Ray Dalio is widely considered one of the greatest living investors. He is the founder of Bridgewater Associates, as well as a master educator through How the Economic Machine Works and his latest book Principles For Navigating Big Debt Crises. What follows are my notes of Dalio’s article Paradigm Shifts, which provides an overview of big economic paradigm shifts since 1920, our current paradigm, and a shift he sees beginning in the next few years.
Identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops.Ray Dalio
- Market relationships operate in a pattern for a period of time (paradigm) ➡ people adapt ➡ overdo adaptation and believe it will last forever ➡ paradigm shift
- The paradigm shift is opposite in many ways to the old paradigm
- Example: Unsustainable rate of debt growth ➡ buying investment assets ➡ drives up asset prices ➡ everyone gets bullish ➡ borrowing capacity for debt runs out + debt service costs goes up relative to income ➡ squeeze on cash flows ➡ paradigm shift ➡ credit problems emerge (e.g. defaults) ➡ reduced lending and spending ➡ asset prices go down
- Example: Extended period of low volatility ➡ people borrow more ➡ increases volatility
- Understanding the current paradigm and the possible shift is key to investing well.
- Anything you can invest in eventually performs poor enough to ruin you, including “cash” (i.e. short-term sovereign debt). Central banks can print more, depreciating value to hold interest rates well below inflation rates
- Investors commonly get caught following the overly popular conventional wisdom (“housing prices will never go down”) when the paradigm shift exposes them.
part I: paradigms and paradigm shifts over the last 100 years
how paradigms and paradigm shifts work
- Market pricing reflects expectations and collectively pains a picture of a consensus view on the future
- Successful investing requires having a better idea about future than the consensus view.
- Consensus view is heavily influenced by recency bias (last few years) – not what is likely to happen next.
- Big paradigm shifts always happen for roughly the same reasons
- In every decade there were long periods (1-3 years) with characteristics opposite from the rest of the decade.
- Big swings in economy + markets came from a sequence of actions + reactions by policy makers, investors, businesses, and workers. The swings, though, happen around “equilibrium” levels, for example:
- Debt growth is in line with income growth required to make the debt payments.
- Economy’s operating rate isn’t too high or too low
- Projected returns of cash are below the projected returns of bonds, which are below projected returns of equities (a yield curve across risk asset classes)
- At the end of each decade, investors expected the next decade to be the same (though, in fact, they turn out to be quite different)
- Every major asset class had great and terrible decades
- Investing theories often change, mostly to explain how the last few years worked (recency bias). Theories get most popular at the end of the paradigm right when they’re the most risky.
1920s: “Roaring”: Boom to Bursting Bubble
- Started: Markets discounting negative growth (chasing higher growth): stocks outperformed bonds
- Fast growth fueled by increasing debt.
- Ended: Markets discounting high growth and ending in a bubble (i.e. debt-financed purchases of stocks at high prices) with stocks crashing
- Opposite of the 1920s.
- Start: Reactions to bubble bursting + high debt levels. Markets discounting high growth rates.
- Debt crisis ➡ Depression ➡ Fed easing ➡ Rise in gold, stock, & commodity prices (1932-37).
- Fed easing = breaking link to gold, 0% interest rates, printing lots of money, devaluing USD.
- Rise in asset prices ➡ rise in compensation (wages) ➡ widened wealth gap ➡ conflict between socialists and capitalists ➡ global rise in populism & nationalism.
- 1937: Fed + fiscal policies tightened ➡ stock market and economy tanked
- Decade ended with the beginning of World War II.
1940s: War & Post-War
- War-driven economy and markets
- Governments borrowed heavily and printed a lot of money ➡ stimulating employment supporting war
- Production was strong, but mostly consume in war, which muddies growth and employment data since it’s not attributable to long-lived growth.
- War pulled U.S. out of post-Depression slump.
- Monetary policy accommodative ➡ Rise in stocks, bonds, & commodity prices (commodities in early war, stocks toward war’s end)
- Monetary policy accommodative: low interest rates, large budget deficits (war + post-war reconstruction)
1950s: Post-War Recovery
- People were financially conservative and risk-averse (after two decades of depression + war)
- Monetary policy accommodative ➡ stocks did great.
- Government reduced budget deficits, private debt was in line with income.
- Decade ended financially healthy, middle-class workers in high demand.
- Market discounting modest growth and low inflation.
1960s: Boom to Monetary Bust
- First half: Markets discounting slow growth.
- Start: Debt-financed boom ➡ Balance of payments problem ➡ End: Paradigm shift ending Bretton Woods (1971 death of gold standard)
- Stocks doing well (until 1966) ➡ everyone gets really bullish (15 years of great returns) ➡ fast growth in GDP, debt, inflation ➡ Fed tightened monetary policy ➡peak in stock market (for 20 years)
- Yield curve inverted (first time since 1929)
- Second half: Debts > income + inflation increase ➡ “growth recession” ➡ real recession.
- Ended with US balance of payments problem ➡ draw down in gold reserves. Fed left with two bad choices: (1) tighten monetary policy (and wreck the economy) or (2) too much stimulation to keep USD up and inflation down.
