Ray Dalio: How the Economy Works

So, as Sasha mentioned, it's been 25 years that we've been friends and professional colleagues, and so when I look in the room and I see these old friends, I'm so happy to be here. He also mentioned that I'm very systematic, meaning I got in a habit of every time I would make a decision to write down the criteria I would use to make that decision. We're getting a little echo, I think. And it's not a big room, so I don't even know if I need a mic, but so every time I would make a decision, I would write down the criteria I used for making those decisions, because cause effect, everything happens because of a cause. And the same things happen over and over again. And so by taking the time to write them down and then seeing how those criteria would have worked over a period of time, I could get perspective. And so I wrote down those principles. And as Sasha mentioned, I wrote a book called Principles, which just was a collection of the life and work principles. So the culture that we have is very, very important. It was really the most important thing in terms of whatever success we've had. At the same time, I wrote down the economic and investment principles. So what I thought I would do today is to share with you what I think are my most important economic and investment principles, and then look at the world through the perspective of those principles. In other words, rather than just tell you what I think, I want to tell you how it works. And then we can apply that mechanics. You can decide, does it work that way or not? So are these principles valuable? Because if you know the principles, it's like giving a man the ability to fish rather than to just give the fish. I can tell you what I think, but if these principles are right, then you could apply them yourself to whatever time or circumstances exist. So I broke it down in terms of economic principles and investment principles, because the markets follow the economy. So in order to understand economics and all the markets, you have to understand, in order to understand the market, you have to understand the economy. So I want to describe how I think the economy works. I think it's like a perpetual motion machine. And there are four big forces, three important equilibriums and two levers. If you get this down, I think this basically, everything through my eyes is along those lines. Over a period of time, we raise our living standards because we learn how to do things better. We become more efficient. That's called productivity. Output per man hour. And that is something that evolves over a period of time. That is, because it evolves, it is not something that is a big thing, that we see as a big thing. But it's the most important thing over a period of time. The big things that we see and feel every day are debt cycles. There's a short-term debt cycle and there's a long-term debt cycle. When I say a short-term debt cycle, what I mean is what we think of as normally the business cycle, right? You have a recession, you have a weakness in the economy. When the rate of economic activity is too low, then central banks produce credit. And credit is buying power. So you produce that credit, it makes purchases of goods, services, and financial assets happen. And so the economy picks up. That cycle usually lasts seven to 10 years. As the economy picks up, the demand rises relative to the capacity. As you get later in the cycle, the central bank puts the brakes on it, they raise interest rates, tighten monetary policy. As there's less slack in the economy, the unemployment rate is low, they put the brakes on it, interest rates go up, tightness of monetary policy, then you have a recession, slow up, and that's the cycle, right? And because credit is buying power by providing it, it also produces debt. And debt means the obligation to pay back. And so by its very nature, it's cyclical. First comes the stimulation, then comes the paying back, which means when you produce credit, you can spend more than you earn. And when you pay back, you have to spend less than you earn, and that's the nature of the cycle. And I think we're all acquainted with that type of cycle. And with that cycle goes market cycles, which we'll talk about. That's what I mean by the short-term debt cycle. There's also a long-term debt cycle, which is the accumulation of all of those shorter-term debt cycles. Because everybody wants things to go up. They want their asset prices, the markets to go up. They want employment to go up. They want everything to go up. And for that reason, central banks, over a period of time, stimulate, and they do that by, normally, lowering interest rates until interest rates hit zero. And then, when interest rates hit zero, they can't do that anymore. And then, we come to the need to print money and buy financial assets, which we call quantitative easing. And when they can't do that anymore, or there are limitations, we come to the end of the long-term debt cycle. So there's a short-term debt cycle, a long-term debt cycle, and productivity. Now, related to all that is politics, internal politics and external politics. In that normal cycle, they're related. As we're gonna see, in terms of that dynamic, period that we're going through, 2008 and nine, there was a debt cycle, and interest rates hit zero. And that's very similar to 1929 to 32, there was a debt crisis, and interest rates hit zero. And in both of those cases, there was the printing of money and the buying of financial assets, which caused those financial asset prices to go up and more liquidity in the economy. And that particularly benefited those who had financial assets. And it contributed to the wealth gap and the income gap, as did technology. And as a result of that, in the 1930s, as also happened now, politics entered into the picture. So as we're seeing in the world right now, that issue of wealth gap is causing