In my last post, I mentioned and commented on an article produced by some senior directors of Blackrock. Today I would like to comment on an article by Ray Dalio. Both articles highlight how we are dealing with the endgame caused by a monetary policy of the central banks that has been debasing currencies. If the diagnosis of the issues in both articles is similar, the prognosis and the suggested measures to be taken are not.
While Blackrock’s investing advice leans towards real goods in general (stocks, gold, real estate), Dalio’s article underlines how, in similar circumstances, gold is superior to shares, since the latter find themselves in a bubble caused by the massive amounts of money coming from central banks, some of which have flooded also the stock markets.
Ray Dalio is the founder, co-Chief Investment Officer and co-Chairman of Bridgewater Associates, a global macro investment firm and the world’s largest hedge fund. According to their website, Bridgewaters Associates manages about $150 billion in assets.
In July 2019, Dalio published on his Linkedin site Paradigm Shifts, which received a lot of attention (over 600 comments only on his site).
Dalio opens his article mentioning one of his investment principles: “Identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops. ”
According to Dalio, each paradigm in itself bears unsustainable forces that drive up its flourishing but also ultimately lead to its end. These forces last long enough for most people to believe that they will never end.
A classic, recurring example for one of those forces is a growing rate of debt supporting the purchase of investment assets. The consequent increase in asset prices leads investors to borrow and buy those investment assets. This, according to the author, is unsustainable because borrowing and buying those assets will eventually run out of borrowing capacity while the debt service costs rise relative to their incomes. Debtors get subsequently squeezed and credit crises emerge. When these things happen, there is a paradigm shift.
The article is divided into two parts: “Paradigms and Paradigm Shifts over the Last 100 Years” and “The Coming Paradigm Shift”.
Paradigms and Paradigm Shifts over the Last 100 Years
According to Dalio, there are four main forces behind the paradigm we have been in since 2009. I’m going to mention only the first two, as they seem to me to be the most important ones.
a) Central banks have been lowering interest rates and performing quantitative easing (i.e., creating currency and buying financial assets) in ways that are unsustainable.
As QE impacts the growth of the economy less and less, and there is an excess of debt and non-debt liabilities (e.g., pensions and healthcare liabilities), currency creation by monetizing fiscal deficits will become increasingly likely: monetizations of debt will pick up, which will reduce the value of money. (It is worth noting that a central tenet of the author is that monetary policy shifts are the main drivers of paradigm shifts.) According to Dalio, creditors will eventually see their real returns diminish to zero (and possibly, beyond that, into negative territory), forcing them to move into other assets.
b) A big part of the wave of private equity and venture capital investing, but also of stock buybacks, mergers and acquisitions, of the last years has been funded by both cheap money and credit, using the enormous amount of cash that was pushed by the central banks into the financial system and exploiting their low interest rates policy.
That resulted in an increase of equities and other asset prices (Dalio avoids using the word bubble), droving down future returns, and it made cash nearly worthless.
This has benefited the holders of financial assets (i.e. those who participate in the financial world), increasing the wealth gap and creating a widespread anti-capitalist sentiment leading to increased pressure to shift more of the money being created into the hands of those who are not investors/capitalists (e.g. through higher tax rates).
The Coming Paradigm Shift
According to Dalio, there will be an enormous amount of increasing debt and non-debt liabilities (e.g., pensions and healthcare) that cannot be funded with assets, because central banks will run out of instruments to boost the markets and the economy. This will cause what Dalio calls the “big squeeze” while, simultaneously, real interest rate returns will be so low that investors holding the debt won’t want to hold it and will start to move to assets they think are better (not necessarily only in terms of performance, but also for risk reduction). Dalio foresees “some combination of large deficits that are monetized, currency depreciations, and large tax increases. ”
So, as the financial assets that traditionally hedge against a currency depreciation (e.g. stocks and real estate) are overvalued (this point differentiates his analysis from Blackrock’s), he concludes his analysis that advises gold:
“Most people now believe the best “risky investments” will continue to be equity and equity-like investments, such as leveraged private equity, leveraged real estate, and venture capital, and this is especially true when central banks are reflating. As a result, the world is leveraged long holding assets that have low real and nominal expected returns and that are also providing historically low returns relative to cash returns (because of the enormous amount of money that has been pumped into the hands of investors by central banks and because of other economic forces that are making companies flush with cash).
“I think these are unlikely to be good real returning investments and that 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.
Additionally, for reasons I will explain in the near future, most investors are underweighted in such assets, meaning that if they just wanted to have a better balanced portfolio to reduce risk, they would have more of this sort of asset. For this reason, I believe that it would be both risk-reducing and return-enhancing to consider adding gold to one’s portfolio.”