to normally maintain a “neutral interest rate,” which is defined as neither stimulative nor restrictive. (I know I would.) Most recently – last summer – that rate was estimated at 2.5%. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

As it turned out, of course, that was a very bad call. . . . . . . history wouldn’t have led us to expect this much inflation from overheating. So something was wrong with my model . . . . One possibility is that history was misleading . . . . Also, disruptions associated with adjusting to the pandemic and its aftermath may still be playing a large role. And of course both Russia’s invasion of Ukraine and China’s lockdown of major cities have added a whole new level of disruption. . . . In any case, the whole experience has been a lesson in humility. Nobody will believe this, but in the aftermath of the 2008 crisis, standard economic models performed pretty well, and I felt comfortable applying these models in 2021. But in retrospect I should have realized that in the face of the new world created by Covid-19, that kind of extrapolation wasn’t a safe bet. (Emphasis added) I salute Krugman for this incredible bout of candor (although I have to say I don’t remember a lot of 2009-10 market forecasts that were optimistic enough to capture the reality of the subsequent decade). Krugman’s explanation for his error is fine as far as it goes, but I don’t see any mention of abstaining from modeling, extrapolating, or forecasting in the future. Humility may even be seeping into one of the world’s biggest producers of economic forecasts, the U.S. Federal Reserve, home of more than 400 Ph.D. economists.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Similarly, although most of us believe the free market is the best allocator of economic resources, we haven’t had a free market in money for well over a decade. The Fed might prefer to reduce its role in capital allocation by being less active in controlling rates and holding mortgage bonds. • There must be risks associated with the Fed keeping interest rates stimulative on a long-term basis. Arguably, we’ve seen most recently that doing so can bring on inflation, though the inflation of the last two years can be attributed largely to one-off events related to the pandemic. • The Fed would probably like to see normal interest rates high enough to provide it with room to cut if it needs to stimulate the economy in the future. • People who came into the business world after 2008 – or veteran investors with short memories – might think of today’s interest rates as elevated. But they’re not in the longer sweep of history, meaning there’s no obvious reason why they should be lower. These are the reasons why I believe that the base interest rate over the next several years is more likely to average 2-4% (i.e., not far from where it is now) than 0-2%. Of course, there are counterarguments. But, for me, the bottom line is that highly stimulative rates are likely not in the cards for the next several years, barring a serious recession from which we need rescuing (and that would have ramifications of its own).

But I assure you Oaktree isn’t going to bet money on that belief. What we do know is that inflation and interest rates are higher today than they’ve been for 40 and 13 years, respectively. No one knows how long the items in the right-hand column above will continue to accurately describe the environment. They’ll be influenced by economic growth, inflation, and interest rates, as well as exogenous events, all of which are unpredictable. Regardless, I think things will generally be less rosy in the years immediately ahead: • A recession in the next 12-18 months appears to be a foregone conclusion among economists and investors. • That recession is likely to coincide with deterioration of corporate earnings and investor psychology. • Credit market conditions for new financings seem unlikely to soon become as accommodative as they were in recent years. • No one can foretell how high the debt default rate will rise or how long it’ll stay there. It’s worth noting in this context that the annual default rate on high yield bonds averaged 3.6% from 1978 through 2009, but an unusually low 2.1% under the “just-right” conditions that prevailed for the decade 2010-19. In fact, there was only one year in that decade in which defaults reached the historical average. • Lastly, there is a forecast I’m confident of: Interest rates aren’t about to decline by another 2,000 basis points from here.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: providing estimates of where the Fed sees interest rates, economic growth and inflation at different points in the future should be junked. . . . The basic problem with forward guidance is that it depends on data that the Fed had a miserable record of forecasting. It was consistently too optimistic about an economic recovery after the 2007-2009 Great Recession. In September 2014, policy makers forecast real gross domestic product growth in 2015 of 3.40% but were forced to constantly crank their expectations down to 2.10% by September 2015. The federal funds rate is not a market-determined interest rate but is set and controlled by the Fed, and nobody challenges the central bank. Yet the FOMC members were infamously terrible at forecasting what they themselves would do . . . In 2015, their average projection of the 2016 federal funds rate was 0.90% and 3.30% in 2019. The actual numbers were 0.38% and 2.38%. . . . To be sure, many current events today have caused uncertainty in markets, but the Fed has been in there hot and heavy with its forward guidance. Recall that early this year the central bank believed that inflation caused by frictions in reopening the economy after the pandemic and supply-chain disruptions was temporary. Only belatedly did it reverse gears, raise rates and signal that further substantial hikes are coming.

And the questions I’m asked these days overwhelmingly surround: • the outlook for inflation, • the extent to which the Federal Reserve will raise interest rates to bring it under control, and • whether doing so will produce a soft landing or a recession (and if the latter, how bad). Afterwards, I wasn’t completely happy with my remarks, so I rethought them over lunch. And when it was time to resume the program, I went up on stage for another two minutes. Here’s what I said: All the discussion surrounding inflation, rates, and recession falls under the same heading: the short term. And yet: • We can’t know much about the short-term future (or, I should say, we can’t dependably know more than the consensus). • If we have an opinion about the short term, we can’t (or shouldn’t) have much confidence in it. • If we reach a conclusion, there’s not much we can do about it – most investors can’t and won’t meaningfully revamp their portfolios based on such opinions. • We really shouldn’t care about the short term – after all, we’re investors, not traders. I think it’s the last point that matters most. The question is whether you agree or not. For example, when asked whether we’re heading toward a recession, my usual answer is that whenever we’re not in a recession, we’re heading toward one. The question is when. I believe we’ll always have cycles, which means recessions and recoveries will always lie ahead.

One would think a recession is priced in, but many analysts say that’s not the case. This stuff is hard…!!! Bruce’s comment highlights another weakness of having a short-term focus. Even if we think we know what’s in store in terms of things like inflation, recessions, and interest rates, there’s absolutely no way to know how market prices comport with those expectations. This is more significant than most people realize. If you’ve developed opinions regarding the issues of the day, or have access to those of pundits you respect, take a look at any asset and ask yourself whether it’s priced rich, cheap, or fair in light of those views. That’s what matters when you’re pursuing investments that are reasonably priced. The possibility – or even the fact – that a negative event lies ahead isn’t in itself a reason to reduce risk; investors should only do so if the event lies ahead and it isn’t appropriately reflected in asset prices. But, as Bruce says, there’s usually no way to know. At the beginning of my career, we thought in terms of investing in a stock for five or six years; something held for less than a year was considered a short-term trade. One of the biggest changes I’ve witnessed since then is the incredible shortening of time horizons. Money managers know their returns in real time, and many clients are fixated on how their managers did in the most recent quarter. No strategy – and no level of brilliance – will make every quarter or every year a successful one.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Thus, we have (a) extrapolation forecasts, most of which are correct but unprofitable, and (b) potentially profitable forecasts of deviation, which are rarely correct and thus are generally unprofitable. • Q.E.D.: Most forecasts don’t add to returns. At the lunch described at the beginning of this memo, people were asked what they expected in terms of, for example, Fed policy, and how that influenced their investment stance. One person replied with something like, “I think the Fed will remain very worried about inflation and thus will raise rates significantly, bringing on a recession. So I’m in risk-off mode.” Another said, “I foresee inflation moderating in the fourth quarter, allowing the Fed to turn dovish in January. That will allow them to bring interest rates back down and stimulate the economy. I’m very bullish on 2023.” We hear statements like these all the time. But it must be recognized that these people are applying one-factor models: The speaker is basing his or her forecast on a single variable. Talk about simplifying assumptions: These forecasters are implicitly holding everything constant other than Fed policy. They’re playing checkers when they need to be playing 3-D chess. Leaving aside the impossibility of predicting Fed behavior, the reaction of inflation to that behavior, and the reaction of markets to inflation, what about all the other things that matter?

• Worry about rising inflation has turned out to be well founded thus far, but there is still no consensus as to its primary cause (Federal Reserve policy or supply chain/labor market bottlenecks?) or whether it will prove transitory or long-lasting. All three of the conditions listed above were present months ago, and they’re little changed today. Thus, in the investment environment, it’s still Groundhog Day. Yet there are changes taking place, and they’ll be the subject of this memo. My focus isn’t the “little macro” changes, like what will happen to GDP, inflation and interest rates next year, but rather the “big macro” changes that will have an impact on our lives for many years. Many aren’t actionable today, but that doesn’t mean we shouldn’t bear them in mind. The Changing Environment for Investing As I’ve written before, the world I remember of 50, 60 and 70 years ago was a pretty static place. Things didn’t seem to change very much or very fast. The homes, cars, reading matter, business technology and general environment of 1970 weren’t very different from those of 1950. We were entertained by broadcast TV and radio, drove gasoline-powered cars dependent on carburetors, did most calculations on paper, composed documents on typewriters (with copies made using carbon paper), communicated via letters and phone calls, and got information primarily from books housed in libraries.

Since the Tech Bubble burst in 2000, however, the market has appeared to think mostly about the economy, the Federal Reserve and Treasury, and world events. That’s been even more true since the Global Financial Crisis in 2008. That’s why I’m devoting a memo to a subject I largely disavow. I’ll try below to enumerate the macro issues that matter, discuss the outlook for them, and end with some advice regarding what to do about them. That reminds me to put forth my conviction that we all have views about the future, but as we say at Oaktree, “It’s one thing to have an opinion, but something very different to assume it’s right and bet heavily on it.” That’s what Oaktree doesn’t do. Inflation As of this writing, macro considerations are certainly in the ascendency, centering on the subject of inflation. Over the last 16 months, the Fed, Treasury and Congress have used a firehose of money to support, subsidize and stimulate workers, businesses, state and local governments, the overall economy and the financial markets. This has resulted in (a) confidence in the prospects for a strong economic recovery, (b) skyrocketing asset prices, and (c) fear of rising inflation.

The policy measures described above traditionally would be expected to produce the following: • a stronger economy than would otherwise have been the case; • higher corporate profits; • tighter labor markets and thus higher wages; • more money chasing a limited supply of goods; • an increase in the rate at which the prices of goods rise (i.e., higher inflation); and, eventually, • a tightening of monetary policy to fight inflation, resulting in higher interest rates. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: While the functioning of economies is highly variable and uncertain, economic orthodoxy considers the above process about as reliable as they come. However, I want to take a minute to highlight the uncertainty entailed in thinking about inflation. • Among the defining elements that marked my early years in investing was the 5-15% annual inflation that prevailed in the U.S. from the early 1970s through 1982. Dr. Doom and Dr. Gloom (chief economists Henry Kaufman of Salomon Brothers and Al Wojnilower of First Boston – I forget which was which) regularly admitted in their depressing speeches that they weren’t sure what was causing the inflation or how to bring it down. No one was able to make progress combatting inflation until Fed Chair Paul Volcker solved the problem by raising interest rates dramatically, bringing on a significant double-dip recession in 1980-82. • What about the more recent experience? For years, central bankers in the U.S., Europe and Japan have targeted a healthy 2% rate of inflation, but none of them have been able to produce it. This despite continuous economic growth, significant budget deficits, rapid expansion of the money supply through quantitative easing, and low interest rates – all of which are supposed to be inflationary.

• Finally, for roughly the last 60 years, economists have trusted the so-called Phillips Curve, which posits an inverse relationship between unemployment and inflation: the lower the unemployment rate, the tighter the labor market, the more negotiating power workers have, the more wages rise, and the greater the increase in the prices of consumer goods. But the U.S. unemployment rate fell throughout the last decade – ultimately hitting a 50-year low – and still there was no material increase in inflation. Thus, few people talk about the Phillips Curve anymore. The low reported U.S. inflation rates may be partially attributable to changes in recent decades in the way the Consumer Price Index is calculated, but the truth is that we know very little about inflation, including its causes and cures. I describe it as “mysterious,” so I believe we should put even less stock in predictions surrounding inflation than in other areas. That makes life tough for investors at the moment, because inflation and its impact on interest rates constitute the most important wildcards. Inflation Outlook Today There’s been a great deal written about the current prospects for inflation, and rather than rehash it fully, I’ll deliver a brief summary. Here’s the background: • To support the economy and its participants during last year’s Covid-19-related shutdown, the Fed, Treasury and Congress took drastic action to prevent a global slowdown that could have rivalled the Great Depression.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • The Fed/Treasury actions flooded the financial markets with money, driving strong price increases and the reopening of the capital markets. The wealth effect – from stock market gains totaling in the double-digit trillions of dollars, plus soaring home prices – was significant; this dwarfed the positive impact on consumer balance sheets of higher incomes and lower spending. The following signs suggest we may be headed for a significant period of higher inflation: • All the things described immediately above would normally be expected to result in accelerating inflation. • Concern about rising inflation in the next few years has been a topic of elevated discussion. Initially these anxieties were based simply on economic theory, but in 2021 they’ve been supported by empirical evidence: o Used car prices rose dramatically because of shortages of imported parts. o Home prices skyrocketed. o Materials and component prices escalated: e.g., copper, lumber and semiconductors. o Smartphones were in short supply. • Shortages of labor in certain sectors have added to the threat of rising prices. • The year-over-year increase in the Consumer Price Index was 4.2% in April, 5.0% in May and 5.4% in June. These are the highest readings since September 2008.

• Not only might higher prices for inputs (“cost-push” inflation) and more dollars chasing goods (“demand-pull” inflation) result in an excess of demand over supply and thus rising inflation, but excessive money printing might reduce the demand for U.S. dollars, cutting the currency’s value and causing the dollar prices of imports to the U.S. to rise. • Particularly troubling in this regard is the recent tendency of those in Washington to spend trillions of dollars without identifying solid “pay-fors.” This has coincided with the rising influence of Modern Monetary Theory, which essentially says deficits and debt don’t matter. What if these ideas are ill-founded? On the other hand, here are the arguments for why higher inflation might prove “transitory” (the word du jour). • Many of the shortages affecting finished goods and manufacturing inputs – and the resultant price increases – can be seen as a natural consequence of restarting the economy and, especially, the global supply chain. It’s unrealistic to expect all parts of the global economy to immediately resume efficient functioning, and a lack of a single part can cause significant disruption, making it hard to manufacture finished goods. Since these factors result from the restart, they may prove ephemeral.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Inflation/Deflation I’ve written extensively on the subject of inflation of late, especially in Thinking About Macro four months ago. Since our knowledge of the future is so limited, there’s little for me to add on the subject. But what about the possibility of deflation? People have been warning about both inflation and deflation for the last several years. The only thing I’ve been confident about is that we’re unlikely to have both at the same time. I recently came across a video of Cathie Wood speaking on the subject of deflation. For those who don’t know, Cathie is the investor who gained great fame in 2020 for having been heavily concentrated in the FAANGs, Tesla and other tech stocks, which vastly outperformed the rest of the stock market (in 2020, the average return on five of her seven ETFs was 141%). In the video, Cathie says: We’ve been saying for some time that the risk to the economy is more on the side of deflation than inflation. So, as Covid created all the destruction that it did and with supply chains really being thrown off, we’ve been through a period here of inflation which I think investors are baking into the cake. . . . . . . I was in college [during the 1970s], when inflation was raging, so I know what that is, and I truly believe we are not going back there, and that anyone planning for it is probably going to be making some mistakes. . .

• It should be borne in mind that the prices of raw materials or finished goods aren’t solely determined by current economic developments in a direct, mechanical way, meaning prices aren’t necessarily “right” given prevailing conditions, any more than stock prices are always right. Rather, prices of goods are influenced by economic participants’ psyches and can easily overshoot or undershoot (just as in the stock market). As John Mauldin wrote in Federal Reserve Folly (July 23, 2021), “The rising prices that add up to inflation are the result of producer and consumer expectations for the future.” Thus prices aren’t just the result of supply and demand today, but also an indication of what people think prices © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: will be in the future. We see this in the price of lumber, which rose by roughly 540% between the low in April 2020 – when no one thought there would ever be demand for new homes – and the high in May 2021 – when no one thought the supply of homes could ever meet the demand. Now the price of lumber is down by more than 60% in just the last two months, and we no longer hear much about its contribution to inflation. • Clearly, a lot of the inflation seen in the first half of 2021 can be attributed to increased consumer spending financed by Covid-19 relief and the resultant bulge in savings and wealth. This should prove temporary: a given pool of extra dollars can’t produce elevated spending forever. • The ending of enhanced unemployment benefits in September should bring more workers into the job market, reducing the impact of labor shortages on wages and thus the prices of goods. • The growth of the economy will undoubtedly slow after 2021 or 2022, by which time the impact of 2020’s pent-up consumer demand will ebb significantly. • There’s hope that the recent levels of stimulus, deficit spending and money printing will recede in the next few years (or at least their rate of growth will slow) as the economy continues to expand, meaning these factors will decline relative to the size of the economy. • Technology, automation and globalization are likely to continue to have significant deflationary effects.

The debate rages on regarding whether today’s inflation will prove permanent or transitory. There’s a great deal riding on the answer since higher inflation would doubtless lead to higher interest rates and thus lower asset values. But in my view, it’s impossible to know the answer. (There you have it: important, but not knowable.) There are intelligent people on both sides of the argument, but I’m convinced there’s no such thing as “knowing” what the outcome will be. What Does the Fed Know? The Fed is responsible for keeping inflation under control (among its other jobs). However, Fed leaders admit that they’re not highly confident regarding their expectations. Here’s what Fed Chair Jerome Powell said in a June 16, 2021 press conference (emphasis added): So I can’t give you an exact number or an exact time, but I would say that we do expect inflation to move down. If you look at the forecast for 2022 and 2023 among my colleagues on the Federal Open Market Committee, you’ll see that people do expect inflation to move down meaningfully toward our goal. And I think that the full range of inflation projections for 2023 falls between 2% and 2.3%, which is consistent with our goals. At roughly the same time, St. Louis Federal Reserve Bank President James Bullard also spoke about the uncertainty that’s present: Mr. Bullard . . . said the U.S.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: This is the kind of candid speech we need. But it’s clear from the above that we can’t conclude “we have the answer” on the subject of inflation . . . or even that there is “an answer.” What Does the Market Know? The stock market started off 2016 with a big decline, which seemed to me to be irrational. As a result, I wrote a memo saying the market needed a trip to a psychiatrist (On the Couch, January 14, 2016). The next day, when I went on TV to discuss that memo, I was pressed on whether the stock market’s decline foreshadowed something dire. “No,” I said: the market doesn’t “know” much about the future that we don’t collectively know. That inspired me to write another memo five days later with the same title as this section: What Does the Market Know? (January 19, 2016). What is it telling us today? In recent months, signs of rapidly rising inflation have been everywhere, and the media have tied the occasional stock market dips to inflation fears. For example, the S&P 500 Index experienced a moderate decline for the 10 trading days ending on June 18. Here’s what The Wall Street Journal had to say the next day: U.S. stocks retreated Friday, as traders warily eyed the Federal Reserve for hints of where monetary policy is headed. The Dow Jones Industrial Average had its worst week since the week ended Oct. 30. The index of blue-chip stocks on Friday fell 1.6%, or 533.37 points, to 33290.08.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: “The markets will be more spooked by 2022 turning to a rate hike, because that will mean they have to taper as well,” said Derek Halpenny, head of research for global markets in the European region at MUFG Bank. (The Wall Street Journal, June 19) As usual, media commentators stand ready to explain in a logical fashion why the markets did what they did (I always wonder where they look to get the explanation). They’re also glad to tell us what that means for the future, invariably through extrapolation. Regardless, the theme thus far in 2021 has been rising inflation. That and the associated fear of higher interest rates have been used to explain much of what’s been going on in the stock market. The data reflected rapidly rising inflation, and stock market investors turned negative. So far, so good. You might say the stock market was efficiently reflecting developments and the outlook. But the bond market didn’t see it the same way: In bond markets, the yield on the 10-year Treasury note fell to 1.449% Friday, down from 1.509% Thursday. The 10-year yield has fallen for five straight weeks . . . Consumer prices paid by city dwellers in the U.S. rose more than 7% [in May] and more than 9% in April on an annualized basis. If this keeps up the rest of the year, it will be the highest inflation rate the U.S. has experienced since the 1980s.

But fear not, say some investors and the Federal Reserve, the bond market isn’t worried. Yields fell over the last week and remain low by historical levels, even after rising on the back of [Fed Chair] Jay Powell’s speech Wednesday. And if markets aren’t worried, maybe we shouldn’t be either. . . . (Allison Schrager, senior fellow at the Manhattan Institute, Bloomberg Opinion, June 18) The stock market was afraid of higher inflation and interest rates, but the bond market – where price movements are governed predominantly by the outlook for rates – gave us higher prices and lower rates, seemingly unconcerned about inflation. That brings me to gold, which historically has been bought for protection against inflation. Despite all the inflationary signs, the market for gold seems to agree with the bond market that the outlook for inflation is benign. Gold futures fell 0.3%, adding to their losses from Thursday, when they suffered their largest drop in over 10 months. For the week, gold fell 5.8%, its worst one-week performance since the week ended March 13, 2020. (The Wall Street Journal, June 19) The price of gold hit an all-time high of $2,067 per ounce on August 6, 2020, likely driven by the Fed’s enormous injection of money into the economy and markets. And then, on June 18, 2021, when concern about inflation seemed to be rising, it hit $1,773, down 14% from the high reached 10 months earlier.

(Gold prices from Goldhub) So in June we had bouts of stock market weakness, reportedly on inflation fears, and rising bond prices (declining yields), seemingly based on bond buyers’ conviction that economic weakness will keep inflation subdued. And we saw gold, the classic anti-inflation tool, marked down just as stock © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: market investors were described as being concerned about inflation. Not only do the markets not know what’s coming, but they often behave in ways that make little or no long-term sense. I concluded my 2016 memo What Does the Market Know? by saying that, on the subject of when to buy and sell securities, “the market has nothing useful to contribute.” I think we can say the same about what it knows about future macro events. Perhaps the market’s thought process is best understood through this old cartoon – one of the greatest of all time – which I included in On the Couch. Markets function like highly sensitive instruments, absorbing events and publishing their reaction, be it bullish or bearish. While markets are usually good “observers,” hyper-attuned to current developments, they sometimes seem to view events through either a positive or a negative lens (and to oscillate between the two), as shown above. Further, they’re rarely good “predictors,” in the sense of knowing what comes next. Because their reaction to short-run developments tends toward excess, the markets provide a lot of false positives and negatives regarding their significance. But the fact that markets can overemphasize current developments and fail to look far enough into the future doesn’t mean they should be ignored entirely.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: of 2020, which “no one” thought made sense when it began. The markets certainly did a much better job of recognizing the potential impact of the Fed/Treasury actions than did most commentators.) What Do the Forecasters Know? Although it’s on the subject of stock market returns rather than inflation, I can’t fail to share some data regarding forecasts supplied by Sheldon Stone, my longest-running partner (we just passed 38 years working together). Last December, he shared a New York Times article by Jeff Sommer entitled “Clueless About 2020, Wall Street Forecasters Are at It Again for 2021” (December 18, 2020). According to the article: In December 2019, the median forecast on Wall Street held that the S&P 500 would rise 2.7% in 2020. Since the actual return on the index was 18.4%, that forecast was too low by 16 percentage points. But in April 2020, after the pandemic had taken hold (and after the initial actions on the part of the Fed, Treasury and Congress had been announced and initiated), the consensus forecast return was revised downward to negative 11% – almost 30 percentage points below the eventual outcome. Obviously, nobody could have been expected to have predicted the pandemic. Ditto for the full success of the policy response or the timing and extent of the consequent market bounce.

But the downtrend in rates is over (if we can believe the Fed’s assurance that it won’t take nominal rates into negative territory). Thus, while interest rates can rise from here – implying higher demanded returns on everything and thus lower asset prices – they can’t decline. This creates a negatively asymmetrical proposition. So today’s high asset prices may be justified at today’s interest rates, but that’s clearly a source of vulnerability if rates were to rise. (Note that today’s 1.40% yield on the 10-year Treasury note is up from 0.52% at the low in August 2020 and from 0.93% in just the last seven weeks.) The Fed says rates will be low for years to come, but are there limitations on its ability to make that happen? Can the Fed keep rates artificially low forever? On longer-maturity bonds? And what about inflation? Can the 10-year Treasury note still yield 1.40% if inflation reaches 3%? Will people buy it at a negative real yield? Or will the price fall so that it yields more? Where could inflation come from? © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The price of goods may not rise in dollar terms, but reduced respect for the dollar (or increased quantities of dollars in circulation) could cause it to depreciate relative to the price of goods: same result. On TV on February 7, Treasury Secretary Janet Yellen responded to a question about inflation risk posed by the proposed Covid-19 relief package with a long discourse on the importance of delivering relief to Americans who are suffering. Few would argue with that premise. She also made clear that she believes it’s better to provide too much relief than too little. True as well. But that doesn’t mean (a) the more relief the better or (b) there aren’t risks attached. Experts from both sides of the political aisle have questioned whether the $1.9 trillion relief package under discussion is too much and/or misdirected; Larry Summers, a progressive economist, wrote to that effect in The Washington Post on February 4: . . . a comparison of the 2009 stimulus and what is now being proposed is instructive. In 2009, the gap between actual and estimated potential output was about $80 billion a month and increasing. The 2009 stimulus measures provided an incremental $30 billion to $40 billion a month during 2009 — an amount equal to about half the output shortfall.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The bottom line is that hundreds or perhaps thousands of people make their living as professional market forecasters, despite the fact that the median forecast is of no value: wrong on average, positive in good years and bad, and way off target when an accurate forecast would have been most profitable. The Role of the Fed A great deal of the current debate over the macro outlook surrounds the Fed and its policies and behavior. In March 2020, the Fed triggered the recovery we’re enjoying by cutting the key federal funds rate to 0-0.25%, initiating loan and grant programs, and buying vast amounts of bonds. This combination was very successful, producing powerful recoveries in the economy and the financial markets. However, the same actions helped create the threat of persistently higher inflation. The Fed has two primary assignments: (a) making sure the economy grows enough to create jobs, leading to full employment, and (b) keeping inflation under control. To some extent, these tasks are in conflict. Stronger economic growth risks overheating and inflation. Higher inflation leads investors to demand higher interest rates to more than compensate for the loss of purchasing power. Higher interest rates threaten to slow the economy. The economic outlook turned positive last summer in response to the Fed/Treasury actions and then was further bolstered by the success of vaccines.

