Ray Dalio. Recent Movements of the Economy and the Market in Perspective

Several people have asked me to explain what is happening lately in the markets and the economy.

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Source: Ray Dalio

Several people have asked me to explain what is happening lately in the markets and the economy. How you probably already know I think everything works like a machine with cause-and-effect relationships that drive what happens…

Therefore, I believe that economies and markets function as machines with basic cause-effect relationships (including human nature) that interact to trigger their movements. Since economies are the aggregates of the markets that make them up, to understand how economies work, one has to understand how markets work. My mental model of how markets and economies work is briefly described below and transmitted more simply in my 30-minute animated video “How the economic machine works”.

This is how the machinery of the Market and the Economy works

At the global photo level, there are three major forces that interact to drive the market and economic conditions over time.

1) productivity growth,

2) the cycle of short-term debt (which usually lasts between 5 and 10 years), and

3) the cycle of long-term debt (which usually lasts between 50 and 75 years).

These factors also affect geopolitics both within and between countries, which also affects the market and economic conditions.

Productivity growth

The growth of productivity is the factor that has a greater long-term impact on the economy and markets, although in the short term it does not seem so important because it is not very volatile (Maybe that’s why politicians wrongly do not pay much attention).

Productivity trends increase over time as people learn and become more efficient so that they can increase production per hour worked. As explained in more detail in “Productivity and structural reform: why countries succeed and fail, and what should be done to make countries in failure successful” the growth of a country’s productivity is due to its competitiveness and the cultural factors.

Competitiveness is mainly a function of the relative value that a country offers, the most important thing is the value of people (measured by the cost of people educated in a similar way in other countries). Culture (that is, values ​​and ways of operating) is very important because it influences the decisions people make about work, savings rates, corruption, reliability and a series of other factors that are determinants and they are highly correlated with the growth of productivity in subsequent years.

These factors mentioned above have a direct impact on the quality of: a) people (through the educational system and the quality of family guidance), b) infrastructure, c) rule of law and d) market systems, all of which they are highly correlated with the growth rates of later years.

In terms of what is happening lately, productivity growth in developed countries has been relatively slow and is concentrated more and more in a decreasing percentage of the population and in the areas of automation is reduced by the need to have workers with a strong impact on the labor market, which causes the gap between those who have and those who do not have resources to be widened, while at the same time improving the profit margins of the companies.

The Cycles of Credit and Debt

The credit / debt cycles cause oscillations around the upward trend in productivity. Credit and debt give purchasing power that feeds spending on goods, services and investment assets (first), which causes stronger economic activity and higher prices (below). The provision of credit also creates debt, which creates the need to pay in the form of debt service payments (which will come later), which in turn decreases the expenditure on goods, services and investment assets (more advanced)

nte) which causes a slowdown in economic activity and a reduction in prices (after).

That is, credit / debt increases growth at the beginning and depresses it later. Central banks provide it to put into the gasoline economy when the economy is depressed or slowing down, and restrict it to put the brakes on when the economy is growing rapidly. For these reasons, the effects of credit / debt on the demand, production and prices of goods, services and investment assets are inherently cyclical, so we have cyclical credit / debt movements around the upward trend of the productivity described above.

Basically the credit / debt cycles have two forms. Cycles of short-term debt and long-term debt cycles.

The Short Cycles of the Debt

The cycle of short-term debt lasts between 5 and 10 years, depending on how long it takes the economy to go from a slowdown phase to a more dynamic one and how much demand will grow in the dynamic phase.

In the cycle in which we are now, the expansion has been long because it started from a very depressed level (the 2008 slowdown was very deep) and because the demand growth has been relatively slow (due to the hangover from the crisis of the debt and the growing wealth gap since the spending of those with a lot of wealth have a lower propensity to spend than those with little wealth).

When the growth of credit-financed spending is faster than the capacity growth at the beginning of the cycle, this leads to price increases until the growth rate of spending is restricted by central banks that restrict credit; what happens at the end of the cycle (phase that is where we are now)

At that time, demand is strong, capacity is limited and earnings growth is strong. Also at that time, the strong demand for credit, the increase in prices / inflation and, eventually, the monetary policy adjustments of the Central Banks to curb growth and inflation, make the prices of shares and other assets go down. They fall because all the investment assets are valued as the present value of their future cash flows and the interest rates are the discount rate used to calculate the current values, so that the higher interest rates reduce the current values ​​of these assets.

