Ray Dalio talks about a new paradigm, a shift in the underlying economic rules and factors affecting the markets going forward, in his latest July interview.
“I think that there are three big components forces at work that have not existed in our lifetime before” said Ray Dalio.
The components Ray Dalio refers to is the maturing of a long term debt cycle where interest rates are at or near zero and where monetary policy is a major driver, where a currency is created and the debt is monetized and where there is a rising power.
But before Ray Dalio talks about a new paradigm he briefly discusses the evolution of monetary policy over the past eight decades.
“There are three stages in monetary policy, the first one began in 1945, the beginning of the new world order” said Ray Dalio. “In 1944 we established the dollar as the world’s reserve currency, it was connected to gold, then in 1971 that broke up” he added.
“I think that there are three big components forces at work that have not existed in our lifetime before”
In 1971 under an executive order President Richard Nixon announced that the US would no longer convert dollars to gold at a fixed value and the gold standard was abandoned just like that.
So the new paradigm back then was the abandonment of the gold standard, which handed over unimaginable power to the Fed to create the world’s reserve currency at will.
Ray Dalio refers to this period as an arch linking the creation of currency, the supply of credit with demand.
“So there was an arch where central banks could produce demand by producing credit” said Ray Dalio.
Ray Dalio talks about a new paradigm, in terms of the central bank’s metaphoric arch failing to bridge credit, money supply with consumption
The velocity of money (M2) in the first quarter of 2020 reads 1.374, which is worse than the financial crisis of 2008 and the great recession.
“So there was an arch where central banks could produce demand by producing credit”
So the central bank’s interest rate monetary policy has been a blunt tool, then monetary policy widens to asset purchases, but it too has shortfalls which gives Ray Dalio talks about a new paradigm a platform for discussion.
“When interest rates are no longer effective and hit zero as they did in 2008 then you go to a new monetary policy, which I call monetary policy two, the printing of money to buy financial assets” said Ray Dalio.
“With that comes implications, lots of liquidity which bids up assets prices. We had an environment that was very good for capitalism, corporate tax cuts all of that causes asset prices to rise. Of course, it also contributes to the wealth gap,” he said.
“So this long term debt cycle of monetary policy is an overarching influence, it is important to understand where we are in that cycle,” he added.
Ray Dalio agrees that the central bank’s creation of currency to buy assets, known as quantitative easing QE widens the wealth gap.
“Related to that cycle is the wealth gap cycle, periods of prosperity that occur after wars during periods of peace because there is a dominant power that nobody wants to fight” said Ray Dalio. This is known as the prosperous period, according to Ray Dalio.
“Our wealth gap is the largest since the 1930s” – Ray Dalio
“During that period there is a lot of credit, expansion of prosperity, property development and so on and that creates wealth gaps, values gaps, and political gaps” he said. “Our wealth gap is the largest since the 1930s” added Ray Dalio.
Moreover, the rise of a great power to challenge the existing world leadership, trade wars, all those factors are in place and were in place before we had the coronavirus noted Ray Dalio.
Ray Dalio talks about a new paradigm in terms of three component forces; the inadequacy of monetary policy through interest rates and QE to stimulate consumption, the maturing of the long term debt cycle, and the rise of China as a challenge to US hegemony.
Referring to the current drivers of the market Ray Dalio talks about a new paradigm where the central banks are the market makers
So the market is driven by the size of the central bank’s balance sheet, its asset purchases, rather than price discovery and fundamentals.
“Today the economy and the markets are driven by central banks through the coordination of the central government” said Ray Dalio. “The purchase of financial assets by the Fed reserve of government securities are the drivers of that market” he added.
“Central banks are the market makers” he added
“Traditional valuations don’t apply when markets are effectively being run by central banks”.
“If they didn’t go out and make lending to fallen companies including falling angles that were just above investment grade we would lose large parts of our economy,” added Ray Dalio.
“The priorities of the central bank regarding the asset they own are not then the same as free-market allocation” – Ray Dalio
“The priorities of the central bank regarding the asset they own are not then the same as free-market allocation. As a result, the capital market is not a free market traditionally allocating resources” he added.
In late stages you are going to see the central bank’s balance sheet explode, they have to because the alternative is a sinking ship.
Ray Dalio talks about a new paradigm with central banks effectively fixing prices
How do you invest in this new paradigm?
“I think it is important to understand that there is a real economy that has its supply of stock and the financial economy that has its supply-demand of money and credit. The price of the asset will equal risk-free return which will equal something close to zero and a risk premium” he said. “So you could make the PE go from 25 times to up to 40 or 50 times by the demand. That may seem implausible, but it is no less implausible then zero interest rate. Multiples shouldn’t be used it the traditional way as a reference” he added.
A good store of wealth is reciprocal to the value of money, such as gold and equities that are not economically sensitive, according to Ray Dalio. He recommends holding reflationary assets.
The central bank’s limiting factor to keep creating currency has to do with the demand for that money and debt noted Ray Dalio.