Thus, we’re seeing strong economic growth – real GDP rose at an annualized rate of 6.4% in the first quarter – and expectations remain high for the rest of 2021 and perhaps 2022. Yet, the Fed continues to hold interest rates near zero and buy $120 billion of bonds per month. Why stimulate an economy that’s doing so well, and run the risk of inflation? In fact, the Fed seems to be relatively unworried about inflation. At first it said it didn’t think there would be inflation (recent data has disproved that). Then it said if there is inflation, it will be transitory. And the Fed went on to say if inflation appears to be other than transitory, they have the tools with which to fight it. By maintaining its high level of accommodativeness, the Fed is showing that it’s more worried about economic sluggishness than about inflation. One informed observer told me that if growth falls back to the recent norm of 2% or less despite all the stimulus that’s been thrown at the economy, the Fed feels we risk serious stagnation. And let’s remember that (a) ever since the turn of the century there has been slow GDP growth and serious discussion of “secular stagnation” and (b) while the economic recovery from 2009 through 2019 was the longest in history, it was also the slowest since World War II.

while there are enormous uncertainties, there is a chance that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation, with consequences for the value of the dollar and financial stability. (Emphasis added) Normally one would expect such a flood of additional liquidity into the economy to cause inflation to accelerate, but the Fed says no. Of course, although central banks might like to see inflation increase (as it makes it cheaper to repay debt), they have to discourage such talk for fear of fueling inflationary expectations. On the other hand, we’ve had substantial deficits and accommodative monetary policy ever since 2008 and no serious inflation. We’ve seen a 50-year-low in the unemployment rate and yet not the inflation the Phillips Curve would have predicted. And Japan and Europe have been trying for 2% inflation for years without success. Is inflation a threat anytime soon? The answer’s clear: who knows? In addition to these major risks, there are others that – although perhaps smaller, less consequential or less imminent – should nevertheless be considered: © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: pandemic reopening and will fade, and that the Fed should stay focused on getting as many people back to work as possible. Any move to reduce support for the economy, by first slowing the U.S. central bank’s $120 billion in monthly bond purchases, is “still a ways off,” Powell said, with 7.5 million jobs still missing from before the pandemic. (Reuters, July 14) But even if economic sluggishness is the greater risk – and who’s to disagree with the Fed and insist it’s not – the risk of inflation is still real, as would be the consequences. I’m sure we’re all much better off with the Fed possibly overshooting on stimulus, rather than undershooting. And I believe the Fed was right to do all it did despite the possibility of negative ramifications. Still, we must consider those ramifications. • Higher inflation could lead to higher interest rates as investors demand positive real yields, but also if tighter monetary policy and higher rates are employed to fight the inflation. • Higher interest rates could negatively affect the economy. • Higher interest rates make investors demand higher returns, leading to lower prices for financial assets and the possibility of a market collapse (see 1972-82). • Higher inflation would hit low-income Americans the hardest, since they spend the lion’s share of their incomes on necessities, and threaten the lifestyle of the millions of retirees and others on fixed incomes.

• Higher interest rates would raise the cost of servicing the national debt, further swelling the annual deficits (and therefore the national debt). • Larger deficits could make lenders (and foreign buyers) demand still-higher interest rates on U.S. debt securities, creating a negative feedback loop. • If we continue to print enough money to pay the interest and fund the deficit, eventually the value of the dollar and its use as the world’s reserve currency could be called into question. • As we’ve experienced in the past, rapidly rising prices could cause inflationary expectations to become embedded in Americans’ psyches, making the increases self-perpetuating and hard to combat. Further, we should consider the negative aspects of accommodative monetary policy itself: • Fed largesse can be viewed as implying the existence of a “Fed put,” or a guarantee of future bailouts. The consequences can include increased moral hazard (the belief that investors can take risk without consequences) and a diminution of the risk aversion that must be present in order for markets to be safe. • The above conditions can lead businesses and investors to use more leverage, magnifying the potential damage from a slowdown. • As we’ve seen in the last 16 months, the Fed can’t stimulate the economy without increasing the value of the economy. And who receives the benefit? The people who own the economy (i.e., the owners of equities, companies and real estate).

” But even Lord Keynes asserted that while deficits are a reasonable way to jumpstart a sluggish economy, governments should run surpluses in times of prosperity and use them to repay the debts incurred in times of weakness. However, in the 21st century, concepts like fiscal discipline, budget surpluses and debt repayment seem to have gone out the window. The U.S. has run large and growing deficits for more than 20 years, and that seems less likely than ever to change. Traditional economics asserts that this will be inflationary, but as mentioned earlier, the deficits of the 2010s didn’t bring on substantial inflation. Perhaps they merely helped support an economy that would have been even weaker in their absence. Regardless, we’ve now entered into a time of testing. As I said earlier, in 2020, we saw trillions of dollars of increased benefits, Fed bond-buying, expansion of the Fed balance sheet, federal fiscal deficits, and additions to the U.S. national debt. All of these things increased sharply as a percentage of the total economy. We’ll see the consequences in the future. Alan Greenspan made the Fed highly activist starting in the 1990s (giving rise to the concept of the “Greenspan put” and eventually the “Fed put”), a posture that has persisted through three financial crises already in this young century. Again, the Fed’s rescue actions have been essential and appropriate, but in my view they should not be permanent.

In many ways, we’re back to the investment environment we faced in the years immediately prior to 2020: an uncertain world, offering the lowest prospective returns we’ve ever seen, with asset prices that are at least full to high, and with people engaging in pro-risk behavior in search of better returns. This suggests we should return to Oaktree’s pre-Covid-19 mantra: move forward, but with caution. But a year or two ago, we were in an economic recovery that was a decade old – the longest in history. Instead, it now appears we’re at the beginning of an economic up-cycle that’s likely to run for years. Over the course of my career, there have been a handful of times when I felt the logic for calling a top (or bottom) was compelling and the probability of success was high. This isn’t one of them. There’s increasing mention of a possible bubble based on concerns about valuations, federal government spending, inflation and interest rates, but I see too many positives for the answer to be black-or-white. In the interest of moving toward a conclusion, I’m going to briefly recap the pros, cons and counter- arguments: • The economic outlook is positive, although Chairman Powell warns that the recovery remains “uneven and far from complete,” with inadequate job creation. • Thus he says the Fed will keep interest rates low for years. But with fiscal and monetary policy extremely accommodative, rates are already on the move up and vulnerable to increased inflation.

• Inflation stayed low in the 2010s despite records being set in terms of duration of the economic recovery, deficits and low unemployment. However, inflation’s ability to remain so is uncertain. • The temperature of the market is elevated, and there are signs of euphoria and risky behavior. • Valuations are high relative to history, as security prices have run ahead of economic gains. High multiples are justified by today’s low interest rates but dependent on continued low rates. • Risk compensation is skimpy, as seen in the premium valuations of favored companies and in historically narrow yield spreads on credit. • Washington poses a risk because of one party’s control and the anti-capitalist policies of its most progressive members. My hope is that the narrow majorities render radical legislation less likely. • As to exogenous risks, President Biden will pursue greater harmony, but tension with China and Iran and the racial and social divisions at home continue to cloud the outlook. * -- The earnings yield on a stock or stock index is the ratio of its earnings to its price. Thus it’s the e/p ratio: the inverse of the p/e ratio, or 1 divided by the p/e ratio. A forward-looking p/e ratio of 22 equates to an earnings yield of 1 ÷ 22, or 4.5%. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: With arguments on both sides, I feel the prices of most assets are in a gray area – certainly not low, mostly on the high side of fair, but not so high as to be unreasonable. The bottom line is this: given current conditions, should investors be at their usual risk position, more defensive or more aggressive? While the risk-adjusted returns of most asset classes seem to be at rough equilibrium relative to each other, all absolute returns are ultra-low, commensurate with today’s equally low interest rates. On balance, I think it’s appropriate to be in one’s normal stance, perhaps with a modest bias toward defense. Since the rewards for moving further out on the risk curve – such as yield spreads – aren’t lavish, I have trouble seeing this as a time to aggressively chase high returns. Moreover, the surer one is that rates will soon rise meaningfully, the more cautious one should be today. Because the primary risk lies in the possibility of rising inflation and the higher interest rates that would bring, I think portfolios have to make allowances: even though we can’t predict, we should prepare.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: might like to have faster growth in the years ahead than the economy would provide on its own, but I don’t think the long-term rate of growth can be lifted perpetually through monetary and fiscal policy, and certainly not without the risk of negative consequences. To have a healthier allocation of capital, I’d like to see a free market in money, and to me that means interest rates that are “naturally occurring.” Rates held artificially low distort the capital markets, penalizing savers, subsidizing borrowers, lifting asset prices and encouraging increased risk taking and the use of more leverage. Again, I’d prefer to see a Fed that’s reluctant to intervene other than when intervention is essential. * * * In my first memo of the pandemic, I wrote the following about the coronavirus: No one knows much about it, since this is its first appearance. As Harvard epidemiologist Marc Lipsitch said on a podcast on the subject, there are (a) facts, (b) informed extrapolations from analogies to other viruses and (c) opinion or speculation. The scientists are trying to make informed inferences. Thus far, I don’t think there’s enough data regarding the coronavirus to enable them to turn those inferences into facts. (Nobody Knows II, March 3, 2020) Substitute “economists” for “scientists” and “inflation” for “coronavirus,” and I think this paragraph can serve well today.

This possibility means (a) bonds with maturities much above ten years are obvious candidates for underweighting and (b) inflation beneficiaries should be considered for overweighting, including floating-rate debt, real estate capable of seeing rent increases, and the stocks of companies with the power to pass on price increases and/or the potential for rapid earnings growth. When it comes to finding decent returns in this environment, the options are slim. Investors have plowed capital into the mainstream public “beta” markets. As a result, prospective returns have come down – fully reflecting the reduction in interest rates – and markets have become quite efficient. In most cases, price has converged with – if not run ahead of – intrinsic value. That means it’s harder than ever to outperform, other than by taking on additional risk and being lucky enough to do so in an environment where such action is rewarded. Although no markets are starved for capital these days, there may be alternative “alpha” markets where investment skill can add to returns, hopefully without a commensurate increase in overall risk. Some of this additional return is simply a premium for bearing illiquidity, and the pain suffered by some institutions during the 2008-09 crisis shows how important it is to correctly assess one’s ability to live with illiquidity.

In thinking about the causes of inflation, there are few facts and only one prior inflationary episode in the U.S. in our lifetimes from which to extrapolate. Thus, I consider anything anyone says today about inflation in the coming years to be Lipsitch’s “opinion or speculation” . . . or, as I’d say, “guesswork.” I’ve written in the past about the way I tend to come across great material just as memos are approaching the finish line. Thus, I want to include a quote that connects with Lipsitch’s view. It’s from Bill Miller, a legendary investor with an outstanding record: No one has privileged access to the future and market forecasts tend to be about as accurate as calling a coin toss. There are, of course, analogies that can be drawn about how the current environment maps onto previous historical data, but success in that depends crucially on how the future will, in fact, resemble the past, and whether the cited analogies turn out to be the governing ones. The record seems to show that sometimes they will and sometimes they won’t and we are back at the coin toss. (Bill Miller 2Q 2021 Market Letter, July 9, 2021) The following quote does a terrific job of summarizing the challenge entailed in decision-making in cases like this: No amount of sophistication is going to allay the fact that all your knowledge is about the past and all your decisions are about the future. (Ian H. Wilson, former GE executive) © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: That doesn’t mean people won’t express forceful opinions regarding inflation in the period ahead. As I wrote 17 years ago: “Confident” is the key word for describing members of [the “I know”] school. For the “I don’t know” school, on the other hand, the word – especially when dealing with the macro-future – is “guarded.” Its adherents generally believe you can’t know the future; you don’t have to know the future; and the proper goal is to do the best possible job of investing in the absence of that knowledge. (Us and Them, May 7, 2004) So what does that mean for investor behavior today? If we can’t know whether today’s inflation will prove transitory or be with us for a while, is there nothing for investors to do? The answer lies in the title of a 2002 memo of mine: You Can’t Predict. You Can Prepare. No one can confidently predict whether we’re entering an inflationary era, but the consequences of doing so would be significant. Thus, I’ll briefly rehash the opinion regarding market exposure that I expressed in my review of 2020. In January’s memo Something of Value, I described the way my genetic makeup, early experiences, and success in blowing the whistle on some unsustainable financial innovations and market excesses had turned me into something of a knee-jerk skeptic. My son Andrew called this to my attention while our families lived together last year, and what he said struck a responsive chord.

The old me likely would have latched onto today’s high valuations and instances of risky behavior to warn of a bubble and the subsequent correction. But looking through a new lens, I’ve concluded that while those things are there, it makes little sense to significantly reduce market exposure: • on the basis of inflation predictions that may or may not come true, • in the face of some very positive counterarguments, and • when the most important rule in investing is that we should commit for the long run, remaining fully invested unless the evidence to the contrary is absolutely compelling. Finally, I want to briefly touch on the level of today’s markets. Over the four or five years leading up to 2020, I was often asked whether we were in a high yield bond bubble. “No,” I answered, “we’re in a bond bubble.” High yield bonds were priced fairly relative to other bonds, but all bonds were priced high because interest rates were low. Today, we hear people say everything’s in a bubble. Again, I consider the prices of most assets to be fair relative to each other. But given the powerful role of interest rates in determining those prices, and the fact that interest rates are the lowest we’ve ever seen, isn’t it reasonable that many asset prices are the highest we’ve ever seen? For example, with the p/e ratio of the S&P 500 in the low 20s, the “earnings yield” (the inverse of the p/e ratio) is between 4% and 5%. To me, that seems fair relative to the yield of roughly 1.

They are locked into a politics of denial, distraction, and self-indulgence that can only be overcome if readers like you take back this country from the ideologues and spin doctors of both the left and the right. . . . With faith-driven catechisms that are largely impervious to analysis or evidence, and that seem removed from any kind of serious political morality, both political parties have formed an unholy alliance – an undeclared war on the future. An undeclared war, that is, on our children. From neither party do we hear anything about sacrificing today for a better tomorrow. In some ways, our most formidable challenge may be our leaders’ baffling indifference to our fiscal metastasis. (Emphasis added) The good news is that we’ve muddled through and enjoyed a good measure of prosperity despite the existence of these issues. The bad news is that little or nothing has been done about them. The Role of the Fed I won’t spend a great deal of time on this subject since everyone knows the story. But it has to be part of a memo that purports to discuss important changes that are underway. Historically, the job of central banks has been to control the level of inflation and make sure the economy grows fast enough to create “full employment.” In recent years, however, the Fed seems to have taken on the additional task of keeping the securities markets on an upward trajectory.

This has been achieved through the radical lowering of interest rates and the injection of massive amounts of liquidity into the economy. The Fed funds rate – the bellwether of short-term interest rates in the U.S. – was reduced to zero for the first time during the Global Financial Crisis of 2008-09. And it worked – what followed was the longest economic recovery in U.S. history. But rates weren’t raised when the recovery was at its strongest, and when they finally were raised in 2017-18, the markets threw a tantrum and the Fed backed down, cutting rates instead. Now the Fed funds rate is zero again, the markets are far higher than they were in the last decade, and we’re seeing serious inflation. The Fed has announced that it’s going to “taper” its stimulative program of bond buying, and it is widely expected that it will begin to raise interest rates next year. Will the © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

25% on the 10-year Treasury note. If the p/e ratio were at the post- World War II average of 16, that would imply an earnings yield of 6.7%, which would appear too high relative to the 10-year. That tells me asset prices are reasonable relative to interest rates. Of course, it’s one thing to say asset prices are fair relative to interest rates, but something very different to say rates will stay low, meaning prices will stay high (or rise). And that leads us back to inflation. It isn’t hard to imagine rates increasing from here, either because the Fed lifts © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: them to keep the economy from overheating or because rising inflation requires higher rates in order for real returns to be positive (or both). While the possibility of rising rates (and thus lower asset prices) troubles us all, I don’t think it can be said that today’s asset prices are irrational relative to rates. Whereas folks from the media try to get me to say “buy” or “sell” and “in” or “out,” I formulate my view nowadays in terms of the appropriate mix of aggressiveness versus defensiveness. Given the above crosscurrents, Oaktree is maintaining a balance between the two that’s generally in line with our normal stance (as opposed to the elevated defense we maintained going into 2020). Having said that, it’s reasonable to make some adjustments at the margin in response to the risk of inflation. Investors who feel strongly about the risk, or who worry more about interim markdowns (and less about gains they might forgo if inflation fails to materialize), might wish to emphasize: • floating-rate debt; • investments in businesses with largely fixed costs or the ability to pass on cost increases, or that can otherwise incorporate inflation in prices (like certain landlords); and/or • situations where profits have the potential to grow faster than prices rise. These are all ways one might prepare today for an inflationary environment.

Based on monthly estimates, there was actually a funding surplus this past summer. It is no wonder the 10-year Treasury yield reached a low of 1.17% in August despite high inflation rates. (The Wall Street Journal, November 18, 2021) So guess what: The U.S. is still able to issue debt at low interest rates, a ringing endorsement of its creditworthiness from buyers. And who’s the main buyer supplying that endorsement? The U.S. By the way, a few progressive Democrats have announced their opposition to the reappointment of Jerome Powell as Fed chair, because they think he’s not active enough in addressing climate change. So now we have a Fed that’s supposed to control inflation, foster growth and employment, support markets, and fight climate change. How many roles can one institution have and still maintain a coherent effort? Developments in China In the 43 years since the Maoist period ended in 1978, China has been the fastest growing major economy in the world. And it continued to grow in 2020, when no other large economies did. Will the superior growth continue? Will China become the world’s biggest economy? The answers to these questions will be very important.

I consider it reasonable for investors to give a nod to the possibility of higher inflation, but not to significantly invert asset allocations in response to macro expectations that may or may not prove accurate. July 29, 2021 © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: You Bet! As I’ve written in past memos, I have an indelible recollection of the first book I read as a Wharton freshman in 1963. The book was Decisions Under Uncertainty: Drilling Decisions by Oil and Gas Operators by C. Jackson Grayson, Jr. (who in 1971 would take on the role of “price czar” in the Nixon administration’s efforts to get inflation under control). The best and most lasting thing I took away from Grayson’s book – and the first thing I remember learning in college – was the observation that you can’t tell the quality of a decision from the outcome. This revelation had a profound influence on me as a 17-year-old and represented the first critical building block in my understanding of how the world works. As Grayson explained, you make the best decision you can based on what you know, but the success of your decision will be heavily influenced by (a) relevant information you may lack and (b) luck or randomness. Because of these two factors, well-thought-out decisions may fail, and poor decisions may succeed. While it might seem counterintuitive, the best decision-maker isn’t necessarily the person with the most successes, but rather the one with the best process and judgment. The two can be far from the same, and especially over a small number of trials, it can be impossible to know who’s who.

The Fed has already adopted a ‘set it and forget it’ stance on rates and QE, and these tools are not as well-suited to the current economic challenges as MSLP and MLF.” So either there is a fiscal package soon and risk assets move higher, or inflation expectations trend lower, forcing the Fed to use more bullets. Our hunch is the Fed will be forced to react. (Emphasis added) The economic recovery everyone’s counting on is not an independent event, unaffected by developments. Rather, it is highly dependent on progress against the disease, as described above, but also on the continuation of fiscal expenditures in the interim. Sadly, the outlook for action in this latter regard is not good. Partisan enmity is at a level I’ve never seen before, especially given the fight over the Supreme Court nomination. With the two houses of Congress in the hands of warring parties, I’d be pleasantly surprised if they can agree on anything before the election. The bipartisan Problem Solvers Caucus in the House restarted the negotiations a couple of weeks ago by surfacing a proposal that would come out in the middle between the Democrats’ target of $3 trillion and the Republicans’ willingness to spend $500 million, and compromise on the individual components as well. [Note: I’m a national co-chair of No Labels, the organization that supports the caucus and the goal of bipartisan cooperation.]

And fear of missing out on the low rates gives people a reason to act now, accelerating transactions that might otherwise have taken place in the future. Second, lower rates increase the discounted present value of future cash flows. In the most theoretical sense, the current value of an asset is the discounted present value of the cash flows it will produce in the future. We discount future cash flows because a dollar to be received in the future isn’t worth a dollar today: money invested today should bring back more in the future. If you demand a return of 7%, you’ll pay $0.51 today for $1 to be received in ten years. (Discounted cash flow, or “DCF,” is widely used to quantify the potential return from investments. The discount rate that sets the estimated future cash flows equal to the initial investment is the return the investment will produce if the flows materialize as expected. Thus, reversing the sentence just above, if you can put up $0.51 today and get back $1 in ten years, the implied return is 7%.) The rate at which we discount future cash flows depends on the risks involved in waiting for them. These include the risk of actual loss as well as the loss of purchasing power to inflation. If something’s risky, we should demand a high return and thus use a high discount rate. However, the rate we use is also a function of prevailing interest rates and the returns available on other investments (opportunity costs).

• Additionally, there may be permanent changes to our way of life – altering things like travel, business’s reliance on offices, and activities involving crowds – that affect the path of recovery. • Something else that keeps me from thinking about the coming months as a normal recovery is that just five months after the onset of the pandemic in the U.S., and just a few months after the bottom was reached in the market and the economy, investor optimism has been restored and the prices of many assets have regained their prior highs. That’s a much faster recovery than normal by historic standards, and it seems to give short shrift to the conditions that continue to challenge the economy. • Lastly, the effects this time are highly uneven, with people of color and low-income Americans affected disproportionately, at a time of heightened sensitivity to this issue. They’re more likely to have lost their jobs and less likely to have enjoyed gains in net worth from asset appreciation – not to mention their higher rates of infection and death due to the pandemic. Whites and white-collar workers and professionals, on the other hand, are more likely to have kept their jobs and to have benefited from asset price inflation through home ownership and participation in the stock market.

When those things are low, a low discount rate will be used. And the lower the discount rate, the higher the resulting present value. Thus low interest rates raise the DCF value of all investments. Third, a low risk-free rate brings down demanded returns all along the capital market line. The yield on the 30-day Treasury bill is often referred to as the risk-free rate. There’s no credit risk, since the obligor is the government (which can print all the money it needs for repayment), and there’s no risk of losing purchasing power to inflation, since repayment at maturity is only days away. Since the risk-free rate can be earned with complete safety, and most people prefer safety over risk (all else being equal), investors shouldn’t take risk without being compensated for doing so. As investments increase in terms of the level of uncertainty, an incremental “risk premium” should be incorporated in their potential returns. Thus the notion of the “capital market line” that slopes upward and to the right, showing the relationship between risk and return, as follows: © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

In particular, the slow return of customers and the regulations that limit the scale of operation may prevent newly opened public-facing businesses from being much more profitable than they were when they were fully closed. • Worry that political or financial considerations will keep the Fed and/or Treasury from renewing their monetary and fiscal tools to combat the economic slowdown. • The significant long-term damage done to state and city finances. • The likelihood that there’ll be widespread defaults and bankruptcies despite the Fed and Treasury machinations. • The impact of potentially permanent changes to business models in industries like retail and travel, and on office buildings and high-density urban centers. • The possibility of increased inflation (or, some say, deflation), long-term damage to the reserve status of the dollar, a downgrade of the U.S. credit rating, or an increase in the cost to finance our vastly expanded deficits. There are always positives and negatives, and we can list them, consider their validity and try to assess what they boil down to. But what matters most at a given point in time in determining market behavior is which ones investors weight most heavily. Following the March 23 low, the emphasis certainly was on the positives. Does It Make Sense?

To be facetious, the government could send every American a check for $1 million, at a cost of $330 trillion. Would there be negative consequences from doing this, such as burgeoning inflation, a downgrade of U.S. creditworthiness or the dollar losing its status as the world’s reserve currency? If the answer is yes, is there a point below $330 trillion at which those ramifications might kick in? And if so, where? Could we be there already? Obviously, what these government entities are doing is cushioning the financial impact of the economic deepfreeze. And as I mentioned on March 31 in Which Way Now?, they clearly have the ability to distribute enough money to make up for businesses’ lost revenues and workers’ lost wages. But what’ll be the impact on America of the loss of a substantial portion of the second quarter’s production of goods and services? How will the economy rebound, and at what speed? If we have stops and starts, and if workers return gradually as suggested on page 4, is a V-shaped recovery still likely? What’ll be the effect if some unemployed workers who used to earn less than $1,200 per week can receive more than that in benefits? Finally, I want to talk about the Fed’s role and the impact of its behavior. Just two months ago, I attended a dinner with the president of one of the 12 Federal Reserve Banks. I asked him whether the Fed might adopt the tactic of buying corporate bonds, given the limited room for rate cuts.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Reserve System and accordingly a voting member of the Federal Open Market Committee. Here’s his reply: There is no limit on the ability of a central bank to create reserves, as long as someone is willing – or through government edicts, forced – to take them. This was true in the extreme circumstances of Weimer Germany, Brazil in the 1970s/80s, and it is true Zimbabwe today, as well as in the much more benign current situation in Japan. The key question is the impact of that reserve creation on money supply and the demand for money. Treasury’s appetite for deficit financing will remain high as long as real and nominal interest rates remain low. In the last five months, the Fed has swollen its balance sheet by $3 trillion and the Treasury has added $3 trillion to the expected deficit, for a total increase of liquidity in the economy of $6 trillion, probably with more to come. It’s normal to assume that an increase in liquidity on that order will increase the demand for goods relative to the supply, bringing on increased inflation, as it already has for financial assets. (Note, however, that even with interest rates low for a decade and near zero today, inflation hasn’t come close to the Fed’s target of 2%. If growth remains weak and inflation stays low, the Fed is likely to believe it can continue an activist regime.)

