by Umar Farooq
Ray Dalio, founder, Bridgewater Associates, explains why the 1930s hold clues to what lies ahead for the economy. Ray Dalio is a macro investor whose fortune was built on a supernatural ability to spot big macro trends.
Dalio predicted in 2007 that the US housing bubble would burst, and warned the Bush administration that major banks were on the verge of collapse. The government at that time ignored him. Likewise, after the 2008 collapse of Lehman Brothers, Dalio immediately recognized that the Federal Reserve would have to print trillions of dollars to bail out the system and so he placed his firm for big profits, buying assets like gold and foreign currencies.
Now Dalio has a new warning about the markets for anyone who is willing to listen.
According to Dalio, this is not a normal business cycle; monetary policy will be a lot less effective in the future; investment returns will be very low. Dalio argument is made up of three parts.
First, there are three main forces that drive all economies: 1) productivity; 2) the short-term debt cycle, or business cycle, running every five to ten years; and 3) the long-term debt cycle, over 50 to 75 years.
Second, there are three equilibriums that markets gravitate towards: 1) debt growth has to be in line with the income growth that services those debts; 2) economic operating rates and inflation rates can’t be too high or too low for long; and 3) the projected returns of equities have to be above those of bonds, which in turn have to be above those of cash by appropriate risk premiums. Without such risk premiums the transmission mechanisms of capital won’t work and the economy will grind to a halt.
Third, there are two levers that policy-makers can use to bring about these equilibriums: 1) monetary policy, and 2) fiscal policy. With monetary policy becoming relatively impotent, it’s important for these two to be coordinated.
What does this template tell us about the future? By and large, productivity growth is slow, business cycles are near their mid-points and long-term debt cycles are approaching the end of their pushing-on-a-string phases. There is only so much one can squeeze out of a long-term debt cycle before monetary policy becomes ineffective, and most countries are approaching that point. Japan is closest, Europe is a step behind it, the United States is a step or two behind Europe and China a few steps behind America.
Dalio don’t see an abrupt crisis in the immediate future. Instead, he consider this as the beginnings of a longer-term, gradually intensifying financial squeeze. This will be brought about by both income growth and investment returns being low and insufficient to fund large debt-service, pension and health-care liabilities. Monetary and fiscal policies won’t be of much help, according to Dalio.
“Governments often go into debt in order to finance big spending projects which stimulate economic growth. But eventually the amount of growth you can generate from debt reaches a point of diminishing returns. We can already see plenty of data to support this assertion. China has taken on hundreds of billions of debt over the last several years in order to maintain its economic growth. But measures of China’s “debt efficiency” now show, according to the Wall Street Journal, that it takes “increasingly more debt to generate the same GDP growth.” So China is rapidly reaching its limit in terms of how much economic growth it can squeeze from its debt.” Simon Black
As time passes, how the money flows between asset classes will get more interesting. Dalio concludes his piece predicting that “savers will seek to escape financial assets and shift to gold and similar non-monetary preserves of wealth, especially as social and political tensions intensify.”
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