Here are some things I think I think about Ray Dalio’s provocative piece titled “The World Has Gone Mad and The System is Broken”.
So…Ray Dalio wrote a short piece that is getting A LOT of attention. It basically implies that asset prices are insanely overvalued and the markets are due for a big “paradigm shift”. I think he makes some cognizant points, but I also don’t agree with the basis from which he makes some of these points. Let’s see if I can explain:
1) Are Central Banks “pushing money” on people?
The whole premise of the first paragraph is that Central Banks have implemented QE and forced money onto people which has resulted in a lot of asset chasing.¹ I’ve never understood this mentality to be honest. When the Fed engages in QE they expand their balance sheet and buy a bond from the private sector. In a low inflation environment bonds become increasingly similar to cash so these sellers of bonds are selling one cash-like instrument for another. As a result, the private sector ends up holding more low interest bearing cash-like instruments and the Fed holds higher interest bearing cash-like instruments. So the whole basis of this theory is that if someone who was already holding a risk averse asset then sells that risk averse asset for something very similar then they will suddenly become less risk averse and run out and drive up stocks? That doesn’t even make sense. If I have a moderate risk tolerance and hold a portfolio of 50% bonds and 50% stocks and I want to sell my bonds because I read a scary article about how bonds are super risky because interest rates are going to rise (more on this later) then I will swap out some part of my 50% bonds for cash or something else that’s relatively low risk (to maintain my moderate risk profile). I don’t swap out my whole bond position for a stock position or a role of the dice at the roulette wheel.²
Anyhow, the evidence doesn’t even mesh with this. Global Central Banks have been implementing QE for 10 years now. The average annual return of the Vanguard Total World Index is 8.9% per year over that period. That is 0.02% higher than the average 35 year return. So, if investors are acting crazy today then they’ve been crazy for 35 years. Which might be true. It’s probably true. I actually think investors are usually kind of crazy. But they’re not any crazier today than they were 35 years ago.
Then again, I actually agree with Ray that aggregate future returns are going to be lower. I don’t think that’s a “paradigm shift” though. It’s been occurring for years now and is most obvious across any bond market portfolio. With a lower growth global economy the rates of returns on everything are coming down some. This doesn’t strike me as some reason for alarm. It’s just the expected rate of change in an economy where people are getting old as hell, population growth is slowing, productivity is declining and growth is reverting back to its long-term mean.
2) Will deficits drive up interest rates?
The whole second paragraph seems confused to me.
First, he insists that large deficits have to drive up interest rates? Where is the evidence for this? How can people still believe that large deficits necessarily drive up inflation and interest rates? We have ample evidence disproving this theory. Sure, it’s true that deficits could drive up rates. But there’s no ironclad law of economics by which large government deficits necessarily drive up rates. Inflation (of which interest rates are a function) is just so much more complex than that. For instance, in an economy like Argentina a large deficit might be problematic because they don’t have the domestic output and resources to absorb that sort of government balance sheet expansion. But in a place like Japan or the USA or even most developed economies there is little evidence that government deficits are at a point where they are causing high inflation. Could that change? Sure. But are deficits the dominant factor causing inflation? The evidence in most developed economies appears to be a clear “no”.
Second, he contradicts his first paragraph here. If investors should be worried about high inflation and high interest rates then selling your T-Bonds to the Fed makes a lot of sense. You would want to sell your bonds (which expose you to both real and nominal principal risk) and pile into stocks and other riskier assets because those assets tend to perform well during very high inflations. Bonds, on the other hand, perform terribly in high inflations. So, I don’t see the problem here. If Dalio really believes that high inflation is coming then people should be selling their bonds and buying instruments that have less interest rate risk and/or have greater purchasing power protection (like stocks and other riskier assets).
Third, he asks the same question here that Bill Gross asked in 2011 when the Fed was wrapping up QE2 – “who will buy the bonds?” I debunked the Gross piece in real-time (and made a nice chunk of change taking the other side of his trade), but the conclusion is the same. Who will buy the bonds when/if governments continue to run large deficits? Well, if inflation remains relatively low then people will rationally buy more and more bonds because bonds will outperform cash. If inflation ticks higher then bonds will be bid down. This will be particularly true in the USA where the US government issues the highest quality risk free sovereign debt in the world. Yes, it’s true – if we have a hyperinflation then the demand for debt will collapse, the government will be effectively insolvent and that would be a mess. But are we really still predicting hyperinflation in the USA?
3) Now we’re talking.
I really like Ray’s 3rd and 4th paragraphs. I think there are many local governments and pensions that are running unsustainable balance sheets. Or, at least have unrealistic expectations. And I think that a lot of these localities and pension programs are going to get shutdown or restructured. Don’t get me wrong – I might not believe that interest rates have to shoot much higher because of federal government debt, but that doesn’t mean that many corporate and local governments aren’t in worse shape than we think. There are even strong arguments that it’s nuts to buy many of these developed economy bonds at negative rates. But there’s no need to make sweeping generalizations that imply that the “whole system” is broken. Parts of the system always work less efficiently than other parts. You need to know where to pick your battles. Dalio has proven that he can do that so I am surprised to see him make these kind of generalized conclusions….
I also think that inequality is a growing concern and that it threatens the viability of a capitalist economy. We see this with the growing numbers of “socialist” sympathizers in both politics and in general. This is a failure of capitalists. When capitalists allow inequality to grow to a point where there are populist uprisings then the capitalists have failed. It is like the big stack in a poker game not realizing that, in order for the game to continue, she can’t take all of the chips. The other players need to have some chips to keep playing the game. It’s not a perfect analogy, but it’s good enough to portray our reality where the big stacks have so many chips that the small stacks feel more pressure than they might otherwise. In my opinion, capitalists need to look out for the well-being of capitalism by accepting the reality that the system, while probably not “broken”, is not working well for everyone and it creates an environment where the populists will want to tear the whole system down. That would be bad for everyone in the end. But that’s the world we seem to be veering towards – one where balance and objective pragmatism are flung aside in favor of extremist views and persistent overreaction. And so here I am writing this article that is probably more balanced than most and that no one will read because…it isn’t extreme enough. [Deep breaths].
NB – If I could restart this blog I would rename it “You’re Probably Overreacting About Something in Finance or Economics and I am here to Explain it Using Actual Evidence and Bad Jokes”. Just kidding, that would be a stupid name and no one would read that blog.
NB 2 – My personal view is that living standards have never been higher in the USA and around the world while inequality is also growing. I think capitalism has done much more good than bad and certainly more good than a Socialist regime would have done. But public perception is that inequality has increased so much now that the small stacks at the table are worse off than they should be. And public perception is what matters most here.
¹ – I really respect Ray’s strategy structuring this run-on paragraph. It included so much information and so many words that it was almost impossible to digest and deconstruct.
² – I guess this would all be different if they were buying high risk assets. For instance, if the Fed took all the public stocks off the market then I guess the demand for stocks would rise and there’d be a strong argument that this would create a wealth effect of some sort.³ But even this wouldn’t create more actual investment so I still fail to see the transmission mechanism through which QE creates an economic boom….
³ – Then again, there’s an efficient market type of analysis that says the market would account for this fictitious buyer and added risk in the market which would not result in any change in valuations and wealth.