As with oil reservoirs, what will be the impact of long-term inactivity on the ability of the economy to produce? How long will it take to restart the economy and bring it back to its previous level of functioning? Lastly, what would be the effect of the Treasury continuing to add trillions of dollars each quarter to the deficit (which was running at $1 trillion even before the virus hit) and of the Fed continuing to pump trillions more into the monetary system? Last June, in my memo This Time It’s Different, I discussed Modern Monetary Theory, which – to simplify – says federal deficits and debt don’t matter. It’s no longer just a theory; we have to deal with its implications now: • What would be the effect of the above on the value of the dollar, and thus on the dollar’s status as the world’s reserve currency? (Of course, in this environment, other countries are likely to behave much the same as we do, meaning the dollar may not be debased relative to other currencies.) • Might a reduction of the dollar’s reserve-currency status make it harder for us to finance our deficits and raise the interest rates we have to pay to do so? • Might money-printing to that degree bring on an increase in inflation? • Might a supply shock stemming from reduced global output of raw materials and finished goods add to the increase in inflation? The factors that create inflation are truly mysterious, but these certainly seem like reasonable candidates, especially when combined.

Here’s Randy Kroszner’s view: I think this is the key point: whether it is Japan, where the BoJ’s balance sheet exceeds 100 percent of GDP and continues to grow rapidly, or the ECB with a balance sheet of more than 50 percent of Eurozone GDP and growing, or the Fed with a balance sheet of just over a third of US GDP and growing, inflation has been below the 2 percent target, and expectations of inflation over short and long horizons remain low. Even when the U.S. was growing 2-3 percent pre-Covid, we didn’t see an uptick in inflation or inflation expectations. As long as there continues to be a very large demand for super liquid safe assets like bank reserves and cash, the central banks can maintain large balance sheets – and even increase them – without a sharp increase in money supply that ignites inflation. The ongoing uncertainty over the course of the virus and the policy responses will undoubtedly keep the demand for safe liquid assets high for some time. It’s also normal to assume that monetary expansion like this can lead to a weaker dollar, downgrades of the U.S.’s creditworthiness by rating agencies, higher interest costs on national debt, and/or jeopardy to the dollar’s status as the world’s reserve currency. All these things could increase the difficulty of servicing the U.S.’s expanded national debt, feeding back into still-higher deficits.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Have you thought about what the reported 32.9% decline in second quarter GDP really means? Answer: it’s the percentage by which 1Q2021 GDP would be below 1Q2020 GDP if GDP were to decline in the next three quarters at the same rate as it did in 2Q2020. If that seems incredibly complex, so was Conrad’s explanation: • Actual second quarter real GDP (without seasonal adjustment or annualization) was $4.31 trillion. That was down 7.0% from $4.63T in Q1 on the same basis. • If the three subsequent quarters were also down 7.0% from quarter to quarter, 3Q2020 would be $4.00T, 4Q2020 would be $3.72T, and 1Q2021 would be $3.46T. (These are figures you’d never see, since they omit seasonal adjustment, annualization and adjustment for inflation. But I think they present a fair if not technically correct picture for these purposes.) • It’s that figure of $3.46T for 1Q2021 GDP that – after annualization and adjustments for seasonality and inflation – would be 32.9% below GDP in 1Q2020. • Interestingly, after the assumed declines, GDP in the four quarters 2Q2020 through 1Q2021 (as enumerated above) would sum to $15.49T for the year. But that would be down only 18.9% from the actual total of $19.11T in the four prior quarters (2Q2019 through 1Q2020). So, again, the 32.9% reported decline in Q2 is the difference between 1Q2020 GDP and projected 1Q2021 GDP assuming quarterly GDP continues to fall at the 2Q2020 rate.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: to the tantrum the stock market threw in the fourth quarter of 2018, when the yield on the ten-year Treasury got up to 3.25%. It was enough to end the program of interest rate increases that Janet Yellen had initiated and bring on a series of cuts instead.) If investors believe the Fed can always be counted on to keep the markets aloft, that will encourage dangerous behavior. And, anyway, it seems like an impossible task and, in my opinion, a questionable goal for the Fed. Third, the kneejerk reaction to trillions of dollars of deficit spending on the part of the Treasury and further trillions of dollars of bond buying by the Fed is worry about inflation. The injection into the economy of trillions in added liquidity would seem to have the potential to create too much money chasing too little in the way of goods, causing prices to rise (as it has done for assets). Further, as a result of the rescue measures, we’re running a multi-trillion-dollar deficit and adding trillions to the national debt, which as a percentage of GDP now approaches the high established after World War II. Printing large amounts of money has had severe consequences in the past. One wonders whether the 2020 version might bring about some of the things traditionally associated with currency debasement: • undesirably high inflation, • weakness of the U.S. dollar, • a downgrade of the U.S.

credit rating, • an increase in the cost of borrowing to cover the increased deficit, • rising interest rates generally, adding further to the cost of debt service, and thus to the deficit and debt, • the allocation of an increasing share of the federal budget to debt service, and • the dollar’s loss of status as the world’s reserve currency. Of course, there are rejoinders: • We’ve been engaged in deficit spending for a long time without any rekindling of inflation or other ill effects. (Of course, this can be likened to the frog sitting in the pot of water that’s being heated. It doesn’t notice the gradually rising temperature until it’s too late.) • Nations have been trying to create 2% inflation for years without success. Thus (a) inflation isn’t easily ignited and (b) inflation isn’t the problem – the lack of it is. • Modern Monetary Theory says (over-simplifying) that deficits and debts don’t matter. (But most economists disagree, and common sense suggests it’s unlikely a country can spend beyond its means to an unlimited degree without repercussions.) • Finally, there’s no obvious candidate to replace the dollar as the reserve currency. All I know is that (a) the Fed and Treasury seem unworried about the possibility of any of the above and (b) anyway, they consider continuing the program indispensable. Fourth, what the Fed does worry about is anemic growth.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: “The risk here is a downward spiral,” [Lael Brainard, a Fed governor, noted in a recent speech], warning that the economy could be trapped in a vicious cycle of low interest rates, muted inflation and weak growth. Long-term trends such as disappointing productivity gains and limited labor force growth are sapping the economy’s potential. In July, the Congressional Budget Office said the U.S. economy could expand in the long run at an average annual rate of just 1.8 percent — down from more than 4 percent in 2000. (The Washington Post, October 3) Because this is the Fed’s prime concern, it’s less worried about the risks entailed in its efforts to rescue and stimulate the economy as described above. It is perfectly willing to see inflation at 2%, something that it hasn’t been for years. In fact, it recently announced an averaging approach under which monetary policy will remain loose and rates low until inflation averages 2%. That is to say it will be permitted to run above 2% for a while as a way to bring the average up to 2%. Some say the worst of all worlds would be stagflation, which I lived through in the 1970s: high inflation and economic weakness. Certainly it was a dismal decade. But others think economic sluggishness is more likely to lead to disinflation (declining inflation) or even deflation, a phenomenon so rare we know little about it.

The secular deterioration in economic growth has created a condition of excess resources and disinflation. (Hoisington Quarterly Review and Outlook, Third Quarter 2020) My answer is that I have no idea whether we’ll see inflation, stagflation, stagnation, disinflation or deflation, and Oaktree won’t bet on any of them. It’s one of the tenets of our investment philosophy that our investment decisions aren’t driven by macro forecasts. Not that it wouldn’t be nice to know what the future holds in these regards; rather it’s simply that most investors – and certainly we – aren’t capable of superior judgments about the macro. So why bet? Finally, I want to state clearly that nothing I’ve written on the subject of the rescue and its possible ramifications is intended to be critical of the Fed and Treasury and their actions. I put it simply: just because something has potential negative consequences doesn’t mean you shouldn’t do it. In the case of the pandemic and associated recession, there was absolutely no alternative. While not perfect, the policy response has been brilliant.

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: On the Other Hand It often happens that just as I’m about to release a memo, I come across something that absolutely has to be incorporated. That was the case on June 12, the day “This Time It’s Different” was published. I was reading a first-quarter report from Ruffer, a London-based money manager, and I came across the following question: Can the Fed, with its discretions and its firepower, keep a market dislocation at bay, or halt it once it has begun? That question caused me to think back to remarks made a few days earlier by Federal Reserve Chairman Jerome Powell regarding how the Fed would deal with the possibility of a trade war and its potential ramifications: We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2% objective. (CNBC, June 4) Together, these two inputs prompted me to reflect on the role and powers of the Fed. In short, is it the Fed’s job to sustain expansions and keep market dislocations at bay ad infinitum?

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Mysterious Most of the time, my memos have their origin in something interesting that’s happening in the world or in a series of events I come across that I think can be interestingly juxtaposed. This one arises from a less usual source: a request. The other day, my colleague Ian Schapiro, the leader of Oaktree’s Power Opportunities and Infrastructure groups, suggested I write a memo about negative interest rates. My reaction was immediate and unequivocal: “I can’t. I don’t know anything about them.” And then I realized that’s the point. No one does. But Ian thinks I can make a contribution, so I’ll try. I’ve been saving up clippings on this subject, as you’ll see. Ian’s urging set me to work. * * * For a good while now, I’ve used the term “mysterious” in connection with inflation (and deflation). What causes rapid inflation? How can it be stopped? Economists offer explanations and prescriptions regarding each occurrence, but they rarely apply the next time. And that brings us to the subject of negative interest rates. I find them no less mysterious. The fact that we know what they are – as we do with inflation and deflation – doesn’t alter the fact that we don’t know for sure why negative rates are prevalent today, how long they’ll continue in force, what might cause them to turn positive, what their consequences are, or whether they’ll reach the U.S.

 We can have economic strength without inflation.  Interest rates can remain “lower for longer.”  The inverted yield curve needn’t have negative implications.  Companies and stocks can thrive even in the absence of profits.  Growth investing can continue to outperform value investing in perpetuity. I rarely participate in a meeting these days without someone asking about one or more of these propositions. The bottom line is that for any of the nine to be true, things really have to be different this time. I’ll discuss the outlook for each below. The avoidable recession – The questions I get most often these days are “Is the U.S. heading for a recession?” and “When will it start?” My answer to the first is a simple “yes.” (At least I can never be proved wrong.) We’ve always had economic cycles, and I believe we always will. Eventually, favorable developments will lead people to engage in behavior premised on excessively optimistic assumptions, and eventually the over-optimism of those assumptions will be exposed and the excesses will correct in a period of negative growth. Moreover, even economies that aren’t marked by excesses are subject to exogenous shocks. When people ask about the coming recession, what they mostly mean is “Might it be a long way off?” Well, the longest U.S. recovery on record lasted ten years, and the current one is in the twelfth month of its tenth year.

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Today, large numbers of bonds – the vast majority being government bonds from Europe and Japan – carry negative yields to maturity. They constitute roughly two-thirds of the bonds in Europe and 25- 30% of all the investment grade debt in the world. A few corporate bonds also offer negative yields, however, and there’s even a handful of negative-rate high yield bonds (the ultimate oxymoron). Further, on September 4 Bloomberg pointed out the prevalence of negative real rates: While over $17 trillion of the global stock of debt trades at nominal yields below zero, the figure jumps to $35.7 trillion when inflation is taken into account. . . . In the U.S., more than $9 trillion of the nation’s government debt carries yields lower than the CPI rate. With a negative-rate instrument, the price you pay for a bond today exceeds the sum of the face amount that will be repaid when it matures plus the interest you’ll receive in the interim. That means if you buy a negative-yield bond and hold it to maturity, you’re guaranteed to lose money. Why, then, would anyone want to buy a negative-yield bond? Here are some reasons that make sense:  Fear regarding the future (relating to recession, market declines, credit crisis or further declines in interest rates, among other factors) that causes investors to engage in a flight to safety, in which they elect to lock in a sure but limited loss.

 A belief that interest rates will go even more negative, giving holders a profit, as it implies bonds will appreciate in price (as they would with any decline in rates).  An expectation of deflation, causing the purchasing power of the repaid principal to rise.  Speculation that the currency underlying the bond will appreciate by more than the negative interest rate. The concept behind negative rates is simple. It’s merely the reverse of the traditional norm, in which lenders receive interest from borrowers. Generally speaking, interest rates are a function of two variables: (a) the time value of money and (b) expected changes in the purchasing power of money (i.e., inflationary or deflationary expectations). (Of course, interest rates should also incorporate a risk premium to compensate for any credit risk entailed.) If, for example, lenders want a 2% annual real return to compensate for the time value of money and expect 2% inflation over the next five years, a five-year Treasury note should yield 4%. But if lenders expect deflation at 3% per year, that note should theoretically yield negative 1%. Are today’s negative rates in Europe and Japan telling us deflation lies ahead? Or have lenders changed their views regarding the time value of money? Or are rates negative simply because governments and central banks want them to be?

But how, exactly, do low rates contribute to wealth creation?  Low interest rates encourage spending on the part of consumers. Low rates reduce the cost of borrowing, lifting demand for things that are often bought on time or leased, like cars, homes and appliances. Further, low rates translate into lower monthly payments on floating- rate mortgages, leaving consumers more disposable income to spend. Finally, with rates low, spending instead of saving entails little in the way of opportunity costs.  Low rates likewise encourage investment on the part of businesses by reducing the cost of capital, and therefore the return hurdle for expenditures.  Increased demand for goods and services leads to increased hiring, reduced unemployment and a tighter labor market, and thus to wage inflation. Rising wages encourage consumer spending by putting more money into wage-earners’ pockets and improving their mood.  By reducing the interest expense on companies’ floating-rate debt, low rates enhance companies’ profits; make it easier for them to service their debt; and leave them more cash for capital expenditures (which add to GDP), and dividends and stock buy-backs (which put money in investors’ pockets).  Low rates reduce the discount factor used in calculating the net present value of future cash flows. Thus, all else being equal, there’s a direct connection between declining interest rates and rising asset prices.

“In today’s global economy, private investment demand is manifestly unable to absorb private savings . . .” (Lawrence Summers, Financial Times, October 12)  Unfavorable demographic trends mean central banks can’t maintain positive rates without curbing growth.  The lack of inflation means investors needn’t demand protection against the loss of purchasing power over time. The wonders of technology may continue to make products available cheap or free, capping inflation.  Fear of deflation adds further to the willingness to invest without such protection.  “The rise of businesses dealing in intangible products has rendered the economy less capital- intensive . . .” said Grant’s Interest Rate Observer on July 26. This reduces the demand for long-term borrowings.  Certain regulations require financial institutions to invest in home-country sovereign bonds regardless of the yield they offer (and whether it’s positive). This artificially lifts the demand for (and thus the prices of) those bonds. Everyone has favorites from this list. But everyone differs, including the “experts.” Some people think we have negative rates because central bankers want them, some think it’s because the market sets them, and some think it’s some of each. “Did interest rates fall, or were they pushed?” asks Grant’s. Given all the above, no one should feel the reasons for negative rates are fully understood.

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: a self-fulfilling, placebo-like component to many of the Fed’s tactics.) In this regard, I think its first round of QE was more effective than its second, and its second round was more effective than its third. Accordingly, there could be a diminishing return from permanent QE, as the psychological effect abates. And who knows exactly how QE works? Last week, at a conference I attended, a participant suggested that under Modern Monetary Theory (see more below), the Treasury could issue a potentially unlimited amount of debt, and if third-party buyers failed to take it up, the Fed could buy it under QE. Does this seem reasonable? If the Fed credits banks with reserves, the banks lend a multiple of those reserves, and the borrowers use the loan proceeds to make purchases or investments, does the process really inject money into the economy, or is it mostly a matter of bookkeeping? Or are they one and the same? Of course, this question is relevant to all nations with fiat currencies. Quantitative easing is generally considered to have contributed to the past decade’s low prospective investment returns, resultant risk-taking, asset inflation, and increasing wealth divide. As with any other prescription, shouldn’t we worry about possible side effects like these? Can government actions permanently raise the level of demand in an economy, or do they mostly accelerate future demand into the present?

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: interest rates unjustifiably low in an attempt to help Hillary Clinton win the presidency. (The New York Times, June 20) Regardless, it’s clear that, at this time, Trump thinks low rates are good and there’s no reason to worry about potential negative ramifications. But that doesn’t mean they don’t exist. Is There a Downside to Low Interest Rates? The truth is, there are ways in which low rates are undesirable and potentially harmful. They include these:  Low rates stimulate the economy, as described above, and most economists and businesspeople believe there’s such a thing as the economy becoming too hot. The principal worry is excessive inflation. While some inflation is a good thing, too much isn’t. It’s generally accepted that too much of the positives described on page three can lead to excessive demand for goods and services; too-tight labor conditions, leading to excessive wage inflation; too much market power in the hands of sellers of goods; and thus rising prices.  Too much inflation imposes a hardship on people living on fixed incomes, since their costs increase rapidly while their incomes don’t. Also, low-income households typically don’t have the means to hedge against inflation that high-income ones do, such as through investments in equities and real assets.

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us:  Importantly, the pessimistic signals sent by negative rates may mean they have a contractionary rather than stimulative effect. Research has suggested that Japan’s negative rate policies may have backfired, actually lowering inflation expectations instead of firming them, as hoped. (The New York Times, September 11) Last week famously blunt ING boss Ralph Hamers excelled himself, all but calling the ECB idiotic for planning to shift rates further downwards. “The negative rate environment is making consumers so uncertain about their financial environment that they’re starting to save more rather than less,” he said. Mr. Hamers has a point. Rather than encouraging people to borrow and spend, the data suggests nervous eurozone consumers are hoarding. Eurostat reports the eurozone household savings ratio is at a five-year high of nearly 13 per cent. (Financial Times, August 5)  If interest rates for small savers ever were to go negative, it would give rise to the juxtaposition of income penalties for households with benefits for “the elites” through their ability to profit from rising equity prices. Economic impact aside, the boost to populist politics would likely be dramatic.  Negative rates can distort the workings of floating-rate financial products. Lenders and depositors might have been happy in the past receiving interest rates at a spread over the base rate Euribor.

underlying inflation is already close to target and the Fed’s past attempts (in the late 1960s/early 1970s) to trade off a little more inflation for sustained lower rates of unemployment turned out very badly. Alternatively, higher labor costs from an © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: economies and central banks. This means the task of managing an economy is difficult, and its goals shouldn’t be thought of as dependably achievable. I think a recent article from The Times provides a great picture of how challenging the job is, and how many ways there are to be wrong. Here’s most of it: Heading into their policy decision and news conference Wednesday [June 19], there were a lot of ways Federal Reserve officials could have messed things up. One possibility was a repeat of the meeting in December, when markets judged Chairman Jerome Powell and the Fed to be oblivious about negative forces building in the markets and in the global economy, and sold off precipitously over the next days. But the opposite risk was present as well — that out of fear of repeating the December episode, Mr. Powell would exhibit too much of a hair-trigger reaction to recent signs of a slowdown in inflation pressures and industrial activity. If those turn out to be false alarms, a rate cut now would be counterproductive by signaling pessimism and making the Fed look jittery and perhaps even overly influenced by President Trump’s threats to try to demote Mr. Powell over interest rate policy. . . . In effect, Fed officials are indicating they think it’s pretty likely they will need to cut rates, but are waiting for more evidence.

benefits from an unlimited appetite for its debt, since it’s the safest of any major sovereign. For these reasons, expanding the national debt isn’t a problem. And like the cardholder described above, since there’s no limit to its credit, the U.S. can add the interest that accrues to the unpaid balance. What happens if these conditions change? Could a tipping point be reached at which there’s so much debt that people question the U.S.’s creditworthiness and ability to repay its borrowings? In that case, the demanded interest rate would rise, meaning the debt and interest mightn’t be repayable without massive money printing that would result in debasement of the dollar. Thus, could there come a day when it takes unacceptably more purchasing power to pay off U.S. debt denominated in dollars that have depreciated? I put these questions to my friend Randy Kroszner, former member of the Fed’s Board of Governors and Deputy Dean at the University of Chicago’s Booth School of Business. Here’s his response: I think the last three decades for Japan and the last decade for the U.S. have shown (and continue to be showing) that countries with credible institutions can “get away with” higher debt levels without a raid by bond vigilantes than most had once thought. That said, it leaves the country vulnerable to a change in sentiment, exactly as you describe. “Getting away with it” for too long erodes the credibility of the institutions over time.

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: this subject with differing degrees of confidence. Yet I remain certain that none of them “know.” If I had to take a guess – and that’s all it would be – I’d say interest rates won’t go negative in the U.S. in the current cycle. If we go back to the possible reasons for them listed on page four, I think we’ll conclude that the factors at play in the U.S. make negative rates less likely:  Stronger current economic growth  Better growth prospects  Thus no need for emergency measures  Higher inflation expectations (especially given the tightness of the labor supply)  Less pessimism  Better uses for long-term capital So I don’t think current conditions in the U.S. call for negative rates. But that doesn’t rule them out. When you express an opinion, the real question is whether you’ll bet on it and whether you’ll give odds. I might put up $60 to win $50 from you if negative rates don’t materialize. But that’s not a sign of much confidence on my part. In particular, I wonder about monetary stimulus. The U.S. fed funds rate is below 2% as I write, thanks to the two recent rate cuts (and there might be another cut on the way soon). Yet most stimulus programs have entailed rate cuts totaling several percent. So there’s every possibility that in the future, the Fed’s response to economic weakness could take rates into negative territory. And the current slowdown in U.S.

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Economic strength without inflation – For the last 60 years, there has been widespread (albeit not universal) acceptance of the so-called Phillips curve, which posits an inverse relationship between the rate of unemployment and the rate of inflation. In other words, as unemployment falls and the labor market tightens, workers gain bargaining power and employers have to compete for a declining number of available workers. This results in rising wages, which translates into increasing inflation. The U.S. has seen unusually little unemployment during the Trump presidency, and today it’s at a 50-year low. Nevertheless, there hasn’t been much wage inflation until very recently, and there still isn’t much general inflation. There are reasons why the relationship underlying the Phillips curve as defined above might be different from what it was in the past:  Since the U.S. labor force participation rate (percentage of adults who are either employed or looking for work) is at its lowest level in more than 40 years, it might be more meaningful to look at the non-employment rate (the percentage of adults who aren’t working) rather than the unemployment rate (the percentage of adults looking for work who aren’t working). By the former measure, the labor market isn’t so tight.

 Inflation might be structurally lower now and in the future than it was in the past, altering its relationship to conditions in the labor market. Automation, the shift of manufacturing to low- cost countries and the prevalence of free/cheap stuff in the digital age might help explain today’s unusually low rate of inflation. For examples of the third of these, think about recent trends in the price of photographs, cellphone calls, messages (texts and emails versus telegrams and faxes) and books.  On the other hand, the cheapening of things like those listed just above could halt, and a more traditional relationship between inflation and unemployment could resume. Excessive inflation creates a number of serious economic and social problems, typically requiring central banks to raise interest rates to cool it off, with the effect of dampening economic growth and job creation. Likewise, rising inflation can cause investors to demand higher interest rates on bonds and loans to compensate for the risk of losing purchasing power. This can make it harder for borrowers to service their debt, causing defaults to rise and discouraging investors from taking risk and providing financing. (On the other hand, there’s a level of inflation that’s desired such that, among other things, workers will see wage growth, and the U.S. can repay outstanding debt with dollars representing a reduced amount of purchasing power.

Today that desired rate is about 2%, and policymakers worry about the fact that it hasn’t materialized despite the low unemployment rate.) Rising inflation could be seen as a potential contributor to the end of the recovery. So far it hasn’t shown up despite the tightness of the labor market. Has the Phillips curve relationship been revoked for good, or is inflation in the offing? Who knows? The word I use to describe inflation is “mysterious.” It’s rarely clear how it gets started, and in the 1970s and early ’80s, when it reached the mid-teens in the U.S., no one could figure out how to stop it until after Paul Volcker became Fed chair. It’s mysterious why there’s so little inflation today, and whether there’ll be inflation in the future. But I’m not confident that it’ll still be below 2% a few years from now. © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Can it do so if inflation strengthens? Will it leave rates so low that there’s little room to reduce them in the future should stimulus be needed? If deficits and debt grow faster than GDP, won’t that put upward pressure on interest rates? Or if the Fed cuts rates, as many people now consider likely, will the markets be cheered by the stimulus, or will they fall in response to the economic concerns at which the rate cuts are directed? Certainly no one can say. Equanimity regarding the inverted yield curve – Something else we’ve heard a lot about over the last couple of years is how risky it is when the yield curve inverts. The yield curve is usually upward-sloping, meaning lenders demand higher interest rates when they lend for longer periods as compensation for the increased uncertainty (especially with regard to possible declines in the purchasing power of the currency between the time the loan is made and when it’s repaid). But sometimes, long-term rates fall below short-term rates, and the curve is said to be “inverted.” The curve has been unusually flat in recent months, and today it’s actually inverted. Because most periods of inversion have been associated with recessions, the condition is considered worrisome. In that regard, the Financial Times noted on June 1 that “the [yield curve] has ‘inverted’ before every US recession in 50 years.” (Note, however, that this is different from saying every inversion has been followed by a recession.)

