Ray Dalio Warns Another 1930s Episode Looms

Jeff Cox of CNBC reports Bridgewater's Ray Dalio warns of ‘serious problems’ and a bond ‘blow-off’ as a repeat of the late 1930s looms:
Hedge fund titan Ray Dalio is worried that the current landscape is starting to resemble Depression-era conditions that could hammer investors.

In a LinkedIn post Thursday, the billionaire Bridgewater Associates founder said high levels of debt and central banks’ ineffectiveness are two of the key factors that need watching. The U.S.-China conflict is adding to the problems as an existing power battles an emerging one.

“If/when there is an economic downturn, that will produce serious problems in ways that are analogous to the ways that the confluence of those three influences produced serious problems in the late 1930s,” Dalio wrote.

The post was consistent with a previous warning he delivered about a “paradigm shift” in which gold will serve as a profitable hedge as investors get caught holding too much risk.

In the latest essay, he spoke of how central banks are being forced to keep interest rates low and “print money to buy financial assets” in order to prop up markets and make huge fiscal deficits affordable. He said there are “strong deflationary forces at work” as capacity has surged.

“These forces are creating the need for extremely loose monetary policies that are forcing central banks to drive interest rates to such low levels and will lead to enormous deficits that are monetized, which is creating the blow-off in bonds that is the reciprocal of the 1980-82 blow-off in gold,” he said.

Dalio’s firm, which manages $124.7 billion for clients and is the largest hedge fund operation in the world, has performed poorly this year. Bridgewater’s Pure Alpha fund was recently off 6% year to date and Pure Alpha II is down 9%, according to Bloomberg News.

Dalio directed readers to study the economic and investing conditions of 1935-45 as “there is a lot to be learned by understanding the mechanics of what happened then (and in other analogous times before then) in order to understand the mechanics of what is happening now. It is also worth understanding how paradigm shifts work and how to diversify well to protect oneself against them.”

Read the full Dalio LinkedIn post here.
So what did Ray Dalio post on LinkedIn and why does he fear a repeat of the 1930s? Dalio posted a Bridgewater Daily Observations research comment, The Three Big Issues and the 1930s Analogue: (added emphasis is mine):
The most important forces that now exist are:

1) The End of the Long-Term Debt Cycle (When Central Banks Are No Longer Effective)


2) The Large Wealth Gap and Political Polarity


3) A Rising Work Power Challenging an Existing World Power


The Bond Blow-Off, Rising Gold Prices, and the Late 1930s Analogue

In other words now 1) central banks have limited ability to stimulate, 2) there is large wealth and political polarity and 3) there is a conflict between China as a rising power and the U.S. as an existing world power. If/when there is an economic downturn, that will produce serious problems in ways that are analogous to the ways that the confluence of those three influences produced serious problems in the late 1930s.

Before I get into the meat of what I hope to convey, I will repeat my simple timeless and universal template for understanding and anticipating what is happening in the economy and markets.

My Template

There are four important influences that drive economies and markets:
  1. Productivity
  2. The short-term debt/business cycle
  3. The long-term debt cycle
  4. Politics (within countries and between countries).
There are three equilibriums:
  1. Debt growth is in line with the income growth required to service the debt,
  2. The economy’s operating rate is neither too high (because that will produce unacceptable inflation and inefficiencies) nor too low (because economically depressed levels of activity will produce unacceptable pain and political changes), and
  3. The projected returns of cash are below the projected returns of bonds, which are below the projected returns of equities and the projected returns of other “risky assets.”
And there are two levers that the government has to try to bring things into equilibrium:
  1. Monetary policy
  2. Fiscal policy
The equilibriums move around in relation to each other to produce changes in each like a perpetual motion machine, simultaneously trying to find their equilibrium level. When there are big deviations from one or more of the equilibriums, the forces and policy levers react in ways that one can pretty much expect in order to move them toward their equilibriums. For example, when growth and inflation fall to lower than the desired equilibrium levels, central banks will ease monetary policies which lowers the short term interest rate relative to expected bond returns, expected returns on equities, and expected inflation. Expected bond returns, equity returns, and inflation themselves change in response to changes in expected conditions (e.g. if expected growth is falling, bond yields will fall and stock prices will fall). These price changes happen until debt and spending growth pick up to shift growth and inflation back toward inflation. And of course all this affects politics (because political changes will happen if the equilibriums get too far out of line), which affects fiscal and monetary policy. More simply and most importantly said, the central bank has the stimulant which can be injected or withdrawn and cause these things to change most quickly. Fiscal policy, which changes taxes and spending in politically motivated ways, can also be changed to be more stimulative or less stimulative in response to what is needed but that happens in lagging and highly inefficient ways.

