The good, bad and ugly of low interest rates, according to Howard Marks

As the world waits for another round of easing by central bankers to prevent a "recession" across the globe, Oaktree Capital Management Co-Chairman Howard Marks cautions investors how an additional monetary stimulus could be counter-productive for the economy.

Howard Marks in his latest memo dated July 26 talked specifically about the US Federal Reserve Bank. In the memo, he talked about the upside, as well as the downside, of the low-interest-rate environment and how it could be counter-productive for the US at a time when the economy is still expanding.

The US market hitting fresh record highs largely on expectations of another round of easily by the US Federal Reserve in its next policy meeting on July 30-31.

Many people take Fed actions at face value, said Howard Marks. “When the Fed cuts interest rates, as the consensus expects it to do soon, investors take that as a “buy” signal,” he said.

Their thought process is simple: weak economy → rate cuts → economic stimulus → stronger GDP → higher corporate profits → higher stock prices.

But, is it all that simple? Mark argued. The vast majority of Fed actions consist of 25-basis-point interest rate cuts or increases, doesn’t a cut of 50 basis points means the Fed finds the outlook particularly worrisome?

If a rate-cut of 25 basis points is good news for the markets, is a cut of 50 basis points better or worse? Well, a rate cut essentially means that the US Fed thinks that the trouble is looming, and secondly, it doesn’t guarantee that the trouble will be solved.

Coming to the good part of low-interest rates —Marks in the memo said that low-interest rates encourage spending, investment, help in increasing demand, lower interest cost for debt-heavy companies, and a rate-cut would essentially mean more rate-cuts in the offing.

But, is there a downside to all this? Yes, mark argued. “The truth is, there are ways in which low rates are undesirable and potentially harmful,” said the note.

There is evidence that low-interest rates can help stimulate the economy, but investors should also watch out for excessive inflation or the economy becoming too hot. “Too much inflation imposes a hardship on people who are living on a fixed income,” the memo said.

Marks added that low rates also penalise savers by reducing the returns available on safe instruments such as cash, money market funds, as well as saving the account.

In terms of stocks markets, Marks is of the view that low-interest rates encourage excessive use of leverage, and induce investment in undressing companies and shaky securities.

The US economy is still expanding, and monetary stimulus via rate cuts (just like fiscal stimulus via deficit spending) is in order when the economy is weak and failing to create jobs, highlighted Marks.

The stimulus might not be the need of the hour especially at a time when the economy is expanding. He explained by saying that "stimulus maybe somewhere between unneeded and counterproductive at times like today when the economy is growing acceptably, the unemployment rate is at a 50-year low, wages are rising, and the recovery has just become the longest in history.”

Note: The above article is compiled from the recent memo of Howard Marks.