Baupost chief Seth Klarman blames Federal Reserve for ‘financial fantasyland’

Seth Klarman has told investors in his hedge fund that the Federal Reserve’s response to the 2008 financial crisis and the ensuing decade-plus of low interest rates had helped “erect a financial fantasyland”.

“A consequence-free era of virtually unlimited low-cost capital had come to an end,” Klarman, the head of Baupost Group and a prominent figure in investing, declared 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 downbeat outlook cuts against a rally that has sent major global stock benchmarks soaring this year, as sliding inflation figures give investors confidence that the Fed could soon stop lifting interest rates.

Klarman likened the sharp rise in interest rates last year to kryptonite, saying it had finally helped deflate the “everything bubble”, including the unravelling of investments in unprofitable so-called growth companies that had soared during the pandemic boom but had little inherent value.

“These included scores of profitless early-stage companies that could have come public only in a bubble, a staggering volume of bonds that sported cartoonishly low yields, most of the absurd ‘meme stocks’, and stocks such as Tesla — intensely hyped, egregiously overvalued, and priced only for the smoothest of rides — whose shares dropped by nearly two-thirds,” he wrote.

Shares of companies that had risen to record highs in 2020 and 2021 deflated sharply last year, dealing a blow to investors across the venture capital, crypto and technology industries who had ploughed money into businesses with high revenue growth but little or no profits.

“Time spent on due diligence came to seem to them a hindrance to maximal capital deployment, and the usual warning signs of excess — financial profligacy, a proliferation of dubious business models, and obvious red flags — were mocked or ignored,” he wrote.

Despite the rebound in markets this year, Klarman warned that last year’s sell-off “probably has further to go” and that a sovereign debt crisis could lie ahead.

Klarman spent much of his letter critiquing the Fed’s response to the financial crisis, when the central bank cut interest rates close to zero and began hoovering up Treasuries and mortgage-backed securities. The policy dramatically reduced the returns on safer investments, such as US sovereign debt, and prompted many investors to buy riskier and higher-yielding securities.

“Microscopic interest rates, like grains of sand at the beach, had gotten into everything,” he wrote. “The central bankers had fallen behind the curve, having failed to anticipate that the massive expansion of the Fed’s balance sheet would be difficult to reverse and that a decade-plus of low interest rate policies had finally run aground.”

He warned that “persistently low rates have a pernicious effect on investor behaviour”, with many asset managers moving into illiquid assets, including venture capital and private equity.

“An entire new generation of investors may well have come of age never having actually experienced an economic downturn, a protracted market downdraft, or interest rates above rock-bottom levels,” he wrote. “Like Halley’s comet, these are things many investors have heard about but may never have actually seen, or can’t quite imagine.”

Baupost benefited from the market volatility in 2022, netting $1.6bn from its hedging, which helped offset losses in its stock portfolio, including Just Eat Takeaway, Google-owner Alphabet and Instagram-parent Meta.

Klarman told clients the firm had added to positions in several of its public equity bets after prices declined, as well as investing in three Chinese companies that he said were “extremely undervalued”. It is the biggest exposure to China Baupost has had in many years and comes at a time when many other investors are pulling back from the region.

Baupost said it posted a mid-single digit decline last year, significantly outperforming the S&P 500.