For a simpler explanation of this template see my 30-minute animated video “How the Economic Machine Works” and for a more comprehensive explanation see my book Understanding the Principles of Big Debt Crises, which is available free as a PDF here or in print on Amazon. Also, to learn more about our extensive debt cycle research, please visit our debt crises research library on Bridgewater.com.

Looking at What is Happening Now in the Context of That Template

Regarding the above template and where we are now, in my opinion, the most important things that are happening (which last happened in the late 1930s) are a) we are approaching the ends of both the short-term and long-term debt cycles in the world’s three major reserve currencies, while b) the debt and non-debt obligations (e.g., healthcare and pensions) that are coming at us are larger than the incomes that are required to fund them, c) large wealth and political gaps are producing political conflicts within countries that are characterized by larger and more extreme levels of internal conflicts between the rich and the poor and between capitalists and socialists, d) external politics is driven by the rising of an emerging power (China) to challenge the existing world power (the U.S.), which is leading to a more extreme external conflict and will eventually lead to a change in the world order, and e) the excess expected returns of bonds is compressing relative to the returns on the cash rates central banks are providing.

As for monetary policy and fiscal policy responses, it seems to me that we are classically in the late stages of the long term debt cycle when central banks’ power to ease in order to reverse an economic downturn is coming to an end because:
  • Monetary Policy 1 (i.e., the ability to lower interest rates) doesn’t work effectively because interest rates get so low that lowering them enough to stimulate growth doesn’t work well,
  • Monetary Policy 2 (i.e., printing money and buying financial assets) doesn’t work well because that doesn’t produce adequate credit in the real economy (as distinct from credit growth to leverage up investment assets), so there is “pushing on a string.” That creates the need for…
  • Monetary Policy 3 (large budget deficits and monetizing of them) which is problematic especially in this highly politicized and undisciplined environment.
More specifically, central bank policies will push short-term and long-term real and nominal interest rates very low and print money to buy financial assets because they will need to set short-term interest rates as low as possible due to the large debt and other obligations (e.g. pensions and healthcare obligation) that are coming due and because of weakness in the economy and low inflation. Their hope will be that doing so will drive the expected returns of cash below the expected returns of bonds, but that won’t work well because a) these rates are too close to their floors, b) there is a weakening in growth and inflation expectations which is also lowering the expected returns of equities, c) real rates need to go very low because of the large debt and other obligations coming due, and d) the purchases of financial assets by central banks stays in the hands of investors rather than trickles down to most of the economy (which worsens the wealth gap and the populist political responses). This has happened at a time when investors have become increasingly leveraged long due to the low interest rates and their increased liquidity. As a result we see the market driving down short term rates while central banks are also turning more toward long-term interest rate and yield curve controls, just as they did from the late 1930s through most of the 1940s.

To put this interest rate situation in perspective, see the long-term debt/interest rate wave in the following chart. As shown below, there was a big inflationary blow-off that drove interest rates into a blow-off in 1980-82. During that period, Paul Volcker raised real and nominal interest rates to what were called the highest levels “since the birth of Jesus Christ,” which caused the reversal.

