October 5, 2018
By Steve Blumenthal
“Typically the worst debt bubbles are not accompanied by high and rising inflation,
but by asset price inflation financed by debt growth. That is because central banks make
the mistake of accommodating debt growth because they are focused on inflation
and/or growth—not on debt growth, the asset inflations they are producing,
and whether or not debts will produce the incomes required to service them.”
– Ray Dalio, A Template For Understanding Big Debt Crises
Ray Dalio and his team at Bridgewater Associates run the world’s largest hedge fund. They are global macro investors, meaning they can invest in anything anywhere — currencies, debt instruments and equities. They are agnostic to direction. They bet up. They bet down. Success depends on being on the right side of the trade. And they’re good. So good that they manage $150 billion and their clients pay them a management fee of 2% and 20% of profits. That should tell us something.
Dalio’s Template for Understanding Big Debt Crises is a master class on how economies work, how they cycle, how bubbles begin, how they end, who wins, who loses and how you and I might better navigate the period immediately ahead. If you’ve already read Dalio’s 471 page e-book (link provided again below), then hit me with a big high five. It’s a roadmap of sorts to help his firm position and profit. Success depends on understanding how the economic machine works, understanding where we sit in both the short-term and long-term debt cycles, understanding human behavior and having the courage and conviction to place your bets.
Ray is sharing his firm’s research with us in the hope that policy makers will make good decisions. To which I have concerns. His work is a study of history. We have been here before though few of us have personally lived through the challenges that long-term debt accumulation cycles present. In part, his research is intended to help us navigate the challenges such periods present.
His message is that we are at the end of a long-term debt cycle. Few of us have seen one. And the decisions global central bankers and policy makers make will determine just how bumpy the next two to 10 years will be. The outcome ranges from what Ray calls “beautiful” or “ugly.” He’s on a mission to “do right.”
I hope policy makers are listening and I believe his “Template” will help you better prepare and even prosper through the systemic shocks that lie ahead.
A long-term debt cycle looks like this:
During the upswing of the long-term debt cycle, lenders extend credit freely even as people become more indebted. That’s because the process is self-reinforcing on the upside—rising spending generates rising incomes and rising net worths, which raises borrowers’ capacities to borrow, which allows more buying and spending, etc. Most everyone is willing to take on more risk. Quite often new types of financial intermediaries and new types of financial instruments develop that are outside the supervision and protection of regulatory authorities. That puts them in a competitively attractive position to offer higher returns, take on more leverage, and make loans that have greater liquidity or credit risk. With credit plentiful, borrowers typically spend more than is sustainable, giving them the appearance of being prosperous. In turn, lenders, who are enjoying the good times, are more complacent than they should be. But debts can’t continue to rise faster than the money and income that is necessary to service them forever, so they are headed toward a debt problem.
When the limits of debt growth relative to income growth are reached, the process works in reverse. Asset prices fall, debtors have problems servicing their debts, and investors get scared and cautious, which leads them to sell, or not roll over, their loans. This, in turn, leads to liquidity problems, which means that people cut back on their spending. And since one person’s spending is another person’s income, incomes begin to go down, which makes people even less creditworthy. Asset prices fall, further squeezing banks, while debt repayments continue to rise, making spending drop even further. The stock market crashes and social tensions rise along with unemployment, as credit and cash-starved companies reduce their expenses. The whole thing starts to feed on itself the other way, becoming a vicious, self-reinforcing contraction that’s not easily corrected. Debt burdens have simply become too big and need to be reduced. Unlike in recessions, when monetary policies can be eased by lowering interest rates and increasing liquidity, which in turn increase the capacities and incentives to lend, interest rates can’t be lowered in depressions. They are already at or near zero and liquidity/money can’t be increased by ordinary measures.
This is the dynamic that creates long-term debt cycles. It has existed for as long as there has been credit, going back to before Roman times. Even the Old Testament described the need to wipe out debt once every 50 years, which was called the Year of Jubilee. Like most dramas, this one both arises and transpires in ways that have reoccurred throughout history.
