The title here paraphrases Bridgewater Associates founder Ray Dalio based on a conversation he had with CNBC at the World Economic Forum in Davos, Switzerland. And what Dalio said makes a lot of sense.
The Bridgewater founder’s view is that we are late in the economic cycle and should expect very good things from asset markets. But he also believes central banks will have a tricky time dealing with the consequences. My extended analysis is below followed by the Dalio video.
We have to start with the Taper Tantrum
Let’s give this topic the full-on view by looking back to the mid-cycle pause associated with the shale oil bust a few years ago. I’ve gone through my archives and read a bunch of stuff from that time period just now and I want to recap what happened back in 2014 and 2015 because I think it’s relevant to thinking about what ‘late cycle dynamics’ look like and where the risks lie.
The Fed embarked on its last round of monetary stimulus designed to boost the US economy in 2012 when it announced that it would buy $85 billion of US government and mortgage backed securities per month. These large scale asset purchases, known as quantitative easing or QE, had been conceived in the throes of crisis to add liquidity to financial markets. But after panic subsided, with interest rates already at zero percent, the Fed used purchases to try and boost economic growth as fiscal policy was dialled back.
Then in 2013, then Federal Reserve Chairman Ben Bernanke announced that the Fed would ‘taper’ its purchases. That signalled monetary tightening. Bonds sold off as interest rates rose, with the final purchases made in October 2014.
Now, if you look at growth, you see that the Fed got the policy right.
US economic growth slowed until early 2013, the period addressed by QE, represented by the first arrow above. And then growth accelerated through the beginning of 2015, the period addressed by tapering and represented by the second arrow.
Then came the Shale Bust
Monetary policy acts with a lag. So, even though US growth was accelerating in 2014, higher rates would eventually have a dramatic impact. A bust in the oil sector, which began in mid-2014, led to economic distress by over-leveraged firms who could not re-finance in the tighter monetary environment. A large-scale drop in capital expenditure in the sector ensued. As I put it in 2014, a global economic growth slowdown was slowing oil demand growth, irrespective of what was happening in the US. And that meant that, shale, a sector which had been buoyed by easy money in the US, was in trouble.
By 2015, I was writing that “it is clear now that the drop in oil prices has been both precipitous enough and long-enduring enough that we should start talking about this as a crisis in the making” — meaning the drop in oil prices was not stimulative as commonly thought at the time; the oil price drop was anti-stimulative, through a loss of capital investment, and it was crisis-making.
My view at that time was that we were at a cycle inflection point — just as we are today. The Fed had moved to reduce policy accommodation and the effects of that tightening were being felt in a relatively large market. The first question was whether the tightening was enough to trigger crisis. The answer, in retrospect was clearly yes, as junk bond yields soared due to the shale bust.
But the second question was whether the Fed would see a crisis developing and hold its fire, much as it did during the US government bond crisis in the mid-1990s. The answer here again was yes. At that point, we had to wait for the lag in monetary policy’s impact and see whether the tightening and the crisis were large enough to trigger recession.
I made a list of tail risk candidates in late 2014 that included shale, junk bonds, and US capex, but also included municipal debt, emerging market corporates, Australia and Canada. My view then was that shale, junk bonds, and US capex were not enough to cause recession. You had to see knock-ons to other more tangentially related markets in my tail risk list.
The Mid-Cycle Pause Debate
And when we didn’t see more tangential risks materialize as a result of the oil bust, we had to believe that we would only get a mid-cycle slowdown. This was a real issue.
Look back at the GDP growth chart and look at the deceleration in growth in 2015. We have to remember that, at the time, the Fed bias remained toward tightening. And so, there was an active debate as to whether the US would enter recession. In April 2015 I wrote, “my overall view here then is that the mid-cycle pause story is balanced on a knife’s edge.” And as the year went on, I continued to push the view that we would see material slowing in US growth but likely no recession.
Some people like Peter Schiff were saying openly that the US economy was in recession. As 2016 began, I said we were not in a recession — stall speed, yes, but not a recession. But because the Fed started to raise interest rates in December 2015, even as the economy was decelerating, I went on recession watch in January 2016. And I remained on recession watch through the middle of the year as the Brexit vote approach.
By August, I was off recession watch and became optimistic about growth. And by November 2016, I was writing a ‘mid-cycle pause post-mortem’ in defense of the Fed’s rate hike campaign. They saw the dangers of the shale bust paused and continued to tighten incrementally. And the economy recovered. That’s policy with foresight.
In retrospect, we can see the Brexit vote and the speculation around a potential bankruptcy of Deutsche Bank in the summer of 2016 as the low point for that cycle. Bond yields bottomed at that point. Now, Bill Gross is even saying this was the bottom for years or decades to come. But, there was truly a lot of angst around all of this. And this whole experience shows you what a mid-cycle pause looks like — the economic slowdown, the market reactions, the policy debates and the eventual re-acceleration of growth.
So what about Ray Dalio’s Boom Bust comments, then?
We’re in a completely different part of the economic cycle now though — definitely late-cycle. What Ray Dalio is saying is that he agrees with Jeremy Grantham, who is bullish about 2018. Dalio is saying that we’ve done the household deleveraging without a big crisis — what he calls a “beautiful deleveraging”. And we are now in a “Goldilocks” period economically, with corporate tax cuts adding fuel to send stock prices up. In fact, he goes as far as to say, that “If you’re holding cash, you’re going to feel pretty stupid”. Like Grantham, he’s calling for a market blowoff.
This is dangerous stuff.
Let me repeat what I wrote in November: We are in the most dangerous period in the business cycle. It’s late cycle. And there is no angst now —none. Everyone is bullish. At the same time, the Fed is hiking and the yield curve is flattening. And some Fed officials have told us point blank that they don’t care if the yield curve is flattening because this time may be different. This is where the danger is.
How is the Fed supposed to heed a flattening yield curve when no one is in cash, everyone is bullish and stocks are going through the roof? It can’t.
Now, If you look at Treasury futures, since the end of 2016, the market has been moving to the Fed, not the other way around. The Fed has been tighter than expected. And it will continue to be tighter than expected. Rates will go up on the short end. And as we hit mid-year, I believe the yield curve will begin to flatten more. Meanwhile the stock market will be booming.
And given global growth’s acceleration, soon all major central banks will be tightening policy, not just the Fed. And that policy will feed through with a lag. The hope is that central banks can be clairvoyant enough to foresee the lagged impact monetary policy will have. But the reality is that central banks make mistakes, and those mistakes are most critical when the economy is late cycle, as it is today.
UPDATE 24 JAN 2018: Dalio has now told Bloomberg that we could be facing the worst bond bear market in 40 years. See his comments here.