What people should be focusing on isn’t the usual coincidence of inversions and recessions, but rather the reason for this particular inversion. Understanding the latter might allow observers to sense whether a recession is implied and avoid a “false positive.” The explanation for inversions isn’t always clear, since interest rates (like inflation) can be mysterious. Today I would say the inversion of the curve may be due to the fact that the Fed has brought short rates up at the same time that (a) there’s a surplus of capital for investment at the long end of the yield curve, putting downward pressure on rates there, and (b) there’s less reliance on © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

But stocks of companies with tangible value in the here-and-now are likely to hold up better in less positive times because (a) they’ve previously been disrespected and valued lower and (b) the rationale underlying their prices is less a matter of conjecture and faith. Thus a swing in favor of value may have to await a period in which the “champions” lose some of their luster, perhaps in a market correction (see 4Q2018). But it’ll come. * * * What do all the theories propounded above have in common? That’s easy: they’re optimistic. Each one provides an explanation of why things should go well in the future, in ways that didn’t always go well in the past. In recent years, the U.S. has simultaneously experienced economic growth, low inflation, expanding deficits and debt, low interest rates and rising financial markets. It’s important to recognize that these things are essentially incompatible. They generally haven’t co-existed historically, and it’s not prudent to assume they will do so in the future. Many of the beliefs discussed above suggest we’re in a so-called “Goldilocks” environment: one that’s not too hot and not too cold.  Economic growth won’t be so strong that it brings on excessively high inflation, or so weak that it ends in recession.  Inflation won’t be so low that the economy stagnates, or so high that it leads to burdensome increases in the cost of living and requires contractionary interest-rate increases to cool it off.

The bottom line is that politicians are able to offer simple economic solutions that have considerable appeal but fail to hold up in real life. Since politics is largely about how costs and benefits are distributed – rather than about increasing aggregate benefits – politicians’ simplistic economic prescriptions mustn’t be swallowed whole. January 30, 2019 P.s.: Just prior to publication (I can hardly keep up with the developments in this area!) I received a mass email from a candidate for New York City’s Public Advocate, effectively a “public watchdog,” stating the following: . . . we fought for, and won, a $15 minimum wage, though as we all know, $15 just isn’t enough to support a family in this city. So we need to keep fighting. . . . A $30 minimum wage, adjusted with inflation, for New York City government workers and businesses that employ over 75 New Yorkers would be where we start. This brings to mind the description Winston Churchill used regarding the folly of a nation trying to tax its way to prosperity: “like a man standing in a bucket and trying to lift himself up by the handle.” © 2019 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: U.S. companies have been holding abroad. The results will generally be very positive for corporate profits, cash flows and perhaps capital investment (see below).  The unemployment rate is down to 4.1%, nearly the lowest level in 60 years, meaning we’re nearing “full employment” (albeit with an unusually low percentage of adults participating in the workforce). With so little employment slack remaining, it seems reasonable to think near-term GDP growth will translate into wage gains, and thus back into further increases in demand.  Although low, today’s prospective returns are described as being reasonable in the context of low interest rates.  The low levels of inflation worldwide mean central bankers needn’t rush to raise interest rates to restrain it. There’s no obvious reason to predict hyperinflation.  Thus the near-term rise in interest rates – while probable – can be expected to be gradual and limited in scope.  Except in pockets, investor psychology can’t be described as euphoric and imprudent (although it has been strengthening of late). For years the markets have been “climbing a wall of worry,” an old-fashioned phrase used to describe a healthy ascent that’s occurring not because of euphoria and risk-obliviousness, but rather despite a catalog of perceived ills.

 The known catalysts for a market downturn – recession, ballooning inflation, much-higher interest rates, major central bank missteps, a governmental breakdown in Washington, and war – can’t be assigned probabilities that are more than modest. Negatives – As opposed to the positives listed above, most of the negatives surround either (a) positive fundamental factors that have the potential to deteriorate or (b) the high prices being paid for those macro-positives, and the investor behavior creating those prices.  While the outlook isn’t dire, a number of subjects do represent genuine uncertainties and provide basis for concern: the possibility of slow long-term economic growth, the potential for rising interest rates and inflation, the impact of reversing stimulative monetary policy and the Fed switching to being a net seller of securities, the implications for employment as automation increases, the world’s dependence on China’s growth, and political and geopolitical tail risks. As the markets have risen, talk of all these things seems to have gone quiet.  We know interest rates are likely to rise (creating competition for most asset classes and arguing for lower asset prices). We just don’t know by how much.  Some of the elements characterizing the macro-economic environment can be described as “long in the tooth” or “unusually elevated.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Debt levels:  “One remarkable feature of the past decade is that between 2007 and 2017, the ratio of global debt to GDP jumped from 179 per cent to 217 per cent, according to the Bank for International Settlements.” (Financial Times)  “In the last year Congress has passed a gargantuan tax cut and spending increase that, according to Deutsche Bank, represents the largest stimulus to the economy outside of a recession since the 1960s. It sets the federal debt, already the highest relative to GDP since the 1940s, on an even steeper trajectory [and] stimulates an economy already at or above full employment which could fuel inflation . . .” (Wall Street Journal)  “Debt levels crept up as central banks suppressed [interest rates], with the proportion of global highly-leveraged companies – those with a debt-to-earnings ratio of five times or greater – hitting 37 percent in 2017 compared with 32 percent in 2007, according to S&P Global Ratings.” (Bloomberg)  The debt of U.S. non-financial corporations as a percent of GDP has returned to its Crisis level and is near a post-World War II high. (New York Times)  Total leveraged debt outstanding (high yield bonds and leveraged loans) is now $2.5 trillion, exactly double the amount in 2007. Leveraged loans have risen from $500 billion in 2008 to almost $1.1 trillion today.

In the last twenty years we’ve had painful first-hand experience with the results of efforts to prevent the economy from slowing. GDP growth can be enhanced temporarily through a shot of fiscal adrenaline (like a tax cut), but that can’t raise it permanently.  And doesn’t it seem odd that the government is implementing a stimulative tax cut just as the Fed is raising interest rates and reversing its purchases of securities? The Fed is concerned that a continuation and possible strengthening of the recovery will cause inflation to accelerate; thus it’s acting to “remove the punchbowl.” That makes sense. Why is the government taking fiscal actions in the opposite direction?  The unanimous willingness of former “deficit hawks” to pass a bill that adds more than $1 trillion to deficits and debt is indicative of what I’ve seen described as “ideological pliability.” Those who voted for it must have concluded that giving out goodies garners the most votes. That bodes ill for fiscal discipline in the future. The centerpiece of the tax law is the reduction of the stated tax rate on corporate profits from 35% to 21%. What are its merits?  Our corporate tax rate shouldn’t be higher than the rates in other countries, as it has been to date. A higher rate gives companies an incentive to increase capacity abroad rather than in the U.S.; encourages U.S. companies to merge into foreign companies or relocate overseas; and gives foreign companies superior profitability.

The legislation will increase the nation’s longer-term fiscal burden, which is already facing other pressures, such as higher debt service costs and entitlement spending as the baby-boom generation retires. While this does not seem to be a great concern to market participants today, the current fiscal path is unsustainable. In the long run, ignoring the budget math risks driving up longer-term interest rates, crowding out private sector investment and diminishing the country’s creditworthiness. These dynamics could counteract any favorable direct effects the tax package might have on capital spending and potential output. Of all the possibilities, I find myself agreeing with Dudley’s take on the likely consequences. All else equal, the tax law is likely to result over time in higher deficits, higher national debt, higher economic growth, higher inflation, higher interest rates, higher federal debt service requirements, and thus still-higher deficits and debt. These things tend to go together, and together they constitute the fiscal path Dudley describes as unsustainable. The outlook was troubling before; the tax cuts will make it worse. The reward from the tax law is pretty clear: it’s likely that in the short run the economy will strengthen, corporate profits will increase and take-home pay will rise for most Americans. But the long-term benefits are less certain, and meaningful hidden risks exist. * * * Next I want to spend some time on SALT.

But I do think this is the kind of environment – marked by too much money chasing too few deals – in which investors should emphasize caution over aggressiveness. On the other hand – and in investing there’s always another hand – there is little reason to think today’s risky behavior will result in defaults and losses until we see serious economic weakness. And there’s certainly no reason to think weakness will arrive anytime soon. The economy, growing but relatively free of excesses, feels right now like it could go on a good bit longer. But on the third hand, the possible effects of economic overstimulation, increasing inflation, contractionary monetary policy, rising interest rates, rising corporate debt service burdens, soaring government deficits and escalating trade disputes do create uncertainty. And so it goes. * * * Being alert for the ability of others to issue flimsy securities and execute fly-by-night schemes is a big part of what I call “taking the temperature of the market.” By also incorporating awareness of historically high valuations and euphoric investor attitudes, taking the temperature can give us a sense for whether a market is elevated in its cycle and it’s time for increased defensiveness. This process can give you a sense that the stage is being set for losses, although certainly not when or to what extent a downturn will occur.

Quantitative investors, on the other hand, do so based on quantitative assessment of securities’ fundamentals and price. In closing on the subject of quantitative investing, I want to mention a few issues related to timeframe (some of them suggested by my son Andrew).  Most quantitative investing is a matter of taking advantage of standard patterns (the factors that have been correlated with outperformance) and normal relationships (like the usual ratio of one stock’s price to another’s or to the market).  Quants invest on the basis of historic data regarding these things. But what will happen if patterns and relationships are different in the future from those of the past?  Is it important that most quantitative investors have operated only in periods when interest rates were declining, inflation was low and volatility was low, and when the trends in these regards were fairly stable? Will their approaches prove dynamic enough to adjust if rates, inflation and volatility rise or become more variable? And if they do rise or become more variable, what historic data will quants use in their rule-making?  Likewise, is it significant that there’s limited history of investment performance in periods influenced by quants? In other words, will increased quantitative investing influence the effectiveness of quantitative investing, and thus alter the requirements for success? We’ll see, but certainly it can’t be said that most quantitative investors are proven in these regards.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Before starting in, I want to apologize for the length of this memo, almost double the norm. First, the topic is wide-ranging – so much so that when I sat down to write, I found the task daunting. Second, my recent vacation gave me the luxury of time for writing. Believe it or not, I’ve cut what I could. I think what remains is essential. Today’s Investment Environment Because I don’t intend this to be a “macro memo,” incorporating a thorough review of the economic and market environment, I’ll merely reference what I think are the four most noteworthy components of current conditions:  The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.  In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.  Asset prices are high across the board. Almost nothing can be bought below its intrinsic value, and there are few bargains. In general the best we can do is look for things that are less over-priced than others.  Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need. Ditto In January 2013, I wrote a memo entitled “Ditto.

However, there have been exceptions: banks issued their own currencies in our nation’s first century, and it can be argued that the “Green Stamps” of my childhood, and airline miles today, have a lot in common with currencies.  For a long time currencies were backed by (and exchangeable for) gold or silver, but that’s no longer the case. The truth is, there’s nothing behind currencies these days other than their issuing governments’ “full faith and credit.” But what do they promise? New currencies are sometimes created out of thin air (like the euro, which wasn’t legal tender sixteen years ago), and sometimes they’re devalued.  Currencies change in value relative to each other, in theory based on differential purchasing power, and in practice based on changes in supply and demand (which can stem, among other things, from changes in purchasing power). Bitcoin fans argue that it qualifies as a currency under these criteria: most importantly, it’s something that parties can agree to accept as legal tender and a store of value. That actually seems right. When I first responded to comments on the memo – even before my recent enlightenment – I found myself admitting that much of the criticism I had leveled at Bitcoin is applicable to the dollar as well. Whereas I said Bitcoin “isn’t real” because it has no intrinsic or underlying value, that’s certainly true of the dollar and other fiat currencies: there’s nothing behind them either.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us:  All the relevant data regarding Bitcoin – number outstanding, number newly created, and transactions – are recorded in the “blockchain,” a sort of transparent electronic ledger of which everyone can have his or her own copy.  Bitcoin can’t be debased by unlimited issuance, since the blockchain process has been set to permit only a gradual increase from today’s 16 million, to 21 million in 2140. In this sense Bitcoin is better than the dollar, of which a lot more can be issued at any time, diminishing its purchasing power through inflation. As Steven and Murray have written, “a purchase of Bitcoin is nothing other than a short sale of the currencies of the world. Merely by limiting the growth of supply, Bitcoin would become more valuable as other currencies devalue.”  Since the blockchain exists on each person’s individual computer, rather than in a central location, it can’t be hacked, and thus Bitcoin can’t be stolen, counterfeited, or secretly created in amounts exceeding the authorized total. Likewise, Bitcoin isn’t subject to the currency controls on portability that are often imposed by failing governments. (But I wonder whether the technological claims made for the blockchain might be its Achilles’ heel. While I certainly don’t have the ability to assess these claims for myself, I wonder how many of Bitcoin’s advocates do either.) Where will we go from here?

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: All I’m saying is that for all the things listed above to simultaneously be gaining in popularity and attracting so much capital, credulousness has to be high and risk aversion has to be low. It’s not that these things are doomed, just that their returns may not fully justify their risk. And, more importantly, that they show the temperature of today’s market to be elevated. Not a nonsensical bubble – just high and therefore risky. Try to think of the things that could knock today’s market off kilter, like a surprising spike in inflation, a significant slowdown in growth, central banks losing control, or the big tech stocks running into trouble. The good news is that they all seem unlikely. The bad news is that their unlikelihood causes all these concerns to be dismissed, leaving the markets susceptible should any of them actually occur. That means this is a market in which riskiness is being tolerated and perhaps ignored, and one in which most investors are happy to bear risk. Thus it’s not one in which we should do so. What else:  My observations are always indicative, not predictive. The usual consequences of the conditions I describe – like an eventual increase in risk aversion – should happen, but they don’t have to happen.  And they certainly don’t have to happen soon. No one knows anything about timing.

They aren’t absolute, like the laws of physics (e.g., gravity), but they reliably establish tendencies and limits. If the price of something goes up, the amount consumed is likely to go down. If wages rise, the number of people employed for a task is likely to decline. If tax rates go up, there’s likely to come a point at which there’s less incentive to work, and thus less output. If a government spends more, to pay the bills it has to either print money (which tends to be inflationary), raise taxes or borrow. Shortly after publishing “Economic Reality,” I added a new section to the version appearing on Oaktree’s website, saying economics is largely the study of choice. If you only have $10, do you want to buy a $10 book or two $5 hamburgers, or make a $10 gift, or add $10 to your savings? The only thing we know you can’t do is do them all. Further, decisions and actions have consequences. For example, spending can provide us with enjoyment, but it will also make us poorer. Reality in Politics I’ve always gotten a kick out of oxymorons – phrases that are internally contradictory – such as “jumbo shrimp” and “common sense.” I’ll add “political reality” to the list. The world of politics has its own, altered reality, in which economic reality often seems not to impinge. No choices need be made: candidates can promise it all. And there are no consequences. If something might have negative consequences in the real world, politicians seem to feel free to ignore them.

A thorough understanding of how investors’ minds work is essential if one is to figure out where a market is in its cycle, why, and what to do about it. For me, the markets’ recent behavior – certainly on December 11, but also at other points in 2015 – reinforces that observation. This memo is my attempt to send the markets to the psychiatrist’s couch, and an exploration of what might be learned there. 2012-14: An Uncertain World In September 2012, I wrote a memo called “On Uncertain Ground.” To begin it, I observed that “The world seems more uncertain today than at any other time in my life.” I went on to list the things that worried me. Few of them are less troubling today. Certainly the period of the post-crisis recovery hasn’t been carefree. Here are the things that concerned me in 2012, as viewed from that perspective:  Macro growth – It seems to be broadly accepted that overall economic growth will be slower in the years ahead than in the latter part of the twentieth century. Do lower birth rates and slowing gains in productivity doom us to reduced macro gains? What does this mean for everything else? In particular, if growth remains slow, will it lead to slowing inflation, or even deflation?  Trends in the developed world – Will the developed nations be able to compete in a globalized economy? How will incomes hold up as developing nations produce goods cheaper, and as the quality of those goods improves?

 Trump’s campaign promises have included tax reform; reduced income tax rates on corporations and big earners; some form of tax holiday to enable corporations to bring in profits stranded abroad; a reduction of business regulation (Carl Icahn tells me this will be huge); a big infrastructure program ($1 trillion announced); an end to bank-bashing; less pressure on pharmaceutical and health care companies to cut prices; and an end to the estate tax. That’s quite a pro-business agenda.  The populist power of Sen. Warren will be reduced.  Businessmen and Wall Streeters will be welcome to serve in the administration, not verboten as in recent years. At the bottom line – if everything works as promised – there will be massive fiscal stimulus; big increases in GDP growth, corporate profits and jobs; higher inflation than otherwise would have been the case; a big increase in the national debt; and more of everything for everybody. Writing in the Financial Times, Anthony Scaramucci, a member of Mr. Trump’s economic advisory council, said the president-elect would finance the new spending plan with “historically-cheap debt and public-private partnerships” and said it would cut deficits by stimulating economic growth. “Economies around the world are fighting deflation largely because of a post-crisis move toward fiscal austerity. We can close the wealth gap in America by replacing emergency-level interest rates with fiscal stimulus.

“Secular swings are hard to forecast, but the secular sweep downwards in interest rates is over, and we are about to have a gentle swing upwards.” I always feel it takes a degree of innate optimism to be a devotee of stocks (with their reliance on conjectural returns awarded by the market) as opposed to bonds (which bring contractual returns guaranteed by their issuers). Thus U.S. equity investors have exhibited an optimism regarding the Trump administration that virtually no one foresaw a week ago. Equity investors like inflation because it pumps up profits. Bond investors dislike it because it raises interest rates, reducing the value of the bonds they hold. But the two can’t go in opposite directions forever. At some distant point, higher interest rates can cause bonds to offer stiffer competition against highly appreciated stocks. Finally on the subject of the market outlook, I’ll pass on some observations from Stanley Druckenmiller – the owner of one of the very best investment records in history, and certainly not someone congenitally biased to optimism (or anything else): Billionaire investor Stanley Druckenmiller told CNBC on Thursday he's "quite, quite optimistic" about the U.S. economy following the election of Donald Trump. "I sold all my gold on the night of the election," the founder and former chairman of Duquesne Capital said in a “Squawk Box” interview. © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Citizens of almost every other country have an easier way to respond when the “soak-the-rich” movement arrives (see the big earners who moved away when France enacted a 75% top rate a few years ago). Thus most governments are aware that while they can raise tax rates on people of means, in most cases they can’t make them sit still and take it. * * * Another way national governments can make it easier to accomplish their financial goals is by printing money. But flooding the market with more currency debases the value of the currency. They can increase people’s nominal incomes, but eventually they’ll find their fatter wallets don’t contain any more spending power than they used to. In “The Limits to Negativism” (October 2008), I discussed the fact that in Weimar Germany, the government took the 1,000 mark note and over-stamped it “One Million Marks.” But it still only bought one goat. The mark fell from 60 to the U.S. dollar in early 1921 to 320 to the dollar in early 1922 and 8,000 to the dollar by the end of 1922. It’s hard to believe, but according to Wikipedia (user-maintained and perhaps not always the most authoritative): In December 1923 the exchange rate was 4,200,000,000,000 Marks to 1 U.S. dollar. In 1923, the rate of inflation hit 3.25 x 106 percent per month (prices double every two days). One of the firms printing these [new 100 trillion Mark] notes submitted an invoice for 32,776,899,763,734,490,417.05 (3.28 x 1019, or 33 quintillion) Marks.

[That’s not a misprint.] The great advantage for governments in creating inflation lies in the ability to meet obligations with debased currency. That was the motivation behind Germany’s hyperinflation in the 1920s – to make it easier to cover expenses and debts denominated in Marks. © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Today most nations want to see inflation. That would reduce the “real” value of their national debt and ease repayment in real terms. Treasuries and central banks have tried to encourage inflation by cutting interest rates and increasing the amount of money in circulation. Quantitative easing, for example, consists of the Fed using newly printed dollars to buy outstanding debt; this should increase the amount of money in circulation and thus raise the dollar price of goods. Voilà: inflation. But governments’ efforts have been strikingly unsuccessful and, so far, inflation is MIA. Inflation is a mysterious (and, I think, largely psychological) phenomenon. The U.S. government couldn’t figure out how to stop it in the 1970s, and the nations of the world can’t find a way to start it today. Classically, inflation has resulted from (a) “demand pull” – too many buyers for a fixed supply of goods, or (b) “cost push” – rapid increases in the costs of production. Neither of these causes is in evidence today. Thus inflation is quite feeble, and that’s disappointing to countries that would like to pay their debts with cheaper currency. * * * A related tool for national economic betterment consists of another route toward currency debasement: devaluation. A nation can increase its ability to deal with the rest of the world by adjusting its currency’s rates of exchange. Let’s say the U.S.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Mr. Trump’s economic proposals will also result in larger federal government deficits and a heavier debt load. His personal and corporate tax cuts are massive and his proposals to expand spending on veterans and the military are significant. Given his stated opposition to changing entitlement programs such as Social Security and Medicare, this mix of much lower tax revenues and few cuts in spending can only be financed by substantially more government borrowing. According to Moody’s, Trump’s program would cause the federal budget deficit to increase from $640 billion today to $3,151 billion in 2026 (rather than $1,289 billion under current law), and federal government debt to increase from $14 trillion today to over $37 trillion in 2026 (versus about $24 trillion under current law – all figures in 2009 dollars, adjusted for inflation).  Finally, I’ll mention Trump’s most unrealistic claim: that he could trim the federal debt by negotiating the ability to pay it off at a reduced amount. He built his net worth in part by borrowing money and not paying it back, and he seems proud of his companies’ repeated use of bankruptcy as a strategic tool. But Trump doesn’t have an ongoing need to tap the world capital markets, as the U.S.

The result, in my view, approaches the undoing of “one man, one vote.” While each person’s actual vote is the same, his or her influence on the outcome is not. Here are just a few data points, according to Business Insider (October 31):  Nearly $6.6 billion is the amount candidates, parties, and outside groups are raising and spending in trying to move things their way in the 2016 election cycle, the Center for Responsive Politics estimates on its website, OpenSecrets.org. It’s a new record. It’s up by $86.5 million, adjusted for inflation, from the 2012 presidential cycle, which had also been a record.  The biggest increases in money flows, compared to 2012, came from outside money groups “that purportedly work independently from candidates,” the report said. They’ve greased this election with $1.3 billion so far (through October 24), $190 million more than at this point in 2012, accounting for 26.8% of total spending.  And it’s getting more concentrated: “The top 100 families” contributed $654 million to candidates, political parties, and outside groups so far, or 11.9% of the total raised, up from 5.6% in the 2012 election cycle.  The top ten families have given a total of $281 million so far this year. It wasn’t many years ago that contributions were limited to a couple of thousand dollars per candidate per race. Now $100,000 isn’t an uncommon ask, and there are legitimate (but possibly cynical) ways to donate millions.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: How about an example of central economic control in action? Here are some excerpts from an article about Venezuela that appeared in The Atlantic of May 12, 2016 (I’ve added some emphasis and reordered the paragraphs): A case in point is the price controls, which have expanded to apply to more and more goods: food and vital medicines, yes, but also car batteries, essential medical services, deodorant, diapers, and, of course, toilet paper. The ostensible goal was to check inflation and keep goods affordable for the poor, but anyone with a basic grasp of economics could have foreseen the consequences: When prices are set below production costs, sellers can’t afford to keep the shelves stocked. Official prices are low, but it’s a mirage: The products have disappeared. Here’s a shocker: you can set prices for goods, but you can’t make people produce them. That sounds a lot like economic reality. These ineffective – or counterproductive – price controls were only one part of a huge economic mess. How did it arise? Not long ago, Venezuela – “a seemingly modern, seemingly democratic nation just a few hours’ flight from the United States” – was wealthy and a good place to live.

Sitting atop the world’s largest reserves of oil at the tail end of a frenzied oil boom, the government led first by [Hugo] Chavez and, since 2013, by [Nicolas] Maduro, received over a trillion dollars in oil revenues over the last 17 years. But then it saw the beginning of: The experiment with ‘21st-century socialism’ as introduced by . . . Chavez, a self- described champion of the poor who vowed to distribute the country’s wealth among the masses, and instead steered the nation toward the catastrophe the world is witnessing under his handpicked successor Maduro . . . In the last two years Venezuela has experienced the kind of implosion that hardly ever occurs in a middle-income country like it outside of war. Mortality rates are skyrocketing; one public service after another is collapsing; triple-digit inflation has left more than 70 percent of the population in poverty; an unmanageable crime wave keeps people locked indoors at night; shoppers have to stand in line for hours to buy food; babies die in large numbers for lack of simple, inexpensive medicines and equipment in hospitals, as do the elderly and those suffering from chronic illnesses. This is the fate that has befallen a once-wealthy and once-modern nation operating under central economic control. Shall we give it a try? * * * © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

And the risky tranches ended up in banks’ portfolios, causing them to require rescues. Importantly, this time around I see no analog to sub-prime mortgages and MBS in terms of their combination of fragility and magnitude. I don’t mean to suggest there aren’t a lot of things to worry about: swollen central bank balance sheets; complete ignorance as to how they will be unwound and how interest rates will be moved higher; the seeming inability to generate economic growth and inflation; and the many other macro negatives © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others . . . which by definition means your thinking has to be different. . . . For your performance to diverge from the norm, your expectations – and thus your portfolio – have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking. Second-level thinking is what immediately pops into my mind when I think about Charlie’s observation. And it’s a good general heading under which to discuss the great many things that make superior investing a challenge. In short, to borrow from Charlie, anyone who thinks it’s easy must be a first- level thinker. Let me use some simple examples from the book to illustrate the difference.  First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”  First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!”  First-level thinking says, “I think the company’s earnings will fall; sell.

