“So the real question that I think people should think of is:
Are we at the end of a long-term debt cycle?”

— Ray Dalio

 

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Gigantic Debt
Gigantic Debt

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I’ve written a great deal about debt.  In last week’s piece, I showed the enormity of the problem.  Growth is slow and I believe will remain in the 1.5% range.  Not good enough.  Debt is the significant problem and we are seeing something few have witnessed before.  We are at the end of a long-term debt super-cycle.

Governments and central bankers are struggling to find a fix.  The implications affect your and my financial health.  Understanding debt and deleveraging cycles should be at the top of our to-do list.  How you are positioned today matters.

As I shared last week, global public and private debt is at a record 234% of GDP.  As we saw in the numbers, debt is a drag on growth.  Historical work tells us that trouble begins when debt-to-GDP reaches 90%.  In many places, it exceeds 300%.  We need a fix.

I went back deep into Bridgewater Associates’ (Ray Dalio’s firm) research paper, Economic Principles, specifically the section entitled, “How the Economic Machine Works.”  I think it is perhaps the most important investment research piece you should read.  We sit in the late stages of a long-term debt cycle.

What does this mean in plain English?  In the early stages of expansion, when debt is low, debt fuels economic activity.  If you make $100,000 a year in income and can borrow $20,000 you can spend $120,000.  Credit is money just as much as your income is money except that someday you have to pay the loan back.

When your debt is low, you have more capacity to borrow and you can spend more than you earn.  Borrow from tomorrow, spend today.  More money flows through the system.  Economy expands.  The payments come due in the late stages of the cycle, deleveraging advances, pressure builds and economies slow.

Over time, we go through periods of credit expansion and then contraction.  There are shorter-term cyclical cycles and longer-term secular cycles.  The historical data is there for us to see if we care to look.  I’m saying we better look.

Ray Dalio believes we are in a period similar to the mid-1930s.  That doesn’t mean the path forward plays out like it did between 1935 and 1945, but it should grab our attention.

At CMG, we require our interns to read “How the Economic Machine Works” and I require that my children read it (kid one and kid two have been already hit on the head and next summer, I’m putting kid three to the test).  Anyway, it is the best working model on global economic cycles, debt, education, inflation and more I have read.  You’ll find the link below.

Dalio believes we are at the end of a debt super-cycle.  He believes there is the possibility for a beautiful deleveraging or the deleveraging will be ugly.  Beautiful requires central bankers making right moves and fiscal authorities (elected officials) providing appropriate stimulus.  All happening in sync with each other.  Needed is a massive restructuring of debt.

We don’t know how this is going to play out.  The central bankers are monetizing the debt.  Our elected officials are… well, let’s just say it’s “a mess.”

When I googled “How the Economic Machine Works” piece, my eye caught a link to a Ray Dalio interview from last month’s CNBC Institutional Investors Delivering Alpha Conference.  I dove right in, took some notes and share with you a “crib notes” summary:

Andrew Ross Sorkin asked, “What’s the tipping point for the markets?  How do you as an investor position yourself now?  We’ve been talking about this issue now for now many years.”

Ray Dalio replies, “Do financial pro forma financial statements for five years forward.  Think about what this means for monetary policy and also what it means for cash flows.  So, if you take the ECB’s policy and you say that has to go on for five years, as you start to get even months into this (their buying of bonds) they can’t buy the same stuff (not available anymore) they have to then continue to buy different things.

Start to think of the implications of that.  Or take Japan and you think what they can buy and what can they do.  They are starting to buy things that are riskier assets and there is greater monetization. [SB here: this means this type of monetization puts the government’s debt on the Fed’s books and puts money back into the system – read more about what monetization means here].

As a result of that, investors and holders of financial assets will start to think about alternatives [think about how zero interest rate policy has driven investors into riskier assets – this is what he means].  And those alternatives when that happens will probably have a profound effect on the nature of the market action.  In other words, kind of the end of the cycle that we’ve been through.”