During the period leading into the 1980-82 peak, we saw the blow-off in gold. The below chart shows the gold price from 1944 (near the end of the war and the beginning of the Bretton Woods monetary system) into the 1980-82 period (the end of the inflationary blow-off). Note that the bull move in gold began in 1971, when the Bretton Woods monetary system that linked the dollar to gold broke down and was replaced by the current fiat monetary system. The de-linking of the dollar from gold set off that big move. During the resulting inflationary/gold blow-off, there was the big bear move in bonds that reversed with the extremely tight monetary policies of 1979-82.

Since then, we have had a mirror-like symmetrical reversal (a dis/deflationary blow-off). Look at the current inflation rates at the current cyclical peaks (i.e. not much inflation despite the world economy and financial markets being near a peak and despite all the central banks’ money printing) and imagine what they will be at the next cyclical lows. That is because there are strong deflationary forces at work as productive capacity has increased greatly. These forces are creating the need for extremely loose monetary policies that are forcing central banks to drive interest rates to such low levels and will lead to enormous deficits that are monetized, which is creating the blow-off in bonds that is the reciprocal of the 1980-82 blow-off in gold. The charts below show the 30-year T-bond returns from that 1980-82 period until now, which highlight the blow-off in bonds.

To understand the current period, I recommend that you understand the workings of the 1935-45 period closely, which is the last time similar forces were at work to produce a similar dynamic.

Please understand that I’m not saying that the past is prologue in an identical way. What I am saying that the basic cause/effect relationships are analogous: a) approaching the ends of the short-term and long-term debt cycles, while b) the internal politics is driven by large wealth and political gaps, which are producing large internal conflicts between the rich and the poor and between capitalists and socialists, and c) the external political conflict that is driven by the rising of an emerging power to challenge the existing world power, leading to significant external conflict that eventually leads to a change in the world order. As a result, there is a lot to be learned by understanding the mechanics of what happened then (and in other analogous times before then) in order to understand the mechanics of what is happening now. It is also worth understanding how paradigm shifts work and how to diversify well to protect oneself against them.
When Ray Dalio warns of something, investors listen. Almost every major global pension and sovereign wealth fund is an investor in either Bridgewater's All-Weather Fund or the Pure Alpha funds or both.

There's a reason why Ray Dalio is running the world's largest hedge fund, he has built a great organization since starting from humble beginnings in a two-bedroom apartment in the mid-1970s till now. He's now one of the wealthiest men on the planet and was even featured on CBS 60 Minutes last year and again more recently (it aired again in July).

I met Ray Dalio in late 2003/ early 2004 when I was working for PSP Investments as a senior investment analyst. Before then, I invested in Bridgewater in 2003 when I was working at the Caisse investing in a portfolio of directional hedge funds (CTAs, global macros and L/S Equity funds).

The only reason Dalio met with me on that occasion was because Gordon Fyfe, the former President and CEO of PSP, accompanied me on that trip. Ray Dalio doesn't meet investors, he simply doesn't need to but he agreed to meet us.

Anyway, I remember I was worried about the US housing market and thought it was going to end badly. Ray kept trying to sell his All-Weather Fund and I kept harping on deleveraging and deflation.

At one point, he got visibly annoyed as I kept pushing my points and he just blurted out: "Son, what's your track record?".

That was the end of that, I got put in my place by Ray Dalio and kept my mouth shut after that but I was fuming inside.

Gordon Fyfe, who is now President and CEO/ CIO of BCI, loved it and kept teasing me in the car on our way back to the airport after that meeting.

But Ray Dalio was right, I was young, arrogant, brash and cocky and should have just listened more and kept my mouth shut. And he's right, I didn't have a track record to fall back on (still, I was right!).

I won't lie, I loved ripping into hedge fund managers and challenging their views. I took my job seriously and would ask tough questions, especially if they were trying to blow smoke my way.

There are some things I like about Ray Dalio and Bridgewater, and others I have publicly criticized, like his incessant talk of how radical transparency is behind his firm's success. For me, it's another radical marketing scheme which enamors some investors, doesn't do anything for me. In fact, it creeps me out a little.