populism, populism of the left and populism of the right, and that's having an effect on the markets and having an effect on the economy. So we're also seeing a situation very much like the 30s, in which we're seeing a rising power challenging an existing power. That's a geopolitical cycle. When a rising power in the form of China, a challenging and existing power in the form of the United States. And if we look at histories and cycles of those periods, there's a cycle of conflict and peace. Normally, peace happens after a war because some dominant country wins the war, nobody wants to fight the dominant power, and you have an extended period of peace until there's then that particular conflict. I'm not saying we're gonna have a military conflict or anything like that, although that always exists as a possibility. So these cycles, these things have happened over and over again. So politics can affect the cycles. For example, the shift in the United States to be able to create tax cut changes helped the corporate tax picture and caused stock prices to rise. Okay, those are the cycles. Then when I look at what's happening, I compare it to three equilibriums. What are these three equilibriums? First, that debt growth has to be in line with the income growth that's required to service the debt. If debt growth is faster than the income growth that's going to service the debt, we're going to have an adjustment. And so I'm always doing the pro forma, what is the ability to service that debt? So that's what I'm watching. Second equilibrium is that the rate of economic activity, economic capacity utilization, is neither too high nor too low. What that means is if you have it pressing up too much over an overheating economy, that's going to cause a tightening of monetary policy and a correction. And if you have it too low so that the economy is depressed and there's a lot of slack, that's going to cause an adjustment to bring it up. And so I'm always watching where are we relative to that, because that's a key driver of these cycles. And the third is that the projected returns of equities are above the projected returns of bonds, which are above the projected returns of cash by appropriate risk premiums. In other words, the capital markets produce the circulation of buying power in the form of this credit coming around. And this relationship of the cash to bond yields, to stock yields and asset classes, determines how money flows through the economy. And a normal condition is, for reasons I won't digress into, to have cash have a lower return than bonds that have to have a lower return from equities having to do with how the system works, basically central banks put cash on deposit and people with better ideas have to make a profit to that, they use that money to create these other level of economic activity and have to have higher returns. And when that's not the case, the way they tighten it is that there are two levers. So now there are two levers, monetary policy and fiscal policy, right? Monetary policy then is the means by which the brakes and the gas are put on. And the brakes and the gas being put on become reflected in each of these other items. So let's say if debt growth is too high relative to income growth and capacity utilization is high and stretched, monetary policy will be tightened. And that tightening of monetary policy will change the projected return of cash relative to bonds and of equities, those risk premiums. And that will slow the economy down and that will drive those cycles. And that's how the economy is operating in these perpetual motion kind of way. And you could almost picture, literally can picture where you are in those cycles and what is happening and you can anticipate what is going to happen next from that because it's that perpetual motion machine. So that's my template in a nutshell. And if you keep thinking, like where are we now? Then you can kind of think where we are. Okay, so I'm just gonna show you some charts to help to convey the picture. This is real GDP going back to 1900. So this is, that line is productivity, right? And that's a big inevitable force that happens over a period of time. Even the biggest economic turbulence looks like a bump in that cycle, right? Productivity is a big force. Betting on productivity is a big force. But what happens is that cycle, as you get later in the long-term debt cycle, that productivity begins to slow because there needs to be investment and there needs to be other things. And when you activity, when there's prosperity and so on, you get more productivity. It's a self-reinforcing cycle. So these charts are just meant to show productivity and how it's changing over a period of time in the developed countries and then in China. So just to give you a quick picture here, you could see it in varying degrees bend over as they are later into their longer-term debt cycle. This United States over the last 10 years versus since 1980. So in each one of those cases, you can see it declining. Japan, which is large later in that debt cycle and so on, basically hardly any growth in productivity. So, okay, that's what productivity looks like. Now, where are we in the short-term debt cycle or the business cycle? This is what the cycle looks like that I was describing. In other words, what happens from the capital markets perspective as you begin to go to higher levels of operating rates, lower levels of unemployment, central banks begin to tighten, liquidity starts to tighten, then risk premiums start to rise. Okay, in this cycle, we're nine years into the cycle. Unemployment rates are comparatively low and there's less slack. So no surprise, central banks tighten monetary policy. And the way they tighten monetary policy is by either raising interest rates or lowering the purchases of the financial assets that they buy by expanding the balance sheet. So that's where we are in that cycle. Now, if