On Dalio's "Paradigm Shifts" and the Second Act of Unconventional Monetary Policy

This post analyzes Ray Dalio’s recent article entitled “Paradigm Shifts.” Dalio is a global macro investor that I respect very much for his thoughtfulness and success. Unlike most SA articles or posts on this blog, what follows is more of a stream of consciousness than a structured thesis, point, counterpoint, and conclusion.

“Every decade had its own distinctive characteristics, though within all decades there were long-lasting periods (e.g., 1 to 3 years) that had almost the exact opposite characteristics of what typified the decade.”

What typified the last ten or so years? Extended stock market gains, global disinflation, stock buybacks, mergers and acquisitions, venture capital, the rise of passive investing, low real GDP growth, low volatility, Quantitative Easing/the expansion of the Fed balance sheet, artificially low interest rates, big tech, and reduced cost of labor. 

Nearly all of these are related in one form or another. QE and low interest rates led to stock market inflation and the rise of passive investing which is inherently a low volatility strategy. Cheap money also allows for stock buybacks and m&a, further inflating asset prices. Technology monopolies (think FANG stocks) reduce economic dynamism through reduced competition and displaces labor leading to lower GDP growth and labor costs. 

Dalio on when the next paradigm shift will occur: “I think that it is highly likely that sometime in the next few years, 1) central banks will run out of stimulant to boost the markets and the economy when the economy is weak, and 2) there will be an enormous amount of debt and non-debt liabilities (e.g., pension and healthcare) that will increasingly be coming due and won’t be able to be funded with assets.”

The first statement is inevitable. Every subsequent round of QE provided less stimulus than the one before in every metric examined. With the average interest rate cut at 5% going into a recession, a rate cut and round of QE will not reflate the economy. However, in a classic pushing on a string dilemma, even small unwinds of the Fed balance sheet have led to taper tantrums (stock market volatility and defaults of overleveraged companies in the real economy). The only way forward is to continue pulling on that string and see where it leads us.

The U.S. can’t continue to roll over its debt ad infinitum. However, with Japan’s debt to GDP ratio at over 250%, I’m less inclined to believe that a pending fiscal crisis is imminent. The number of unfunded pension liabilities and interest payments on debt will remain a burden on the economy for decades until something is done. 

So what can be done?

Governments can grow out of their debt, but with debt, demographics, and disinflation all burdening economic growth, this is unlikely. Not to mention the fact that a look at global PMI shows industrial production grinding lower, a symbol of economic malaise. They can try austerity like Greece, but that is a painful pill to swallow and with these debts a simple reduction of spending and increase in taxes will not get our economic house in order. Some warn of default, but the U.S. has a printing press and will never allow that to happen. Continued financial repression in the form of near zero interest rates and QE to stimulate spending and growth will not work for the diminished returns effect described above. The only option is to inflate away the debt. Here’s what Dalio says:

“so there will have to be some combination of large deficits that are monetized, currency depreciations, and large tax increases, and these circumstances will likely increase the conflicts between the capitalist haves and the socialist have-nots.”

A depreciation in the exchange rate is a form of cost push inflation. It increases the cost of imports and decreases the cost of exports, so consumers and foreigners will demand more local goods and services. Additionally, budget deficits financed by money creation has been the cause of every bout of hyperinflation in history. Printing money to finance deficits if highly inflationary because it decreases the value of money and creates artificial demand where none existed before.

So what is the second act of monetary policy and the global macro paradigm? Here are some ideas that most investors are not prepared for:

Currency depreciation, debt monetization, high inflation, de-globalization, increased populism/global conflict, monopoly busting, increased taxes, continued technological innovation driving down the cost of labor.

Lastly, with risk assets at near record highs, there’s a chance that increased liquidity does not go into risk assets like in the last cycle. Instead, investors will use easy money to buy real assets in fear of central banks losing control of the price of money. This may take years, or even decades to transpire. This could also be complete heresy, but I believe the writing is on the wall. More of the same cannot continue forever. If this transpires, buy gold, Bitcoin, real estate, and commodities. Sell stocks and bonds.