The Conversation: Ray Dalio

Ray Dalio, founder and co-chief investment officer, Bridgewater Associates — the world's biggest hedge fund — manages $150 billion in assets. With over 50 years of experience in macro investing, 72-year-old Dalio has been successful in creating a practical investing template by analysing patterns in history and has helped Bridgewater’s flagship Alpha Fund clock net gains of $46.5 billion since inception in 1991. Dalio’s book, Principles for Dealing with the Changing World Order, examines the big cause-effect relationships of economic events that have shaped the world we live in.

THE MACRO VIEW

As a macro expert you have seen several market and economic cycles, but what was the trigger for a deep-dive into the study of cycles over the past 500 years?

In my roughly 50 years of global macro investing, I found myself surprised by big events that never happened in my lifetime but happened many times before. I learnt that I needed to understand those events to handle what was coming at me. For example, it was only because I studied the Great Depression that I was able to navigate the 2008 financial crisis well. A few years ago, I observed three big developments that hadn’t happened in my lifetime but had occurred many times before, which led me to study the past 500 years.

These three big things are: [1] The creation and monetisation of enormous amounts of debt; [2] existing levels of internal conflict and wealth and value gaps, and [3], the rise of China to challenge the existing great power, the U.S., and the current world order. The last time these three things happened together was in the 1930 to 1945 period. It ended in a war and, as usual, the winners of the war established the new world order in 1945. Then we began a cycle which has repeated throughout history and has brought us to where we are now.

What are the probable scenarios that could play out?

To see things happening and to model that, I need to measure things. In my study, I saw clear cause-effect relationships that drive things which I lay out in my book. They lead to my projections, but that doesn’t mean my projections are certain. It gives me probabilities and ranges around them. Using that approach, I see 2022 to 2024 being a period of transition to much more difficult times.

A recession leads to a lot of stimulation by central banks, which causes an economic expansion, followed by inflation. To counter inflation, we see tighter monetary policies and that leads to a recession. So, this cycle repeats again and again. On average, cycles like these last about seven years. But, the length of those is determined by the quantum of debt and money creation and the existing slack capacity before production constraints are hit. When a huge amount of debt and money is created and constraints are hit sooner, inflation sets in quicker. As a result, tightening happens faster, and the cycle is shorter. That is happening now.

We are currently in one of those more intense and shorter expansions. 2022 will be the third year of the expansion after a huge amount of monetary stimulation. A lot of inflation is coming sooner due to these reasons. In 2022, we will be entering into the beginning of the tightening phase of the cycle. Traditionally, in such transition years, interest rate hikes do not knock over the market or the economy in a big way. The transition years are periods that almost nobody remembers. If you think of 2008, the financial crisis comes to mind, but you don’t know what happened during 2010-11. So, that’s how transitionary years are within a cycle.

2022 will also be a big political transition year, both in the U.S. and China. A lot of political manoeuvring will be visible, but very few big initiatives will occur. If there is a geopolitical conflict, it’s likely to happen in a year or two following new leaders assuming their positions. Hence, 2023 will, probably, be a more difficult year and 2024 could be much more difficult, financially and economically.

What should one expect in 2023 and 2024?

Over the next two years, conditions are likely to worsen in all three dimensions — economically, internally and externally. Economically, we will be farther into the expansion phase of the cycle, when inflation and tighter money become more acute, which means we’ll be closer to the end of the cycle. Internally, in the U.S., we will be in a presidential election year in which it’s possible that neither party will accept losing. That would be disruptive. The U.S. could be more vulnerable to international geopolitical challenges. For instance, the frictions related to Taiwan and China, and Ukraine and Russia, could heat up.

Is market underestimating the risks?

Investors look at cash flow and returns. If there is a lot of printing of money — as there has been — it is not desirable to be in cash or bonds given the negative real interest rate. Investors would compare a bond, which is 50-60 times earnings, with a stock. They will react to the changes they are experiencing now and won’t react to the outcomes I am talking about until they see them affecting the cash flow of their investments.

Will the proposed Fed rate hike change the equation?

Cash rates will change relative to the expected returns of asset classes, which will alter pricing and could affect the economy. However, it is unlikely that interest rate increases will bring the cash or bond rates up to attractive levels relative to alternative investment returns. So, projected rate increases will not be adequate enough to make cash and bonds an attractive alternative, and neither will it be enough to curtail inflation. In relation to inflation there will still be negative returns in these assets even if there is a rate hike. While this should prevent any significant downturn in the markets and the economy in 2022, the next two years (2023 and 2024) should get progressively riskier.

The problem is that current interest rates are built into the price, and everything is sensitive. Because there’s a lot of debt outstanding, if rates rise beyond a threshold then it will start hurting prices and the economy. I believe the interest rate changes needed to bring down inflation and growth to desirable levels won’t occur because they are too negatively impactful to happen. Central bankers will continue to grapple with inflation and growth trade-off in a way that will most likely produce a stagflation.

Every interest rate peak and trough in the cycles since 1980 were lower than the one before, until we hit zero interest rate . Hence, every quantitative easing (QE) was larger than the one before it. So, we need a bigger QE every time debt rises because there is the need for more debt monetisation. But then that’s the nature of the beast.