Ultimately, it’s my belief we are moving towards some form of a global debt “jubilee.” It will require global policy makers to hold hands in coordinated effort and forgive a portion of the debt in a way that gets us well below the current 350% debt-to-GDP ratio we see in the major economies across the globe. A grand “make the world great again” global debt jubilee (print, buy, monetize the debt). Can policy makers come together? Prior to a systemic shock, I have my doubts. “Beautiful” remains a potential but whatever the path we take, it’s going to get bumpy.
Now, if you are of the mindset that everything is rosy so there is nothing to see here, then margin up with your neighbors and hold glasses high with a toast to Amazon joy at this weekend’s dinner party. It always feels this good at the top. A wonderful debt-driven liquidity cocktail that feels really awesome until suddenly it doesn’t. My message remains the same: To speed forward without breaks is unwise, especially when there are more than just a few deep potholes for us to maneuver around.
Dalio’s book is a template for understanding how all debt crises work! Reiterating what I said last week and the week before, put everything else aside, this matters. Next week, I’m going to do my best to pull it all together, list important markers for us to watch (a dashboard of sorts) and share ideas on how you might position and profit. Think shorting subprime in 2008. Of course, much depends on your investment objectives, time horizon and risk tolerance.
Grab that coffee, find your favorite chair and jump in. The balance of this week’s missive is a quick read.
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Included in this week’s On My Radar:
- Ray Dalio’s Template for Understanding Big Debt Crises (OMR Part III)
- Why it Might be a Good Time to Revisit Ray Dalio’s 1937 Analog, by Jesse Felder
- Trade Signals – Equity Bull, Bond Bear, Forward 10-Year Return Range -3.03% to +8.43%
- Personal Note – #1999
Ray Dalio’s Template for Understanding Big Debt Crises (OMR Part III)
Beautiful or Ugly?
The key to handling debt crises well lies in policy makers’ knowing how to use their levers well and having the authority that they need to do so, knowing at what rate per year the burdens will have to be spread out, and who will benefit and who will suffer and in what degree, so that the political and other consequences are acceptable.
There are four types of levers that policy makers can pull to bring debt and debt service levels down relative to the income and cash flow levels that are required to service them:
- Austerity (i.e., spending less)
- Debt defaults/restructurings
- The central bank ‘printing money’ and making purchases (or providing guarantees)
- Transfers of money and credit from those who have more than they need to those who have less.
To date, we’ve looked at how economies cycle and how short-term credit/debt cycles grow to become long-term big debt cycles. We’ve looked at “The Phases of the Classic Deflationary Debt Cycle,” which detailed how to spot bubbles, what the “beautiful deleveraging” looks like and what happens when interest rates move to zero (the “Pushing on a String” phase in the cycle).
Today, I’m sharing a summary of what we learned in the first section of Dalio’s Template and focusing specifically on the Phases of the Classic Deflationary Debt Cycle because that is the significant challenge the bulk of the developed world markets is currently facing. It is the challenge the U.S. faces due to the dollar’s status as the world’s currency reserve. Emerging market countries are facing “Inflationary Depressions and Currency Crises” so I do encourage you to spend time on that section.
If you are reading the book and following my notes, I’ve taken you through the first 38 pages. I’m not discussing the section that covers Inflationary Depressions as those occur in countries where their debt is not financed in their own currency (i.e., EM markets such as Asia, Turkey, India and others… and one can argue Italy as well depending on how the European Union holds together). So do study those pages in the book as they are no less important to the global macro player looking to defend wealth and profit.
