Ray Dalio.......caution ahead

Ray Dalio Sees End Of Supercycle, Issues A Dire Warning

History repeats itself, Dalio notes, as he draws chilling comparisons to 1937

As the U.S. Federal Reserve prepares to tighten monetary policy, perhaps providing clues to raising interest rates in upcoming Fed meetings, Ray Dialo has surveyed the unusual economic environment and has found a troubling historical economic equivalent: 1937.  Given a troubling corollary, Ray Dalio has determined that “we do not want to have any concentrated bets, especially at this time,” a March 11 strategy note written by Ray Dalio and Mark Dinner says. A copy of the memo was reviewed by ValueWalk.

Perhaps one of the most diversified hedge and largest funds in the world with $165 billion under management, Bridgewater Associates is known to invest in most assets utilize a variety of strategies, including algorithmic approaches – and is looking at all investment classes, including stocks, and thinking that risk is just too significant to be concentrated in exposure.

In a relatively rare strategy note written by Ray Dalio, the founder of the famous hedge fund notes that U.S. Federal Reserve tightening is marking the end of a super cycle and central bankers are faced with tough choice. It can do what is economically best for the world, which is a loose monetary policy, or what is best for the U.S., which might mean tightening.

Ray Dalio: End of a long term debt cycle

The economy is approaching the end of a long term debt cycle that is little understood, Ray Dalio writes,  as he says he has more faith in the Fed’s ability to tighten than ease – and this is part of the problem.  If the economic environment changes, the Federal Reserve needs the ability to lower interest rates if necessary.
With rates near zero in an expanding economy, the Fed doesn’t have much room to maneuver.  This is particularly true as Ray Dalio says, at the end of a cycle, central banks are “pushing on a string” and their ability to stimulate the economy is more likely to fail than succeed.

The report observes the Fed has set inside expectations that a rate hike will occur in June or September and that it might be difficult to deviate from this guidance.

Economic comparisons to 1937

It is this tightening that has Ray Dalio concerned as he focuses back on a 1937 analog where debt limits reached their bubble top, interest rates hit zero, money printing kicked off “beautiful deleveraging,” stocks rallied regardless, the economy seemingly improved and then the central bank tightened. Sound familiar?
It happened in 1937 and Dalio draws comparisons to the 2008 crash and today to point to historical equivalents.

Ray Dalio is a student of history, perhaps one of the best noncorrelated fund manager to successfully deliver returns regardless of market environment. He now says the prices of risk assets such as stocks are high, yet the expected are low. If interest rates were to rise and liquidity fall, Ray Dalio isn’t exactly sure of anything, particularly what might tip the proverbial cart, but he notes that all assets are risky at this point.

 

THE DEFLATION BOGEYMAN

The world’s major central banks are currently obsessed with the goal of raising their national inflation rates to their common target of about 2% per year. This is true for the United States, where the annual inflation rate was -0.1% over the past 12 months; for the United Kingdom, where the most recent data show 0.3% price growth; and for the eurozone, where consumer prices fell 0.6%. But is this a real problem?

The sharp decline in energy prices is the primary reason for the recent drop in the inflation rate. In the U.S., the core inflation rate (which strips out changes in volatile energy and food prices) was 1.6% over the last 12 months. Moreover, the Federal Reserve, the Bank of England, and the European Central Bank understand that even if energy prices do not rise in the coming year, a stable price level for oil and other forms of energy will cause the inflation rate to rise.

In the U.S., the inflation rate has also been depressed by the rise in the value of the dollar relative to the euro and other currencies, which has caused import prices to decline. This, too, is a “level effect,” implying that the inflation rate will rise once the dollar’s exchange rate stops appreciating.

But, despite this understanding, the major central banks continue to maintain extremely low interest rates as a way to increase demand and, with it, the rate of inflation. They are doing this by promising to keep short-term rates low; maintaining large portfolios of private and government bonds; and, in Europe and Japan, continuing to engage in large-scale asset purchases.

The central bankers justify their concern about low inflation by arguing that a negative demand shock could shift their economies into a period of prolonged deflation, in which the overall price level declines year after year. That would have two adverse effects on aggregate demand and employment.

First, the falling price level would raise the real value of the debts that households and firms owe, making them poorer and reducing their willingness to spend. Second, negative inflation means that real interest rates rise, because central banks cannot lower the nominal interest rate below zero. Higher real interest rates, in turn, depress business investment and residential construction.

In theory, by depressing aggregate demand, the combination of increased real debt and higher real interest rates could lead to further price declines, leading to even larger negative inflation rates. As a result, the real interest rate would rise further, pushing the economy deeper into a downward spiral of falling prices and declining demand.

Fortunately, we have relatively little experience with deflation to test the downward-spiral theory. The most widely cited example of a deflationary economy is Japan. But Japan has experienced a low rate of inflation and some sustained short periods of deflation without ever producing a downward price spiral. Japan’s inflation rate fell from nearly 8% in 1980 to zero in 1987. It then stayed above zero until 1995, after which it remained low but above zero until 1999, and then varied between zero and -1.7% until 2012.

Moreover, low inflation and periods of deflation did not prevent real incomes from rising in Japan. From 1999 to 2013, real per capita gross domestic product rose at an annual rate of about 1% (which reflected a more modest rise of real GDP and an actual decline in population).

Why, then, are so many central bankers so worried about low inflation rates?

One possible explanation is that they are concerned about the loss of credibility implied by setting an inflation target of 2% and then failing to come close to it year after year. Another possibility is that the world’s major central banks are actually more concerned about real growth and employment, and are using low inflation rates as an excuse to maintain exceptionally generous monetary conditions. And yet a third explanation is that central bankers want to keep interest rates low in order to reduce the budget cost of large government debts.

None of this might matter were it not for the fact that extremely low interest rates have fueled increased risk-taking by borrowers and yield-hungry lenders. The result has been a massive mispricing of financial assets. And that has created a growing risk of serious adverse effects on the real economy when monetary policy normalizes and asset prices correct.

Martin Feldstein, professor of economics at Harvard University and president emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues – MARTIN FELDSTEIN

(This article has been published with the permission of Project Syndicate — The Deflation Bogeyman.

The writer is an emeritus professor of economist at Harvard.

Source: - Business Standard   Date 03.03.2015)