© Oaktree Capital Management, L.P. All Rights Reserved prices always go up” and “real estate is a hedge against inflation.” Conservative debt investors (rather than buyers of homes themselves) were persuaded to buy levered and tranched mortgage-backed securities by the fact that “there has never been a nationwide wave of mortgage defaults.” But in 2007 it turned out that home prices can go down as well as up, and mortgage loans extended casually based on their flawless record can have flaws. Homes and mortgages, bought when everyone liked them, turned out to be terrible investments. The fact is, painful bubbles can’t come into existence if there isn’t an underlying grain of truth. The Nifty Fifty were generally terrific companies. Home prices do tend to rise over time and offset inflation. Mortgages generally are repaid or carry adequate collateral. The Internet would change the world. Oil at $147/barrel was indispensable and in short supply. But in each case the merits were too obvious; the investment ideas became too popular; and asset prices consequently became dangerously high. Following the trends that are popular at a point in time certainly isn’t a formula for investment success, since popularity is likely to lead investors on a path that is comfortable but pointed in the wrong direction. Here’s more from “Everyone Knows”: The fact is, there is no dependable sign pointing to the next big moneymaker: a good idea at a too-low price.

The thinking is that stronger economy = higher interest rates = more competition for stocks from bonds = lower stock valuations. Or it might be stronger economy = higher interest rates = reduced stimulus = weaker economy. One of the reasons for increases in interest rates relates to purchasing power risk. Investors in securities (and especially long-term bonds) are exposed to the risk that if inflation rises, the amount they receive in the future will buy less than it could today. This causes investors to insist on higher interest rates and higher prospective returns to protect them against the loss of purchasing power. The result is lower prices. Finally, I want to mention a new concept I hear about once in a while: upside risk. Forecasters are sometimes heard to say “the risk is on the upside.” At first this doesn’t seem to have much legitimacy, but it can be about the possibility that the economy may catch fire and do better than expected, earnings may come in above consensus, or the stock market may appreciate more than people think. Since these things are positives, there’s risk in being underexposed to them. * * * To move to the biggest of big pictures, I want to make a few over-arching comments about risk. The first is that risk is counterintuitive.  The riskiest thing in the world is the widespread belief that there’s no risk.  Fear that the market is risky (and the prudent investor behavior that results) can render it quite safe.

The fact that an investment is susceptible to a serious negative development that will occur only infrequently – what I call “the improbable disaster” – can make it appear safer than it really is. Thus after several years of a benign environment, a risky investment can easily pass for safe. That’s why Warren Buffett famously said, “. . . you only find out who’s swimming naked when the tide goes out.” Assembling a portfolio that incorporates risk control as well as the potential for gains is a great accomplishment. But it’s a hidden accomplishment most of the time, since risk only turns into loss occasionally . . . when the tide goes out. The fourth is that risk is multi-faceted and hard to deal with. In this memo I’ve mentioned 24 different forms of risk: the risk of losing money, the risk of falling short, the risk of missing opportunities, FOMO risk, credit risk, illiquidity risk, concentration risk, leverage risk, funding risk, manager risk, over- diversification risk, risk associated with volatility, basis risk, model risk, black swan risk, career risk, headline risk, event risk, fundamental risk, valuation risk, correlation risk, interest rate risk, purchasing power risk, and upside risk. And I’m sure I’ve omitted some. Many times these risks are overlapping, contrasting and hard to manage simultaneously. For example:  Efforts to reduce the risk of losing money invariably increase the risk of missing out.

© Oaktree Capital Management, L.P. All Rights Reserved Fixed income investors are directly exposed to another form of risk: interest rate risk. Higher interest rates mean lower bond prices – that relationship is absolute. The impact of changes in interest rates on asset classes other than fixed income is less direct and less obvious, but it also pervades the markets. Note that stocks usually go down when the Fed says the economy is performing strongly. Why? The thinking is that stronger economy = higher interest rates = more competition for stocks from bonds = lower stock valuations. Or it might be stronger economy = higher interest rates = reduced stimulus = weaker economy. One of the reasons for increases in interest rates relates to purchasing power risk. Investors in securities (and especially long-term bonds) are exposed to the risk that if inflation rises, the amount they receive in the future will buy less than it could today. This causes investors to insist on higher interest rates and higher prospective returns to protect them against the loss of purchasing power. The result is lower prices. Finally, I want to mention a new concept I hear about once in a while: upside risk. Forecasters are sometimes heard to say “the risk is on the upside.

In this memo I’ve mentioned 24 different forms of risk: the risk of losing money, the risk of falling short, the risk of missing opportunities, FOMO risk, credit risk, illiquidity risk, concentration risk, leverage risk, funding risk, manager risk, over- diversification risk, risk associated with volatility, basis risk, model risk, black swan risk, career risk, headline risk, event risk, fundamental risk, valuation risk, correlation risk, interest rate risk, purchasing power risk, and upside risk. And I’m sure I’ve omitted some. Many times these risks are overlapping, contrasting and hard to manage simultaneously. For example:  Efforts to reduce the risk of losing money invariably increase the risk of missing out.  Efforts to reduce fundamental risk by buying higher-quality assets often increase valuation risk, given that higher-quality assets often sell at elevated valuation metrics. At bottom, it’s the inability to arrive at a single formula that simultaneously minimizes all the risks that makes investing the fascinating and challenging pursuit it is. The fifth is that the task of managing risk shouldn’t be left to designated risk managers. I’m convinced outsiders to the fundamental investment process can’t know enough about the subject assets to make appropriate decisions regarding each one. All they can do is apply statistical models and norms.

© Oaktree Capital Management, L.P. All Rights Reserved.  Will “structural unemployment” in the future remain stubbornly above the 5% or so of the last few decades?  Will profit margins retreat from their current record levels, and if so, what will be the effect on corporate profits?  Longer term, can progress ever be made on cutting the budget deficit and reducing the unfunded entitlement obligations?  What will be the social ramifications of slow growth, high unemployment and increased income disparity?  Will the U.S. devalue the dollar, the usual path to dealing with excessive national debt?  Will slow growth lead to Japan-style deflation? Or will high-volume money printing to make it easier to repay the debt bring on chronic inflation? (The mere fact that intelligent people worry simultaneously about both these polar opposites is in itself an indicator of the high level of uncertainty that is present.) In Europe:  Can the seeming downward spiral in peripheral Europe’s economies be arrested?  Can Europe’s excessive indebtedness be brought down, and can the chronic deficits that led to that level of indebtedness be trimmed through austerity?  Will richer nations continue to support poorer without insisting on the latter applying painful austerity?  In practical terms, can austerity be undertaken at a time of economic weakness? If austerity is continued, are recession, suffering and unrest unavoidable?

Let‟s take a look at the 1990s, a decade full of lessons about equities. As of 1990, the historic return on equities stood at 9% or 10%, and for that reason attitudes toward them were generally favorable, with that 9-10% return expected to repeat in future decades. But the ‟90s were a salutary period in terms of economic growth, corporate performance, technological and productivity gains, declining interest rates, low inflation and relative peace in the world (as well as naïve optimism regarding the benefits of a credit- © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved.  Can China transition from a highly stimulated economy based on easy money, an excess of fixed investment and an overactive non-bank financial system, without producing a hard landing that keeps it from reaching its economic goals?  Can the emerging market economies prosper if demand from China and the developed world expands more slowly than in the past? Looking at the world more thematically, a lot of questions surround the ability to manage economies and regulate growth:  Can low interest rates and high levels of money creation return economic growth rates to previous levels? (To date, the evidence is mixed.)  Can inflation be returned to a salutary level somewhat above that of today? Right now, insufficient inflation is the subject of complaints almost everywhere. Can the desired inflation rate be reinstated without going beyond, to undesirable levels?  Programs like Quantitative Easing are novel inventions. How much do we know about how to end them, and about what the effects of doing so will be? Will it prove possible to wind down the stimulus – the word du jour is “taper” – without jeopardizing today’s unsteady, non-dynamic recoveries? Can the central banks back off from interest rate suppression, bond buying and easy money policies without causing interest rates to rise enough to choke off growth?

“Due to the low interest rates,” I said, “the bar for each successively riskier investment has been set lower than at any time in my career.” The flatness of the line was a result of sanguine attitudes toward risk. Here are excerpts from my explanation (emphasis in the original):  First, investors have fallen over themselves in their effort to get away from low-risk, low-return investments. When you’re especially eager not to make safe investment A, it takes less compensation than usual (in terms of prospective return) to get you to accept risky investment B. . . .  Second, risky investments have been very rewarding for more than twenty years and did particularly well in 2003. . . . Thus investors are attracted more (or repelled less) by risky investments than perhaps might otherwise be the case and require less risk compensation to move to them.  Third, investors perceive risk as being quite limited today. Because rising inflation isn’t seen as a significant risk, bond investors don’t require much of a premium to extend maturity. And because the combination of a recovering economy and an accommodating capital market has brought default rates to record lows, investors are unconcerned about credit risk and thus are willing to accept below-average credit spreads. Prospective return exists to compensate for perceived risk, and when there isn’t much perceived risk, there isn’t likely to be much prospective return.

But the combination of intractable deficit spending, unsustainable entitlement promises and a total dearth of responsible action in Washington certainly raises alarms regarding the future. Since I see no reason to reinvent the wheel when someone I respect has said something better than I could, I’ll close with a few words from Seth Klarman (emphasis added). Seth doesn’t find much in the things he discusses to inspire confidence, and I agree: There is no free lunch in economics: if governments could print or borrow money in astronomical amounts without any major adverse consequences, why wouldn’t they always do this, forever avoiding downturns while their countries bask in the sunshine of limitless prosperity? Indeed it seems clear that prior misplaced confidence in the Fed contributed greatly to years of complacency that turned the 2008 downturn into a full-blown crisis. Of course there will be a price to pay for today’s policy excesses – an equal and opposite reaction. We just haven’t seen it yet. Will it take the form of a collapse of the dollar and the end of dollar hegemony, high interest rates, failed auctions of U.S. government securities and runaway inflation, a wrenching and protracted downturn requiring exceptional sacrifice, or something else? We will find out soon enough. In most sectors of the economy – government, individual but also corporate – the U.S.

© Oaktree Capital Management, L.P. All Rights Reserved. haven’t really earned.” Asset values are contingent, as Jim Grant once said. But debt is forever. Instead of cutting back on leverage and getting our house in order, government response to the crisis has been to shift unaffordable debt from individual balance sheets onto the national ledger, where every day we owe more than ever before. . . . I believe it is possible that the average citizen understands our country’s fiscal situation better than many of our politicians or prominent economists. Most people seem to viscerally recognize that the absence of an immediate crisis does not mean we will not eventually face one. They are wary of believing promises by those who failed to predict previous crises in housing and in highly leveraged financial institutions. They regard with skepticism those who don’t accept that we have a debt problem, or insist that inflation will remain under control. (Indeed, they know inflation is not well under control, for they know how far the purchasing power of a dollar has dropped when they go to the supermarket or service station.) They are pretty sure they are not getting reasonable value from the taxes they pay. When an economist tells them that growing the nation’s debt over the past 12 years from $6 trillion to $16 trillion is not a problem, and that doubling it again will still not be a problem, this simply does not compute.

” All of these things were the result of thirteen years of rapid inflation and ten years of returns on equities averaging less than 3% per year. “The Labor Department ruling is just one more in a nearly endless string of unhealthy things that have happened to the stock market over the past decade.” “This „death of equity‟ can no longer be seen as something a stock market rally – however strong – will check.” “For better or for worse, then, the U.S. economy probably has to regard the death of equities as [a] near-permanent condition – reversible some day, but not soon.” © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. According to BusinessWeek, then, it was all over for equities. No one would ever buy them again. Whatever caused it, the institutionalization of inflation – along with structural changes in communications and psychology – have killed the U.S. equity market for millions of investors. What a negative article, ostensibly the death knell for an entire market. What was the shift that it marked? Simply this: the end of a lost decade for equities and the beginning of the greatest bull market in history. There‟s literally a lifetime of memos in that one magazine article, but I‟ll spend a little less than that dissecting it. I hope you‟ll find these comments useful. Yogi Lives Lawrence “Yogi” Berra was a baseball catcher and an integral part of the New York Yankees‟ successful dynasty in the middle of the twentieth century. While a great player, he was also the undisputed king of the tortured phrase or malapropism. Here are a few: “It ain‟t over ‟til it‟s over.” “Ninety percent of the game is half mental.” “When you come to a fork in the road, take it.” “Always go to other people‟s funerals, otherwise they won‟t go to yours.” In fact, Yogi supplied the title for this memo, saying “It‟s déjà vu all over again.” Rising to his own defense, however, he denied the tendency for which he is so well known, saying, “I really didn‟t say everything I said.” Do people really say things like these? Or was it just Yogi?

Entitlements, interest and other mandatory expenditures consume all of the taxes collected; forget about the rest of government spending – on things like defense, education, transportation and scientific research. We face huge annual deficits and ballooning national debt. As an aside, one reason our deficit situation isn’t worse today is the ultra-low level of interest rates, which constitute a tremendous subsidy of the government by savers. Even with these low rates, interest on the federal debt consumes roughly 10% of all federal taxes collected. Imagine what the deficit would be if the 10-year Treasury note were at 7% rather than less than 2%. Entitlement programs are the biggest problem, primarily Medicare (healthcare for the elderly), Medicaid (healthcare for the poor) and Social Security (retirement benefits). Politicians in years gone by granted benefits without much thought to the rate at which they would grow and where the money to pay them would come from. Benefits have been expanded or indexed to inflation, and the post-war Baby Boomers, with their much- increased life expectancies, are bound to create an incredible burden; the national debt of $16 trillion is dwarfed by unfunded future benefits, the present value of which is variously estimated at an additional $50-90 trillion. We have problems at the state and local level, in addition to the federal.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Let‟s dissect “The Death of Equities” in that vein. What it says is that inflation has eaten into the outlook for the economy and companies, and there‟s no hope for improvement. Thus people have been throwing in the towel and selling stocks. Other things have come into vogue, attracting the capital that used to be invested in stocks. Mutual fund investors have turned their attention elsewhere. Most corporations can‟t issue new equity because of the dearth of buyers. Stocks have gone through a decade in which their absolute return was negligible and their real return was negative. They‟re selling below replacement value, showing how poor psychology is. They face a litany of negatives, without any real possibility of relief; that‟s the writer‟s “nearly endless string of unhealthy things that have happened to the stock market over the past decade.” The negative factors are clear to the average investor. And from them he draws negative conclusions. But the person who applies logic and insight, rather than superficial views and emotion, sees something very different. He sees an asset class that is unloved. He sees stocks that have cheapened for a decade – once dividends have been subtracted from the returns, and especially when prices are viewed relative to earnings. He sees securities that are priced below the value of the underlying assets on which they have a claim.

In the memo, I mentioned that California had undergone a five-year drought. And that scientists had concluded from looking at ancient trees that a fifty-year drought couldn‟t be ruled out. And that torrential rainstorms had begun just a few months later. That‟s the way it goes. As something goes in one direction for a while, people conclude increasingly that it always will . . . often just when the likelihood grows that it will reverse instead. And that was the greatest shortcoming of “The Death of Equities.” The extrapolator threw in the towel on stocks, just as the time was right for the contrarian to turn optimistic. And it will always be so. Go Around, Come Around It’s easy with the benefit of hindsight to see that the writer of “The Death of Equities” was too negative at the bottom. But being too negative isn’t the only pitfall. Most people also tend to be too positive at the top. The bookend to “The Death of Equities” is the work published in the 1990s by Jeremy Siegel, a highly respected professor of finance at the Wharton School and the author of Stocks for the Long Run. Through his work, Siegel showed that in almost two centuries, there had never been a 30- year period in which stocks didn‟t outperform cash, bonds and inflation, and very few such ten- year periods. Based on the consistency of this record, Siegel labeled stocks very safe (as long as you hold them for the long run).

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Portfolio Structuring Today As I’ve written in recent years, I don’t see a quick return to the prosperity of the past. In the 1990s, for example, we experienced the best of all worlds:  the economy did well,  although incomes grew slowly, the growing use of credit buttressed consumers’ ability to spend,  there were great strides in technology and productivity,  companies reported rising earnings,  stocks appreciated every year, not by their “normal” 10%, but by 20% on average,  the wealth effect from growing 401k’s added to consumers’ willingness to spend,  interest rates declined continually,  capital was readily available,  inflation remained under control,  faith ran high in the ability of the Fed to keep the economy on a steady path, and  there was peace in the world. Now that’s good times! Today, the U.S. economy is doing fairly well, and it should continue to recover in the years ahead. In fact, I think the main immediate risk to recovery stems from uncertainty connected to the European crisis. Will Europe experience a recession (or is it in one already)? Will a European recession cut into America’s growth? Will Europe’s political leaders prove unable to arrive at and implement the required solutions? Will countries exit the euro and/or reschedule debt? Will uncertainty surrounding Europe’s financial institutions impact the U.S. economy and its own institutions?

© Oaktree Capital Management, L.P. All Rights Reserved.  Given the way “inflation hawks” on the Federal Reserve Board resist stimulating the economy when a recovery is underway, there’s concern over the ability to count on further stimulus. However, I expect the Fed to keep interest rates low for a prolonged period of time and/or undertake other stimulus actions. Recent statements from Chairman Bernanke leave little doubt on this subject. On the other hand, just as I think a lot of economics is determined by psychology, so do I believe a lot of the impact of stimulus programs is psychological. Interest rate cuts, and bond buying programs like QE, have shock value when first announced, but I think it diminishes over time. In the end, it’s not easy to make an economy grow when people aren’t thinking expansively.  Today’s low interest rates, engineered by the central banks, mean that investors are consigned to doing business in a low-return world. Interest rates near zero on T-bills, and yields of 1-3% on Treasury notes and bonds, set the base from which the prospective returns on investments entailing risk are established. And because that floor is so low today, even with healthy risk premiums added, the absolute prospective return on many investments isn’t nearly what it was in the past.  The long-term competitive position of the U.S.

© Oaktree Capital Management, L.P. All Rights Reserved. o a strong desire for economic growth and industrialization in order to move the population to the cities and upward in economic terms, o the need to respond to the global financial crisis of 2008 and the non-performing loans it produced, o an expectation that manufacturing would expand without limit as China supplied goods to nations around the world as well as its own growing consumer class, and o resulting certainty that China couldn’t miss. The upshot of all of the above was massive provision of capital in order to advance China’s economic development and urbanization. State-owned enterprises were created and expanded, and infrastructure building was accelerated. Residential construction, in particular, took place at an elevated rate. This may have been yet another instance where too much money led to bad capital allocation decisions. China’s modern era had seen only growth, not cycles of boom and bust. Even when the central government wanted to rein in the rate of building, local governments – which derive a lot of their revenue from sales of land for development – were not similarly motivated. Chinese individuals faced very limited options for investing their capital: bank interest was below the rate of inflation and thus negative in real terms, and foreign investment was prohibited.

China’s economic growth has slowed, and living with declining growth has turned out to be no easier in China than elsewhere. Worldwide economic weakness and cost- advantage-eroding inflation have reduced the demand for Chinese exports, a main prop supporting China’s economy. It has been made clear that (a) internal consumption isn’t enough to give China’s economy the growth it needs and thus (b) China isn’t without © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

” Similarly, the macro future seems far more uncertain today than at any time in my experience, but there’s a good chance it was never as certain as people thought. In the 1980s and ’90s, everything went right. Economic growth was strong. Companies thrived. There were great gains in productivity and technology. Profits rose dramatically. Interest rates declined. Inflation was quiescent. Equities soared. Houses and 401k accounts appreciated, producing a positive “wealth effect.” The world was largely at peace. All of this contributed to positive psychology, feeding back to further spur economic strength in a classic virtuous circle. Was this a period in which favorable outcomes were entirely dependable, or just one in which the underlying processes met up with good luck, producing favorable outcomes? And if the latter, were the results better than people should have expected to continue? Regardless, people did extrapolate them. When stocks returned 20% a year in the 1990s, rather than the normal 10%, investors ratcheted up their return expectations for the subsequent years, and with them their allocations to equities. Everyone knows that if you reach into a bag containing both black and white balls and pull out ten white ones in a row, the probability has increased that the next one will be black. But in the investment world, events like that serve to convince people that there are only white balls – favorable outcomes – in the bag.

Unless you consider loss avoidance overwhelmingly important and can truly forgo making money, the approach for today has to balance risk aversion and the pursuit of return. Moderate investment expectations are an important element in setting one’s course. Anyone who insists on returns like “the good old days” is heading for trouble. A somewhat reliable return in the high single digits or low double digits to mid-teens would represent an outstanding result today. I would counsel against trying for much more – or at least that any attempt to do so should be recognized as entailing some very real risk. What should one do when faced with the conditions confronting us today? I think the smartest response still consists of investing in well-priced corporate securities and income-producing assets. Corporations still have the best chance of adjusting to environmental phenomena such as inflation, dislocation and competition. An obscure 1958 book, Corporate Bond Quality and Investor Experience by W. Braddock Hickman, is said to have given Michael Milken a lot of his inspiration to popularize high yield bonds and foster new issue and secondary markets for them in the 1970s. In his book, Hickman reports on the performance of corporate bonds between 1900 and 1943. He shows that the lower a bond’s quality and rating, the higher the return from holding it. This is a very important conclusion.

Many other nations seem to function no worse without them. But the U.S. has the historical accident of a ceiling, and we must deal with it. Because the limitation is set in terms of absolute dollars and not indexed for inflation or growth, we would run into it every few years even if our debt only grew apace with the economy. “In fact, it’s been raised nearly 100 times over the decades.” (Financial Times, July 16) But thanks to the especially rapid growth of our debt relative to GDP in recent years – exacerbated by the Afghan and Iraq wars and the financial crisis – the ceiling has the potential to provide some real excitement every once in a while. The Relentless Growth of Debt Greece, Ireland, Portugal, Spain, Italy, Iceland, the U.S., California . . . the list of governments with debt problems is long and grows longer. The issue has flared up in the last fifteen months and is often in the headlines nowadays. And yet, the general conditions causing the concern are nothing new. The deficits and debt that worry people today have existed for a good while: similar in kind albeit perhaps © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. presses to pay its debts, the dollars with which it does so will likely have diminished purchasing power.)  The truth is that an AA+ rating is far from meaning “default-prone.” Since only a few percent of single-B bonds default each year on average, at worst AA+ must imply a probability of default of a small fraction of a percent. In fact, many potential triple- As opt for AA+ instead in order to be able to carry more debt. That’s one reason S&P rates only four companies triple-A.  Getting a little more esoteric, what does it mean for a debtor to “meet financial commitments”? As I mentioned in “Down to the Wire,” debtors generally aren’t expected to pay off their debts; rather, it’s the normal expectation that interest will be paid and principal will be refinanced. Interesting, then: even triple-A doesn’t necessarily connote an ability to extinguish one’s debts.  While credit ratings are explicitly defined as relative, relating primarily to the likelihood of payment, I’ve always thought triple-A has a connotation for most people that absolutely nothing can go wrong. For that matter, U.S. Treasurys have traditionally been described as “riskless,” which sounds pretty absolute to me. If that’s a fair description, it doesn’t seem to fit the political process we’ve witnessed in the last few months.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. So now we see:  concern that the emerging market economies have been over-stimulated,  the rising inflation that occurs as a consequence,  uncertainty over whether the monetary tightening which is taking place will result in a soft landing or something worse,  questions about corruption, fraud, non-transparency and inefficiency, and  realization – again – that their economic success isn’t independent of that of the developed world. The fundamental outlook in the emerging markets is still excellent. It’s just that at times in recent years, when problems arose in the U.S., Europe and Japan, investors turned to the emerging markets for investment solutions, and the view that their future would be “superior” morphed into “flawless.” When their securities became priced for that perfection, the realization that they actually had feet of clay – at a time when investor confidence was weakened by the other things I’ve mentioned – took a toll on investor equanimity and security prices. Taken Together None of the issues described above is illusory. The U.S. is a fiscal and political mess, and its leaders inspire little confidence regarding their ability to effect a solution. The outlook in Europe is similarly murky, and the emerging markets have turned out not to be as foolproof as had been believed.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Rather than end there, as I originally thought I would, I want to add a little about the longer-term future. I could prepare the way by repeating my standard confession that I’m given more to worrying than to enthusing, but you already know that. What I want to say is this: the worries concerning the U.S. economic outlook enumerated on page seven are not limited to the current short-term cycle. I touched on most of them in “What Worries Me” (August 2008), “The Long View” (January 2009) and “Tell Me I’m Wrong” (January 2010), and my view of their importance hasn’t changed. I think they’re likely to influence the environment for years. I feel today’s distribution of possible futures is shifted to the left – that is, generally less attractive – relative to the distribution that governed the late twentieth century. The picture in the U.S. is less positive today in terms of consumer-led growth and the supercharging impact of increased credit use, competitiveness and job creation, and the government’s fiscal situation (and thus its ability to stimulate the economy). I think we benefited greatly in that earlier period from the luck of the draw. Things went about as well as they could have for the economy (despite sluggish income growth). Inflation was very much under control, and we benefited from steadily declining interest rates.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved Anything else would be a short-term palliative . . . or a continued exercise in imprudence. Spending that grows no faster than GDP should be an imperative. Shrinking government’s share of the economy seems highly desirable. National debt that is stable or declining as a percentage of GDP sounds compelling. (In addition to balancing the budget and growing the economy, I think we have to accept that the coming decades are likely to see U.S. standards of living decline relative to the rest of the world. Unless our goods offer a better cost/benefit bargain, there’s no reason why American workers should continue to enjoy the same lifestyle advantage over workers in other countries. I just don’t expect to hear many politicians own up to this reality on the stump.) To close, I’m going to borrow some quotations and data from Michael Cembalest, Chief Investment Officer of J.P. Morgan Private Bank (Eye on the Market, July 18): The long-term threat: . . . there are serious questions, most immediately about the sustainability of our commitment to growing entitlement programs . . . the time we have is growing short. (Paul Volcker, The New York Review of Books, June 24, 2010) According to the CBO alternative case (tax cuts do not sunset as planned; AMT keeps getting indexed to inflation; no Medicare cuts take place, etc.), by the year 2024, entitlements plus interest spending will be equal to total government revenue.