- Paradigm shift: Abandoning Bretton woods ➡ 1970s stagflation
1970s: Low Growth + High Inflation (Stagflation)
- Start: high debt levels, balance of payments problem, gold standard abandoned 1971
- Money printed (a lot) to ease debt burdens ➡ slow growth, high inflation ➡ inflation-hedge assets up, stocks/bonds down.
- Two big waves of inflation: 1970-73, 1977-1981.
- End: Market discounting high inflation and low growth.
1980s: High Growth + Falling Inflation
- Start: Markets discounting high inflation and low growth
- Decade marked by falling inflation and high growth: inflation-hedge assets terrible, stocks/bonds great.
- Paradigm shift in early 80s with monetary tightening.
- Paul Volcker (Fed Chair) triggered deflation, economic contraction, emerging market debt crisis (couldn’t pay back U.S. banks).
- Managed well, banks provided with liquidity, and the banks ended up okay.
- Shortage of dollars ➡ rise in USD price ➡ deflation ➡ interest rates decline (w/ strong growth) ➡ stocks & bonds up
1990s: “Roaring”: Bust to Bursting Bubble
- Started with recession, Gulf War I ➡ Ended with “dotcom bubble.
- Monetary easing ➡ debt-financed growth ➡ rising stock prices.
- Bubble: debt-financed purchases at high prices (similar to 1960s)
- Ended with bubble bursting, 9/11 attacks, followed by wars in Iraq + Afghanistan
2000-2010: “Roaring”: Boom to Bursting Bubble
- Similar to 1920s with a big debt bubble before 2008-09 bursting (like 1929-32).
- Start: Market highly discounting growth (expensive stocks)
- Paradigm shift 2008-09 ➡ quantitative easing (huge money printing) ➡ near 0% interest rates ➡ USD down, gold + T-bonds up.
- End: High debt levels, Markets discounting slow growth.
- Quantitative easing ➡ investors sell assets to central banks ➡ investors buy other financial assets ➡ financial asset prices rise (+ lower risk premiums and expected returns)
- Like 1932-37, rise in asset prices ➡ widened wealth gap ➡ rise in populism
- Technological automation, globalizing production ➡ shifted wages down for low/middle-class and up for high-income earners
- Growth slow, inflation low.
- Stocks rose consistently, fueled by Fed stimulus, higher profit margins (automation), tax cuts
- Now, asset prices are relatively high, growth is priced to remain somewhat strong and inflation low.
part 2: the coming paradigm shift
the current paradigm
Features of the current paradigm:
- Central banks lowering interest rates + quantitative easing (printing money and buying financial assets)
- Done unsustainably and is approaching its limits
- Boosted assets prices directly (buying the assets) and indirectly (low interest rates ➡ raised P/Es + debt-financed stock buybacks / real estate acquisitions)
- Interest rates can’t go much lower
- QE is having less and less of an effect. When asset prices hit peaks, they future returns drop relative to cash or other stores of wealth, like gold.
- When there’s too much debt and other liabilities (healthcare, pensions), debt monetization becomes more likely ➡ depreciated currency.
- You can help either debtors or creditors. Dalio thinks central banks are more likely to help debtors.
- The rate of change on money supply (as % GDP) compared to rate of change on interest rates: Money supply outpaced interest rates twice since 1920: 2008-2014 and 1931 – 1945 (Great Depression). EUR and JPY look similar for 2008-2014.
- A wave of debt-financed stock buybacks, M&A, private equity and venture capital.
- Makes cash nearly worthless.
- Rise in asset prices ➡ compensation flat ➡ widened wealth gap ➡ anti-capitalist sentiment + populism
- Automation and globalization ➡ reduced labor costs ➡ sharp rise in profit margins
- Unlikely to be sustained
- Widened wealth gap ➡ rising anti-corporate, pro-worker sentiment
- Corporate tax cuts boosted stock prices.
the coming paradigm shift
Dalio thinks it highly likely in the next few years:
- Central banks run out of stimulants
- “real interest rate returns are pushed so low that investors holding the debt won’t want to hold it and will start to move to something they think is better”
- Enormous debt and liabilities that can’t be serviced ➡ big squeeze ➡ not enough money ➡ debt monetization + currency depreciation + large tax increases ➡ widened wealth gap
- Debt holders will receive low or negative returns
- When asset prices rise because of low interest rates, it gives the illusion investments have good returns, but it’s just future returns pulled forward. The future returns will be lower.
- Wave of liabilities coming due: Social Security, Medicare ➡ battle over
- Which promises won’t be kept
- How much to raise taxes to meet promises
- How much promises will be met through larger deficits (debt monetization via USTs)
Storing one’s money in cash and bonds will no longer be safe.
- Dalio thinkgs the new paradigm will include large debt monetization similar to the 1940s war effort.
- Riskier investments (stocks) will generally not do as well.
- Investments that will do well will be those that like a weaker USD and domestic/international conflict ➡ GOLD