SPECTRE OF THE LATE 1930S HAUNTS RAY DALIO

BY TOM BUERKLE

Ray Dalio has been studying economies and markets to reveal their hidden patterns since launching a hedge fund out of his Manhattan apartment more than 40 years ago. Those efforts have served him and his investors well. Bridgewater Associates was one of the rare managers to post positive returns in 2008, and today it’s the world’s largest hedge fund with $160 billion under management.

Now he’s sharing some of the firm’s research in a new e-book, “A Template for Understanding Big Debt Crises.” He discussed the book and his outlook on today’s markets with Breakingviews Associate Editor Tom Buerkle.

You’ve written about your early mistake in expecting the Latin debt crisis to trigger a depression in 1982. What lesson did you take from that?

That the power of the Federal Reserve to lower interest rates and produce liquidity – and the power of a country’s fiscal policymakers to restructure debt if it’s denominated in its own currency – is much greater than the power of the debt to weigh down an economy, even when the debts are too large to be paid back.

The ideology in 2007, espoused by Alan Greenspan, was that policymakers can’t identify a bubble but they can clean up afterwards. Does that thinking still permeate policymakers’ minds today?

Unfortunately, yes it does. What concerns me most is that central banks don’t take responsibility for controlling bubbles when they are responsible for the debt creation that fuels them. Controlling bubbles should be as much a part of central bank mandates as inflation and growth. I’m pretty sure that the next big debt crisis will be due to one or more big bubbles that the central banks didn’t control.

I’m also worried that legislation that reduced the risks of overleverage by banks – which was good – has also reduced policymakers’ freedom to handle debt crises well. It could be against the law to do what’s necessary to save the financial system.

You mean post-crisis restrictions on future bailouts?

Exactly. There is always a group of lenders, whether it’s banks, that comes under regulation and provides protections to those who put money with them, and there is always a group of shadow banking lenders that develops outside those regulations because it’s more profitable. Existing regulations don’t make adequate provisions for handling the new forms of shadow lending and in fact restrict policymakers’ ability to handle them.

Where does debt concern you today?

I don’t see the sort of debt crisis on the immediate horizon as I saw in 2007 for 2008, but I do see serious problems two or three years down the road. The biggest risks come from multinational companies and countries that borrowed in dollars and have incomes in their local currency, so they have big asset-liability mismatches.

I think sales of U.S. Treasury bonds over the next two to three years will be so large that I find it difficult to see who the buyers will be. There are also other pockets of potential debt problems such as commercial real estate and some lower-grade corporate credits.

I’m also concerned that monetary policy won’t be as effective because the abilities of central banks to push down interest rates and push up asset values through quantitative easing will be much less than in the past. As I see it we are in about the seventh inning of this cycle so we have time, but not a lot, before the next debt crisis emerges.

The Fed’s own forecasts put the federal funds rate in the 3.5 percent range in two years’ time. A normal curve would give a 10-year yield around 5 percent. Would that be a stable equilibrium?

No. We estimate that if the bond yield was to go above somewhere in the vicinity of 3.5 to 4 percent, that would create a bear market for most asset prices and have a negative impact on the economy. I don’t think there are enough Treasury buyers in the United States, so that will mean that a large supply will have to go to buyers abroad. Most likely those sales will happen via a depreciation in the dollar. If we look two or three years out, we have a risk – a significant risk – of the markets and the economy going down because of these sorts of funding problems.

What about the risk of a Fed policy error?

I think the Fed is doing a good job in tightening cautiously. I also think that this time around, it will become a progressively more difficult job as the cycle becomes more extended. No central bank gets it perfect, which is why we always have recessions.

You write that the political consequences of crisis can be greater than the economic ones. Is that what we’re seeing with populism in the United States and Brexit in Europe?

Yes. When you have the next downturn, we will probably have greater conflict and more populism. That has historically resulted in more confrontation within countries and between countries.

Are you concerned that could happen to U.S.-Chinese relations?

Yes. Over the last 500 years, there have been 16 times when an emerging country competed with an existing power, and in 12 of those cases wars resulted. Usually an economic war precedes a military war. How the United States and China deal with the competition will be important. That’s another reason why today’s circumstances are very similar to those in 1935-40.

In the past decade, money has flowed in basically two ways: to passive vehicles and exchange-traded funds, and at the other end of the spectrum to hedge funds, private equity, private credit funds. Do you see more of the same in coming years?

These shifts look to me to be very much like the shifts between active and passive in the past. In a bull market in stocks, passive will tend to do well relative to active strategies like hedge funds or other asset strategies that don’t have systematic biases to long. Then you have a bear market and everything’s totally different and active becomes more popular.

That almost sounds like you’re wishing for a bear market.

I guarantee you that I’m not. We have equal opportunities in up or down markets. All I’m saying is every manager tends to have biases.

First published Sept. 12, 2018

(Image: REUTERS/Brian Snyder)