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Bipolar Disorder
Interview with Ray Dalio, Chief Investment Officer, Bridgewater Associates

By SANDRA WARD

WHEN YOU MANAGE NEARLY $120 billion in institutional assets and your hedge fund provides consistent returns of about 15%, after fees, on average, every year for nearly 16 years running, who wouldn't want to hear your views on the economy? Dalio, founder of Westport, Conn.-based Bridgewater Associates, has built an organization renowned for its penetrating analysis of world markets and its ability to seize investment opportunities among different asset classes, particularly the credit and currency markets. Clients gain access to Bridgewater's latest thinking on global markets through the firm's Daily Observations newsletter. We thought you might like to get the scoop straight from the horse's mouth.

Barron's: What's your outlook for inflation?

Dalio: I think inflation is gradually trending higher. It won't emerge as a threat probably until late 2006. World economies are late in the economic cycle, and there are not the same excesses there used to be. The dollar will go down a lot and commodity prices will go up a lot. There is a structural surplus of labor and there's disinflation from labor and manufactured goods and productivity, but commodity inflation will offset that. The rate at which this will occur will be gradual at first, and as we get later into 2006 we'll have run out of slack and there will be more of a depreciation in the value of the dollar and more appreciation in commodity prices and the Fed will lag that move. Real rates will be relatively low.

You're not concerned the Fed tightens too much?

No, I don't believe they will tighten too much. Rates will continue to rise and the Fed will continue to tighten, but their moves will lag the forces of positive economic growth, a declining dollar and rising commodity prices. The Fed is looking at general inflation, and that will rise slowly. The economy is growing at a moderate pace, and so any tightening will be comparatively slow and modest. The balance- of-payments issue is a major issue, but it is not going to be a major problem this year. This year will be the first attempt to remedy the problem, but what is going to happen is our balance-of-payments position is going to worsen a lot. In 2005, 2006 and 2007 we are going to see our current-account deficit go from 5½% to 6½% to 7½% of gross domestic product. Our need for foreign capital is going to continue to grow at the same time that China's desire to buy our bonds -- and Japan's to some extent, as well -- will diminish. China's desire to have an independent monetary policy will be a driving factor. But there is a bipolarity in the world: The mature industrialized countries are in relative stagnation, and the big reason the U.S. is growing faster than most of other countries is because we are being lent capital. We are substantially dependent on foreign lending.

To put that in perspective, we import about 65% more than we export. Then there are the emerging countries. These countries, with their economic booms, are running current-account surpluses and are net lenders to the developed world. This is a very, very healthy set of circumstances. Emerging countries are using their capital to pay down their debts, and they are buying the U.S. Treasury bonds to hold their own currencies back. There is a very favorable structural shift in wealth to developing nations. We are very, very bullish on emerging countries, particularly Asian emerging countries and their currencies. Fundamentally, though, you have to ask yourself whether the ties between us and the emerging countries that are buying our bonds will last. It doesn't make sense. The balance-of-payment situation reminds me very much of the Bretton Woods breakup in 1971.

When we came off the gold standard?

Yes. What we had then was a fixed-exchange-rate system. Japan then was very similar to what China is now in terms of per-capita incomes and growth rate. Japan was emerging from a post-World War II economy that was dilapidated. Japan and Germany acquired very large surpluses. They believed the U.S. dollar was a credible exchange rate and they needed stability from that, and so we borrowed and overconsumed until the price of the exchange rate was out of line. They had to buy lots and lots of bonds, and when you buy bonds, you have to print money to do that. So Japan and Germany had to stimulate their economies and then they wanted to slow their economies, just like China today.

China has an overheating economy, and because of its fixed exchange rate, it has to produce more money supply. For a country like China to tie its monetary policy to a country like the U.S. doesn't make any sense. One is growing at a 9% real rate, the other is growing at 3%, if it's lucky.

But aren't we beginning to see signs the Chinese want to wean themselves from that system?

Yes. You are seeing signs of the crack. What they want to do is keep everything calm and orderly, just like Japan in the early 'Seventies. There'll be some minor adjustment at first, but the minor adjustment won't change anything. Let's say they revalue their currency by 5%, or even 10%. That won't structurally change anything. U.S. per capita income is about 30 times what it is in China. But by 2006, China will revalue more aggressively. That makes the dollar situation very bearish. I don't think the dollar can rally much beyond this point because so much of the buying of dollars is to prevent it from going down. If the dollar goes up, the central banks are going to buy fewer dollars, and whatever demand exists to help push the dollar up will be offset by fewer dollars being purchased. The only way the dollar can sustain a major move is if there were true demand for dollars, free-market demand to buy dollar-dominated assets.

