Hedge fund manager Ray Dalio has been studying the debt supercycle for some time. He is not the only hedge fund manager to do so, as both lesser known quantitatively focused firms as well as some of Wall Street’s biggest names have been modeling debt outcomes. As previously reported in ValueWalk, Citadel’s Ken Griffin, in an April 2014 speech at the Milken Conference, noted the topic that is actively discussed behind the scenes: an “implosion” date. Tuesday at the Institutional Investor / CNBC Delivering Alpha conference, Dalio, the world’s largest hedge fund manager, who has a history of prognosticating on this topic, said the end of the debt gravy train is nigh.
Calling the current global debt environment and central bank monetary gymnastics a “dangerous situation,” Dalio on Tuesday said behind the façade is a troubling reality. "There's only so much you can squeeze out of the debt cycle, and we're there globally," the founder of Bridgewater Associates said, pointing to a lack of central bank options amid what are emergency measures being used to oddly keep a generally strong economy afloat. "You can't lower interest rates more." Does his warning have validity?
Ray Dalio - The whisper topic among certain quantitative and fundamental hedge fund managers has to do with debt and a mathematical end point
There has always been an active discussion regarding societal debt modeling that has been kept mostly behind the curtain. In 2009, certain quantitatively focused hedge funds were said to have conducted mathematical modeling that attempted to determine probability point at which government debt would become no longer sustainable.
There were two key outputs to the thesis: the point at which debt was no longer mathematically serviceable, and the point at which the market recognized the reality. One of these topics had a higher degree of mathematical certainty than the other.
The serviceability modeling had numerous performance drivers, many of which were variable based on interest rates, other sacrifices made in the budget to accommodate growing debt servicing costs and economic growth projections among others. If the government debt path continues, there is clearly a point at which it overwhelms the debtor’s ability to pay. While the serviceability issue is the more mathematically determinant of the two models, the significant variability in projections was made less clear when monetary gymnastics from central bankers to expand their balance sheets and the money supply was factored. The modeling spits out various results, but one thing is certain, the result won't be pretty. Dalio painted this picture at Delivering Alpha:
…You want to find an analogous period that you look to. But the 1929 period was a bubble, just like 2008. And we had a classic monetary policy -- we had a classic depression 1929-1932. From then, you had the monetization, quantitative easing, essentially monetization, producing of money to make up that gap. And you have the reactions after that. Then you bring interest rates down to close to zero.
So now we have a situation where there's no interest rates hardly and that asset prices have enjoyed the liquidity effect. And so there is no period in time -- it would be the most recent period in time globally that is most analogous to the situation we're in.
Ray Dalio - Market reaction to debt modeling is much more discretionary
The second part of the debt modeling takes place regarding the market reaction point, which is much less a math issue than one of perception. While the serviceability issue has clearer mathematical end points, this modeling is even less clear. The market reaction will likely be driven in part by central bank monetary programs.
Unlike some central bankers, hedge fund managers and market practitioners often think in terms of logical market reaction to supply and demand disruption, and here Dalio notes that central bank action does not take place in a vacuum:
…if you extrapolate, do pro forma financial statements for five years forward and start to look at what that would mean in terms of monetary policy and also what it means for cash flows.
So if you take the ECB's policy and you say that that has to go on for five years, as you start to get even months into it, they can't buy the same stuff. They have to then continue to buy different things. Now start to think of the implications of that. Or take Japan. And you think, well, what can they buy and what can they do?
They are starting to buy things that are going to be riskier assets and there's greater monetization. I think that, as a result of that, investors, holders of assets, particularly financial assets, will start to think about alternatives. And those alternatives, when that happens, will probably have, you know, a profound effect on the nature of the market action. In other words, kind of the end to the cycle that we've been through.
Many hedge fund managers have understood interest rates as a variable that moves other asset prices, particularly stocks. Here Dalio makes critical connections in terms of what central bankers are and are not considering:
I think that the Fed is putting too much emphasis on the business cycle and not enough on the long-term debt cycle. And I don't think they may be paying enough attention to how markets react relative to what's discounted in the curve.
So we have about 50 basis points of typing over the next three years priced into the curve. That affects all asset prices, because all asset prices are affected by interest rates. It's the discount rate for the present value of the future cash flows.
So if there's a change in those interest rates relative to discount, not only does that affect the bond market, it affects the equity market. That has a wealth effect. And when I say they don't know, I think the Fed has different views. And some people have different views. So I wouldn't want to characterize it as a whole.
But I also think they are paying attention to some of those things. But it's a risky thing to discount -- to raise interest rates more than is discounted in the curve particularly -- the duration of assets is lengthened. As interest rates go down, there's a mechanical” connection to asset prices.
Ray Dalio - Why are central bankers at emergency levels when the end of a market cycle is near and they need arrows in their quiver?
The concern is that, in a relatively positive market environment, the Fed remains at emergency levels and in doing so they will be out of ammunition for the next major downturn, which throughout history has gone in cycles, typically lasting near seven years.
Where does that leave investors?
…it's a dramatically different world. We all got used to a world before the crisis, where modest shock was met with massive capacity to ease. Recessions became shorter and shallower, more contained. I don't think there's any precedent for the world we're in today. You know, we're an expansionist, pretty old. It doesn't look that old, but it's old in years.
And, you know, we're in a world where stuff -- bad things happen.
Be prepared, this placid market environment where stocks continually rise in price has always come to an end at some point. The question is when does the market recognize it and how far down is the bottom?
The questions that need to be asked of Bridgewater Associates center around how they are adjusting their strategy to accommodate the end of their perceived debt supercycle?