Since stepping back from running Bridgewater Associates, Ray Dalio has apparently had a lot of free time to author LinkedIn posts and make the media rounds promoting his new e-book (available for free on Amazon) “A Template for Understanding Debt Crises”. The substance of these interviews has been pretty consistent: Dalio argues that we’re nearing the end of the business cycle (the seventh inning, to be precise) and that, while stocks probably have more time to ramp higher, investors hoping to invest for the long term should be cautious: Because the next downturn is, at most, a year or two away.
As any trader familiar with Dalio’s “1937 thesis” is no doubt aware, Dalio is a student of history. In many ways, the modern economy resembles that of the late 1930s: Still-low interest rates have pushed asset prices near full capacity, the wealth gap has widened, populism is ascendant and economic tensions are intensifying around the world (thanks in large part to Trump’s trade war with China, of course).
As Dalio explains in an interview with Business Insider’s Henry Blodget, although the economy is running at full steam, rising interest rates will put a damper on activity, eventually triggering the inevitable downturn. However, with the Fed’s monetary toolkit already largely spent and the US budget deficit already precariously wide, US policy makers will have few options to help revive the economy. The only solution, Dalio believes, is to make sure “capitalism works for everyone.” Otherwise, the US will be doomed to repeat the late 1930s, when the economy kept lapsing into recession until it was finally saved by full-scale industrial warfare.
As Dalio explains, he’s a firm believer in the “endless waltz” theory of capitalism, namely that investors, corporations and consumers will make the same mistakes over and over again, and that the only way we can prepare for these inevitable lapses is by studying the factors that have contributed to them in the past.
This was really research that was done before the 2008 financial crisis. And it lays out a template of how these things happened over and over again. In other words, I believe that the same things happen over and over again, and if you study the patterns of them, you understand the cause-effect relationships, and then, can write down principles for dealing with them well. We dealt with them very well in that financial crisis and in other debt crises, and I wanted to pass that template along.
As Dalio explains, there are six stages to every debt crisis:
- “There’s the early part of the cycle where debt is being used to create productivity incomes and then, it can be serviced well, asset prices go up, everything is great.”
- “And then, you come to the bubble phase of the cycle. And in that bubble phase, you’re in a position where everybody extrapolates the past. Because asset goes up, they think its assets are going to continue to rise. And you borrow money and they leverage. And when you are in that phase, when we do the calculations, you can start to see that maybe you won’t be able to sustain that level of debt growth.”
- “Then, you come into the third phase of the cycle, which is the top. That’s typically the part of the cycle when central banks start to put on the brakes, tighten monetary policy, and the like.”
- “Then, you come into the down leg…”
- “…and when interest rates hit zero percent, you come into a depression part of that cycle because monetary policy doesn’t work normally when interest rates hit zero.”
- “Then, you have to have quantitative easing and you begin that expansion. And then, you carry that along and you begin the cycle.”
These phases are illustrated in the chart below:
According to Dalio, there have only been two times during the last century where we had debt crises where interest rates were cut all the way to zero:
“There are only two times in the history of this century where we had debt crises in which interest rates hit zero. And in both of those times, the central bank had to print money and go to a different type of monetary policy, which we call quantitative easing, and to buy financial assets. And that drives up, in both of those cases, the value of those financial assets and produces a recovery, but it drives interest rates down to zero or near zero, where they are around the world. And that buying, in this case $15 trillion of financial assets, has pushed up financial assets and driven the interest rates down to zero, so it’s caused asset prices to rise. It’s also caused populism, more populism.”
While downturns are inevitable, the real risk arises when the wealth gap blows out…
“Because that process creates a gap between the rich and the poor. Those that have more financial assets see those asset prices go up. And for various other reasons, a wealth gap has developed. If you look at, right now, the top 10%, the top one tenth of 1% of the population’s net worth is equal, about, to the bottom 90% combined. That’s very similar to the late ’30s when we had that stimulation and so on.”
…And the levels of wealth inequality present today are very similar to the 1930s.
Wealth inequality, Dalio argues, breeds a populist reaction which has clearly manifested in the election of President Trump, Brexit and the enduring popularity of anti-establishment parties in Greece, Italy and elsewhere in Europe. This mirrors the rise of Communism in the Soviet Union and Facism (another type of populist movement) in Italy, Japan and Germany.
I think the cause-effect relationships are analogous, meaning that if you have a wealth gap and you have a downturn in the economy where you’re sharing the pie, how do you divide a budget, sharing the budget? There’s a risk that both sides are at odds with each other and there’s also a greater international risk in tensions. Economic tensions produce global tensions, for various reasons. So I think that, in this expansion, we’re about in the seventh inning of a nine-inning game, let’s say. We’re in the later part of the cycle, the part of cycle in which monetary policy is tightening and there’s not much capacity to squeeze out of the economy. And that, as interest rates tend to rise, if they rise faster than is discounted in the curve, it can hurt asset prices.
What’s really concerning for Dalio is the fact that, now as then, there are two powers vying for economic supremacy. In the 1930s, it was the US and the UK vs. Germany. Today, it’s the US and China.
But I think that that, what concerns me is that. It concerns me also internationally because the situation, internationally, is quite similar to the late ’30s, in that, in these periods of time, these geopolitical cycles, there is an established power and an emerging power that then, have a rivalry. At first, it’s an economic rivalry, and then, it can become quite antagonistic. So back then, the United States and England won World War I and we had the peace. But then, as there was a rising Germany and a rising Japan, there became that kind of economic rivalry that became more antagonistic. I think that we have a situation where there is a rising China, and the United States is an existing economic power, and there is a rivalry about that. And there can be an antagonism about that.
While Dalio stops short of forecasting the outbreak of World War III, he does have a few suggestions to avert a societal upheaval – and that’s to make sure that capitalism works for the majority of people. But creating more opportunities for middle- and working-class Americans, in Dalio’s estimation, would likely pay for itself as the American corporate sector would be rewarded with higher productivity, which has remained stubbornly low for two decades.
Well, I think one of the things is to make sure that capitalism works for the majority of people. To look at the bottom 60% of the population and use that as metrics to say, “Is that improving or not?” And how do you approach that wealth gap? It’s not just a wealth gap. I think that more important than the wealth gap is an opportunity gap, that people need to be made useful by being able to have jobs and so on. So I think that there should be — that should be considered, you know, an imperative.
Unlike analysts at BAML and other sell-side banks, who see dollar-denominated debt in the international corporate sector as a potential risk (just the fear of such a crisis has helped drive market routs in Turkey, Brazil and Argentina this year), Dalio is more concerned about the amount of dollar-denominated debt that the Treasury will need to sell to fund its deficits.
The private sector debt, for the most part, I don’t have much in the way of concerns for. When we do our pro forma financial numbers and we look at, we see pockets that will probably have problems servicing their debt. There’s a lot of cash around. I am concerned in about a two-year period about the amount of dollar-denominated debt that we’re going to have to sell abroad because we’re going to have to fund the deficits. And then, in addition, we’ll have our balance sheets, the Federal Reserve’s balance sheets go down. And that’ll involve a significant amount of selling of dollar-denominated debt.