THE U.S.-CHINA EQUATION

Against such a backdrop, how do the fundamentals of the dollar look like as a reserve currency? What does that mean in relation to other currencies?

History shows us that a reserve currency is an exorbitant privilege to have because the country can borrow a lot, but it also leads to one of the big reasons why all reserve currencies stop being reserve currencies. Similarly, history shows us that having a world’s reserve currency comes from being the leading world empire, but all empires decline. Since the dollar has been the world’s reserve currency since 1945, a lot of portfolios of sovereign wealth funds and forex reserves are denominated in the dollar, and so the world is overweight in dollars. These dollar exposures are held in dollar-denominated debt assets which now have very negative real returns. So, they are undesirable to own. Yet the U.S. will have to sell a lot more dollar debt to fund its big deficits. A shift away from holding dollar-denominated debt would produce either interest rates rising significantly, causing a bad economic downturn, or the Fed having to print a lot more money which would produce more inflation. So, that’s a very risky situation.

Today, almost all other currencies are not good stores of wealth. So, we are seeing money go into other assets. Over the next few years, the question will be asked: what is good money? Some of the traditional monies printed by central banks have similar issues and they don’t want the currency to rise very much in relation to another currency. But we are soon going to be in an environment where the search for money that is a good store of wealth will lead to a bigger competition between monies.

Is there a risk of geopolitical turmoil culminating into war? Also, can China dump $1 trillion worth of US T-bills and damage the economy?

If China were to sell the $1 trillion of T-bills the Fed will buy that, so it will not have such a big impact. But, it would be a big antagonist move that will raise tensions. I do think we will see significant geopolitical tensions emerging, particularly related to Taiwan, Ukraine, and also Iraq.

History shows us that there are five types of war: trade war, technology war, geopolitical influence war, capital war, and military war. I think the odds favour that we won’t go into a military war since it would be disastrous. At the same time, the Taiwan issue appears to be an irreconcilable ticking time bomb. The big wars will be with the people within countries rather than between countries.

How close is China to dislodging the supremacy of the U.S.?

China has a population four times that of the U.S., and if its per capita income was half of the U.S, then it would be twice as large, which means twice as much in resources and power. China is now not comparable in power, and is gaining power at 2-3% per year. If that were to continue — which is likely — it implies that China will be more powerful in 5 to 10 years.

How has Bridgewater modeled its macro investing template to protect portfolios?

I want a highly diversified portfolio of assets that are not cash and bonds. I want geographic diversification as much as I want asset class diversification. Regarding my geographic diversification I want to favour countries that have three characteristics and are healthy in the ways we talked about — first, they are financially strong, that is, their incomes are greater than their expenditures and their assets are greater than their liabilities; second, I want countries in which there is internal order rather than internal conflict so that then they can be productive. Third, I don’t want to invest in countries where there are significant chances of external conflict.

I create two portfolios — first, a portfolio of assets that perform best in bad times and retain their value in the worst of times. And second, a diversified portfolio of the investments.

You mentioned about 10-year leading economic indicators worsening for the U.S. compared to China and India? Can you elaborate?

I will explain some of the determinants. First is the education level and the cost of an educated person; second, is the level of indebtedness; third, is the investment in infrastructure, and fourth, are cultural influences. For example, the corruption index has a negative 52% correlation with the subsequent 10 years of growth rate. In other words, the higher the level of corruption, worse the growth rate. The other important determinant is goals in life. For instance, there are surveys that show attitudes about the populace towards work. Similarly, there are indicators like the ease of doing business. Each one of these factors into the equation.

China, over the next 10 years, could see a growth rate in the vicinity of 5%; India has a good growth rate of about 6% because it has a large educated population and the cost of educated people is low, with technology and so on. The U.S. has a lower growth rate outlook and the indicators are weakening. For instance, the education advantage of the U.S. is weakening, and so is the level of indebtedness.

Since India hasn’t developed its capital market and made them easily available to foreign investors, I haven’t invested much there. So, I haven’t studied it as carefully enough to do much more than convey the leading indicators results.

RISKS AND REWARDS

As an investor, what would worry you the most today?

As an investor, I worry about cash and debt returning much less than inflation, and about not being well diversified.

What is your view on cryptocurrencies?

I have a very small percentage of my portfolio in crypto — 1-2%. To be clear, there are different types of cryptos. Some act as stores of value and there are others that act as mediums of transactions. I have a greater allocation towards gold, particularly in the portfolio designed to protect, and then there are inflation-indexed bonds and some other assets.

You have mentioned financial assets relative to real assets being dangerously high. How close are we to that tipping point?

We are getting dangerously close. But it’s very difficult to gauge the exact timing even if we were to look at the next three-four years. It’s like a currency defence — what happens is that there is bond selling, followed by debt monetisation and then you get the spiral. So, it’s almost like a currency crisis. You can see that the fundamentals of the currency are not very good and as you get closer to it you can start to pick up the timing, based on the actions that are happening at that point in time.