“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
[drizzle]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