Here’s a look at the table of contents and just below that we’ll conclude with a short “In Summary” review on what we have learned:
I want to reiterate my headline: managing debt crises is all about spreading out the pain of the bad debts, and this can almost always be done well if one’s debts are in one’s own currency. The biggest risks are typically not from the debts themselves, but from the failure of policy makers to do the right things due to a lack of knowledge and/or lack of authority. If a nation’s debts are in a foreign currency, much more difficult choices have to be made to handle the situation well—and, in any case, the consequences will be more painful. As I know from personal experience, the understandings and authorities of policy makers varies a lot across countries, which can lead to dramatically different outcomes, and they tend not to react forcefully enough until the crisis is extreme. Their authorities vary as a function of how powerful each country’s regulatory and checks and balance systems are. In countries where these systems are strong (which brings lots of benefits), there is also the risk that some required policy moves can’t get done because they are inconsistent with the rigid rules and agreements that are in place. It’s impossible to write the rules well enough to anticipate all the possibilities, and even the most knowledgeable and empowered policy maker is unlikely to manage a crisis perfectly. Circumstances that weren’t foreseen must be responded to instantly, often in hours, within a legal/regulatory system that doesn’t have crystal-clear rules. The checks and balances system—normally a critical protection from too much concentration of power—can exacerbate a crisis because it can slow decision making and allow those with narrower interests to block necessary policy moves. Policy makers who try to take the necessary bold actions are typically criticized from all sides. Politics is horrendous during debt crises, and distortions and outright misinformation are pervasive. While these big debt crises can be devastating to some people and countries over the short- to medium-term (meaning three to ten years), in the long run they fade in importance relative to productivity, which is more forceful (though less apparent because it is less volatile). The political consequences (e.g., increases in populism) that result from these crises can be much more consequential than the debt crises themselves. The charts below show real GDP per capita and help to put these big debt crises (and the “little” ones that we call recessions) in perspective. The contractions of more than 3 percent are shown in the shaded areas. Note how the growth rates over time were far more important than the bumps along the way. The biggest bumps came more as a result of wars than the worst depressions (though a case can be made that those wars were caused by the political fallout from those depressions).
That’s the summary. Starting on page 66 you’ll find detailed case studies and I encourage you to look closely at the U.S. Debt Crisis and Adjustment (1927-1938) and U.S. Debt Crisis and Adjustment (2008-2011). It’s really cool how Dalio and his team lists a timeline of newspaper clips so you can experience what was going on along the timeline. Hint: It’s always most bullish at tops and most bearish at bottoms. I really enjoyed reading what was reported and how it flowed with Dalio’s research.
“While tops are triggered by different events, most often they occur when the central bank starts to tighten and interest rates rise.”
– Ray Dalio
OK, my friend… this is simply where we sit today. It just is. What we do about it is up to us.
We have reviewed just 63 of the more than 400 pages. My hope is that by understanding how the economy works, how debt cycles expand and how they reach a point where they must contract we can better see what is coming and better navigate the way forward. How we get through it, AND WE WILL, is yet to be determined. If we know what to look for, we have a better chance at navigating the path ahead.
Next week, I’m going to share my dashboard of indicators with you. There are things we can do to help us seek growth opportunities and protect against meaningful decline. The objective is to participate and protect. We’ll look at various solutions and talk about a few bets to consider. Please know I welcome your comments, your ideas and please share with me anything you feel is most important to you.
Why it Might be a Good Time to Revisit Ray Dalio’s 1937 Analog, by Jesse Felder
I shared this next section with you in an OMR post last July. I’m sharing with you again as it remains fitting to a degree. It is a parallel to where the stock market sits in the cycle today vs. the last time the U.S. was at the end of a long-term debt cycle (2008-present vs. 1929-1942).
Jesse Felder’s post:
- Debt Limits Reached at Bubble Top, Causing the Economy and Markets to Peak (1929 & 2007)
- Interest Rates Hit Zero amid Depression (1932 & 2008)
- Money Printing Starts, Kicking off a Beautiful Deleveraging (1933 & 2009)
- The Stock Market and “Risky Assets” Rally (1933-1936 & 2009-2017)
- The Economy Improves during a Cyclical Recovery (1933-1936 & 2009-2017)
- The Central Bank Tightens a Bit, Resulting in a Self-Reinforcing Downturn (1937)
And if these fundamental parallels weren’t enough, we now have a rather interesting price parallel to consider. The correlation between the S&P 500 over the past four years (black and white candles in the chart below) and the four years leading up to the 1937 top (blue candles) is roughly 94%. As I have suggested in the past, price analogs are not very valuable on their own but when the fundamentals also parallel closely they become far more interesting.