Are you short the dollar?

We are long the yen against the dollar, and we are particularly long emerging-market currencies against the dollar. But we are short the euro against the dollar.

When did you start shorting the euro?

Last December because of Europe's economic stagnation. We have built up the position since. When you look at the dollar, the yen and the euro, it's an ugly contest. They're all pretty ugly. What we are long against the dollar are either commodity exporters such as the Australian dollar or emerging-market currencies. I like emerging-market currencies because their central banks have been artificially holding their currencies back. In a normal cycle in emerging markets, there's a bust, then they maintain an easy monetary policy, and then they have accelerated growth. That is very good for equities, and their equity markets at those stages of the cycle tend to do very well. But they artificially hold their currency down, because they are afraid that if the currency were to appreciate, they would lose their competitive position. They build up big reserves.

Once they are past a certain part of the cycle, these countries typically buy fewer foreign bonds and let their currencies appreciate. Now, increasingly, emerging-market countries are going to let their currencies appreciate. It is very similar to my Bretton Woods comparison: Germany and Japan had big balance-of-payments surpluses, but it was France that first broke ranks with the United States. The French basically said, "Give us the gold instead of checks for gold." Now Korea, in particular, but other Asian countries as well, are beginning to change their reserve mix away from dollars.

What are they turning to?

They're buying more euros and more gold. Gold is going to play a much bigger role. Only 2% of Chinese reserves are in gold. There is a saying that gold is the only asset you can have that isn't someone else's liability.

What's your view on oil?

In late 2006, I think you could see oil over $100. Whenever we've had oil shocks, it's because we've reached capacity, and we are at capacity in refining and extraction. When we look at each country's projections of oil consumption, we find we're consuming at a rate faster than it can be produced.

Yet the industry itself doesn't seem overly concerned, and there's not been any rush to reinvest in the business.

It is very interesting to me because forward oil prices are higher than they've ever been. Usually in an oil shock, spot prices rise and you could almost understand oil companies' not making any investments because the forward prices don't support the spot price. Yet now the forwards have risen materially. I don't understand the industry's behavior, but I think it is part of the cycle.

When a major bull market that goes on for many years starts to reverse, in the initial stages of the turn everybody is looking for the bull market to come back. As with tech stocks. As with gold. Then it goes so much the opposite way that everybody gives up on the story. No one holds any inventories and everybody, in a sense, is short or forward-hedged. That creates the ingredients for the market to move the other way.

These moves now, whether it is gold or oil or commodities, are probably somewhere between 60% and 70% done in general. This is a pause. It is also the time when sentiment changes and readjusts. Then the question is, What is the supply-demand picture going forward? In order to be bearish on commodities, you'd have to be bearish on growth in those countries that are consuming the commodities.The question for commodities is really a consumption question, and we have to assume that the machine doing all the consuming will be forced to slow down. In China's case, I don't believe they are going to slow down. China is overheating and there's the risk of more overheating. As I said before, I think you are going to see very strong commodity prices and disinflationary pressures from labor and manufactured goods causing a gradual upturn in inflation until the world is in its next recession, and that doesn't seem to be a prospect for 2005. It is not much of a risk until late 2006.

With the flattening of the yield curve, a lot of people have been concerned about a recession.

I'm not worried about it. I don't think there has been enough of a tightening through the existing rate structure to cause a recession. The magnitude of interest-rate changes that would be required to cause the economy to slow is about a 4¼% fed-funds rate and about 5½% on the 10-year bond.

How do productivity and employment growth factor into your outlook?

Productivity growth has been following a typical cyclical path but at a significantly higher level. Payroll employment is following a path similar to its historical cycles, but it is much lower. That is a structural difference that is good for businesses and bad for employees.

CHART

But shouldn't productivity growth slow and hiring pick up?

The causes of that productivity growth are going to be with us a while. In the bubble years, corporations invested a lot in plant and equipment. It is paying off. Secondly, there's a surplus of world labor.

There are three basic things that make up an economy: labor, natural resources and capital. There's been a vast increase in the supply of labor. The pricing of labor in China is holding down the pricing of labor in the United States. The world's supply of labor quadrupled with China coming into the market. It's had a big, big effect. The relatively cheap cost of labor helps productivity. Productivity comes partially from investing in plant and equipment but partially from keeping labor cheap. Those two factors are secular changes. That's why profit growth has been stronger, not because top-line revenue growth has been better; profit margins have been better because of lower labor costs.

