Ray Dalio is a great fund manager. In addition of being one of the most successful investors out there, he is also very committed on sharing his points of view on the economy through socials so that other people can learn and benefit from his experiences.
Besides being inspirational, these contents are very insightful for those who want to dig deeper in the subject.
Just recently he released an article entitled Paradigm Shift, a comprehensive analysis on economic cycles, causes and effects and their successions.
In the article, which I strongly recommend to read, Dalio outlines that in the economy there are periods about 10 years long in which the markets and market relationships operate in a certain way.
What stands out is the tendency of market participants to project the current scenario of what has already happened in the future even if (history speaks clearly) it never happened.
The results of this process are new paradigms in which the markets operate more opposite than similar to how they operated during the prior paradigm.
Although no one can precisely predict financial markets, the analysis of past paradigms and the current one can offer interesting points of view to successfully navigate the economic environment for the long-term.
I’m not going to report all Dalio’s article on this post, but it is interesting to briefly see past paradigms and the huge difference between them.
1920s = “Roaring”: From Boom to Bursting Bubble. It started with a recession followed by a fast positive growth funded by an acceleration in debt during the decade. It ended with a classic bubble that burst in 1929, the last year of the decade.
1930s = Depression. This decade was for the most part the opposite of the 1920s. The debt crisis transformed into an economic recession. Interest rates were brought to 0%, there was money printing and the devaluation of the dollar. The widening of the wealth gap resulted in conflicts and a rise of populism globally, the decade ended with the beginning of the war.
1940s = War and Post-War. Governments around the world both borrowed heavily and printed significant amounts of money, stimulating both private-sector employment in support of the war effort and military employment. The war-effort production pulled the US out of the post-Great Depression slump.
After the war, the United States was the preeminent power and the dollar was the world’s reserve currency linked to gold, with other currencies linked to the dollar.
1950s = Post-War Recovery. The post-war recovery was strong (averaging 4% real growth over the decade), in part through continued stimulative policy/low rates. As a result, stocks did great. Since the government wasn’t running large deficits, government debt burdens (government debt as a percent of incomes) fell, while private debt levels were in line with income growth, so debt growth was in line with income growth. The decade ended in a financially healthy position, this was also a period in which middle-class workers were in high demand and prospered.
1960s = From Boom to Monetary Bust. Economic growth, fostered by debt, led to balance of payments problems in the second half, which led to the big paradigm shift of ending the Bretton Woods monetary system.
1970s = Low Growth and High Inflation (i.e., Stagflation). At the beginning of the decade, there was a high level of indebtedness, a balance of payments problem, and a strained gold standard that was abandoned in 1971. Money was “printed” to ease debt burdens, growth was slow and inflation accelerated.
1980s = High Growth and Falling Inflation (i.e., Disinflation). The decade started with the markets discounting high inflation and slow growth, yet the decade was characterized by falling inflation and fast growth.
1990s = “Roaring”: From Bust to Bursting Bubble. This decade started off with a recession, the first Gulf War, and the easing of monetary policy and relatively fast debt-financed growth and rising stock prices; it ended with a “tech/dot-com” bubble.
2000–10 = “Roaring”: From Boom to Bursting Bubble. This decade was the most like the 1920s, with a big debt bubble leading up to the 2008–09 debt/economic bust that was analogous to the 1929–32 debt bust. In both cases, these drove interest rates to 0% and led to central banks printing a lot of money and buying financial assets. The paradigm shift happened in 2008–09, when quantitative easing began as interest rates were held at or near 0%.
2010-Now = Reflation. The shift to the new paradigm, with central banks doing aggressive quantitative easings that pushed up financial prices and pushed down risk premiums and all asset classes’ expected returns. This benefited those with financial assets relative to those without them, which widened the wealth gap.
Equities rallied consistently, driven by continued falling discount rates (e.g., from central bank stimulus), high profit margins (in part from automation keeping wage growth down), and, more recently, from tax cuts. Meanwhile, the growing wealth and income gaps helped drive a global increase in populism. Now, asset prices are relatively high, growth is priced to remain moderately strong and inflation is priced to remain low.
The Coming Paradigm Shift
What happens now?
Since 2009, we have been into a paradigm where:
- Central banks have been lowering interest rates and doing quantitative easing (i.e., printing money and buying financial assets) in ways that are unsustainable. Although this was a strong stimulative force since 2009, this use of monetary policy created a huge debt burden for governments, companies and consumers.
Given the amount of debt, now that interest rates are already low and can’t be lowered much more, central banks have little choice unless they want to create the crisis (and deemed accountable for it). It is likely to see other forms of easing like currency depreciation and public debt monetization, with clear effects on the economy, inflation and stores of value like gold (more on that in a moment).
