Hi!,
Ray Dalio, who runs Bridgewater Associates (the world's largest -$130 billion -and one of the most successful hedge funds with a 37 year track-record), recently gave a fascinating and broad ranging talk (link below) on the current global financial and economic landscape, the deleveraging process and its implications and what is the key risk factor for the global economy going forward. Dalio provides a unique and insightful perspective on the workings of the financial and economic system which clarifies some of the prevalent misconceptions on important topics such as austerity, fiscal and monetary policies and debt deleveraging. To summarise the key points:
-Financial crises repeat themselves regularly, in a familiar pattern, over history and are a surprise to most people as they view them from a frame of reference which only extends only to their life-time experience rather than a serious study of history.
-The economic machine, at its essence, comprises of transactions involving the purchase of goods, services and financial assets with money or credit. Demand should be measured in terms of money or credit used rather than good and services as economic theory suggests.
-Credit is created out of thin air, and credit cycles are key in understanding booms and busts and they tend to repeat themselves every 10 years or so.
-Borrowing is key to growth as goods purchased with credit creates income and leads to a positive cycle of increasing debt and economic activity.
-Lowering interest rates has a positive impact on the economy as it lowers the cost of servicing the debt, makes it less costly to purchase goods and services and boosts asset prices due to a positive present value impact. The increase in asset prices leads to increased wealth and therefore more borrowing and increased economic activity.
-However, eventually (and inevitably) debt begins to grow faster than income (i.e. increasing debt/income ratios) , making it difficult to service the debt with income which then forces debt growth to slow down leading to decreased economic activity and a negative cycle. This is a period of debt deleveraging.
-This can result in a depression which involves a combination of austerity, debt restructuring (i.e. debt write-down) and eventually the printing of money to counter the negative wealth impact of the former activities.
-The printing of money is key to dealing with a depression type scenario as it makes up for the shortfall in money created by the negative wealth impact of austerity and debt restructuring.
-During a period of deleveraging, balance between austerity, debt restructuring (which are both deflationary) and money printing (which is inflationary) is critical to avoid a depression.
-Debt to income ratios will gradually decline as long as nominal GDP is growing faster than the interest cost of servicing the debt. This has been borne out repeatedly over history – for example, UK after World War 11.
-The mistake of government policy is to target growth and inflation only – it should also target debt/income growth as bubbles are more pernicious than inflation and much harder to correct – i.e. US in 1929, Japan in 1989.
-The 2008 financial crisis arose because investors and banks played the carry game (invest in high-yield assets and borrow at low interest cost) with a backdrop of low volatility in markets. With mark-to-market accounting it was easy to see the impact of leverage in the financial markets, but regulators lacked awareness as their frame of reference was only recent financial history.
-Europe has a Euro 2 trillion "hole" in terms of the amount of debt which needs to be written down (with bank assets of Euro 31 trillion and sovereign debt of Euro 3.5 trillion).
-This can only be resolved by massive fiscal transfer from the north to the south which is unlikely, leaving the alternative of austerity and debt restructuring leading to a depression and a "lost decade" with alternating bull and bear markets.
-The printing of money is the only way to make this process less painful – for example, the breaking of the dollar link to gold (i.e. printing of money) in March 1933 marked the bottom of the Great Depression in the US.
-With the ECB being subject to a voting system, the southern countries effectively influence the decision on printing money – which they have recently exercised.
-The US and Japan cannot support the amount of total debt in the system – but since they have the ability to print money they can keep interest rates very low and therefore keep the system going for a long time.
-The debt issue will need to dealt with when the buyers of government debt in the two countries choose to invest in inflation assets. This is unlikely to happen for a while (about 5 years) as we are in a global deflationary environment with the US, Europe and Japan deleveraging and China dealing with the aftermath of its real estate bubble.
-Money printing almost always works – the two major surprises of his career were 1) the breaking of the dollar link with gold in August 1971 which lead to a 4% overnight jump in the stock market and an ensuing bull market, 2) the Latam debt crisis with overexposed US banks, culminating in the Mexican default in 1982, which lead to the printing of money and the bottom for the stock market (Dow at 777).
-Money printing does not necessarily give rise to inflation as the investors selling their treasury bonds to the Fed go out and buy other similar assets (i.e. agency bonds and high grade credit) - it is inflationary only when they buy goods and services. This is in contrast to fiscal policy where the government actually buys goods and services.
-The US has so far been able to achieve the right balance between austerity, debt restructuring and monetary and fiscal policy (a "beautiful deleveraging") - but with growth likely to persist at 1.5-2% for a while it is vulnerable to hitting an "air-pocket" as the room for expansive fiscal and monetary policies is more limited making the balancing act difficult.
-China is likely to experience more normal business cycles as they deal with lower domestic demand, slowdown in exports and inefficient use of capital – however, downturns are likely to be temporary as they have the ability to act decisively on the fiscal and monetary front and are a surplus nation.
-Emerging markets should outperform developed economies as they are largely surplus producing economies and therefore are net creditors.
-There are four basic economic environments which govern the prices of all assets – lower inflation than expected (good for bonds) , higher inflation than expected (bad for bonds) , lower growth than expected (bad for stocks) and higher growth than expected (good for stocks).
--Individual investors should construct a well diversified asset portfolio assuming they do not know what scenario is unlikely to unfold-i.e. include four pieces which perform well under all the above scenarios - i.e. cash, stocks, long duration bonds and gold. The weighting of portfolio should be based on the risk of the assets rather than a simple dollar weighting.
-Stocks are likely to outperform bonds going forward, but the age of high returns is over as the declining interest rate cycle (which led to higher stock and bond prices) has run its course with short-term rates at zero.
http://www.economist.com/blogs/freeexchange/2012/09/learn-macroeconomics-hour?fsrc=gn_ep
Fascinating stuff – providing a simple yet powerful framework to analyse the critical issues the global economy and financial markets face today – deleveraging, austerity, money printing and fiscal policy. As I have noted before, there tends to be a lot of views being expressed in the media on these topics, based on ideological and personal preferences rather than an in-depth analysis of the issues involved. So the key variables to observe going forward is the ability of governments across the globe to maintain a judicious mix of austerity, debt restructuring, money printing and fiscal expansion. Countries which are unable to maintain this balance are likely to underperform, while countries which are able to act decisively on this front are likely to outperform. Europe has crossed the inflection point with the ECB being able to print money - while they still face "a lost decade" going forward, the tail risk event has been decisively taken out. The US faces its biggest challenge in terms of the fiscal cliff and its political impasse vis-a-vis the austerity versus spending debate.
The China stock market offers a buying opportunity of the decade, being the worst performing major stock market this year (-9%, Spain was at -8.7%!), historically low valuations (p/e dipping well below the previous historical low of 15, government yields equalling stock dividend yields), extreme investor pessimism (new brokerage accounts falling below 100,000), global media bearishness ( books and articles titled "The End of the Chinese Dream" , "The Falling Star"), and perhaps most importantly – decisive action on the fiscal policy front after the regime handover in October.
The key here is to construct a well diversified "all weather" portfolio which has something for the four scenarios described above – as noted previously on numerous occasions – EM equities, high quality multinationals, natural resource stocks, EM credit and high quality government bonds, US high yield credit and private mortgages, cash and gold.
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