The developed world remains mired in the deleveraging phase of the
long-term debt cycle. The European deleveraging has been badly managed
and is escalating, bringing Europe closer to either a debt implosion or a
monetization and currency collapse. The impact of the European
deleveraging has spread to the emerging world through diminished capital
flows which have weakened their growth rates and undermined their asset
prices. In the US, the deleveraging is progressing in a more orderly
fashion but continues to weigh on the economy's ability to grow without
the monetary support of the Fed. Our studies of deleveragings have
proven to be invaluable through this period (let us know if you would
like a copy of the expanding library). Because the dynamics of
deleveragings are understandable and observable throughout history, one
can reasonably assess the nature of their outcomes over time. But
because highly-indebted systems that are in deleveragings are also
inherently unstable, the timing of discrete events is always highly
uncertain (e.g., the shift from austerity to monetization, an exit from
the euro, etc.). Through these studies we have continued to refine the
indicators we use to measure how the forces of deleveraging are
impacting various economies and markets, and we continue to make the
relevant adjustments to our investment process that both allow us to
anticipate these shifts and to control our risks through the
unpredictable twists and turns.
At this point in time Europe is
in the most critical stage of the deleveraging process, without a
credible plan that will allow a transition from an "ugly" deleveraging,
where incomes fall faster than debts decline, to a "beautiful" one,
where income grows faster than debts. A transition from an "ugly" to a
"beautiful" deleveraging requires an acceptable mix of default,
redistribution and monetization. Steps have been taken in this
direction, but they remain well short of what is necessary. The range of
potential outcomes for Europe and the impacts on the global financial
system are wide, so navigating this environment will require flexibility
and an understanding of how new policy decisions will affect the path
of the deleveraging.
The unresolved European imbalances and the
differences in their impacts on each country have produced widening
differences in the self-interests of these countries, which have led to
political divergences that have magnified the risks. Unlike a year ago,
Germany and France no longer stand in solidarity as backstops behind the
euro system, but have been divided in their self-interest by divergent
financial conditions which are leading to conflicting rather than
unified political orientations. France's deteriorating finances and
economy have shifted its self-interest toward alliances with "recipient"
(lower credit rated) countries like Italy and Spain and away from
"contributor" (higher credit rated) countries like Germany and the
Netherlands, leaving Germany more isolated as a guarantor of the risks
in the euro system and in its views about how to manage the imbalances.
Given these shifts in the alliances between contributor and recipient
countries we think that the popular assumption that the Germans and the
ECB (which requires agreement of the key factions within it) will come
through with money to make all of these debts good should not be taken
for granted. Said differently, we think that there are good reasons to
doubt that European bank and sovereign deleveragings will be prevented
from progressing to the next stage in a disorderly way, without a viable
Plan B in place. This fat tail event must be considered a significant
possibility.
Given the lack of global private sector credit
creation, the world's economies remain highly reliant on government
support through monetary and fiscal stimulation. Now that the most
recent round of global monetary stimulation has ended, world economic
growth has slowed and central bankers are in the process of stimulating
again. We estimate that in the past few months, global growth has slowed
from about 3.3% to 1.9% and that 80% of the world's economies have
slowed, including all of the largest. The breadth of this slowdown
creates a dangerous dynamic because, given the inter-connectedness of
economies and capital flows, one country's decline tends to reinforce
another's, making a self-reinforcing global decline more likely and a
reversal more difficult to produce. And at this point, while actions
have been taken, none of the world's largest economies are stimulating
aggressively via either monetary or fiscal policy, further reducing the
odds of a reversal.
About half of the global slowdown has been
due to slower growth in China. In recent years, China has been the
locomotive of world growth and its recent sharp slowdown has had
knock-on impacts on numerous countries and markets. China itself now
makes up 12% of world GDP and its interactions with the rest of the
world add to its impact. China is a large export destination for many
countries and is the largest marginal consumer of raw materials in the
world, so its slowdown has disproportionately hurt the economies which
export to China, and its weaker commodity consumption has hurt the
commodity producers. In response to this slowdown, China has begun to
ease monetary policy and is contemplating more aggressive fiscal
stimulation, but the actions have so far been gradual and have not yet
been sufficient to produce a notable economic response.
US
conditions have slipped with the rest of the world and the Fed has
decided to extend its Twist operation; to end it would have been an
inappropriate tightening. Last year's hump in growth has passed as
numerous temporary forces have faded, and private sector credit growth
remains weak, so growth is converging on the growth of income of around
1.5%. Besides the drag from Europe and the potential for a contagious
debt blowup there, numerous US federal programs will expire in the
fourth quarter, and given the likely political divisions after the
election it will be a challenge for the new Congress to deal with these
in a timely manner. Without action, the expiration of these programs
represents a fiscal drag on growth of about 2.5%. Given the lack of new
aggressive Fed stimulation, the threat from Europe, the simultaneous
decline in major country growth rates and the fiscal cliff, the risks to
US growth are skewed to the downside.
Over the past 18 months
what markets are discounting has changed radically, with a clear bias
toward discounting much weaker growth for a longer period of time. This
shift is reflected in the rise in credit spreads, fall in bond yields,
much lower discounted future earnings growth, flattening of the yield
curve, currency moves and shifts in commodity prices. But such price
changes simply reflect a transition from the discounting of one set of
future economic conditions to the discounting of another set of future
economic conditions. After discounting a relatively imminent return to
normalcy in early 2011, markets are now pricing in a meaningful
deleveraging for an extended period of time, including negative real
earnings growth, negative real yields, high defaults and sustained lower
levels of commodity prices. This pricing is the midpoint of discounted
expectations and each market has an equal probability of outperforming
or underperforming. By balancing the portfolio's exposure to discounted
growth and inflation, a disappointment in one asset class will be offset
by gains in another, without the necessity of predicting which it will
be.
Ray Dalio is an American businessman and founder of
Bridgewater Associates. Bridgewater Associates has since attracted many
clients including pension funds and is currently (as of January 2012)
the largest hedge fund in the world with nearly $120 billion under
management.