As far as his now world famous book, Principles, I read it at the bookstore one afternoon and was completely in love with the section on investments at the beginning. That alone is worth the price of the book.

As far as his Principles, there some excellent ones you can read here but one of them really sticks out for me:
“Badmouthing people behind their backs shows a serious lack of integrity and is counterproductive. It doesn’t yield any beneficial change, and it subverts both the people you are badmouthing and the environment as a whole. If you talk behind people’s backs at Bridgewater you are called a slimy weasel.” – Ray Dalio
There are tons of slimy weasels at all organizations and unfortunately, some have way too much power.

Anyway, back to Dalio's comment above. I don't know if he's publicly posting these comments because his Pure Alpha fund is down 6% so far this year and he's trying to explain his positions, but it's not the first time he has warned of populism and rising class tensions.

Back in January, Dalio warned of rising inequality and the limits of capitalism. I agree with him on that front and when I wrote my comment on deflation headed to America a couple of years ago, among the seven structural factors that led me to believe we are headed for a prolonged period of debt deflation, I mentioned rising inequality exacerbated by the global pension crisis:
  1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  2. Demographic time bomb: A rapidly aging population means a lot more older people living longer with little savings spending less.
  3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
  5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  6. Globalization: Capital is free to move around the world in search of better opportunities but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
  7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.
These are the seven structural factors I keep referring to when I warn investors to temper their growth forecasts and prepare for global deflation.

Today on LinkedIn, Stefania Perrucci, CIO at New Sky Capital, posted Noah Smith's Bloomberg comment on how the Fed's stimulus might be undermining growth.

Ms. Perrucci rightly noted:
People are awakening to the possibility of the obvious, i.e. to the fact that monetary policy, when used as the to-go tool in place of better policies, is not a panacea and may contribute to misallocation of resources, thus dragging #productivity down. I raised this point many times in the past. Ironic, that it took Summers of all people to ignite the conversation on major networks, such Bloomberg. There is a time for everything, I guess.
I chimed in and stated:
Two years ago, I wrote a comment on why deflation is headed to America listing seven structural factors that monetary policy is incapable of addressing, including the global pension crisis and rising inequality. In fact, one can argue that central banks have exacerbated rising inequality. It’s incredible how many people were convinced deflation and negative rates will never come to the US. Now, they’re seeing reality kick in.
Central banks have exacerbated the wealth gap and now we are going back into the Twilight Zone on global bonds, just like the summer of 2016.

Will the US escape negative rates? That all remains to be seen but as long as these structural problems persist -- and they will persist -- there's no way the US and the rest of the world will escape a prolonged period of debt deflation.

The Japanifcation of the US economy is happening just like it is happening in Europe which is holding on by a thread.

How long before something blows up? I don't know but I'm more worried of another 1997 Asian crisis if the US dollar keeps rising, putting more pressure on emerging markets with US dollar-denominated debt.

Still, one area where I disagree with Dalio and others is on central banks being impotent as rates fall back to zero. Unlike Bridgewater's traders and portfolio managers, central banks don't have a P & L, they can keep buying financial assets as they create money through a few key strokes.

Nobody has convinced me that the Fed's balance sheet can't triple, quintuple or go parabolic in size. Of course, if it does, gold will go parabolic and have another major blow-off move that Dalio is betting on.

Anyway, I've rambled on enough, enjoy the long weekend.

Below, Ray Dalio of Bridgewater Associates says the easing of monetary policy by central banks "can't continue" and the world is on the brink of a "paradigm shift".

Also, over the last 40 years, China’s rapid economic expansion has altered the world’s geopolitical and economic landscape. Bridgewater’s Founder, Co-CIO and co-Chairman Ray Dalio joins Bridgewater's Senior Portfolio Strategist Jim Haskel to discuss the historical arc of this growth and why the portfolio characteristics of China’s markets are attractive and diversifying despite escalating global tensions.Very interesting discussion, well worth watching.