Debt-to-GDP levels around the world have risen for two generations. In a December 2018 report, Ray Dalio comments: “It seems to me that we are in the last stages of both the short and long-term debt cycles.” What are the investment implications?
According to Dalio, credit cycles are “nothing more than a series of logically driven events that repeat themselves in patterns.” Large debt crises occur when the scale of debt reaches a level where interest rate cuts alone are insufficient to prevent a depression.
Principles for dealing with major debt crises provides a framework for understanding the mechanics of these crises. Dalio establishes six stages, from the germ of the crisis to its resolution. It analyzes 48 historical episodes of debt crisis when GDP growth fell 3% or more. These episodes span both developed and emerging economies. Dalio classifies major debt crises into two types, deflationary and inflationary, and provides economic and market data for both.
Deflationary debt cycles often occur when most of the debt is denominated in a country’s own currency. Dalio believes that policy makers may manage these crises well, but even a good outcome will be extremely costly for some people.
Inflationary debt cycles occur when most of the debt is denominated in foreign currency. This situation makes it difficult for a country’s policy makers to “spread the word about harmful consequences,” a key part of solving the crisis. They must decide who will benefit and who will suffer, to what degree and for how long, “so that the political and other consequences are acceptable.” This process often implies the need to recapitalize systemically important institutions.
In an inflationary cycle, “at the top, people are so caught up in the optimistic scenario, and because optimism is reflected in prices, even a minor event can trigger a slowdown in foreign capital inflows and an increase of national capital outflows “. Generally, they follow the main depreciations of the currency. Once politicians abandon the fight against devaluation, losses from holding the currency average 30% in the first year.
Policymakers have four levers to reduce debt and debt service costs:
- Defaults and debt restructurings
- Printing of money by the central bank
- Transfer of money from those with more to those with less
Each policy has a different effect on the economy and therefore on the markets. Austerity and defaults are deflationary. Money printing is inflationary and stimulates growth. Money transfers, by definition, produce winners and losers. Austerity, defaults and the transfer of wealth are a political challenge. Therefore, it is inevitable that countries choose to print.
A successful resolution occurs when policy makers use the right combination of these four factors. The best result is a “beautiful deleveraging”: “In this happy scenario, debt-to-income ratios decline as economic activity and financial asset prices improve.”
Government actions to reduce the fundamental imbalance are welcomed by the markets. During the Great Depression, there were six major rallies in the stock market, each triggered by a political response.
Effective approaches require coordination of fiscal and monetary policy, which can ensure that money provided through printing is actually spent. On the contrary, a lack of coordination can leave policy makers “pushing a rope”, as expansionary policies fail to generate economic activity. The risk for investors in this scenario is that excessive money printing can lead to severe currency devaluations.
The worst case scenario occurs when the authorities lose control of an inflationary cycle, triggering a hyperinflationary episode. Dalio uses his framework to provide a detailed explanation of the German debt crisis of 1918-1924.
All the crises that Dalio explores share common characteristics. “They eventually led to a huge wave of money creation, fiscal deficits, and currency devaluations (versus gold, commodities, and stocks).” Stock market declines averaged about 50% over the 48 episodes. The depreciation of the currency exacerbated losses for foreign investors, especially in debt inflation cycles.
The book is organized in three parts (each of which is available as a free download). The key lessons are in Part One, which consists of 64 pages on “the archetypal cycle of great debt.”
The second part provides a detailed analysis of three major crises to illustrate Dalio’s framework: Germany’s hyperinflation, the Great Depression, and the recent global financial crisis. The third part provides a brief description of the 48 episodes. This is where investors will find, for each episode, charts on stock prices, long-term nominal interest rates, the yield curve, movements in the real exchange rate versus trade-weighted indices, and price. of gold.
Large debt crises can be career-defining events for investment managers. Prominent examples include John Paulson’s success in the 2008 global financial crisis and the 1998 failure of the hedge fund Long-Term Capital Management, which was triggered by a debt crisis in Russia. Dalio provides investors facing a major debt crisis with a framework to understand the possible economic scenarios ahead, supported by empirical evidence. In addition, it tells investors what information they need to obtain to determine the investment implications.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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