Ray believes the historical parallel to today is the period between 1935 and 1945.  He suggested as investors it is important to find an analogous period to look to.  A few additional comments from Ray on this:

– The 1929 period was a bubble just like 2008
– 1929 to 1932 we had a classic depression
– From then you had the monetization. Quantitative Easing, the producing of money to make up that gap
– Then you bring interest rates down close to zero
– So now we have a situation where we have no interest rates, hardly. And asset prices have enjoyed the liquidity effect
– So that period is the period most analogous to today

A few more highlights:

  • There’s only so much you can squeeze out of a debt cycle and we’re there, globally.
  • You can’t lower interest rates more, materially. Maybe they go the other way.  And you are also at the limit of QE because the spreads are limited.  In other words, the way QE works is that the central bank comes in and buys an asset… it causes all the assets to go up in price, so globally those forces that were behind us are no longer behind us.
  • So the real question that I think people should think of is – are we at the end of a long-term debt cycle?
  • I think Japan is one step ahead of Europe and Europe is one or two steps ahead of the U.S. and the U.S. is probably two steps ahead of China in terms of the limited ability to produce stimulation to produce that kind of growth.
  • We’re in a situation where central banks want to drive you out of cash and out of bonds.
  • The realistic economic growth rate is 1.5% to 2.00%.

Quoting former Fed Chairman Paul Volker, Sorkin said, “Dalio has a bigger staff and produces more relative statistics than the Federal Reserve does.”  Sorkin asks Dalio, “So what is it that you know that the Fed might be missing?”   Dalio responds:

  • In my humble opinion, I think 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 to what is discounted in the curve [SB here: for your client not immersed in our financial language, this is the yield difference between shorter-term vs. longer-term bonds].
  • So (right now) we have about 50 bps (1/2 of 1%) of Fed tightening over the next three years already priced into the curve. [SB: meaning the market is pricing in a 50 bps point Fed Funds rate hike.]
  • 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 is a change in those interest rates relative to discount, not only does it affect the bond market it affects the equity market. That has a wealth effect.
  • It is a risky thing to raise interest rates more than is already discounted in the curve particularly when the duration of assets have lengthened. [SB: investors have gone into longer-dated bond funds to increase their yields, when rates rise, longer-dated maturities suffer loss more than shorter-dated maturities.]

Sorkin asks, “When Jamie Dimon says the Fed should raise interest rates, you think that is wrong.”  Dalio answers:

  • That’s right. It is wrong.
  • At this stage, the risks are so asymmetric.
  • Look, there is no doubt that you can slow the world economy, the U.S. economy. Tightening (central bankers raising interest rates) will work.
  • When you look at the inflation pressures (and this is a global thing) and you look at the demographics, all of those means that the risks are so much more on the downside.
  • If you have a downturn and you don’t have that power… we’ve (most of us alive) never been in a world like this.

Asked about the impact of Brexit, here are a few other comments I found important:

  • I think that populism, the wealth gap, the nationalism, the impatience – all of is a global phenomenon.
  • It is similar to the late 1930’s, and that concerns me.

Sorkin asked, “As an investor, what do you do about it?”

  • Dalio smiles and says, “Well, that’s a complicated question.” But adds, “You diversify.  You have a whole bunch of uncorrelated investments bets.  And then you understand it (the situation) as best you can.”

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You can watch the 32-minute discussion here.

As a hedge fund manager, Dalio tries to stay six months or six days ahead of what is happening.  If someone tells you they know how this is going to play out, take the information in with a high degree of skepticism.

We can know if player “A” does this, then “X” is likely to happen and if player “B” does that, then “Y” is a probable outcome, but we just don’t know who is going to what and when.

Beautiful or ugly?  A or B?

The differences between how deleveragings are resolved depend on the amounts and paces of 1) debt reduction, 2) austerity, 3) transferring wealth from the haves to the have-nots and 4) debt monetization.  What we are saying is that beautiful ones balance these well and ugly ones don’t and what we will show below is how.

There are many important players in the game and many complicated moving parts.  Brexit comes to mind.  Putin’s actions are another.

Recognize where we are in the cycle.  In my mind, debt is the issue.  History can teach us a great deal about human behavior and also show us potential solutions.  Yet the outcome is dependent upon a number of diverse players with diverse interests.

Our job as advisors and money managers is to do our best to stay one or two steps in front of the “beautiful” or the “ugly.”  Unfortunately, at this moment in time, the risks are asymmetrically skewed to the ugly.

My notes above covered about two-thirds of the 32-minute CNBC Delivering Alpha Conference interview.  I encourage you to watch the full video.

Dalio says, “We’re in a situation where central banks want to drive you out of cash and out of bonds.”  He called it a dangerous situation, as central banks run out of assets to buy and push investors into riskier assets.  He believes raising interest rates is risky as it’s not priced into the yield curve.  In sum, “There’s only so much you can squeeze out of a debt cycle and we’re there, globally.”