Just 12 years ago, in 1999, the CBO estimated that this would not happen until 2060. The crossing point has moved in by 36 years. In 1967, the government estimated that Medicare expenses would grow by 7x by 1990 (unadjusted for inflation); they grew by 61x instead. In addition to the lack of cost controls on entitlements, demographic changes are a problem as well: the ratio of workers to Social Security recipients has declined from 17-to-1 in 1950 to 3-to-1 today. The short-term threat: As the largest buyer and holder of U.S. Treasury bonds, we need to seriously assess the risks. We hope that the U.S. government adopts a serious policy to ensure the interests of the investors. (China Cabinet Development Research Center, and the Chinese Foreign Ministry, after the Moody’s downgrade watch was announced and S&P reportedly told lawmakers it might downgrade U.S. debt if payments were missed.) © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

It outlined the percentage gain in average inflation-adjusted after-tax income of various income groups between 1979 and 2007:  Top 1% of the population in terms of income 275%  Next 19% 65  Middle 60% 40  Bottom 20% 18 According to the CBO: The share of income going to higher-income households rose, while the share going to lower-income households fell.  The top fifth of the population saw a 10-percentage-point increase in their share of after-tax income.  Most of that growth went to the top 1 percent of the population.  All other [quintile] groups saw their shares decline by 2 to 3 percentage points. An October 26 article in The New York Times reported the following conclusions: . . . the report said government policy has become less redistributive since the late 1970s, doing less to reduce the concentration of income. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved But what if you had money and nerve in 2006 or early 2007? The results would have been disastrous. In those times you needed caution, conservatism, risk control, discipline and selectivity to stay out of trouble. In short, when the market is defaulting on its job of being a disciplinarian, discernment becomes our individual responsibility. So then, which is the right set of equipment for today? I think we’re back to needing the cautious attributes, not the aggressive. An unusually large number of thorny macro issues are outstanding, including:  the so-so U.S. recovery;  the U.S.’s deficit, debt ceiling impasse and dysfunctional political process;  the economic impact of deleveraging and austerity;  the over-indebtedness of peripheral eurozone countries;  the possibility of rekindled inflation and rising interest rates;  the uncertain outlook for the dollar, euro and sterling; and  the instability in the Middle East and resulting uncertainty over the price of oil. With all of these, plus prices that are fair to full and investor behavior that has increased in aggressiveness, I would rather gird for the things that can go wrong than ensure maximum participation if things go right. (Of course that’s not an unfamiliar refrain from me.)

Orders, sales and profits were strong. Cash was piling up in corporate coffers. The Fed gave increased thought to increasing interest rates to cool off the economy and prevent the rekindling of inflation. But in the summer it was reported that the economy had cooled, and earlier estimates of GDP were revised downward. A possible double-dip recession became the topic of the day. At the same time, an unseemly political confrontation regarding the U.S. federal debt ceiling exposed a flawed, unconstructive political system at work; produced a downgrade of long-term Treasury debt on the part of Standard & Poor’s; seemed to take us to the brink of a default; and sapped confidence at all levels. Despite the economy’s weakness, further government aid for the economy has been rendered untenable by widespread negative feelings about the stimulus programs of 2007-08 and the popular view that the government took care of Wall Street but not Main Street, combined with the nearness of the next presidential election. Especially with stimulus unlikely, government actions that discourage growth should be viewed skeptically. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. There can be no easy solution. Social programs and tax policies have been put in place that will combine with demographic and income trends to create challenging conditions. “The Middle-Class Tax Trap” (The New York Times, April 17, 2011) outlined the consequences: [Consider] the “current law baseline,” a Congressional Budget Office projection in which the Bush-era tax rates aren’t renewed in 2012, the Alternative Minimum Tax (which is supposed to hit only the rich but increasingly bites into middle-class paychecks) isn’t indexed for inflation, and Medicare payments to doctors are slashed 20%. With these changes, the deficit drops away in the next 10 years, and more important, it stays manageably low for the decades after that. . . . This is how the “current law baseline” cuts the deficit: Thanks to inflation and bracket creep, its tax code generally subjects more and more Americans to rates that now fall only on the wealthy. Today, for instance, a family of four making the median income . . . pays 15% in federal taxes. By 2035, under the C.B.O. projection, payroll and income taxes would claim 25% of that family’s income. The marginal tax rate on labor would rise from 29% to 38%. Federal tax revenue, which has averaged 18% of G.D.P. since World War II, would hit 23% by the 2030s and climb ever higher after that.

© Oaktree Capital Management, L.P. All Rights Reserved things happened that had never happened before and had been considered capable of happening only once in several generations or centuries. But they happened, and sometimes a few in a single week. These were negative “black swan” developments, and they had a number of ramifications. First, they imposed substantial losses. Second, they called into question the predictability and understandability of the financial world and introduced new levels of uncertainty. And third, they set off a search for things that would provide certainty and safety in the newly uncertain world. This search led many to look to gold. On the Merits of Gold I have no doubt: gold is the ideal investment. It serves as a reliable store of value, especially in challenging and uncertain times. It’s a hedge against inflation, since its price rises in sympathy with the general level of prices. It exists without the involvement of man-made constructs such as governments. And it’s desired and accepted all around the world (and always has been). The supply of gold is finite. It can’t be created out of thin air. Thus it’s not subject to dilution or debasement, as is paper currency when governments decide to print more. In comparison, currency can be similarly reliable only if backed by gold. Finally, gold is tangible, meaning you can take delivery and store it. Most other investment media exist only in the form of figures on a computer screen.

But gold is something you can actually hold and know you own. Thus it’s one of the few things you can depend on in an uncertain world. Gold is perfect. Except, of course, gold is nothing but a shiny metal. Since its real-world applications are limited to jewelry and electronics, very little of its value comes from actual usefulness. Further, the amount put to those uses each year is small compared to the total amount in existence, so its value for those purposes is at the margin and can’t be of much help in putting a price on the world’s gold reserves. There’s little intrinsic to gold that enables it to serve as a store of value and a hedge against inflation. Gold serves those purposes only because people impute to it the ability to do so. It’s self-deception, nothing but the object of mass hysteria like that exhibited in “The Emperor’s New Clothes.” Gold has no financial value other than that which people accord it, and thus it should have no role in a serious investment program. Of this I’m certain. A Never-Ending Argument The foregoing aren’t my views, of course. Rather, they’re my effort to summarize the prevailing – and obviously polar – points of view regarding gold.engenders

In general (albeit with some prominent exceptions), the last half of the twentieth century was marked by the rise of a cult of equities, and the last quarter century was probably the best ever. From 1979 through 1990, the S&P 500 averaged an annual return of 15.4% and showed losses in only two years (4.8% in 1981 and 3.1% in 1990). Economic prosperity, rising corporate profits, a trend among consumers toward borrowing to spend, and the subsidence of inflation and interest rates all made for a most hospitable environment. When the stock market’s performance improved even further in 1991-99, with an average return of 20.6% and no down years, the fawning kicked up a notch. From the low of 7 reached in 1980, the p/e ratio on the S&P 500 eventually exceeded 33 in 1999. The market’s dramatic © Oaktree Capital Management, L.P.Reserved

Rather than healthy performance that could be extrapolated, this swollen return should have come as a warning that valuations were unsustainable and likely to regress toward the mean. But investors consistently fail to recognize that past above average returns don’t imply future above average returns; rather they’ve probably borrowed from the future and thus imply below average returns ahead, or even losses. The tendency on the part of investors toward gullibility rather than skepticism is an important reason why styles go to extremes. Wharton’s Professor Jeremy Siegel, the author of Stocks for the Long Run, used historical data (a) to demonstrate that there had never been a long period when stocks didn’t outperform cash, bonds and inflation, and thus (b) to argue that most people of average risk tolerance should have roughly 100% of their capital in the stock market. But Siegel, like many laymen, failed to pursue the most critical line of inquiry. The right question to ask in the late 1990s wasn’t, “What has been the normal performance of stocks?” but rather “What has been the normal performance of stocks if purchased when the average p/e ratio is 33?” Many investors were seduced by the performance of stocks in the late 1990s by the promise of wealth and a secure retirement, and by the meshing of equity participation with the allure of the technology, media and telecom industries.

” I don’t doubt that, but what if that “better life” comes to be defined as having more savings and less debt, rather than a new car or another handbag? According to The Wall Street Journal of December 17: . . . businesses ranging from shoemakers to financial services to luxury hotels don’t expect American consumers to return to their spendthrift ways anytime soon. They see consumers emerging from the punishing downturn with a new mindset: careful, practical, more socially conscious and embarrassed by flashy shows of wealth. Prudence dictates that people should have savings. But I hasten to point out that “should” isn’t the same as “will.” There’s a maxim that “No one ever went broke underestimating the intelligence of the American consumer.” I’d prefer to see consumers save rather than return to over-spending – it’s healthier for families and for the economy in the long run, providing reserves in case of emergency and capital for investment. But I won’t be shocked if they don’t. The Outlook for Real Estate Just as happened in homes, commercial real estate saw an explosion of excesses in the years leading up to the crisis. Investors and funds – perhaps pursuing the myth that real estate is a good inflation hedge regardless of the price paid – were aggressive buyers. Capitalization rates or “cap rates” (the demanded ratio of net operating income to price) fell to 4% and sometimes less, implying price/earnings ratios of 25 or more.

© Oaktree Capital Management, L.P. All Rights Reserved Howard: Would you be equally sure if it were $2,000? Gold bug: A little less, but yes. Howard: At $5,000? Gold bug: That’s a tough one. Howard: And at $10,000? Gold bug: No; there it would be ahead of itself. Howard: So the price of gold matters? Gold bug: Sure. Howard: Then how can you be sure it’s fairly priced at $1,400? Gold bug: Hmm . . . . . The point is, in investing, price has to matter. Nothing can be a good buy solely on the basis of its attributes alone, without considering the value they give rise to and the relationship of price to that value. And there’s no quantifiable value against which to compare price in the case of gold. There; that’s it. Either you agree with those statements or you don’t. The gold bug’s usual recourse to the difficulty in pricing gold is to point to a past price for the metal and how little it has appreciated since then. For example, gold hit a high of $850 in 1980 and has gained only 2% per year since then. The Leuthold Group is often quoted (e.g., Reuters, November 29) as observing that it would have to be at $2,400 today to merely equal the 1980 price in inflation-adjusted terms. But those making a claim for gold’s cheapness on the basis of comparisons against historic prices typically point to hand-selected observations, as in Leuthold’s case.

This year, even though economic and geopolitical fundamentals are still shaky and new things to worry about arise from time to time, the credit markets are generally wide open for companies deemed to have critical mass. In “Warning Flags” in May, I observed that certain types of deals could be completed that exemplified behavior in the most heated pre-crisis days but had become impossible in late 2007 and 2008. These included issuance of CCC-rated, covenant-lite and payment-in-kind bonds; dividend recap transactions; and the organization of structured entities for investing in debt. Recently there have been additions to that list:  The issuance of 100-year bonds.  The issuance of 50-year bonds callable in five years (if interest rates go up, the buyer will be stuck with a low-rate bond, but if interest rates go down, the issuer can quickly replace the bond with one bearing a lower rate).  The issuance of inflation-adjusted Treasury Inflation-Protected Securities (TIPS) that will return minus 0.55% plus the rate of inflation (if there’s no inflation, the return will be negative, and if the rate of inflation is positive, the yield on the TIPS will be below that rate).  The issuance of bonds through so-called “drive-by deals.” When a deal is announced in the afternoon and priced the next morning, investors have little time to study its creditworthiness and covenants.

For years, things like the superiority of American products blunted foreign competition. One of the results was that the American worker enjoyed the highest wages and standard of living in the world. But now China, Korea and other nations have eclipsed much of our manufacturing advantage, allowing them to produce goods that are not just cheaper but at times better. It stands to reason that today, goods produced with high-priced inputs will not compete successfully. In order for U.S. goods to be competitive, our costs will have to come down, and with them our relative standard of living. Why should any country’s workers be able to command a higher standard of living if the goods they produce aren’t demonstrably superior? These trends have already taken effect in “legacy industries” like airlines and autos. For example, one of the main goals of the auto bankruptcies was to limit retirees’ lifetime benefits. I think we’ll continue to see declining relative costs in the U.S., to the betterment of our competitiveness but the detriment of our workers. Inflation, Exchange Rates and Interest Rates The macro question I get most often concerns the outlook for inflation. And as someone who lived through stagflation in the 1970s and paid interest at 22-¾%, I think it’s very much worth considering. The hyperinflation of the ’70s was sparked by the Oil Embargo of 1973.in

Under any of these circumstances, companies are likely to do poorly, so you’d rather own senior securities (debt) with the promise of positive returns if held to maturity, rather than junior ones (equities), to which just about anything can happen. And if inflation is declining – taking interest rates with it – you’d rather secure a fixed rate of return with a bond than hold a totally variable instrument like a stock. With inflation at zero or negative, the thinking goes, locking in today’s interest rates will prove to have been a godsend. Finally, if we get back into another crisis, wouldn’t we rather hold bonds? Look how well they did during the last one. © Oaktree Capital Management, L.P.Reserved

© Oaktree Capital Management, L.P. All Rights Reserved which inflation lifted wages, contributing further to inflation, and so forth. Rising prices frightened people into demand-pull inflation by convincing them to stock up on goods to avoid higher prices later. And people borrowed to invest in assets like land out of a belief that no matter what interest rate they paid to finance their purchase, the asset’s price would increase at a faster rate (the epitome of inflationary thinking). No one knew how to solve the problem. I used to go to hear “Dr. Gloom” and “Dr. Doom” (economists Al Wojnilower of First Boston and Henry Kaufman of Salomon Brothers) compete to be more depressing. They talked about how hard it would be to get inflation down to “an acceptable level.” One day, I heard someone ask for the definition of “an acceptable level.” He was told “one-third less than whatever it is at the time.” Finally, however, in the early 1980s Paul Volcker and the Fed implemented the painful solution of significantly higher interest rates, inflation subsided, and the stock market took off. Over the next 25 years, rising inflation and interest rates were forgotten as possible sources of risk. Today, labor in the U.S. lacks the power to demand strong wage increases or COLAs. Further, the sluggish macro picture argues against demand-pull. Strong inflation is usually associated with higher levels of prosperity and stronger demand for goods than I foresee.

Finally, inflation often presupposes pricing power on the part of manufacturers, which I also don’t see. Those are the factors that argue against an increase in inflation. However, because of other forces – primarily financial and international – it could take increasing numbers of dollars to buy a given quantity of the imported goods on which we’ve become so dependent (a.k.a. inflation).  As I mentioned earlier, debtors want there to be inflation so they can repay their debts with currency that’s worth less. To accomplish this, debtor nations have the ability to debase their currencies by printing more of it. For the clearest example, see “The Limits to Negativism” (October 15, 2008) on the subject of the Weimar Republic. Post-World War I Germany was assessed war reparations it couldn’t afford, so it simply over-stamped its 1,000 mark notes “1 million marks.” All of a sudden it had created enough marks to pay its debt to the world . . . and destroyed the purchasing power of its currency.  A dollar weakened by reduced demand for it (e.g., as a vehicle for the investment of China’s reserves) would, likewise, equate to more dollars per item bought from abroad.  Finally, “stores of value” like gold hold value only because people agree they will. The same goes for currencies. Profligate spending, runaway deficits and declining world position could reduce the role of the dollar as a reserve currency, again cutting into its purchasing power.

© Oaktree Capital Management, L.P. All Rights Reserved  the ramifications of high debt levels and the necessary austerity measures,  the economic future of the developed world,  the impact of China and other emerging nations,  the likelihood of deflation versus hyperinflation, and  the soundness of currencies and sovereign debt. Thus it shouldn’t come as a surprise that people are groping for something they can depend on. Since gold acts as a barometer of expectations regarding inflation and concern about economies and currencies, its popularity has risen as sentiment regarding these things has declined. Being away from home tends to alter one’s perspective. While traveling, I was shocked to hear someone (okay, a gold producer possibly “talking his book”) describe the U.S. as having a corrupt political system in the grip of special interests and being committed to the debasement of the dollar. While I know the stimulative actions being undertaken may well cause the dollar to weaken, I like to think the part about corruption isn’t true. But I have to admit that I’m not all that happy with what’s going on in the U.S., and especially in Washington, D.C. (see “What Worries Me,” August 2008 and “I’d Rather Be Wrong,” March 2010). While other nations are enacting austerity measures to trim their deficits and debt, I don’t see much coming from Washington. So if not corrupt, then perhaps just weak-kneed.

I’m certainly in no position to predict a decline in the purchasing power of the dollar (that is, a bout of strong inflation). However, I do think it’s very much worth worrying about. When Paul Volcker left the Fed in 1987, he was asked at his first public appearance, “Will interest rates go up or down?” He answered presciently: “Yes.” Of course, his answer is still the right one. But from today’s levels, I think rates are more likely to go up than down (there’s so little room for the latter).

That’s what happens when a borrow- and-spend cycle that has advanced beyond prudence is brought to a halt. It’s important to recognize, however, that one potential solution – traditionally perhaps the easiest – isn’t available to the members of the European Union: currency devaluation. A key element in the situation is the absence of independently floating exchange rates. Think for a moment about international finance. Countries differ in terms of growth rates, productivity and inflation rates. In recognition of the differences, interest rates and exchange © Oaktree Capital Management, L.P.Reserved

© Oaktree Capital Management, L.P. All Rights Reserved Reduced faith in the dollar means it would take higher interest rates to attract non-U.S. 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. What to do about them? The list of possibilities is long:  Buy TIPS.  Buy floating rate debt.  Buy gold (but only at the “right” price, and what’s that?)  Buy real assets, such as commodities, oil and real estate (ditto).  Buy foreign currencies.  Make investments denominated in foreign currencies.  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.  Buy the securities of companies that earn their profits outside the U.S.  Hold cash (to invest once interest rates have risen).  Sell long-term bonds (and possibly go short). 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.

rates change relative to those of other countries. In general, countries that are better off in terms of growth, productivity and inflation will have stronger currencies and pay lower interest rates. The easiest way for a nation with excessive foreign debt to solve its problem is through devaluation. If the drachma weakens relative to the deutschemark, a Greek who owes a German a certain number of drachmas now owes him fewer deutschemarks (of course, if the debt is denominated in deutschemarks, he now owes him more drachmas). This process can occur through an explicit devaluation or through hyperinflation, and we’d be overwhelmingly likely to see it in action from a standalone Greece. Between 1980 and 2000, the drachma depreciated by roughly 85% relative to the deutschemark, a reflection of economic reality. But with the countries of Europe tied together with a single currency, this can’t happen. Nations throughout Europe are doing what they can. That means reassuring financial markets and implementing austerity measures, but not devaluing (as long as the debtor nations in question remain part of the E.U.) So, Will It Work? “Will It Work?” was the title of a memo I wrote on March 5, 2009, discussing whether the Obama administration’s rescue plan would be successful. The problems were new and huge, like today’s in Europe, and the solutions being attempted were untested, also like today’s. The last section of “Will It Work?

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. One final point: When I provide this answer to the frequent question about inflation, I ask people whether they agree. Usually they do. Then I ask how much of their portfolio they’re willing to devote to protecting against these macro forces. If their answer is 5%, 10% or 15%, I point out that that’s pretty close to doing nothing. The question is whether you’re willing to devote at least 30-40%. Few people are. But that’s the thing: It’s easy to say, “I’m worried about inflation.” It’s something very different to say, “I’m worried enough about inflation to do something meaningful about it.” Let me know when you decide how much you’re willing to devote. The Environment for Business Moving all the way out on the timescale, I’d like to say a few words about some of my biggest- picture concerns. I worry about long-term problems that are being left untreated, such as our massive deficits and our under-funded Social Security, Medicare and education systems.

Even if we just hold, our 2½% notes will be desirable museum pieces, as in, “Do you remember the good old days, when you could get 2½% on Treasurys?” (In truth, though, how much lower can yields go from here?)  Finally, if the economy, inflation and interest rates surprise on the upside relative to today’s low expectations, having locked in a yield of 2½% won’t turn out to have been a good thing. From 2½%, it’s clear that rates have much further to go up than down. Any substantial increase in bond yields would bring meaningful interim price declines. It must be borne in mind that holders of the bonds of creditworthy issuers don’t have to worry about permanent capital losses (unless they’re frightened into selling when things are down). A bond that’s money-good will outlive any negative interim fluctuations, pay par at maturity and deliver the yield at which it was bought. So the real risk for people who invest in these bonds is that their returns turn out to be sub-par under the circumstances. If inflation turns out to be normal, investors in the 2½% note may end up with no more purchasing power down the road than they have today – that is, a real return of zero. Thus, if there are positive surprises in the environment, bond holders are likely to wish they had stocks instead. Portfolio construction is supposed to strike an appropriate balance between safety and certainty on one hand and aggressiveness and gains-seeking on the other.

” I quoted from Paul Krugman (The New York Times of February 16, 2009): As the great American economist Irving Fisher pointed out in the 1930s, the things people and companies do when they realize they have too much debt tend to be self-defeating when everyone tries to do them at the same time. Attempts to sell assets and pay off debt deepen the plunge in asset prices, further reducing net worth. Attempts to save more translate into a collapse of consumer demand, deepening the economic slump. (Emphasis added) The yoking together of the European nations introduces some interesting ramifications. Some Northern European export economies – Germany in particular – are doing quite well. At this stage of the cycle, they might be considering rate increases and their currencies might be strengthening. But it’s doubtful the ECB will raise rates anytime soon, and the euro has weakened versus other currencies. Thus, for example, the German economy and German exports will be stimulated when they arguably don’t need it. Germany will export more than it otherwise might have, with some of its gains recirculated in the form of aid to other countries. Good so far, but possibly inflationary. Complicated and not easy. The analysis of sovereign debt is in large part political, not economic. Thus the open questions are political, as described above, complicated by the multi-national aspect of the E.U.

These included our reliance on government stimulus and artificially low interest rates; the uncertain outlook for consumer spending, jobs and state and municipal finances; and the risks pertaining to inflation, exchange rates and interest rates. Here’s how I concluded: My goal in this memo isn’t to express a forecast. I know no forecast – and certainly not mine – is likely to be correct. What I do want to do is caution that the considerable risks I see may be less than fully appreciated by those setting asset prices today. The greatest market risks lie in failure of the macro economy to live up to the expectations embodied in today’s prices. . . . Most people view the future as likely to repeat past patterns, which it may or may not do. They tend to think of the future in terms of a single © Oaktree Capital Management, L.P.Reserved

growth stocks that will provide appreciation in a strong environment, a measure of protection in a weak environment, and a meaningful dividend yield regardless. To me, and given my standard view that we don’t know what the macro future holds, these stocks’ potential over a range of possible scenarios is more attractive than bonds which will do well in periods of economic weakness or deflation but poorly in strength or inflation. © Oaktree Capital Management, L.P.Reserved

And most recently, people swallowed the canard that innovation, financial engineering and risk modeling could take the uncertainty out of investing. The developments enumerated above constituted a strong tailwind behind the economy and the markets over the last several decades, and they produced a long-term secular uptrend. Short-Term Cycles Despite the underlying uptrend, there’s been no straight line. The economy and markets were punctuated every few years by cyclical bouts of short-term fluctuation. Cycles around the trend line made for frequent ups and downs. Most were relatively small and brief, but in the 1970s, economic stagnation set in, inflation reached 16%, the average stock lost almost half its value in two years, and Business Week magazine ran a cover story trumpeting “The Death of Equities.” No, my forty years haven’t been all wine and roses.

