Ray Dalio, Chairman and Chief Investment Office at Bridgewater Associates, L.P, released a note on August 25, in which he laid out his thesis that the Fed’s next big move will be to ease rather than tighten. Mr. Dalio’s thesis is:
- the global economy is at the end of its long-term debt cycle with high asset prices and high debt levels;
- risk of deflationary contraction is increasing relative to risk of inflationary expansion;
- the Fed will react to what happens and its ability to lower interest rates is limited, therefore QE is likely.
We agree with Mr. Dalio. In fact, we believe that we may have crossed the pivotal turning point. Based on this belief, we see equities in the short term (<12 months) being supported by global central bank actions. It is not yet time to exit equities, but it is a good time to begin thinking of short and defensive positions, as well as playing volatility, which we believe will continue to increase in the short term. In the medium term (12 < time <= 24 months), we see high chances of a bear market and believe a net short equity strategy will be successful. In the long term (> 24 months), we believe economies will begin to stabilize and growth will come back.
End of the long-term debt cycle
Debt per household has been on a steep incline since the ‘90s, and debt as a multiple of real median household income is at historic levels (Chart 1). Portions of this money have been invested into assets like stocks, bonds, and real estate, sending valuations to historical, or near historical, highs. This has created an illusion of security because household net worth has shot up.
If assets were expected to provide increasing returns in the form of earnings, and inflation was expected to rise, then this situation would not be worth discussing. We will show this is not the case; the risks of deflation and lower asset returns outweigh the risks of inflation and above average returns. We believe the Fed sees this and is already reacting to it, as shown by the decision to delay raising rates in September.
Chart 1: Real household debt, household debt to income multiple
Despite record valuations, asset returns in the form of earnings are already below historical values. Chart 2 shows S&P 500 real earnings growth alongside the S&P PE ratio. It can be seen that while earnings growth is lackluster, the PE multiple remains high above its long term median level of 14.6 and has been so for the majority of the run-up in debt.
Chart 2: Real S&P 500 earnings growth, S&P 500 PE ratio
Chart 2 also illustrates that the S&P 500 experienced strong earnings growth in the early 2000s, leading up to the Great Recession. Why don’t we believe that earnings growth will return back to those high values and justify the current high earnings multiple? Three reasons:
1) Much of the earnings growth experienced in the early 2000s, while beneficial to shareholders, came at the expense of employees through low or no pay increases and/or job cuts. America’s median real income peaked in the year 2000 and has been on a slow decline since. At same time household debt has been rising, pushing the cost of housing along with it. In short - consumers are tapped out. The labor force participation rate has also been in decline since 2000, including the categories of those aged 25 to 54, women, and the educated. The slack in the labor market does not incent employers to raise wages and cause consumers to spend, which would cause inflation.
2) Because much of the population has not experienced real income growth for over a decade, there is increasing demand for government entitlements, which the government has been financing with debt. Because government debt is considered risk free, investors will purchase it over riskier assets and projects, leaving a higher proportion of ideas and projects unfunded than the money supply would suggest. This lowers the economy’s ability to grow by slowing innovation and productivity. [Greenspan, 2013]
3) After decades of high growth, China is slowing down. The Chinese slow down in a globalized world is having two major consequences: lower demand for western corporations services and technologies, and lower demand for commodities. While lower commodity prices are good for some industries, like manufacturing, the benefit of cheaper manufacturing costs comes at the expense of commodity related capital investments and rising inflation. Low inflation incents households to delay spending, lowering corporate earnings and economic growth prospects.
We believe these three factors are shaping the near to medium term economic climate (<= 24 months), and pushing the global economy into a large deleveraging phase. Our proprietary global macro model is pointing to the economic shift already having crossed the pivotal turning point (Chart 3). Our model processes over 290,000 global economic variables, then uses a series of dimensionality reduction and feature extraction algorithms to display a 3D topography of the global economy. We have superimposed the S&P 500 in orange, and pointed out the dotcom bubble and the Great Recession. Our model has the recent peak in the global economy occurring in January 2015.
Chart 3: Global economic topography, 2000 to present
However, it is not just lackluster earnings growth, real median income decline, declining labor force participation rates, consistent government deficits, a Chinese slow down, and our proprietary model that point to the end of the long term debt cycle. Debt investors are pricing it in. Chart 4 shows yield curves for US treasuries from 1995 to present. The curve has been flattening since the recovery began with decreasing yields on long-term debt, an indication that investors’ expectations of future inflation are decreasing.
Chart 4: US Treasury yield curves
Also the spread between junk bond and Treasuries yields is beginning to break out (Chart 5). Debt investors are already beginning to price in low growth and recession risks into their investments.
Chart 5: BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread©
Fed has limited options
The Fed and other central banks have few options left. It is clear deflationary risks are high, and they must react. Interest rates are at zero and have decreased, as Mr. Dalio points out, in each successive expansion/contraction mini cycle since the eighties (Chart 6). With deflation high on the minds of central bankers globally, and limited ability to stimulate inflation through lowering interest rates, QE is coming back.
Chart 6: Fed fund rate
Bottomline for investors
We believe that the party is not over - yet. We see equities in the short term (<12 months) being supported by global central bank actions. However, now is a good time to begin thinking of short and defensive positions, as well as playing volatility, which we believe will continue to increase in the short term. In the medium term (12 < time <= 24 months), we see high chances of a bear market and believe a net short equity strategy will be successful. In the long term (> 24 months), we believe economies will begin to stabilize and growth will come back.
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