How The Economic Machine Works & Why You Need To Prepare Your Portfolio For It

July 17, 2017

How The Economic Machine Works & Why You Need To Prepare Your Portfolio For It

  • Productivity growth is the long-term key, make sure your portfolio follows it.
  • The global distribution of wealth is shifting very quickly.
  • Preparing your portfolio for what’s going to happen doesn’t even cost that much. On the contrary, it is even more profitable.


Ray Dalio is famous for many things. One of them is his explanation of how the economic machine works where he describes how productivity growth, the long-term debt cycle, and the short-term debt cycle affect an economy.

Today, I’ll briefly summarize his findings as they are reported in a 300-page document and, most importantly, see how Dalio’s economic philosophy can affect our investing strategies.

Dalio’s Economic Principles

Out of the three major impacts on an economy, productivity growth has the largest impact while credit cycles can put the economy out of balance for a while. In the long term however, the economy will grow alongside productivity growth and there isn’t much that can be done about that trend.

Figure 1: Long term GDP growth trend and temporary imbalances. Source: Economic Principles.

Imbalances between productivity growth and economic growth can be created by short-term and long-term debt cycles.

The short-term debt cycle depends on monetary circumstances where the FED tries to maintain stability by slowing down an overheating economy and stimulating a slowing economy. Short-term debt cycles usually last from a few years up to a decade.

Figure 2: The short-term debt cycle in the U.S. Source: Economic Principles.

The debt cycle that almost nobody thinks about is the long-term debt cycle as we all hope that nothing will change in our lifetime because such debt cycles take almost a century to develop.

Figure 3: The U.S. long term debt cycle – this is similar for the rest of the developed world. Source: Economic Principles.

The figure above shows how the long-term debt cycle is coming close to its end as Dalio uses a 75-year time span as a typical long-term debt cycle period. What’s also significant is that the household debt burdens have reached historically unsustainable levels.

Figure 4: U.S. household debt levels. Source: Economic Principles.

Due to the high debt burdens and eventual necessary deleveraging, interest rates will be kept low for as long as possible. This is until inflation forces Central Banks to increase interest rates.

Figure 5: Historic U.S. interest rates. Source: Economic Principles.

We’ve been living with low interest rates for more than 8 years now. After the 1930s, interest rates had remained low for almost two decades which led to a 35-year period of rising interest rates from 1947 to 1982. If something similar happens again, the expected returns from investments, economic growth, and the global distribution of wealth may look very differently in the next few decades than what mainstream finance predicts, and the main reason behind that is the shift in productivity.

Nobody knows when the shift in the economic environment will happen, but there is one trend that’s extremely significant for economic growth that’s pretty clear and relatively certain.

The productivity growth in current emerging markets will make those markets much wealthier in the future.

Figure 6: Estimation of future productivity growth per country. Source: Economic Principles.

What’s also significant is that productivity is responsible for two thirds of GDP growth, and thus you need to make sure your money follows the long-term growth in productivity. Of course, at a reasonable price.

All of the above will lead to a shift in global GDP ratios, which further strengthens the emerging markets investment case.

Figure 7: Emerging markets are, and will continue to gain in global GDP share. Source: Economic Principles.

If you don’t believe emerging markets will become the economic leaders in the future, just check out what the situation was before the 1870s and colonization. Things are about to change again, and quickly.

How The Economic Machine Affects Our Investments

The problem with all of the above is that nobody knows when the long-term debt or the short-term debt cycles will turn.

If I write an article about how a small recession might hit us next month, the number of clicks would be huge, however if I say there is a possibility that something might happen in the next 20 years that will significantly impact the way we live, barely anyone would listen. This is human nature and we as investors have to accept it, understand it, and take advantage of such situations where we can.

What we have discussed leads to the conclusion that every portfolio should be prepared for a completely different economic scenario. One where global productivity is shifting back to its actual historical balance, where China and India are the global leaders, and where the currently developed world enters a long and painful deleveraging phase.

The good side of such a scenario is that it doesn’t cost much to prepare your portfolio for it, just in case it happens soon.

If you are overweight stocks in developed countries where productivity growth is slow and demographics aren’t growing, you might want to think about increasing your exposure to emerging markets. This isn’t only logical because of the above described facts, but also more profitable because investments in emerging markets are cheaper on average. Emerging markets assets are cheaper because Central Banks in the developed world keep liquidity high and assets prices inflated as the last point of defense before succumbing to emerging markets, inflation, and slow productivity growth.

Another option to protect your portfolio from eventual higher inflation is commodities, which are still in a slump. This is normal as commodities are cyclical.

The third protection method that’s excellent for low interest rates or higher inflation is to own precious metals as in case of turmoil, they can give the necessary opposite effect.

This is a lot to think about, I know. However, it can really change your financial life for the better in the long term and at little cost. Keep reading Investiv Daily as we are constantly analyzing interesting low risk, high potential reward investment strategies for the current economic environment.