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A Hedge-Fund Titan Puts Away the Punchbowl

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01/03/2018 | 05:31pm CET
By Greg Ip 

The U.S. economy and stock market have just turned in their best performance in years, so it seems like buzzkill to hand the microphone to someone who thinks the path ahead could be much bleaker.

Still, when it's Ray Dalio, founder of hedge-fund manager Bridgewater Associates LP, it's worth listening. That's not so much because of Bridgewater's size and success but because Mr. Dalio looks at the world through a unique prism.

That prism explains how his firm managed to anticipate and profit from the 2008 financial crisis. While he doesn't see another crisis in the offing, he does see the same underlying stresses at work: Americans have accumulated far more debt than they have assets and income to support.

Not only will this drag on growth and markets, it will leave the economy acutely vulnerable to higher interest rates. The relevant parallel, he says, is not the early 1930s, when the economy imploded, but the late 1930s when the Federal Reserve tightened monetary policy and inadvertently extended the Great Depression. Today, the central bank must balance the short-term need for higher interest rates to contain inflation against the long-term need for low rates to work off the debt overhang and sustain high asset prices.

"It becomes more and more difficult to balance those things as time goes on," Mr. Dalio said when we met at his Westport, Conn., office in November. "It may not be a problem in the next year or two, but the risk of not getting it right increases with time."

Mr. Dalio is famous for a management style he dubs "radical transparency" described at length in his part-memoir, part self-help manual "Principles," published last fall. While the work is light on investment insights (the subject of a second book), it provides Bridgewater's basic framework.

"We 'finance people' see the world very differently from the way economists do," he writes in "Principles." The views of finance people tend to be shaped more by trading experience than by formal economics. They assign much more weight to financial factors such as debt, asset prices and cash flow than do economists who emphasize "real economy" factors such as employment and investment. Finance people are wary of how macroeconomic data obscures crucial details of individual companies and households. Some economists do think like finance people, such as former Fed Chairman Alan Greenspan, but they are in the minority.

One of Mr. Dalio's first big, correct calls was that when the Fed jacked up interest rates in 1981 to slay inflation, it would trigger a crisis; the next year Mexico's default touched off Latin America's lost decade. Then came a very wrong call: that a depression worse than in the 1930s would follow. Instead, the Fed slashed interest rates and sparked a spectacular recovery.

Such experiences drove Mr. Dalio to comb through a century of economic and financial history in search of "timeless and universal" principles, focusing in particular on the U.S. in the 1930s, Latin American in the 1980s and Japan since the 1990s.

As he sees it, since the 1970s, inflation-adjusted interest rates have steadily declined while investors have accepted ever lower compensation for risks such as bankruptcy, recession and volatility (i.e. the "risk premium" has declined). This directly raises asset values and indirectly lifts growth by spurring borrowing. His team estimates this has contributed three percentage points a year to stock returns since the 1970s while boosting private and government debt to 325% of gross domestic product.

In 2007, Mr. Dalio's team concluded that the cost of servicing Americans' debts was growing faster than their cash flows, creating the conditions for a crisis.

He doesn't blame the Fed for this debt bubble. In fact, he praises it for understanding exactly what was needed when it burst: By slashing short-term interest rates to zero and buying bonds to push down long-term rates, it engineered the right combination of economic growth, debt write-offs and low interest rates necessary to start the painful process of "deleveraging," or working off all that debt.

The problem is that with interest rates and risk premia near all-time lows and debt and asset values near all-time highs, there's little fuel left to repeat the process. Just as the Fed can't cut rates much, it can't raise them much either or debt servicing would swamp cash flow and asset prices would sink. Thus Mr. Dalio foresees years of low interest rates, and while he thinks stocks are appropriately valued, he thinks returns to a typical stock-bond portfolio over the next decade will be around zero after inflation and taxes. Whatever you need to retire, save it now: Don't count on portfolio returns.

When Mr. Dalio speaks, how closely should you listen? As with many famous investors, it's hard to know how much his public views drive Bridgewater's actual strategy, which remains secret. Since Bridgewater detailed this thesis in a series of newsletters in 2016, events haven't exactly followed the script. Last year, the S&P 500 index rose 19.4%, the best since 2013; Bridgewater's competing diversified fund returned about 12%.

Mr. Dalio says the promise of less regulation and lower taxes coupled with very low volatility have elevated stock valuations, which increase wealth and spending. But that doesn't translate into higher long-term growth or sustained returns, he says: "It's not changing the world as we know it."

In fact, his biggest worry is that lower corporate taxes and higher stock prices do nothing for the bottom 60% of households who own almost no assets and whose stagnant wages are the mirror image of expanding profit margins, feeding resentment and political polarization. Says Mr. Dalio: "If we do have an economic downturn, I worry we will be at each other's throats."

Write to Greg Ip at [email protected]

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