In this case, the fundamental parallels are only getting tighter as time passes. Despite the yield curve currently sending a clear red flag, the markets are now pricing in better than even odds of two more rate hikes this year. It seems ‘central bank tightening into a self-reinforcing downturn’ is becoming a more distinct possibility as the economic cycle ages and inflation pressures grow. In other words, “the policy stakes are now very high,” and history provides a clear road map for markets.
Source: The Felder Report
Now, given all this, you’ll see in the next Trade Signals section, the overall trend in the equity market remains moderately bullish while the direction in interest rates is up. That’s bad news for high quality bonds, bond funds and ETFs. To which, the Zweig Bond Model has done an excellent job. It remains on a sell signal.
Trade Signals – Equity Bull, Bond Bear, Forward 10-Year Return Range -3.03% to +8.43%
S&P 500 Index — 2,931 (10-03-2018)
There are no changes in the equity and fixed income signals since last week’s post. You’ll find the charts below.
Households have 55.74% of their money allocated to stocks. There is a high 0.89 correlation between stock ownership and 10-year subsequent returns. The idea is that if a majority of investor money is in stocks, where will the new buying come from. If stock ownership is low, there is more money to buy stocks in the future. More buyers than sellers sends prices higher… same supply-demand rules that work in every market whether it is stocks, bonds, bananas, beans or beer.
The following is data from 1951 to June 2018. It ranked stock allocations into five buckets. Highest to lowest (current regime is highlighted in yellow). Note the “Average GPA% 10-Years Later”(average annual gain %) – right hand column. The best 10-year subsequent return was 8.43%. To put that in perspective, there have been 705 ten-year data points since 1951. There was one 10-year period that returned -3-03% and one 10-year period that returned 8.43% when in the “Highest 20%” household ownership. The average of all 10-year periods when in the “Highest 20%” ownership is 3.98%. My two cents is to simply look at the “Average GPA% 10-Years Later” column… “We are here” in red vs. We’d be “Better off here” in green.
For additional commentary, click HERE for the latest Trade Signals.
Important note: Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Long-time readers know that I am a big fan of Ned Davis Research. I’ve been a client for years and value their service. If you’re interested in learning more about NDR, please call John P. Kornack Jr., Institutional Sales Manager, at 617-279-4876. John’s email address is email@example.com. I am not compensated in any way by NDR. I’m just a fan of their work.
Personal Note – #1999
Ten stocks out of 500 stocks in the S&P 500 Index have accounted for more than all of the 10% gain in the index in 2018. That means the remaining 490 stocks have collectively lost money. An unusual and unhealthy divergence. Something we have not seen since #1999.
I shared that stat with 35 independent advisors at a VanEck client event in NYC yesterday. My daughter, Brianna, stopped by to listen to my presentation. Frankly, I feel I could have done better. I spent too much time on the debt challenges (which after this week you may be feeling the same) and I feel I could have be tighter and crisper. I asked Brianna how she thought I did. “Good overall,” she said, “but you really had a big mistake. It’s not ‘pound’ 1999, it’s ‘hashtag’ 1999.” Ugh… I’m looking in the mirror and seeing more and more of my old man. Talk about recurring patterns.
A dominant Penn State lost to Ohio State giving up two touchdowns in a heartbreaking late game loss. But in sports and in life… “Ever forward… never backward” is the best path (hat tip to Rory). And, of course, the time tailgating with old fraternity brothers and family (Matt, Kyle, Tyler, Connor, Dan and Chase) was the most important win.
To give you a feel for what it’s like having fun with 110,000 of your newest, closest friends, here is a short video – TV timeouts provide a lot of downtime between plays. Fun indeed…
The weekend is shaping up nicely. Brianna, Matt and Kyle are coming home. A golf tournament with Matt tomorrow – he’s our horse and a big family cookout is planned for Sunday. So I’m heading into the weekend excited.
I’m in Chicago next Wednesday and Thursday for an ETF conference, Las Vegas the following week and Denver in early November. The plan is to get a little smarter on leveraging travel time and set aside time to meet in a city near you for dinner and macro discussions. I’ll have my team organize the events and let you know where and when. Perhaps we’ll start in Denver. Stay tuned…
Have a great weekend!
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With kind regards,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
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