you look at how markets behave in that part of the cycle, this is breaking the cycles into three parts, the early phases of the cycle, the mid phase of the cycle, and the late phase of the cycle. And this is across the world, different countries. This is the United States, this is Europe to show how the historical. So we're in a period of time, this period of time, which is relatively late in the cycle, is also associated with a period of time where there is less attractive returns, greater vulnerability. So that's largely where we are in the cycle. Interest rates have hit their lows, in some cases can't go lower. And then we're dealing with the issue of quantitative easing. So taking this back to, this goes back to 1900, this shows debt to GDP ratio in the United States. And it just shows how the cycle that we're going through now is very similar to the cycle that we went into the 30s. In other words, because of that debt crisis and interest rates hitting zero, you had the printing of money. This shows the central bank's balance sheet, the monetary base, the acceleration of printing of money. Same thing happened in the 2008 financial crisis. You could see that what happens is you have the debt crisis, you have the hitting of zero in interest rates. They're stuck, so they have to print the money. And then we have the reaction, very similar to 1932 to 1937. The economy picks up. 1937, they start to tighten monetary policy because they're worried that the economy's overheating and inflation's going to rise. And they cause a recession. That's the first time they used the word recession. Recession, it was like re-depression. They used the term recession, and that was the 1938 period. Now, I talked about debt, but there are also unfunded liabilities that we don't call debt, which would be pension and healthcare liabilities. And I just wanted to give you a picture of what that's like. That has, there's a lot of liabilities out there, promises that have to be kept. And so the liabilities are very large. I want you to focus then on these, the bottom charts before I put the top charts in, because I want to convey, as it relates to both the markets and the economy, the important, the realizing that we've been, really in a golden age of capitalism in the following sense. This chart shows how profit margins have increased. In other words, they've more than doubled since 2000. That means if you didn't have an expansion in profit margins, you wouldn't have, you'd have the stock market 40% lower. You had an expansion in profit margins. And at the same time, you had a decrease in the form of employee compensation in profit margins, largely because of a number of factors, but technology has been replacing people. And so it's made it more efficient so that that was an element. Also, globalization has helped. Just to show you a couple of charts pertaining to this. This is number, the globalization movement. And this is the capital movement. And these scatter diagrams show, if you go, the globalization companies that have gone global on the margin have improved their profit margins more. And those that are more concentrated have improved their profit margins more. And those who have reduced union membership have produced their profit margins more. And so as a result of that, this has contributed to the growth of the wealth gap and the profit gap. It's been great for companies, but it has not been good for a certain percentage of the population. If you look at the conditions of the bottom 60% of the population, bottom 60 means the majority, the conditions have been bad. There has not been, since 1980, any income growth, real income growth in the United States. In a Fed survey, the 40% of all Americans could not raise $400 in the event of an emergency. So there is a gap. And with that gap has come, this is the wealth gap, the top 110th of 1% of the population's net worth is almost the same as the bottom 90% combined. And as a result, we have populism. Populism of the left and populism of the right. That was a phenomenon that developed countries didn't used to have. And so now it is a not only political phenomenon, it's an economic and market phenomenon. Because as we come to go into the political elections in a number of countries in Europe and in the United States, it will be really a conflict over capitalism versus socialism or the left and the right. And it's going to become rather extreme in both of those cases. And that has an implication. Just as these profit margins improved, and then tax rates. That's the effect of corporate tax rate and how the effect of corporate tax rate is. That's been fantastic. So imagine you have profit margins increasing, you have the tax rate going down, you have cheap money. Cheap money has been used to borrow, to buy back stock, or make mergers. That's also supportive to stock prices and so on. Many of those things will not continue. We think profit margins will go down. I think you're at the best of the corporate tax rates. And in terms of the issue in terms of the wealth gap. So we're entering a newer environment, including an environment which is not going to be as conducive to the purchasing of financial assets by central banks and all of that. We're going from headwinds, from tailwinds to headwinds. And to give you a flavor of what this political situation is like, and the polarity and the entrenchedness, these are two charts. The first, they go back to 1900. The first chart, which is the red chart, shows how conservative the Republicans are. Surveyed, economically conservative. So they're more conservative than they have ever been. The Democrats, it shows how liberal they are in terms of policies. And they're more liberal than they have ever been. So the two have not had greater polarity than we have today in politics. And this shows how much is, the votes cast along party lines. In other words, Republicans sticking with Republicans