© Oaktree Capital Management, L.P. All Rights Reserved profits with low risk. But their buying drove up both the cost of the assets and the riskiness of the environment, transforming their “low-risk” strategies into high-risk ones. The consequences have become clear. Greenspan and Bubbles One of the most obvious ways in which investors change the environment is through the creation of asset bubbles, like the one that popped in the summer of 2007. In a process that invariably looks silly after the fact, they reach the conclusion that an investment is a sure winner, usually on the basis of simplistic platitudes that simply can’t hold up under scrutiny. These include “Internet stocks must rise because these companies are going to change the world,” “real estate (or gold) is a good hedge against inflation,” “home prices can never decline nationwide,” “oil will appreciate because it’s being consumed faster than it’s being found,” and “alternative investments (or hedge funds or private equity funds) hold the key to meeting investment goals.” Because of the strength attributed to these platitudes, investors go on to conclude that the investments they support will be profitable regardless of the price at which they’re undertaken. How can this be right? It’s not possible that something can be a good investment regardless of the price paid. But when a logical-seeming platitude is adopted by the stampeding herd, that belief is the result. That’s how we get bubbles.

Bubble thinking is irrational, given that it’s built on a belief that there’s no price too high. This goes on to manifest itself in a variety of ways. In the 1970s, when hyper-inflation was rampant and interest rates were astronomical, people concluded that no matter the interest rate paid, borrowing to buy “inflation protected” assets like real estate would be profitable. That’s bubble thinking. In my forty-year career, I’ve seen bubbles in growth stocks, small stocks, oil stocks, emerging market stocks and tech stocks, as well as such surefire winners as silver, homes and buyouts. In each instance, there was a logical underlying rationale for the desirability of the subject assets, but people overlooked the possibility that bubble thinking had raised prices to dangerous levels. Alan Greenspan greatly influenced economic and market developments during his term as Fed Chairman from 1987 to 2006, and his record on the subject of bubbles was poor. He set the world on its ear in 1996 by railing against “irrational exuberance” as the Dow Jones Index soared past the 6,000 level, but he was quiet thereafter, rationalizing appreciation well beyond 10,000 based on gains in productivity. Here’s his position on bubbles: . . . bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong.

The popularization – with a big push from brokerage firms looking for business and media hungry for customers – was based on success stories, and it convinced people that “anyone can do it.” Not only did this overstate the ease of investing, but it also vastly understated the danger. (“Risk” has become such an everyday word that it sounds harmless – as in “the risk of underperformance” and “risk-adjusted performance.” Maybe we should switch to “danger” to remind people what’s really involved.) To illustrate, I tend to pick on Wharton Professor Jeremy Siegel and his popular book “Stocks for the Long Run.” Siegel’s research was encyclopedic and supported some dramatic conclusions, perhaps foremost among them his showing that there’s never been a 30-year period in which stocks didn’t outperform cash, bonds and inflation. This convinced a lot of people to invest heavily in stocks. But even if his long-term premise eventually holds true, anyone who invested in the S&P 500 ten years ago – and is now down 20% – has learned that 30 years can be a long time to wait. The point is that not everyone is suited to manage his or her own investments, and not everyone should take on uncertain investments. The success of Bernard Madoff’s Ponzi scheme shows that even people who are wealthy and presumed sophisticated can overlook risks. Might that be borne in mind the next time around? At Ease with Risk Risk is something every investor should think about constantly.

© Oaktree Capital Management, L.P. All Rights Reserved Here’s another way to put it, from The Wall Street Journal of November 24, When it comes to booms gone bust, “over-investment and over- speculation are often important; but they would have far less serious results were they not conducted with borrowed money.” That statement wasn’t made in reference to current events; that was Irving Fisher writing 76 years ago (“The Debt-Inflation Theory of Great Depressions,” Econometrica, March 1933). Borrowed money lets economic units expand the scale of their activity. But it doesn’t add value or make things better; it just makes gains bigger and losses more painful. There’s an old saying in Las Vegas: “The more you bet, the more you win when you win.” But they always forget to add “. . . and the more you lose when you lose.” In one of those beautiful phrasings that demonstrate his mastery of language, Jim Grant of Grant’s Interest Rate Observer has described liquidity and leverage as “money of the mind.” By this he means they’re intangible and ephemeral, not dependable like assets or equity capital. Someone may lend you money one day but refuse to renew your loan when it comes due. Thus, leverage is purely a function of the lender’s mood. The free-and-easy lending of 2003-07 has turned into an extreme credit crunch, and the unavailability of credit is both the root and the hallmark of today’s biggest problems.

© Oaktree Capital Management, L.P. All Rights Reserved and considerably larger losses in nifty-fifty stocks. The stock market stayed in the doldrums for years, brokers drove cabs (literally), and Business Week ended a dismal decade with its downbeat cover story on stocks. In fact, the economy, markets and attitudes turned so negative for so long in the 1970s that rather than a downward cycle around the long-term upward trend, one might say the decade marked a downturn in the long-term trend (clearly there’s no standard for these things). Regardless of what you call it, the decline was so big that it took almost eleven years for the Dow Jones Industrials to get back to the high it reached at the beginning of 1973. But in 1982, stocks returned to what would be a 25-year bull market, and there arose an even greater cult of equities. Wharton Professor Jeremy Siegel wrote Stocks for the Long Run, showing there’d never been a long period in which stocks hadn’t outperformed cash, bonds and inflation. Everyone concluded stocks were the asset class of choice and the ideal investment. “65/35” was the usual stock/bond balance in institutional portfolios, but eventually stocks became more heavily weighted, as strong performance in the 1980s and ’90s further fired peoples’ ardor and as stocks’ long-term return was upgraded to 11%.

Further, the entire economy runs on trust: that the people to whom we provide goods and services will pay their bills; that contracts will be adhered to; and that money will retain value, or at least the part that inflation doesn’t erode. Belief is what makes the economic world go round. Take a minute to think about how we would behave in a world in which there wasn’t trust in money, the institutions that store it and the mechanisms that move it from one place to another. Clearly, we’d be sunk without trust in the financial system. I’ve described in the past how financial institutions are vulnerable to loss of faith because of their unique combination of opacity, leverage, conscious risk bearing, and their use of short-term deposits and borrowings to fund longer-term, illiquid assets. When providers of capital lose faith in a financial institution, they line up to withdraw their money. But the institution can’t give them all back their money, because it can’t liquify all of its assets immediately.downward

© Oaktree Capital Management, L.P. All Rights Reserved and Sue handles Rich’s loan application. And, of course, someone like me manages investments for all of them. But how does an economy function if nobody actually makes anything – and if we have to buy all of our stuff from other countries? I’m exaggerating for impact, but you get my meaning. We make less and less each year – and we consume more. Can an economy be successful if it consists of nothing but service providers, government workers and retailers? (Think about the unions you hear the most about in connection with the upcoming presidential election: the Service Employees International and the American Federation of State, County and Municipal Employees – no longer the Teamsters and Auto Workers.) Can a nation prosper without producing goods? I just don’t know the answer. And then there’s the question of where we’ll get our stuff from. Of course, we’ll buy it from other countries. But that leads to other questions: To what extent will rising inflation in cheap-labor countries raise the cost of the imports on which we depend so thoroughly? What will we sell to the rest of the world in order to get currency with which to buy their stuff? And for how long will they buy it from us? Certainly American goods have become less price-competitive, and other countries have learned to produce for themselves. Think about what we export. Movies? Computer software? Other countries are increasingly making their own.

© Oaktree Capital Management, L.P. All Rights Reserved  Most of the time, the end of the world doesn’t happen. The rumored collapses due to Black Monday in 1987 and Long-Term Capital Management in 1998 turned out to be just that. * -- Money has to be someplace; where would you put yours? If you put it in T-bills, what purchasing power would be accorded the dollars in which they’re denominated? If the government’s finances collapsed, what good would your dollars be, anyway? What depository wouldn’t be in danger? If you and many others decided to put billions into gold, what price would you have to pay for it? Where would you store it, and how would you pay for the truck to move it? How would you spend it to buy the things you need? What would people pay you for your gold, and what would they pay you with? And what if you bought credit insurance on all of your holdings: who would be able to make good on your claims? No, I don’t see any viable way to plan for the end of the world. I don’t know any more than anyone else about its probability, but I see no use in panicking. I think the outlook has to be viewed as binary: will the world end or won’t it? If you can’t say yes, you have to say no and act accordingly. In particular, saying it will end would lead to inaction, while saying it’s not going to will permit us to do the things that always have worked in the past.

” Regardless, positive thinking and thus risk taking are likely to be diminished. All I can say for sure is that the world will be less rosy in financial terms, and results are likely to be less positive than they otherwise would have been. UAwash in Money In the longer term, we have to wonder about the effect on the world of a glut of newly printed dollars, sterling and euros. The reason owning printing presses makes repayment easy is that it lets a nation cheapen its currency. But one would think that more units of currency per unit of GDP means a debasement of the currency, and thus reduced purchasing power (read: higher inflation). Walking along Hyde Park on Sunday, I saw a street vendor selling old stock certificates. Do you have any banknotes, I asked? Anything from the Weimar Republic? For the last few weeks, I’ve wanted to get some of those. In Weimar Germany, the government enabled itself to pay World War I reparations by cheapening its currency . . . literally. So the 1,000 mark note I bought was simply over- stamped One Million Marks in red. Voila! Now we’re all rich.

© Oaktree Capital Management, L.P. All Rights Reserved The mark fell from 60 to the U.S. dollar in early 1921 to 320 to the dollar in early 1922 and 8,000 to the dollar by the end of 1922. It’s hard to believe, but according to Wikipedia (user-maintained and perhaps not always the most authoritative): In December 1923 the exchange rate was 4,200,000,000,000 Marks to 1 U.S. dollar. In 1923, the rate of inflation hit 3.25 x 10 P P percent per month (prices double every two days). One of the firms printing these [new 100 trillion Mark] notes submitted an invoice for 32,776,899,763,734,490,417.05 (3.28 x 10P P , or 33 quintillion) Marks. [That’s not a misprint.] Lord Keynes judged the situation this way: The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance. But it’s not that easy. People with things to sell aren’t that stupid. So instead of 1,000 marks, a goat now costs one million marks. That piece of paper used to be a thousand mark note – and now it’s a million mark note – but it still buys the same goat. The benefit to the government is that it’s able to pay off its old nominal debts in currency of which it suddenly has a lot more . . . but which no longer has much purchasing power.

© Oaktree Capital Management, L.P. All Rights Reserved UThe Fed’s Dilemma Investors are hoping the Fed will ride to the rescue with rate cuts and capital injections that bolster the economy. It did so in September, allowing sentiment to improve and debt prices to recover for a while, and again in December. The markets rejoice when the Fed cuts rates (all but the bond market, which worries that rekindled inflation will push up interest rates, which will push down bond prices). Personally, I think a rate cut sends a mixed message. It implies help is on the way, but it makes me wonder about the peril that made the Fed take the step. It’s like the guy who goes to the doctor and sees him pull out a gigantic hypodermic. Nice to know he’s getting treatment, but isn’t the condition worrisome? Along those lines, the Fed’s 50 basis point cut on September 14, which exceeded most expectations, caused breakingviews.com to run the headline “Does Ben [Bernanke] know something we don’t?” Around November 27, investors concluded they could count on a significant rate cut, causing the Dow to move up 546 points in just the next two days. Surely they think lower rates will stimulate the economy and help offset the credit crunch. But here are the counters:  Will making money cheaper cause financial institutions to borrow and lend, or people to borrow and spend? Can a rate cut offset the frightening aspects of declining creditworthiness?

Low interest costs provide scant compensation when loans go unpaid. Thus the Fed can offer cheap money, but it can’t make people borrow it, spend it or risk it. The phrase for that problem is “pushing on a string.” It’s a big part of the reason why Japanese economic growth has never been successfully restarted. For this reason, some observers are suggesting that Washington add fiscal stimulus (tax cuts and spending increases) to the Fed’s monetary policy. In this way, consumers’ reticence can be offset by direct government spending.  Will fear of rising inflation deter the Fed from stimulative action? In general, central bankers view their primary job as keeping inflation from accelerating as the economy grows. Avoiding slowdowns is usually secondary. Prices are moving up sharply in food and fuel, and the overall rate of inflation has broken out from the low levels of the past decade. This may limit the Fed’s freedom to stimulate the economy and risk a reheating. And I hear some worry about a return to the “stagflation” of the 1970s, in which inflation roared ahead but economic growth couldn’t gain traction.  What will lower rates do to the willingness of foreigners to hold dollar reserves? We need foreigners to hold dollar-denominated securities. They’re the swing buyers of billions of dollars of Treasury securities each year. If they won’t do so, who’ll finance our fiscal and trade deficits? If investing at U.S.

A commercial trader may buy oil, for example, in the course of its main business (like an airline, utility or oil refiner) and thus have a reason to hedge against price rises. Or it may be an oil producer that wants to protect against falling prices by selling its future production at the current price. People making value judgments deem these to be “legitimate” reasons. Speculators, on the other hand, are non-commercial traders – anyone without direct reliance on oil in its business. The current furor implies they don’t have valid reasons for buying oil. But what about the long-term investor who wants to own natural resources as part of a balanced portfolio? Or the individual seeking protection against inflation? Or the sovereign nation that wants to put part of its reserves into something other than depreciation-prone dollars? These motives aren’t “illegitimate,” and they don’t deserve to be disparaged. In particular, some have suggested that pension funds should be barred from trading in oil. This has to have more to do with scapegoating and short-term perception than it does with preventing improper behavior or solving our nation’s energy problem.

© Oaktree Capital Management, L.P. All Rights Reserved In the “Information Age,” the lack of a college degree or computer literacy is a much greater handicap than it used to be. With non-information jobs increasingly moving overseas, what jobs will our less-educated citizens occupy? You might say education holds the answer, but (a) our public education system is in decline, and (b) how, especially given these jobs’ greater productivity, can there be enough tech-based jobs to keep our entire population gainfully employed? The Energy Problem When I began to drive in 1964, oil was $4 a barrel and gasoline was 29 cents a gallon. Then, in 1973, OPEC put an embargo on oil exports. We saw lines around the block at gas stations, and we were permitted to fill up just every other day. The price of oil jumped to $35 by 1980 or so, and then it subsided. It spent the period from 1986 to 2001 between $10 and $30 before going on to hit $92 in 2007 and $148 earlier this year. The bottom line, however, is that from about 1880 until a few years ago, we were in an environment of cheap energy. For over a hundred years, the price of oil didn’t rise, meaning it got dramatically cheaper in inflation-adjusted terms. This encouraged exactly the behavior one would expect: rapidly growing oil consumption, lagging increases in supply, little attention to the development of alternative energy sources, insufficient investment in mass transit, and weak efforts at conservation.

© Oaktree Capital Management, L.P. All Rights Reserved The ‘70s saw a 37% decline in the S&P 500 in 1973-74; huge losses in the “nifty-fifty” growth stocks; the Arab oil embargo in 1973; inflation in the high teens; short-term interest rates in the 20s; and an infamous Business Week cover story, “The Death of Equities.” Stagflation ruled, and there seemed to be no way out of the wage-price spiral. People wore buttons promoting President Ford’s WIN program (“Whip Inflation Now”), but neither the buttons nor the program did any good. New York stockbrokers were driving cabs, and it was extremely difficult to find employment in the investment industry. That means that in order to be part of the investment industry in the ‘70s, you pretty much had to have your job by 1969. And that in turn means you had to be at least 21 by 1969 . . . and sixty or older today. There aren’t many of us still working. I can tell you, no one was talking about a “V” in the 1970s. We experienced financial malaise lasting almost a decade. The best we felt we could hope for was a “saucer- shaped” recovery, a far different story. As I said in “The Tide Goes Out” in March, economies aren’t hard-wired, and no one knows in advance how things will go. Further, some of the ingredients this time never have been seen before. When taken together, I see problems that may not go away any time soon and the possibility of a sluggish period lasting more than months or quarters.

© Oaktree Capital Management, L.P. All Rights Reserved investments by China and Dubai in our oil and port industries were rebuffed, and last fall (before it was clear how desperately we needed more capital), people were grumbling about sovereign wealth funds’ growing influence over our financial institutions. Well, what do you expect to happen? If we spend more than we bring in, and thus send dollars overseas to pay our tab, isn’t it reasonable to expect that some will be brought back and spent here? Clearly, the oil producers will have the ability to buy our assets. And some, like Qatar and Abu Dhabi, are far too small for the amounts involved to be invested or spent in those countries without making their inflation worse than it already is. We’re already seeing the effects. Financial institutions ran to sovereign wealth funds when they needed to add to their capital; who else is there? Room rates in hotels around the world are soaring in dollar terms. Powered by foreign buying, prices in the contemporary art market are moving out of sight, and so are high-end real estate prices in London and other cities of choice. Last month it was reported that a villa in the south of France had been sold to a Russian for $750 million: a great outcome for the seller, but also a sign that eventually we may be priced out of our own assets.

© Oaktree Capital Management, L.P. All Rights Reserved Second, consumer spending is a principal lynchpin of the economy, and there’s no reason to think the near-term outlook here is positive:  Employment, earnings, the wealth effect and consumer psychology in general are all likely to be negative, and thus to act as depressants on the economy.  Higher energy costs and higher mortgage payments (driven up as inflation worries lift interest rates) both have the potential to hamper consumer spending.  Consumers aren’t likely to be able to borrow as easily as in the past. Credit cards may not be available as freely. Borrowing on home equity could be nearly impossible and, anyway, there isn’t as much equity to borrow against.  The American consumer hasn’t saved in years and thus has very little in the bank to spend.  The consumer may realize that savings are essential – at last. If so, in order to save, he’ll have to spend less than he makes – at last. This, too, will depress spending. The record over the last decade – and even the first half of 2008 – shows the American consumer to be incredibly resilient and unwilling to break the spending habit. Thus it isn’t impossible that spending will stay strong . . . just illogical. Basically, I think this economy has to hunker down. Financial institutions have to strengthen their balance sheets. Consumers should do so as well. There should be less risk tolerance and financial innovation.

Regulation is destined to increase, and in exchange for its support of financial institutions, the Federal government is likely to demand that they carry less leverage and take less risk. Thus financing could be scarce. But positives do exist. Dollar-denominated exports look very cheap to the rest of the world and will bolster the U.S. economy. And the Fed will do everything possible to help (but it can reduce rates only so far and has to remain vigilant regarding inflation). The usual tug-of-war is taking place between the optimists and the pessimists. On July 18, the Financial Times quoted Deutsche Bank chief executive, Josef Ackermann, as saying, “We are seeing the beginning of the end of the crisis.” But the very next day, The New York Times quoted Alan Blinder (ex-vice chairman of the Fed board of governors): “The financial system looks substantially worse now than it did a month ago.” On balance, I continue to think the odds favor economic sluggishness for a not- insubstantial period of time. Given today’s general dearth of beaten-down assets outside of residential real estate and financial institutions, investing gradually probably won’t cause you to miss great opportunities. But it will keep you out of trouble and ensure that you have capital with which to take advantage of any bargains ahead. In my book, going slow here makes the most sense.2008

© Oaktree Capital Management, L.P. All Rights Reserved  The economic news, while not dire at the moment, isn’t rosy. Consumer spending, inflation, employment and business investment all remain exposed to negative future developments. Default rates among highly levered companies have just begun to rise.  Finally, the viability of derivatives such as credit default swaps has yet to be tested. That means either (a) they’re not going to cause trouble, or (b) they’re going to cause trouble and have yet to do so. This is another case where potential negatives have yet to be dispelled. The markets have seen substantial gains since the time of Bear Stearns’s rescue. They give me the impression that people who refrained from trying to “catch a falling knife” may have concluded that they waited too long, and thus they rushed to buy out of fear that they’d look bad if they stayed uninvested. The FT of April 28 summed up in a way I thought was very much on target: The awkward truth is that nobody knows for sure how severe an impact the credit crunch will prove to have on the global economy and on financial markets. On fundamental grounds a wealth-preserving investor might well feel justified in being cautious until the extent of the downside becomes clearer.

Our active distressed debt funds gained 20% that month, and the markets never looked back. Investors in all asset classes forgot the panic that had gripped them just a few months earlier and became preoccupied with making money. Because only modest returns were expected from high grade bonds (with their 4-5% yields) and U.S. common stocks (following the 2000-02 bear market), investors sought solutions in non-traditional investments with brief track records at best, and thus little or no clarity regarding the risks involved. Vast sums flowed to hedge funds, and thousands of new ones were formed. High yield bonds and leveraged loans began to be issued again . . . because now there were buyers. This enabled buyouts to be financed and then recapitalized, and quick payouts to equity holders resulted in eye-popping IRRs, attracting more capital to buyout funds. Real estate attracted vast amounts of capital, too, even when “cap rates” – current cash yields – sunk below 5%; what could be better than a tangible asset providing inflation protection? Borrowing power became virtually unlimited, as is often the case when providers of capital are eager to put money to work. Thus the financial environment reflected (1) a vast ability to leverage, (2) an uninhibited search for return, and (3) investors competing to make investments by accepting lower returns and decreased safety. This combination supported new investment techniques, which grew rapidly despite being untested.

And then it turns out that the old rules do still apply, and the cycle resumes. In the end, trees don’t grow to the sky, and few things go to zero. Rather, most phenomena turn out to be cyclical. I’m hearing again – as often in the past – that we’re in a Goldilocks economy. It’s not so hot that there’s risk of inflation accelerating, which would require restrictive measures on the part of the Fed.

© Oaktree Capital Management, L.P. All Rights Reserved below 9%, making the company more productive, or selling it at an increased valuation. But the ability to do these things is either highly dependent on market conditions (leveraging cheap or selling dear) or skill-based. The wide disparity among private equity results for any given period of time shows how much they are a function of the skill of the general partners, and thus that most of the return on private equity is far from intrinsic to the asset class. Everyone Knows Two years ago, the herd knew residential real estate was a can’t-miss way to build wealth. “You can live in it,” “it’s a hedge against inflation,” and “they’re not making any more land” were oft- recited mantras . . . just as they had been in the mid-1980s (See “There They Go Again,” April 2005). After ten years of rapid appreciation, owners of condos felt they had it made, and non- owners felt they were on the outside looking in. People lined up to put down deposits on condos that hadn’t been built yet, and many assembled portfolios that way. No one talks that way anymore. The air came out of the condo balloon fast once prices stopped going up, putting the virtuous circle into a stall. The cheap financing that appeared to provide a ticket to financial security is now seen to have lured many buyers into water over their heads.

Exchange rates exist so that currencies will be valued fairly relative to each other in view of countries’ differing growth rates, interest rates, inflation prospects and fiscal and trade deficits, etc. Further, exchange rates change as the outlook for these things changes. Their current status is widely known, and predicting changes is something few people can do right more often than others. Thus it seems unlikely that some people will be able to regularly generate higher returns than others. If it’s so hard to value currencies, commodities and precious metals, why do I think we can invest intelligently in equities, corporate debt and whole companies? It’s because these things generate income, and an expected stream of future income can be translated into a current value.

Later, a few more years of good returns had raised the historic figure – and thus expectations for future returns – to the range of 10-11%. And from the late 1960s through the late 1990s, nothing – and I mean nothing – was more universal than the belief that stocks could be relied on for 9-11% per year. I don’t think I’ve ever seen an assumption that was less questioned than this one. The next step in cementing this expectation was the publication of “Stocks For the Long Run” by Wharton’s Jeremy Siegel, one of the nation’s highest-rated professors. Siegel’s message had the effect of minimizing worry about the variability of equity returns. He demonstrated with past data that stocks could be depended on to beat cash, bonds and inflation over the long term. In the popular perception, this morphed into an expectation that stocks could be depended on to beat cash, bonds and inflation . . . period. Along with the boom in tech/media/telecom stocks and the first-day gains of IPOs, Siegel’s data contributed to one of the greatest equity manias of all times. Of course, it evaporated after the TMT stocks collapsed in 2000 and was buried as the major stock averages did the unthinkable, declining for three straight years for the first time since the Great Crash. So what do people expect from stocks today?

© Oaktree Capital Management, L.P. All Rights Reserved decline), and those that lagged will catch up or move ahead. Instead of being encouraged by months or years of price appreciation, investors should be forewarned.  It’ll Always Beat the Cost of Borrowing – Speculative behavior usually features the belief that assets will always appreciate faster than the rate of interest paid on money borrowed to buy them with. We saw a lot of this in the inflationary 1970s. But for the most part, statements including the words “always” and “never” are usually a sign of trouble ahead.  The Supply/Demand Picture Doesn’t Matter – The relationship between supply and demand determines the price of everything. The higher the demand relative to the supply, the higher the price for a given asset or strategy. And, the higher the price, the lower the prospective return (all else being equal). Why can’t investors remember these two absolute rules?  Higher Risk Means Higher Return – There are times, especially when the prospective returns on low-risk investments appear inadequate, when people reach for more return by going out further on the risk curve. They forget that riskier investments don’t necessarily bring higher returns, just higher projected returns. Forgetting the difference can be fatal.  Anything’s Better Than Cash – Because it entails the least risk, the prospective return on cash invariably is lower than all other investments. But that doesn’t mean it’s the least desirable.

© Oaktree Capital Management, L.P. All Rights Reserved time below to go through these areas and cite some rule violations I see occurring. (I’m not saying that these investment areas are without merit. It’s just that I wince when I see uncritical analysis and unsupported conclusions.) Let’s take the example of real estate. Almost twenty years ago, real estate was the site of many classic mistakes, and lots of money lost. In the mid-1980s, institutional investors charged into real estate, under banners like “They’re not making it any more” and “It’s a good inflation hedge.” What they missed was the fact that:  while it’s true that no one’s making more land, there’s a lot left to develop, and easy access to capital enables market-glutting buildings to be built on it,  something’s only an inflation hedge if bought at a fair price to start with, and  unlike the 1970s, inflation wouldn’t be an issue for the next twenty years, and thus inflation protection wasn’t worth paying up for. Tax reform in 1987 reduced the demand for tax shelter purposes, and the economic slowdown of the early 1990s turned real estate into a basket case. They UstillU weren’t making any more land, but that didn’t help institutional investors avoid huge losses. Today, real estate seems to be the site of investing error again – with no one harking back to the last time around. This is especially true in private homes, with individuals rather than professionals doing most of the “investing.