In addition, a more restrictive monetary policy slows down the growth of earnings, which makes most of the investment assets worth less. For these reasons, it is common to see how economies in the phase of strong growth are accompanied by the fall in the price of shares and other prices of assets, which does not stop being contradictory for many people. Precisely at this time is where we are in the current cycle of short-term debt.

Specifically, during the expansion phase of the cycle in which we find ourselves, the Central Banks created exceptionally low interest rates, which made it attractive for companies to borrow money to buy their own shares and those of other companies, which boosted the prices of shares and has left the Balances of companies much more indebted.

In addition, the corporate tax cuts of EE. UU they have contributed to further increase the price of the shares and also the budget deficit, which will require the Treasury to issue still more debt.

In addition to creating exceptionally low interest rates, the Central Banks printed a large amount of money and bought a large amount of debt, which supported the increase in the price of assets in the markets. These increases in asset prices produced initially through low interest rates and the purchase of debt by the central bank and, more recently, in the form of corporate tax cuts (in the US economy), It has taken us to the last phase of the short debt cycle when the constraints on productive capacity have led the FED to start raising interest rates, to which the FED has begun to sell the debt it acquired via QE

As a result, we are now seeing the classic late growth of solid earnings and strong economic growth that is accompanied by falling stock prices due to the financial contraction.

That’s when the cracks begin to appear in the system and what most people never expected to happen begins to happen.

Typically, in this phase of the short-term debt cycle (which is where we are now), the prices of stocks that have been most fashionable and other assets similar to stocks that work well when growth is strong (for example, investments in risk capital

or real estate) begin to decline and corporate credit spreads and high-risk loans begin to expand. Typically, that happens in the areas that have had the greatest debt growth. In the previous cycle, it was in the mortgage debt market. In this cycle, it has been in corporate and government debt markets.

When the cracks begin to appear, those problems that one can anticipate and those that do not begin to appear, so it is vital to be able to identify them quickly and stay on the sidelines.

Of course, psychology, especially fear and greed, plays an important role in the behavior of markets. Most people spend eagerly buying when things go well to sell when the fear that prices are going to fall. In the late cycle stage of the short-term debt cycle, once monetary policy begins to harden and the first cracks appear, market movements are like a blow to the face for investors changing their psychology, which it leads to a setback in the price of assets and the demand for higher risk premiums (that is, cheaper prices).

In general, the contraction in credit leads to a contraction in the demand that reinforces itself until the pricing of the different asset classes and the policies of the Central Banks change to reverse it something that comes when the Banks Central banks reduce interest rates in an aggressive manner (generally around 5%), which causes the expected returns on stocks and bonds to change, causing share prices to be cheap.

For these reasons, it is generally better to buy stocks when the economy is very weak, there is excess capacity, and interest rates are falling, and to sell shares when the opposite occurs.

Because these cycles occur relatively frequently (every 5 to 10 years approximately), people of a certain age have experienced some of them, because the short-term debt cycle is reasonably easy to recognize.

The Long Cycle of the Debt

From here is when the thing gets especially interesting

The long cycles of the Debt tend to last between 50 and 75 years and happen after linking several short cycles of debt that go increasing the indebtedness and the load borne to give service to the debt that is becoming more and more.

The Central Banks try to neutralize this greater debt service burden with interest rate reductions and when interest rates can not be reduced further they try to print money and buy debt.

Because most people want markets and economies to rise and because the easiest way to do it in the short term is by lowering interest rates and making credit available, there is a tendency among policy makers monetary incentives to continue applying stimuli until they run out of ammunition or mechanisms to apply them.

When risk-free interest rates reach 0% in a large debt crisis, additional interest rate decreases no longer have a spurring effect. That drives the Central Banks to print money and buy financial assets. That happened in 1929-33 and 2008-09. and causes the prices of financial assets and economic activity to recover as they did in 1933-37 and 2009-now. Both in the case of the 1930s and in our most recent case, this led to a rebound in the short-term debt cycle, which ultimately leads us to a tightening of monetary policy (something that happened in 1937 and what is happening in the last two years). This time, the monetary tightening takes place through increases in interest rates and the reduction of the Federal Reserve Balance.

For all the reasons given, the point at which we find ourselves today is quite similar to 1937.