and Democrats sticking with Democrats. And so it shows the entrenched conflict that we're having. This is in the United States. This is not just a United States phenomenon. It is a European phenomenon as much. We're going to be going into elections in Europe for the European elections, and then we're also going to have changes in politics. And there's going to be more movement to political extremes. For example, in the UK, I think it's likely that Jeremy Corbyn will be in power, which will have an effect on capital flows. So we're entering a period of time in which we're rather late in the cycle. Central banks have less power than they used to, to ease. And we're having this populism in an election cycle. So that's kind of the lay of the land. If you look at Europe, you can judge the capacity of a country to ease by looking at the level of interest rates relative to zero and the amount of quantitative easing that can take place and its marginal effects. So let's say in the United States, you go from 2.5% to zero, and you're done. In Europe, you're at zero. And in Europe, there are limitations, caps at 33% of certain types of debt that they have hit, that they can't go beyond unless there's some sort of an agreement. And politically, it's very difficult to have an agreement. So in Europe, there's going to be a problem for the ECB in terms of being able to have the ability to stimulate. And Japan is in a position somewhat similar with these negative interest rates, slightly negative interest rates, father, and a lesser ability to stimulate. So that's the lay of the land, I think, in terms of markets and economy within the template that I showed you to begin with. Okay, in terms of the rising power, challenging existing power, China will be an important influence in the world that we're operating in for the rest of our lifetimes. It'll become an increasing influence in that globalization and so on. So this just shows where they are, United States and China, in relative output. This is what I believe that what's likely in terms of equity market cap and share of debt security is outstanding. In other words, the Chinese markets are big and becoming bigger and more liquid and more effective. And they're going to play an important role, as will the Chinese economy and the environment we're in, not only in the form of trade, but also in the form of the whole geopolitics, particularly reflected through technology. If you look at history and what caused countries to succeed and fail, it was particularly led by technology. So I've been, over the last several months, wanting to research the rise and declines of world reserve currencies. And in order to do that, I have to watch the arc of each one of these reserve currencies. There's the US dollar. Before that, there was the British pound. Before that, there was the Dutch guilder. And as a result of that, I needed to understand a number of things about the economies that made them reserve currency. How did they become reserve currencies? How did they lose their reserve currency status? And that led me to watch a number of factors and studying those. And I love putting together statistics and numbers to put together indices. So these are the six main factors that you can judge a country's power by. Power is a vague thing. You can have economic power, you can have military power, you can have power in different ways. But this is the, when I went to each one of these four cases, here's the Dutch cycle, here's the British cycle, here's the US cycle, here's the Chinese cycle, reflected in this dynamic. And what you can see, this classic cycle, is first, it's innovation, meaning technology, education, and competitiveness, mostly a new technology. And the new technology, like the 5G technology today, and the issues pertaining to Huawei and other technology companies, if you have technology, it works both economically and militarily. And so there's always a new technology. In the case of the Dutch, it was the ability to build ships that can go anywhere around the world. And they took those ships, and because the Europeans were experts in fighting, because they always fought with each other, they took the guns, they put them on the ships, and they go out to the rest of the world, and they accounted for half of world trade. Can you imagine that? And when they go out there with half of world trade, they're bringing their money, the Dutch guilder, okay? So they bring the money, and when they bring the money, it becomes a world reserve currency. And in order to go out in the world, they have to have a military to support that. And so these cycles go on. And if you look at that, this is, the red line is China, and the blue line is the United States in terms of the averages of these things. And it goes back to 1500. And one of the things you could see there is that the Chinese have typically been number one or number two, although the world was a different size then. Those were all very far away places. We now have one sort of world. So those are the economic principles. So I think we're late in the business cycle, relatively late. I would say the seventh inning of the business cycle. There is a relatively tightening of monetary policy. We have less capacity, and we have greater polarity, and we have a situation in which we're going to have political issues. And those political issues will be market issues. Because as we start to think, will this be a movement to the right or a movement to the left, that will affect capital flows. So these are my list of investment principles, the template that I look. First, the theoretical value equals the present value of future cash flows. In other words, every investment is a lump sum payment for a future cash flow. So when we think, what is something worth, we look at those projected cash flows, and we discount it with an interest rate. That's the theoretical value. The actual value