There is perhaps not hotter topic these days than the epic stock-bond “disconnect” or, if you’re the type who’s inclined to put a negative spin on everything, you might call it “the jaws of doom”. Indeed, this is in many respects the defining feature of markets in 2019 for the extent to which it neatly encapsulates the current zeitgeist.
We’ve addressed this on any number of occasions this year and when it comes to the “jaws” characterization, guilty as charged – we’ve used that rather hyperbolic headline at least twice.
But, as any analyst will tell you, the apparent “anomaly” shown in the chart below isn’t really perplexing. The explanation is that stocks are hoping the Fed has enough ammo and credibility to head off a recession and bonds are reacting both to the promise of a return to accommodative policy and the economic weakness which necessitated the dovish pivot in the first place.
The “jaws of doom” story makes for great headlines and endless click fodder for financial media outlets. The narrative is always the same. Either stocks need to plunge, thus “catching down” to what equity investors will view, in hindsight, as the economic reality reflected in bond yields. Or else bond yields need to rise, closing the gap with stocks, a scenario which, all else equal, would likely entail a brightening economic outlook, a more upbeat take on inflation and less dovish central banks.
Either way, somebody has to be “wrong”. Or so the story goes.
Notably, Thursday brought a hotter-than-expected read on consumer prices stateside and a horrific 30-year auction, which pushed yields sharply higher, suggesting the jaws may be set to close from the bottom up. If that’s the case, we should all hope yields don’t accelerate too quickly, lest rapid rate rise should unnerve equities perched at record highs.
In any case, the latest edition of Goldman’s “Top Of Mind” series finds the bank “dissecting the market disconnect”, and along for the ride is none other than Ray Dalio.
As a reminder, the bank’s “Top Of Mind” notes are expansive takes on whatever the market topic du jour happens to be. They combine interviews with Goldman’s own employees and also with outside sources in an effort to provide a balanced and comprehensive assessment on whatever seems to be the most important question on market participants’ minds (hence “Top of Mind”). Goldman’s Allison Nathan conducts the interviews and collates the charts and analysis.
Below, find selected excerpts from the bank’s interview with Dalio, who weighed in on the “disconnect”, before elaborating on all manner of topics including the timeline on a recession, the four factors influencing his relatively downbeat take on global growth and, of course, parallels to the 1930s.
Allison Nathan: Equities and Treasuries have both rallied sharply. Is there a disconnect between the pricing of stocks and bonds today?
Ray Dalio: I don’t see an inconsistency in the recent performance of stocks and bonds because stock values are fundamentally determined by the present value of expected cash flows. So, when the Fed shifted to a much easier stance, it made sense that both interest rates fell—which was good for bonds—and stock prices rose. But the power to do this is limited. Think of central banks cutting interest rates and purchasing financial assets— Quantitative Easing (QE)—as shooting doses of stimulants into their economies and markets. The financial world is now awash with liquidity chasing investments because of all the rate cuts and especially the QE that put $15trn into the hands of investors since the Global Financial Crisis. The Fed and other central banks easing today will push more money and credit into financial assets, which will cause prices to rise but future expected returns to decline. In other words, it’s short-term bullish and long-term bearish because future expected returns will fall and central banks are running out of stimulants; interest rates are already very close to zero, and the Fed pushing more money into the system by printing it and buying financial assets will soon push the expected returns for equities and other assets as low as they can go. When we get to the point that stimulating via rate cuts and QE isn’t sufficient to offset market and economic weakness, market action will change.
Allison Nathan: How close do you think we are to that?
Ray Dalio: Pretty close. There is now only a limited amount of stimulant left in the bottle, and the sooner we use it, the sooner it will run out. I’d say that there is about a one-to-three year supply left, depending mostly on domestic and international political outcomes and the policies that result from them. The Fed only has room to cut about 2%, which isn’t much because past recessions needed about 5% of cuts. These cuts, together with QE, might be enough to prevent a recession for a few more years. But interest rates in Europe and Japan have no significant room to decline at the same time that printing money and buying financial assets will have very limited effects. So we’ll see “pushing on a string” in that part of the world. All told, I think monetary policies will be dangerously low on power in a couple of years when the next downturn is more likely to come.
Allison Nathan: What’s driving your pessimistic outlook on global growth?
Ray Dalio: I’m focused on four factors. First, we’re well along in what I call the short-term debt cycle, which is also called the business cycle. We don’t see the same rates of debt growth and spending growth as we’ve seen in the past because balance sheets won’t sustain that, so we will see a slowing. At the same time, pension and healthcare liabilities will increasingly be coming due, which will intensify the squeeze in the same sort of way that debts coming due does. Second, we’re also late in the long-term debt cycle, which is what we discussed before about central banks running out of stimulants left in the bottle. The third factor is political polarity in an election year, which will largely be a clash between socialism and capitalism. This clash is classically due to today’s substantial wealth, income, and opportunity gaps, which most likely will either lead to big changes in policies that aren’t good for the capital markets and the capitalists—such as a rolling back of the corporate tax rate cut and raising other taxes—or it won’t lead to such changes, in which case the clash between the rich capitalists and the poor socialists in the next downturn will be ugly. The fourth factor is increasing geopolitical risk, especially as China continues to emerge and challenge US leadership in many areas.
This period is most analogous to the late 1930s, when we were also at the end of short- and long-term debt cycles, so monetary policy was limited, the wealth gap was similarly wide, populism was on the rise, and the existing world powers of the UK and the US were being challenged by the emerging powers of Germany and Japan. Each of those factors—the downward pressures coming from the maturing IOUs, central banks not having much power to stimulate, the large wealth and political gaps within countries, and the challenging of leading world powers by strong emerging world powers—leads to difficult consequences.
Allison Nathan: Do you think these risks will culminate in a US or possibly global recession in the next few years? And how severe of a downturn is it shaping up to be?
Ray Dalio: I think there will be slow growth rather than a meaningful recession in the near term. When exactly the next recession will occur is difficult to say; I can’t tell you whether it’ll be in the next one, two, or three years. I can say that by most measures this cyclical expansion is old and we are currently seeing global weakening. But when the downturn comes, there is little doubt that it will exacerbate these internal and external conflicts; if they seem difficult now when times are good, imagine what they’ll seem like when times are bad. That said, I don’t think the next downturn will be as severe as the 2008 financial crisis. We anticipated that crisis by calculating the debts coming due, and determining that we were headed for a classic debt crisis. Next time around, I think the downturn will be like a big squeeze in a politically challenging environment, much more akin to what we saw in the late 1930s.
Allison Nathan: So is now the time to start reducing risk? How should investors be positioning today?
Ray Dalio: The question really is how does one reduce risk? People seem to think that going to cash reduces risk. But that’s only the case from a standard deviation perspective. When interest rates are negligible—below the inflation rate/nominal GDP growth—and you pay taxes on that, you’re not getting any return. Cash over the long run is the worst performing asset class and therefore the riskiest asset class. So where do you go? To me, going to any one asset increases risk. So the best way to deal with the challenging environment I foresee is by diversifying well. I think investors today are mostly leveraged long, meaning they own risky assets and have substantially leveraged those assets through company buybacks, private equity, and so on. In order to diversify against this—i.e. reduce exposure to leveraged long portfolios—investors should look to other stores of wealth and areas that have intrinsic diversification. For example, I think gold and Chinese assets are two assets that are now underweighted in portfolios relative to what’s desirable from a portfolio construction perspective and therefore could be useful diversifiers