The monetary hardening almost never gives a perfect result and generally they usually follow contractions of the economy. These contractions of the economy are more difficult to reverse in the last stage of the long-term debt cycle because the capacities of central banks to lower interest rates and the purchase of financial assets are limited. When they can no longer do that, the cycle of long-term debt is over. Proximity to the end can be measured by a) the proximity of interest rates to zero b) the amount of remaining capacity of central banks to print money and buy assets and the ability of these assets to increase their prices.

The limitation on the ability to print money and make purchases of assets generally occurs when a) the prices of assets rise to levels that reduce the expected returns of these assets in relation to expected performance.

of cash, b) central banks have bought such a high percentage of what was on sale that buying assets becomes almost impossible or c) political obstacles stand in the way of acquiring more assets. We can consider that the power of the Central Banks to stimulate the growth of money is “the amount of gasoline left in the tank”.

At this time, the major Central Banks of the world have the lowest amount of fuel in their deposits since the late 1930s, so they are now in the later stages of the long-term debt cycle. Because the key inflection points in the long-term debt cycle occur infrequently (once in a lifetime), they are usually not well understood and surprise people.

In my opinion at the moment we are in the final stages of the debt cycles both short and long term. In other words, a) we are in the final phase of the cycle cycle of short-term debt when profits and earnings growth are still strong and credit restriction is causing asset prices to decrease, and b ) we are at the end of the cycle of the long-term debt cycle when the prices of assets and economies are sensitive to adjustments and when central banks do not have much gasoline to facilitate credit.


Politics is affected by the economy and this affects the economy in a classical way. We are not going to analyze this topic in depth now but I will touch on what I think is more relevant nowadays. As mentioned above, when interest rates reach 0%, central banks print money and buy financial assets, which increases the price of assets to benefit those who own financial assets (for example, the rich). comparison with those that do not, which widens the wealth gap. Other factors, such as technology and globalization (which remove barriers between lower-cost and higher-cost populations) also contribute to the growing wealth gap within countries while reducing the wealth gaps between countries. This causes an increase in populism and greater conflicts both within countries and between countries. Populism can be right or left. Conflicts can become detrimental to the effective operations of government, the economy and daily life (for example, through strikes and demonstrations). This dynamic can become self-reinforced because when populist conflicts undermine efficiency, they can generate more conflicts and a more extreme populism, which is more damaging, and so on. In the worst case, democracies can see threats and favor autocracies, since most people believe that a strong leader is needed to control the chaos.

Because populists are more confrontational and nationalist by nature, and because domestic conditions are more stressful, the risks of confrontations between countries also increase during those periods. In recent years, we have seen populism grow throughout the world. The emergence of populism in developed countries is classically presented with greater force in the cycles of long-term debt when the cycle of short-term debt is reduced, which occurred in the late 1930s and has many possibilities to occur in the next few years, maybe sooner. The outcome of the next elections in the US will have a great impact on almost everything.

There is another geopolitical principle that is relevant today and was relevant in the 1930s (and many other times before) that was highlighted by the great American political scientist Graham Allison that he calls the Thucydides Trap. In short, when a growing power acquires a comparable force to compete with an existing power, there will inevitably be a conflict between these countries. That conflict usually begins being economic and becomes geopolitical in most cases. In general, it affects trade and capital flows. “Wars” in their various forms occur because there is a conflict between countries to establish which country is dominant in several areas and in several places (which become hot spots). In the last 500 years, there were 16 occasions in which an emerging power became comparable to an existing power, and in 12 of those occasions they ended in conventional wars,
Wars are followed by periods of peace because when a country wins a war nobody wants to go to war with that dominant country. This continues until there is a new growing power to challenge the leading power, at which time there is a war again to establish what power is dominant. Therefore, there is a war-peace cycle that has appeared

throughout history and closely follows the cycle of long-term debt. China is certainly a growing power that is gaining comparable strength to challenge the United States in the same way that Germany and Japan rose to challenge the weakening of the “British Empire” and other countries that won the First World War. This type of conflict has important economic implications because the anticipations of such circumstances trigger behaviors on both sides that can adversely affect trade flows, capital flows and supply lines. This problem now plays an important role in the markets and will be with us for years to come.

In other words, as I see it, there is a series of analogous and universal cause-effect relationships that are leading us to a situation similar to those that were promoted in the 1935-40 period. That does not mean that the future is destined to function as it did in the 1940s. Certainly there are levers that can be moved to produce good results. What matters most is whether there are skilled and wise people in command of those levers.


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