Ray Dalio, is a legend amongst money managers, running not only the largest hedge fund in the world (Bridgewater Associates with $120BN under management) but also one of the most successful funds in the business. Their flagship fund has returned 22.75% per annum over the last three years. Ray gives only occasional interviews, and his annual feature with the financial magazine Barron's is a must read for investors and people who are interested in the macro themes for the global economy and financial markets. To summarise:
-There are three methods of debt deleveraging for an economy : 1) Austerity which implies less spending and is therefore deflationary and constricts growth, 2) Restructuring of debt by paying less which is also deflationary as it has a negative effect on wealth and causes credit to decline ,and, 3) Printing money through quantitative easing which puts money into the system and is inflationary and stimulates the economy.
-The US has been able to achieve a "beautiful" deleveraging by pursuing all three options in a balanced manner and has therefore avoided high deflation or a depression and managed slow (but positive) growth. The Fed will do more quantitative easing if the economy slows down again.
-Fiscal stimulus is also important as the government has to spend more to offset declining sales and tax revenues and fund unemployment and other social benefits. This causes wealth redistribution as the wealthy need to be taxed more thereby causing social tension.
-The key is to keep nominal interest rates below the nominal growth rate of the economy, without printing too much money so as to cause inflation. This can be achieved by simultaneously having some austerity and debt restructurings.
-Europe is a unique case in history, as there is no decision-making process which typically produces an agreement for a country about using monetary and fiscal stimulus to reflate an economy. The LTRO operation of the ECB saved a debt collapse in Europe by financing banks to buy government debt (and refinance their debt) as investors have less money to buy the debt. The ECB needs to continue with this programme but there is resistance from some individual central banks due to the repayment risk on this debt.
-The current European situation is analogous to the US in 1789. After the colonies declared independence in 1776, they all had debt problems and no central taxation, and it was only in 1789 when a constitution (and a country) was formed that a treasury and central taxation was feasible. This allowed revenues to be produced for the country and the issuance and restructuring of debt.
-Europe is fast reaching a decision point where it will have to decide whether it wants to create a sufficient central government having the ability to collect taxes and issue debt that obligates the whole. The key question is how much pain will this cause Europe and does the pain cause a collapse before it forces the right choices to be made.
-Europe will be in a depressed state and if its banks delever in an orderly way, supported by refinancing by the ECB, the impact on the global economy can be manageable. Banks in countries like the US, China and Brazil can replace the European banks in terms of lending sources.
-However, there is a 30% risk that in the next six-month to two-year period there is a bad shock from Europe as there is no clarity on whose has got authority and control and no clear means to achieving a resolution. There are no provisions in the Maastricht Treaty for the break-up of the monetary union and exits of countries, compounded by a lack of enforceability on country debt and no resort to local currencies to devalue and repay the debt.
-Currently the global economy is slowing down and the big question is whether we get a big European shock that will favour low-risk assets. But to the extent we get negative conditions we will get central banks printing money which will cause a rally in stock markets around the world.
-So we are likely to get bull and bear markets going forward with no big trend, with the upswing lasting twice as long as the downswing. Currently we are in the higher stages of the up-cycle.
-Neutral on bonds, and over the next few years long-term bonds are likely to be a poor investment as the yield will be low relative to inflation and growth and therefore provide an inadequate return.
-The US economy will be slowing into the year-end and 2013 will be difficult year with the negative impact of the fiscal-cliff and higher taxes. The key here will be how well is the policy managed, particularly in the year after a US election which makes it more difficult.
-China and emerging markets are doing much better, as they were previously in a bubble since their debts were growing too fast relative to incomes, but growth rates have slowed significantly and are likely to remain at a moderate pace going forward.
-Neutral on commodities, with the slowing in demand. Positive on gold over the longer-term and investors should have about 10% of their assets in gold, because of the good long-term growth prospects as well as being a diversifier against the other 90%. Gold is like an alternative currency and with the massive money printing going on in the developed world, it is important to have some gold.
-Deleveragings go on for about 15 years, as an adjustment to a debt bubble which is typically a 30-40 year process typically culminating in a last two year surge like we had from 2005-2007 and 1927-1929 in the US, and 1988-1990 in Japan.
Fascinating thoughts, and his point about the requirement for quantitative easing to make deleveragings manageable is critical to the outlook for the global economy. In the US, the Fed has made it amply clear that they will act if the economic and financial conditions deteriorate enough. The ECB has been more ambivalent on this approach, but their LTRO programme was a game changer and it is likely that they will continue this policy going forward due to the serious structural issues facing Europe (as outlined above). Therefore, while the current market weakness is likely to continue into the summer , subsequent concerted actions by central banks will produce a market rally into the year-end. For long term investors, adding to long positions on market downturns and perhaps trimming positions on market surges makes sense. Buying the European stock market on further weakness later in the summer making further ECB action very likely, could be an attractive play. China, India and other emerging markets continue to present attractive buying opportunities.
Some charts which illustrate themes more clearly than words:
-With the forthcoming US elections, the state of the economy and unemployment levels are traditionally important factors in determining the outcome. In addition, the stock market is a key real-time indicator of the election outcome as the graph below clearly illustrates. The pressure on the Fed to act will increase as the economy slows and the market weakens.
-Investor "Risk-Love" sentiment in the US (from Deutsche Bank) has decidedly turned negative, which typically precedes a market downturn and subsequent policy action. We are getting closer to that point.
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-The change in the China credit multiplier (from Deutsche Bank) is a great leading indicator for industrial growth, and is now predicting a surge in growth.
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-The above combined with extremely attractive stock market valuations on a historical basis (see chart below from Morgan Stanley) , make the market an attractive value buy.
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