Dalio suggests broad diversification.  Note his fund was up 13% in 2008.  He thinks we are nearing but not yet at a tipping point.  Beautiful or ugly?  I’m praying for beautiful but have a close eye on ugly.

Grab a coffee.  If you’re inclined, take a look at the section called “An In-Depth Look at Deleveragings,” which is contained in Economic Principles (see link below).  Also, you’ll find the most recent Trade Signals charts.

I hope you find this week’s post helpful.  And please share this piece with a friend if you feel they may find it useful.  Wishing you the very best.

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Included in this week’s On My Radar:

  • “An In-Depth Look at Deleveragings” (from Economic Principles, Ray Dalio and Bridgewater Associates)
  • Trade Signals – Extreme Pessimism (S/T Bullish), Equity and HY Trends Bullish, Zweig Bond Model Bearish… No Sign of U.S. Recession (10-19-2016)

“An In-Depth Look at Deleveragings” (from Economic Principles, Ray Dalio and Bridgewater Associates)

Last week I wrote, “What troubles me most is the amount of debt and leverage that exists here, there and everywhere… a massive overabundance of debt.”  There are some pretty good charts and you can find that post here.

So what can we do about it?  The following can serve as a road map for what we need to keep On Our Radars:

The deleveraging process reduces debt/income ratios.  When debt burdens become too large, deleveragings must happen.  These deleveragings can be well managed or badly managed.

Some have been very ugly (causing great economic pain, social upheaval and sometimes wars, while failing to bring down the debt/income ratio), while others have been quite beautiful (causing orderly adjustments to healthy production-consumption balances in debt/income ratios).

In this study, we are going to review the mechanics of deleveragings by showing how a number of past deleveragings transpired in order to convey that some are ugly and some are beautiful.  What you will see is that beautiful deleveragings are well balanced and ugly ones are badly imbalanced.

The differences between how deleveragings are resolved depend on the amounts and paces of 1) debt reduction, 2) austerity, 3) transferring wealth from the haves to the have-nots and 4) debt monetization.  What we are saying is that beautiful ones balance these well and ugly ones don’t and what we will show below is how.

Source: Economic Principles, p. 23.  Consider coming back to the entire report from time to time.  There is so much data to digest but nonetheless important.


Trade Signals – Extreme Pessimism (S/T Bullish), Equity and HY Trends Bullish, Zweig Bond Model Bearish… No Sign of U.S. Recession (10-19-2016)

S&P 500 Index — 2,147 (10-19-16)

Posted each Wednesday, Trade Signals looks at several of my favorite stock, investor sentiment and bond market indicators.  It is my weekly risk management dashboard, designed to keep me better in sync with the major technical trends.  I hope you find the information helpful in your work.

Click here for the most recent Trade Signals blog.


Personal Note

I’ll be in New York on Monday, October 24, for several interviews — The Street.com, WSJ and Fox Business news.  Nervous?  Yes.  I’ll be sharing a few stock ideas with The Street’s Gregg Greenberg.  I’ll provide you with a link next week, if you are interested.  They are a collection of my best ideas from various conferences and fund managers I know.

I’ve put together what I personally call my “stock shopping list.”  I don’t own them yet nor do any of our clients.  Just my personal plan to allocate a defined portion of my money when the next recession makes the hamburgers really cheap again (as I see a coming 40% to 60% off sale).  I’m thinking 10 years out in regards to the opportunities and believe the next dislocation will offer me a better entry than today.  I want to be prepared to take action.

I’ll then be on Fox Business’ Closing Bell with Liz Claman.  Tune in around 3:55 pm on Monday if you have some down time.  I’m not sure what we will discuss but I know it has to be “punchy.”  Not sure my kids think I’m punchy.  Ugh.  My fingers are crossed.

Finally, Tom Lydon from ETF Trends hosted a webinar this past week.  I presented on valuations and probable 10-year forward returns.  You can watch it here or click on the invite below.  (Registration required.  Once you register, you will be able to view on demand.  You may qualify for one hour CE credit.)  I start around the 25 minute mark.

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If you find the On My Radar weekly research letter helpful, please tell a friend … also note the social media links below.  I often share articles and charts via Twitter that I feel may be worth your time.  You can follow me @SBlumenthalCMG.

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