Seth Klarman told his hedge fund investors that the Federal Reserve’s response to the 2008 financial crisis and the ensuing decade of low interest rates helped “erect a financial fantasy land.”
“An inconsequential era of virtually unlimited low-cost capital had come to an end,” said Klarman, the head of Baupost Group and a prominent investment figure, in a year-end letter to clients seen by the Financial Times. . “A boom based on easy money policies will inevitably contain the seeds of its own destruction.”
The pessimistic outlook runs counter to a rally that has lifted major global stock indexes this year, as falling inflation figures give investors reassurance that the Fed may soon stop raising rates of interest.
Klarman compared last year’s sharp rise in interest rates to kryptonite, saying it ultimately helped deflate the “bubble of everything,” including dismantling investments in so-called unprofitable growth companies that had soared during the pandemic boom but had little intrinsic value.
“These included dozens of non-profit start-ups that could only have gone public in a bubble, a staggering volume of bonds that sported incredibly low yields, most of the nonsensical ‘meme stocks’ and stocks such as Tesla – intensely hyped, blatantly overvalued and priced only for the smoothest rides – whose shares have fallen by nearly two-thirds,” he wrote.
Shares of companies that had been offered at record highs in 2020 and 2021 deflated sharply last year, dealing a blow to investors in venture capital, crypto and technology who had been investing l money in companies with high revenue growth but little or no profit.
“The time spent on due diligence appeared to them as an obstacle to maximum capital deployment, and the usual warning signs of excess – financial debauchery, the proliferation of questionable business models and obvious red flags – were mocked or ignored,” he wrote.
Despite markets rebounding this year, Klarman warned that last year’s sell-off “probably still has some way to go” and a sovereign debt crisis could be looming.
Klarman spent much of his letter criticizing the Fed’s response to the financial crisis, when the US central bank cut interest rates to near zero and began sucking up Treasuries and asset-backed securities. to mortgages. The policy has dramatically reduced returns on safer investments, such as U.S. sovereign debt, and prompted many investors to buy riskier, higher-yielding securities.
“Microscopic interest rates, like grains of sand at the beach, had entered into everything,” he wrote. “Central bankers had lagged the curve, not anticipating that the Fed’s massive balance sheet expansion would be hard to reverse and that a decade and more of low interest rate policies had ultimately failed. ”
He warned that “persistently low rates are having a pernicious effect on investor behavior,” with many asset managers turning to illiquid assets, including venture capital and private equity.
“A whole new generation of investors may well have come of age having never experienced an economic downturn, prolonged market decline or interest rates above all-time lows,” he said. he writes. “Like Halley’s Comet, these are things that a lot of investors have heard of but may not have seen or really can’t imagine.”
Baupost took advantage of market volatility in 2022, recovering $1.6 billion from its hedge, which helped offset losses in its stock portfolio, including Just Eat Takeaway, Google-owner Alphabet, and Meta , parent of Instagram.
Klarman told clients the company added to several of its public equity bets after prices fell, as well as investing in three Chinese companies it said were “extremely undervalued.” This is the biggest exposure to China Baupost for many years and comes at a time when many other investors are pulling out of the region.
Baupost said it posted a mid-single-digit decline last year, significantly outperforming the S&P 500.
