At Davos, Dalio’s Message Tells You Everything You Need To Know

January 29, 2018

At Davos, Dalio’s Message Tells You Everything You Need To Know

  • Dalio didn’t say that cash is trash or that it is stupid to hold cash.
  • I’ll explain in more detail what Dalio said.
  • Is the biggest risk nobody is seeing—with the exception of Dalio—political in nature?



Introduction

I love Davos because there is always a Bloomberg interview with beautiful mountain scenery and a freezing Ray Dalio.

Perhaps because of the cold, Dalio always wants to keep the interview as short as possible and spits out all his thoughts on the economy, markets, etc. Some of it will be misinterpreted by the market, but the key message is always extremely important to hear.

Remember, Dalio is the founder and manager of Bridgewater, the largest global hedge fund with $160 billion of assets under management. I’ll summarize what Dalio said about the economy, interest rates, stocks, and bonds as knowing it is essential for your long term financial wealth.

Dalio’s View On The World

The most important thing many forget in this environment is that, to quote Dalio, “We always have cycles.” So despite the current economy being practically perfect, we can’t expect it to stay this way forever.

Inflation isn’t a problem and growth is good, so the thing to keep in mind is what part of the cycle we are in. A look at the economic capacity utilization and unemployment shows that we are in the late stage of the cycle.

Figure 1: Economic capacity utilization has been having lower lows and lower highs. Source: FRED.

This in combination with unemployment leads to an inevitable situation that can lead to an overheating economy because you can’t produce more than what the capacity is without prices going up.

Figure 2: The unemployment rate in the U.S. is below the natural unemployment rate. Source: FRED.

Unemployment is just another indicator that there is little room to grow for the economy and it could start to overheat because demand grows faster than what the economy can deliver. When that happens, the central bank will be forced to increase rates at a faster than expected rate.

Nevertheless, there is nothing to fear yet as there is still a lot of stimulation coming from tax legislation, the ECB and BOJ are still injecting liquidity into the system, and extremely low interest rates remain. Plus, there’s a lot of cash on the sidelines that will be looking for ways to be deployed. Investors, banks, and consumers are swimming in cash after 8 years of monetary easing.

Those who have cash will feel left out and feel like they are missing the boat, especially since the S&P 500 increased 20% in 2017 and, for example, house prices in the area where I live—near Amsterdam—have increased more than 50% in the last two years. You’ll see headlines that say how it’s foolish to hold cash now, but that isn’t what Dalio believes, he said that those who own cash will feel like they are missing the boat and invest it, thus pushing prices and economic growth higher which will lead to overheating.



All this cash, high employment, and economic stimulation is going to be great for earnings and economic growth which is going to make us all feel even better. But Dalio says that we have to look beyond that and estimates that the party will continue for another year and a half or two.

It’s important to look beyond all this because the stock market usually anticipates what will happen and, therefore, don’t expect to get a letter of warning that it’s time to sell stocks.

What will happen is that central banks will have to tighten monetary policies due to overheating economies. Tightening monetary policies means higher interest rates and interest rates are what are used when pricing assets.

Figure 3: As interest rates go down, stocks and bonds go up. Source: FRED.

What’s also very important to understand is the flattening of the yield curve because as short term interest rates get closer to long term interest rates, due to higher central banks interest rates, it causes a constraint in lending. Why would you lend for longer periods of time when you can do it for shorter times at the same rate?

Figure 4: When the yield curve goes flat, a recession is near. Source: FRED.

When long term interest rates are below short term interest rates, the environment is less prone to lend more money and this can lead to an economic slowdown.

How Vulnerable Are Asset Prices?

According to Dalio, just a 1% increase in interest rates will produce the largest bear market in bonds since 1981. Dalio thinks we are already in a bear market as the environment is good for stocks and bad for bonds.

Figure 5: U.S. 10-year Treasury yield has doubled, lowering bond values. Source: FRED.



Further, Dalio expects a faster tightening process than what the FED is signaling.

How Will The Next Downturn Look? Inequality Issue.

Dalio keeps mentioning the inequality issue as in the last 10 years, the richer have gotten richer while the poorest 50% of the global population haven’t really seen wage increases, didn’t accumulate capital, and have amassed more debt due to lower interest rates. This part of the population is going to push populism back on the table and create major issues around the globe in the next recession.

Who knows, perhaps the next crisis will come from political and not monetary issues.