- Cheap money and easy credit was used to perform a wave of stock buybacks, mergers, acquisitions, and private equity and venture capital investing. Those operations pushed up equities and other asset prices and drove down future returns.
- There was a significant increase in profit margins due to advances in automation and globalization that reduced the costs of labor. Although it may sound great, it is unlikely that this rate of profit margin growth will be sustained in the years ahead.
- Tax cuts helped to boost stock prices in the short term but are a measure that won’t be sustained over the years (also consider that in the past the corporate tax rate was higher, something that could easily happen with if Democrats gain more power)
- The gains in investment asset prices lead to an increase of the wealth gap. Those who held financial assets increased their wealth while those who didn’t have them saw a decrease in wages and rising uncertainties. Like in the 1930s decade, this trend is creating a political anti-capitalist sentiment that wants to shift more of the benefits of money printing into the hands of those who don’t have financial assets.
- Future rates of return declined, and that’s another huge problem. Declining interest rates cause the net present value of assets to go up, creating the illusion of good returns, while they are just future returns being pulled forward by the “present value effect.” The result is that future returns will indeed be lower, creating the problem of funding the amount of liabilities that we have in today’s economy.
The essential element to understand the future of the economy and monetary policy is debt.
Debt is the key
What has happened through the years, resulted into an astonishing amount of debt, something that sooner or later we have to deal with.
Central banks will have hard times dealing with the enormous amount of debt that will be come due into with traditional measures.
What is the easiest way to reduce the debt burden without rising rates that would cause the economy to slow down creating a recession?
The View for Gold
After the end of the Bretton Woods monetary system, all the links with gold were broken and the world entered a full FIAT monetary system.
Since then, central banks all over the world can create as much “money” as they want, and they did so. They are doing it right now.
Given that interest rates are at very low levels, and that central banks are already doing whatever they can to avoid a downturn, there will be less tools to fight the next recession.
When talking about future monetary policy, Ray Dalio said that:
To me, it seems obvious that they (Central Banks) have to help the debtors relative to the creditors. At the same time, it appears to me that the forces of easing behind this paradigm (i.e., interest rate cuts and quantitative easing) will have diminishing effects. For these reasons, I believe that monetizations of debt and currency depreciations will eventually pick up, which will reduce the value of money and real returns for creditors and test how far creditors will let central banks go in providing negative real returns before moving into other assets.
Dalio also stated that:
There is no limit to the ability of central banks to hold nominal and real interest rates down via their purchases by flooding the world with more money, and that it is the creditor who suffers from the low return.
Bonds are a claim on money and governments are likely to continue printing money to pay their debts with devalued money. That’s the easiest and least controversial way to reduce the debt burdens and without raising taxes.
What kind of investments will perform well into a reflationary environment, with large liabilities coming due and rising conflicts between social classes?
According to Dalio, these investments are:
…those that will most likely do best will be those that do well when the value of money is being depreciated and domestic and international conflicts are significant, such as gold.
The curious thing is that most investors are underweighted in such assets, holding portfolio that might not be truly diversified.
There are all the reasons to think that during the next downturn we will see a large use of monetary policy in the attempt of stimulating the economy.
Whether you are investing for the long-term or you are seeking a hedge from potential adverse movements in financial markets, realize that modern monetary policy is all about currency creation.
For decades debt has being used to stimulate the economy and became one of the drivers of this economic growth. In the process of reducing the debt burden, central banks will sacrifice currencies.
Be prepared for this kind of move
Gold is a hedge against monetary policy
Besides being a safe-haven asset and a store of value by itself, it can’t be inflated by central banks monetary policy. Although physical gold is not an income producing asset, it makes a lot of sense to have gold in ones portfolio.
This is the chart of gold price over the last two decades:
If in the year 2000, with gold at $280, you said that it would have reached $1.500 in a matter of a decade, you would have been called crazy.
Gold reached a top of $1.826 in August 2011.
Right now, with gold around $1.400, considering the levels of debt, the overall fragility of the system, record high stock market valuations, the fact that we are at the end of the cycle with very low interest rates and taking into account how central banks need to react when there will be a crisis
I would not be surprised to see a 5-fold increase in gold over the next decade.
What convinces me of this view is that gold comes with a central banks guarantee: they have to do something to stimulate the economy in the coming crash, that is basically what they have done in the last two decades or more.
Something that this times goes far beyond zero interest rates.
I’d like to conclude with Dalio’s comment on gold:
I believe that it would be both risk-reducing and return-enhancing to consider adding gold to one’s portfolio. I will soon send out an explanation of why I believe that gold is an effective portfolio diversifier.
I don’t know about you, but I’d rather pay close attention to what one of the greatest investors has to say. Stay tuned for more updates and analysis and remember that hedges are cheap and usually most valuable when nobody wants them.
Thanks for reading!
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