And a rise in prices to massive new building. Only later does the same surplus of dollars cause a rise in the inflation rate. This leads to a rise in interest rates. And to a drop in real estate prices, with the market now oversupplied by all that new building. In other words, we see some instances where investors in real estate are:  failing to recognize the transitory nature of the factors supporting prices,  taking comfort from rising prices while they should be alarmed,  overlooking the lessons of history, and  declaring “it’s different this time.” As Grant points out, “over the last ten years, bricks and mortar had a cash on cash return averaging 3.3 percentage points above the yield on the ten-year Treasury note. . . . Today, the yield is just 1 percentage point more than that not-very-high number (the ten- year is quoted at 4.5%).” In other words, properties used to provide a solid 3.3% spread over perhaps 6% on the ten-year, for a total return approaching 10%. Now there’s a narrow 1% spread over a low base rate . . . for a total current return of 5.5%.bottom

© Oaktree Capital Management, L.P. All Rights Reserved As the graphic suggests, there is a low return that can be earned on the riskless asset and, from there, prospective return will rise with prospective risk. Thus we have a “capital market line” that, as the academics say, “is upward sloping to the right.” (The “riskless asset” is generally felt to be the shortest U.S. Treasury bill, with regard to which investors don’t worry about credit risk or the risk that inflation will erode the purchasing power of principal before it’s repaid upon maturity.) 1BUThe Market at Work I’ll use a “typical” market of a few years back to illustrate how this works in real life: The interest rate on the 30-day T-bill might have been 4%. So an investor says, “If I’m going to go out five years, I want 5%. And to buy the 10-year note I have to get 6%.” He demands a higher rate to extend maturity because he’s concerned about the risk to purchasing power, a risk that is assumed to increase with time to maturity. That’s why the yield curve, which in reality is a portion of the capital market line, normally slopes upward with the increase in asset life. Now let’s factor in credit risk. “If the 10-year Treasury pays 6%, I’m not going to buy a 10- year single-A corporate unless I’m promised 7%.” This introduces the concept of credit spreads. Our hypothetical investor wants 100 basis points to go from a “guvvie” to a “corporate.

© Oaktree Capital Management, L.P. All Rights Reserved one honest answer, I think it should be “what’s the relationship between supply and demand?” If there are lots of assets for sale and few takers, those assets can often be bought cheap. If there are few assets offered and many would-be buyers, bargains are usually few and far between. While no guarantee of a silver bullet, the former can be the source of some good ammunition. With the latter you’re more likely to shoot yourself in the foot. UThe New Solution This memo’s about hedge funds. They’re the hot topic in the investment world today – the latest would-be silver bullet – largely, I think, because most have yet to disappoint performance-wise and because the big asset classes look unappealing. Common stocks were the big-picture silver bullet in the 1990s. Professor Jeremy’s Siegel’s “Stocks For the Long Run” assured us there had never been a long period in which stocks didn’t beat bonds, cash and inflation. The authors of another book, “Dow 36,000,” were given space on The Wall Street Journal’s op-ed page. Thus when stocks’ popularity – and their representation in portfolios – hit a peak in early 2000, they were ready for a fall. A swoon that included the first three consecutive losing years since the Depression took the S&P 500 down 49% and the NASDAQ down 78%.

Thus investors are attracted more (or repelled less) by risky investments than perhaps might otherwise be the case and require less risk compensation to move to them. Third, investors perceive risk as being quite limited today. Because rising inflation isn’t seen as a significant risk, bond investors don’t require much of a premium to extend maturity. And because the combination of a recovering economy and an accommodating capital market has brought default rates to record lows, investors are unconcerned about credit risk and thus are willing to accept below-average credit spreads. Prospective return exists to compensate for perceived risk, and when there isn’t much perceived risk, there isn’t likely to be much prospective return. In summary, to use the words of the “quants,” risk aversion is down. In May 2003 we at Oaktree began to worry about investors’ indiscriminate behavior (of course, we’re usually early in worrying about overheated markets). We were struck by the rapidity with which the terrified investors of less than a year earlier had become confident and aggressive. “Stressed” bonds that we had bought at yields of 30% to 70% in the summer of 2002 now could be sold at yields of 6% to 9%. Somehow, in that alchemy unique to investor psychology, “I wouldn’t touch it at any price” had morphed into “looks like a solid investment to me.

© Oaktree Capital Management, L.P. All Rights Reserved It isn’t nonsensical for assets to be viewed differently at different times. After all, almost everything incorporates elements of both good and bad. But there are times when investors seem to look only at the positives or only at the negatives. As a result, there are times when there seems to be no price so high that investors won’t pay it, and these inevitably are followed by times when no price is low enough to convince people to buy. This oscillation – from viewing a security, a company or an investment technique as “flawless” to viewing it as “worthless” – has occurred several times during my time in the investment business, with the predictable effect on prices. This “full-or-empty” phenomenon is particularly apparent in media savants’ explanations for each day’s market movement. In “up” times, a strong report on consumer income is interpreted as fueling corporate sales and profits, and thus is used to explain rising stock prices. In “down” times, on the other hand, the same report may be cited as a cause of inflationary pressure, rising interest rates, lower p/e ratios, and thus declining stock prices. UValuing the Future – Credence or Skepticism Some investors spend their time working hard to quantify this year’s earnings and the growth thereafter. Others strive to value real assets, intellectual property and business advantages (and predict what others will pay for them).

© Oaktree Capital Management, L.P. All Rights Reserved  capital floods in,  prices rise,  current returns soar, and  prospective returns decline. But don't forget the significant ramifications. Investors lose interest in other asset classes; thus their prices fall (at least in relative terms) and their prospective returns rise. In other words, the popular asset becomes more expensive and the rest get cheaper. A powerful cult of equity believers held sway from 1978 – when I started to manage portfolios – through 1999, with only minor interruptions. The average return on the S&P 500 was over 17%. There wasn't a year in which the index declined more than 5%. Equity managers and analysts showed up on magazine covers and TV screens. Equities were fawned over in books ranging from "Stocks for the Long Run" (which explained that stocks could be counted on to beat bonds, cash and inflation in any period, providing it was long enough) to the self-explanatory "Dow 36,000." The man on the street accepted stocks as a sure thing. What both the man on the street and the investment professional missed was that the appreciation that powered stocks' record returns had borrowed from the future and made them very expensive. And the view that stocks were all you needed also implied that other assets were superfluous. Thus bonds went out of favor, at least in relative terms. In the 1990s, few of the people I met could think of a convincing reason for their fixed income allocations.

© Oaktree Capital Management, L.P. All Rights Reserved The impact of a decline must be gauged in light of its starting point. Stocks ended up cheap after the S&P's 1973-74 decline of 48%, but that's because the average P/E ratio started in the high teens and ended in single digits. Thus this correction's 45% decline doesn't necessarily have equal import, given that it started and ended with an average P/E ratio above 20! Of course, a case continues to be made that stock valuations are attractive (or, more typically, "are not unattractive") because of the low level of interest rates. Low rates raise the discounted present value of a given stream of future cash flows, and they reduce the competition that stocks face from bonds. As I see it, much of the case for the fairness of valuations today rests on the view that low prospective returns on stocks are reasonable given the low prospective returns on fixed income instruments. Maybe this makes stocks cheap at today's P/E ratios, but I don't consider it much of a positive. Further, in order for interest rates to continue to render stocks attractive, they must stay low. But low rates presuppose low levels of economic growth, demand for capital, and inflation. Are these the arguments on which to build a bullish case? There's also a strong counter-argument regarding economic recovery.

An investment style that does best (or worst) in one period is unlikely to do so again in the next. That was really the problem with the technology bubble. Investors were willing to pay prices that assumed success forever. They ignored the economic cycle, the credit cycle and, most importantly, the corporate life cycle. They forgot that profitability would bring imitation and competition, which would cut into – or eliminate – profitability. They overlooked the fact that the same powerful force that made their companies attractive – technological progress – could at some point render them obsolete. And they failed to consider that the investing fads in favor of these technologies, companies and stocks could reverse, with dire consequences. UFourthU, investors should bear in mind the role played by timeframe. It seems obvious, but long-term trends need time in order to work out, and time can be limited. Or as John Maynard Keynes put it, "Markets can remain irrational longer than you can remain solvent." Whenever you're tempted to bet heavily on your conviction that a given phenomenon can be depended on in the long run, think about the six-foot tall man who drowned crossing the stream that was five feet deep on average. One of the great delusions suffered in the 1990s was that "stocks always outperform." I agree that stocks can be counted on to beat bonds, cash and inflation, as Wharton's Prof. Jeremy Siegel demonstrated, but only with the qualification "in the long run."

I'll proceed below to illustrate the application of some of these concepts to two key asset classes: common stocks, the grand-daddy of all active investments, and hedge funds, a much smaller area that is in the process of attracting a lot of attention (and capital). UCommon stocksU – Among the mantras that were repeated in the past decade, few received as much credence as "stocks outperform." Wharton's Professor Jeremy Siegel documented in his book, "Stocks for the Long Run," that equities have beaten bonds, cash and inflation over almost all long periods of time. In fact, his graph of the movements of the stock market since 1800 looks like a straight line rising from lower left to upper right. Evidence like this allowed people to invest heavily in the stock market while continuing to sleep well. Little did they know that the price gains that made them feel so sanguine about their positions were dramatically increasing their risk. I am a great believer in common stock investing, but I hold tight to a few caveats:  Return expectations must be reasonable.  The ride won't be without bumps.  It's not easy to get above-market returns. We live in the world's most productive economy, under a very effective capitalist system, at a wonderful point in time. In general, it's great to own productive assets like companies and their shares. But occasionally, people lose track of the fact that in the long run, shares can't do much better than the companies that issue them.to

The latter came to be accorded far too little attention as the 1990s wore on, but that seems to have been corrected. Where can we look now for good risk-adjusted returns? UWhat's Been Tried? UCommon stocksU – Among the mantras that were repeated in the past decade, few received as much credence as "stocks outperform." Wharton's Professor Jeremy Siegel documented in his book, "Stocks for the Long Run," that equities have beaten bonds, cash and inflation over almost all long periods of time. In fact, his graph of the movements of the stock market over the last 200 years looks like a straight line from lower left to upper right. Evidence like this convinced people to increase their equity allocations while continuing to sleep well. Little did they know that the price gains that made them feel so sanguine about their positions were dramatically increasing their risk.

© Oaktree Capital Management, L.P. All Rights Reserved  Thus, market prices provide accurate estimates of assets' intrinsic value, and no participant can consistently identify and profit from instances when they are wrong.  Assets therefore sell at prices from which they can be expected to deliver risk- adjusted returns that are "fair" relative to other assets. Riskier assets must offer higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won't provide a "free lunch." That is, there will be no incremental return that is not related to (and compensatory for) incremental risk. I believe strongly that some markets are quite efficient, including those for the world's leading stocks and bonds. Take international fixed income, for instance. Here, people try to decide whether British, French or German government bonds are the cheapest at a given time and establish portfolio weightings accordingly. The primary differences between these bonds, it seems to me, relate to their issuing countries' rates of economic growth and inflation. But it's to make allowance for those differences that there exist differential interest rates and floating exchange rates. And aren't those some of the world's most closely watched phenomena, with hundreds of sophisticated financial institutions on both sides of every question? Can any one participant realistically expect to be able to do a superior job in such a market?

© Oaktree Capital Management, L.P. All Rights Reserved  Most of the time, the consensus forecast extrapolates current observations. Most predictions for growth, inflation and interest rates bear a strong resemblance to the levels prevailing at the time they're made. Thus they're close to right when nothing changes radically, which is the case most of the time, but no prediction can be counted on to foretell the important sea changes. And it's in predicting radical changes that extraordinary profit potential exists. In other words, it's the UsurprisesU that have profound market impact (and thus profound profit potential), but there's a good reason why they're called surprises: it's hard to see them coming!  Each time there's a radical change, there's an economist who predicted it, and that person gets to enjoy his fifteen minutes of fame. Usually, however, he wasn't right because of a superior ability to see the future, but rather because he tends to hold extreme positions (or perhaps he's a dart thrower) and this time the phenomenon went his way. Rarely if ever is that economist right twice in a row. So forecasts are unlikely to help us foresee the movements of the economic cycle. Nevertheless, we must be aware that it exists and repeats. The greatest mistakes with regard to the economic cycle result from a willingness to believe that it will not recur. But it always does – and those gullible enough to believe it won't tend to lose money.

© Oaktree Capital Management, L.P. All Rights Reserved $60-$75 billion for "economic revival." In the short run, as CSFB says, this will "create a buffer to the slowdown in activity." (The long-term effects may be less positive, in that deficits and the Treasury borrowing required to support them can lead to inflation, higher interest rates and crowding out of non-government borrowers). Interest rate reductions also can help ease the contraction, and we may see more of them. They will work at the margin, but I don't expect them to give the economy much of a boost in the short run. One of the most vivid phrases in the business vocabulary is "pushing on a string," and that's what rate reductions can amount to in a hunkered-down world. Will low interest rates get people to buy homes and cars if they've lost their willingness to spend? Will they work with people who realize they have inadequate savings and are overly indebted? Will they cause businesses to invest in expansion if they already have capacity sitting idle? No one knows the answers to these questions, but they should not be assumed to be overwhelmingly positive. A discouraging analogy can be seen in Japan's decade-long doldrums. The government has pushed interest rates nearly to zero and keeps pumping money into the system. But every time the cautious Japanese citizen gets a few yen he puts it in the bank, and economic growth fails to revive. Hopefully, a difference may lie in Americans' higher propensity to spend.

© Oaktree Capital Management, L.P. All Rights Reserved  the current low level of inflation, and  the looming scarcity of Treasury securities as budget surpluses erase the Federal debt (I'm not quite sure I buy that one). Third, high-grade corporates have not been an unfailing source of safety. The February 7 Journal story referenced above included the observation that "of corporate bonds rated investment grade, an unprecedented 3% fell 30% or more in price last year, according to Merrill Lynch & Co." UThe punditsU - As usual, the cresting of stocks in 1999/early 2000 was caused and/or accompanied by the vesting of special powers in "experts." I have previously railed against the brokerage house analysts who set price targets based on where they guessed a stock could sell and gave out "buy" ratings to drum up corporate finance business. The current targets for my wrath are the talking heads from CNBC and its competitors. I resent the role they played in the popularization of equity investing, in the bubble that developed, and in the debacle that followed. They're glad to opine on what stocks are worth, why they went up or down yesterday, and what they're going to do tomorrow. But the more I listen, the more I feel the absence of a few key phrases like "beats the heck out of me" and "darned if I know."

I think one of the elements that roped in so many people and convinced them they could invest safely despite their lack of expertise was the media's repeated message that these things were knowable. Some of the confidence of these personalities has evaporated of late. UThe FedU – The trend of personalizing described above reached its apogee in the deification of Alan Greenspan. For almost fourteen years, Greenspan has done an excellent job at the Fed. He kept a weather eye out for signs of inflation and took steps to avert it when needed. He wisely injected liquidity into the financial system in times of crisis. And he made every effort to keep a steady hand on the economy, trying to avoid sudden moves that could unsettle the participants. He has presided over a terrific economy; I can't imagine a better one. I phrase that carefully, because it will be debated whether he made it great or it made him great. People who know things I don't will decide the question. In January, the markets demonstrated their great faith in Greenspan by leaping forward when the first interest rate cut was announced. "Surely Greenspan will be able to avoid a cessation of growth." Investors were highly confident that he would be able to save them. Yet in 1998-9, when he as good as said "I’m going to slow the economy and rein in this irrational exuberance," no one acted as if he could, and the market continued to roar.

© Oaktree Capital Management, L.P. All Rights Reserved “Wealth effect” is the term used to describe the impact on the economy of major increases in the prices of stocks or other assets. When asset prices rise, people feel richer and spend more. When the resulting demand outstrips supply, inflation heats up. Further, when the upward trend of asset prices inevitably turns down, the wealth effect works in reverse, putting a damper on economic growth (although Greenspan is more likely to have been worried about inflation than economic softness). Prior to expressing his concern about exuberance, Greenspan was credited with the power and wisdom needed to keep the economy rising forever. So how did investors react to his remark? In the first half-hour of trading the next day, they took the Dow down by 145 points (which used to be considered a big move). But the exuberance of which he had warned soon reasserted itself, with the Dow closing the year virtually unchanged from its pre-critique level and moving 1000 points higher over the next six months. If it was irrational exuberance that had taken the Dow to 6,437 in late 1996, what would describe the rise to 7,437, and eventually to 11,497, in relatively short order? And what accounts for Greenspan's two subsequent years of silence on the subject? My guess is that he was feeling pressure from people – perhaps with a political stake in the continuing rise of the stock market-who castigated him for being a wet blanket.

Of course, the bottom line is that lots of things people considered eminently logical in 1999 – like low-risk triple-digit gains – are now being shown to have been far too good to be true. The headlines of 1999 look silly now, and the debunking in 2000 seems obvious (e.g., "What Are Tech Stocks Worth, Now That We Know It Isn't Infinity?" in the Wall Street Journal on April 17). But that's a juxtaposition that marks the end of every market boom. UHow'd We Get Here? In the 1990s, positive macro forces contributed to an extremely benign environment and steadily reinforced each other:  low inflation,  the shift of the federal budget from deficit to surplus,  easy money at low interest rates,  technological gains, and  a high degree of risk tolerance.productivity,

One of the great delusions suffered in the 1990s was that "stocks always outperform." I agree that stocks can be counted on to beat bonds, cash and inflation, as Wharton's Prof. Jeremy Siegel demonstrated, but only with the qualification "in the long run." If you have thirty years, you can rest assured that equity returns will be superior. For someone with a thirty-year time frame, the decline of the NASDAQ in 2000 may have been a matter of indifference. But it didn't feel that way to most people. Time came into play in another way for the TMT entrepreneurs. Many raised the money they needed for a year or two and proceeded to burn it up. They counted on being able to raise more later, but in 2000 capital was denied even to worthwhile ideas. Lots of companies never got the chance to reach profitability. More important than money, they ran out of time. URemember that, for the most part, things don't changeU – The five most dangerous words in our business aren't "The check's in the mail" but "This time it'll be different." Most bubbles proceed from the belief that something has changed permanently. It may be a technological advance, a shortage or a new fad, but what all three have in common is that they're usually short-lived. Most "new paradigms" turn out to be just a new twist on an old theme. No technological development is so significant that its companies' stocks can be bought regardless of price.

© Oaktree Capital Management, L.P. All Rights Reserved backing the large-cap growth stocks and Internet high flyers can imagine prices at which they would be mere "holds" or (heaven forbid) "sells." ULooking on the bright sideU - The bulls - who are firmly in control - have joined with the media to interpret things in a positive light. I got a chuckle out of the article's description of investor reaction to the jobs data released on April 2: Those showed low unemployment, which was good for consumer spending; low wage increases, which implies weak inflation; and mild job creation, which implies a growing but not overheating economy. I'm sure that in other times and climes, it would have come out this way instead: Those showed low unemployment, which carries a threat of renewed inflation; low wage increases, which implies an anemic economy; and mild job creation, which presages weak consumer spending. Of course, economic developments are always subject to varying interpretation. The above passage sent me to the archives for one of the absolute classic cartoons: “On Wall Street today, news of lower interest rates sent the stock market up, but then the expectation that these rates would be inflationary sent the market down, until the realization that lower rates might stimulate the sluggish economy pushed the market up, before it ultimately went down on fears that an overheated economy would lead to a reimposition of higher interest rates."

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients and Friends From: Howard Marks Re: Who Knew? For years, I've railed against people who claim they know what the future holds. And yet, in my last memo on September 3, 1997, I may actually have made a correct prediction, as follows: What could cause a market decline? A drop in investor confidence -- perhaps the commodity that's most freely available today -- would likely be the key, but the reason is hard to foresee…. The next surprise might be geopolitical (oil embargo, war in Korea), economic (tight money, slowing profit growth) or internal to the market (competition from bonds at higher interest rates, discovery of a fraud), but it's most likely to be something that no one has anticipated -- including us. Just the next month, the "Asian meltdown" came into full bloom, with profound ramifications for stock and bond markets all around the world. What this shows is that it's easy to be right about the future . . . if you restrict your predictions to two: (1) something significant is bound to happen eventually, and (2) we never know what it'll be. * * * Speaking of what we can know, I was in a client's office in December, cautioning that I thought we would never reside for long in the investment nirvana of the new paradigm where inflation, interest rates, economic growth, expanding profits and rising stock prices stay properly aligned.

Bought when "riskless," this paper proved to be a disaster; purchased off the trash heap, we found it very attractive. That leads us to the $64,000 question (although many of you already know my answer): Where do we currently stand? What attitudes and behavior characterize today's investors? We think many "investors" have been buying with euphoria and belief rather than hesitance and skepticism. Many investors seem to be most afraid of being uninvested and missing out on the gains others are enjoying; that is, they're most worried about the risk of not taking enough risk. Although many valuation indicators are at all-time highs and price gains in July set record after record, investors are quite willing to accept platitudinous rationalizations like "technology has brought a new era," "globalization offers unlimited opportunities for growth" and "we have nothing to worry about from the business cycle." Some analyses suggest that prices are fair today, implying that future returns will be proportional to the risks involved; by many other standards, prices are too high. We find it very difficult, however, to conclude that stocks are underpriced, and thus that the potential exists for high and dependable returns from here. We find particularly troubling the oft-repeated mantra that "because the outlook continues to call for low inflation and stable interest rates, stocks can continue to rise."

This statement was made at 6,000 and 7,000 on the Dow, and it was made in July at 8,200. But it can't be right regardless of the level of stock prices. Inflation is important because it determines interest rates, and rates are important because they determine valuation multiples for stocks. Thus, for every level of inflation and interest rates, there's a "right" level for stocks. What's the right level for stocks given today's conditions? Might it be below the current level? © 1997 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

We see this in aggressive lending by banks; in the popularity of leveraged structures in many areas of investing; in the strong flow of equity IPOs (and their strong after-market performance); in the explosive issuance of high yield securities (including payment-in-kind preferreds and calamity-linked bonds); and in the massive amounts of capital available for every form of alternative investing. Each of these activities is appropriate at the right time and price, but each can be overdone. We feel the simplest adages remain the best, and few are better than "what the wise man does in the beginning, the fool does in the end." Every cycle eventually proves the wisdom of this old saw. Are we "ringing the bell" on this bull market? Absolutely not; we've learned the folly of attempting to do so. We are not calling for a market collapse, but we do want to recap a few things that we feel are obvious: The market may be either fairly- or over-valued, but it is not under-valued. The best most bulls can say is that the extent of the current over-valuation isn't extreme. With valuations having reached full levels, no one should expect stock prices to continue to out-pace company profits. It is certainly true that there are favorable developments in technology, productivity, taxation, inflation, monetary policy, geo-politics, demographics and labor tractability. These advances justify high multiples, but not ever-higher multiples.

© Oaktree Capital Management, L.P. All Rights Reserved Memo To: Clients From: Howard S. Marks, TCW Re: "Risk in Today's Markets" Revisited Seven weeks ago, we put out a memorandum entitled "Risk in Today's Markets." Its essence was that the excellent returns earned in risky strategies through 1993 had eroded the fear factor in many markets and, coupled with the low yields available on conservative fixed income investments, had caused many investors to take "one giant step forward" on the risk curve. It also pointed out that just as declining rates had acted to raise prices and generate good returns, rate movements could cut the other way too. Lastly, it cautioned that when others are acting imprudently, driven by greed and without much fear, it is important that we raise UourU level of prudence. Unfortunately, the events of the intervening seven weeks have shown these observations to be in order. It is the purpose of this follow-up memo to review the developments of the intervening time period, attempting to make sense out of what has happened and searching for lessons that can be drawn. It's about understanding basics of investing which don't come and go. The current "correction" dates from February 4, when the Federal Reserve Bank raised short term interest rates a small amount in order to choke off inflationary thought and action. The air quickly came out of the bond markets, and the decline has been swift and deep.

© Oaktree Capital Management, L.P. All Rights Reserved URandom Thoughts on the Identification of Investment Opportunities Howard S. Marks -- January 24, 1994 1. No group or sector in the investment world enjoys as its birthright the promise of consistent high returns. There is no asset class that will do well simply because of what it is. An example of this is real estate. People said, "You should buy real estate because it's a hedge against inflation," and "You should buy real estate because they're not making any more." But done at the wrong time, real estate investing didn't work. 2. What matters most is not what you invest in, but when and at what price. There is no such thing as a good or bad investment idea per se. For example, the selection of good companies is certainly not enough to assure good results -- see Xerox, Avon, Merck and the rest of the "nifty fifty" in 1974. Any investment can be good or bad depending on when it's made and what price is paid. It's been said that "any bond can be triple-A at a price." There is no security that is so good that it can't be overpriced, or so bad that it can't be underpriced. 3. The discipline which is most important in investing is not accounting or economics, but psychology. The key is who likes the investment now and who doesn't. Future prices changes will be determined by whether it comes to be liked by more people or fewer people in the future.