Are the high profit margins sustainable? Or will they revert to the mean?

Nothing necessarily reverts to the mean. They may not increase, but they are not likely to decrease because we have this world supply of labor and world supply of equipment. And the complexion of workers is changing. Do you know that 44% of all corporate profits in the United States comes from the financial sector -- people who are shuffling money around? Only 10% comes from those who manufacture things. We are living in a two-tiered economy, and you are on one side of it. You write for Barron's. You are in the financial community. There is that economy. Then there is the person on the assembly line.

In this business cycle, real GDP growth will follow the average; interest rates will follow the average; productivity will follow the average, but move up a notch; employment will follow the average but fall a notch. The main reason for that is: China and India and other emerging countries are changing the balance of supply-demand in labor. They are also changing supply and demand for capital through their foreign exchange interventions.

They add all the surplus of labor and they consume all the commodities, so that means a lot of demand for commodities at the same time there is a lot of surplus of labor.

Another important secular change is the amount of U.S. debt. Because we have a lot of debt, smaller increases in interest rates will shut off the economy more quickly. Debt-service payments are what drive the economy. Individuals don't care about how much debt they have, and the interest rate itself really doesn't matter.

What matters is the monthly payment on the debt. That is true for businesses, too. Because we have much more debt in the economy, it requires less of a rise in interest rates in order to shut off the expansion.

Bond yields bottomed in May of 2003 at 3.38%, and we are going to have an interest-rate increase that will be less than what we are used to -- something like 2¼% -- to cause a cyclical peak in the bond yield at around 5½% to 5¾%.

You've talked about your currency bets, but where else are there opportunities?

We have big spread positions: Essentially, we are long European bonds and Japanese bonds even though interest rates are very low. Against that, we have short positions in U.K. 10-year gilts and U.S. Treasury bonds.

In other words, I don't like U.S. bonds compared with European or Japanese bonds.

I'm long inflation-indexed bonds in relation to nominal bonds. We are long commodities. Oil is my favorite, but I also favor gold and copper.

Commodities will peak when they tighten monetary policy. A lot of people think the recessions after oil shocks in the past were caused by high oil prices. They weren't. They were caused by the tight monetary policies that the central banks employed to fight inflation.

If you examine the amount of oil consumption and how much money was actually taken out of pocket as a percentage of disposable income, it was very small -- amounts equivalent to .8% of disposable income.

We are not used to the fact you can have big commodity moves without having big inflation. I'm a big commodity bull, but I'm not a super inflation bull because I believe that the surplus of labor and productivity changes will negate most of the price rise in commodities.

What about equities?

I'm slightly long equities.

More so in one part of the world versus another?

I'm particularly long Australian and Canadian equities.

Countries benefiting from a commodity boom.

Right. I'm still long small amounts of European equities. In the U.S., I'm very slightly short against very small long positions. The way we look at a position is to look at an outright spread. So I like foreign markets relative to the U.S. market.

That gives me a little bit of a short position, just because I like the others better. We're slightly positive on almost all the equity markets with the biggest equity exposure in Australia.

On a totally different subject, let me add here that there is a revolution going on in how money is being managed. There's going to be a shift away from traditional investing, and traditional investing favors equities most. There are going to be major net flows away from equity markets over the next number of years. Money will go to bonds to some extent and to nontraditional investments, but it will be at the expense of equities.

Thanks, Ray.
URL for this article:
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Sunday, July 31, 2005 / Permalink
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Comments

"Do you know that 44% of all corporate profits in the United States comes from the financial sector -- people who are shuffling money around? Only 10% comes from those who manufacture things."

Wow. I wonder what this statistic is for other countries, and what is the historical curve in the USA and elsewhere.

Laurent

Posted by: guerby / July 31, 2005 03:25 PM

Great post, thanks.

BTW, the link to the article is not working

Posted by: Ray / July 31, 2005 06:46 PM

Excellent article!

A: “Fundamentally, though, you have to ask yourself whether the ties between us and the emerging countries that are buying our bonds will last. It doesn't make sense.” So true.

B: “Another important secular change is the amount of U.S. debt. Because we have a lot of debt, smaller increases in interest rates will shut off the economy more quickly.” Already the ratio of interest payments to personal income is at an all time high. A substantial rise in interest rates will cause this ratio to soar.

Note that A and B are reinforcing. This is a very unstable situation.

Posted by: touche / July 31, 2005 11:24 PM



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