that it will trade at will equal the total amount of spending, if I calculate total amount of dollars spending on something, divided by the quantity of goods sold. So I'm always looking at how much is going to be spent, and what are the motivations of the spenders, and how much is going to be quantity. I try to estimate what the total spending is divided by the quantity to estimate the price. OK, number three is that asset classes will outperform cash over the long term. I explained that. It's required, otherwise the economy comes to a halt. And that the outperformance of asset classes over cash, that beta, cannot be very positive for too long. Because if it was, it would be easy. If it was positive, you just borrow cash, and you buy the long things, and you make a lot of money. It comes with big bumps along the way. And that assets are priced to discount future expectations. Most importantly, inflation, growth, risk premiums, and discount rates. And I'm going to get into that in a minute. And then every investment is a return stream. What I mean is every day you can market to the market, you know what it's like. And so the key is to be able to put together portfolios of return streams so that they balance well, as Hashim was saying. I would say whatever success that I've had in life, or that Bridgewater's had, has to do with knowing how to deal with our not knowing more than anything we know. Because what you don't know is a lot. And you can reduce your risk by a lot more than you could reduce your return by knowing how to diversify well. So diversification can reduce risk more than it reduces return. So it improves the return to risk ratios. And then I'm sorry if I'm getting technical, but there are two types of return streams. There is a beta return stream and an alpha return stream. And what I mean by a beta return stream is that there is an intrinsic reason that that asset class will behave in a certain way that you will know. In other words, if growth rises faster than discounted and interest rates don't rise much, you know that stocks are going to go up. So there is environmental, so you can structure that. Alpha is a zero-sum game. In other words, for me to produce alpha, I have to take money away from somebody else. It's a zero-sum game, like poker at a poker table. So they can be either alphas or betas. And the key to good investing is to create good portfolios of good return streams. And then, in order to balance these, you have to risk balance them. In other words, somebody might think, if I put 50% of my dollars in stocks and 50% of my dollars in bonds, that I have my diversification. But not so, because the volatility of stocks is twice the volatility of bonds. And because of that, you have to risk balance them. And then, the holy grail of investing is to find 15 or more good uncorrelated return streams. I'll get into that in a minute. And then, as Harsha mentioned, systemizing decision rules is critical. And those rules should be timeless and universal. What I mean is, as I said, I write down the criteria. We write down the criteria for investing. And then, we take those criteria, and we test them through all periods of time and all countries, timeless and universal. Because if something happened in one time, and your process is not working in that time, then it must be that you haven't explained the differences. And so by forcing ourselves to try to make those rules timeless and universal, it then becomes the standard that we operate by. So all of the rules that we're operating by are timeless and universal. I'll just pass through some charts. So this, going back to 1975, think of this as the rolling returns of asset classes. What you can see is that all of the asset classes have some times that are good, some times that are bad. On average, they're above zero, but they all have periods of down. And inevitably, what happens is that investors, most investors, love the asset classes that did well. The biggest mistakes of most investors is that they think that the investment that did well is a good investment, rather than it's a more expensive investment. And so here, we have, here's equities recently done well. Here's commodities done very poorly. But here's equities done very poorly in that period of time. So the key, as Hashim was saying, is balance. How to do that. So you can break the drivers of asset class returns into a few categories. This is true for any asset class, and it's true for all asset classes. There are two main things that drive it in terms of, that's inflation and growth. And basically, if you tell me that inflation is going to be higher than expected and growth be higher than expected, I would know what to invest in, higher than discounted. And if you say it's lower, I'll know what to invest in. And most people here would. So those become the two main drivers. They can rise or decline. And then there are discount rates and risk premiums. Discount rates mean, as I told you, the interest rate affects all asset classes. Because the interest rate is the discount rate that you use to compare the cash flow. So you raise the interest rate, and that's negative for all asset classes. And then you have, when you strip all of that, risk premiums out. And that equals the following. This shows what happened in history in relationship to that context. The top chart shows growth assets relative to strong assets that you'd hold if you had a falling growth environment, assets that you'd have a rising growth. Same with inflation. Then it shows what the discount rate is. And then it shows what the risk premium, which was the residual of that. And that's what we have all-weather return. All-weather return, all-weather, is our optimally diversified portfolio. OK. I'm going to skip this chart. What it's meant to show, basically, is that how diversification can substantially improve your risk-to-return ratio. I want to turn to this chart. So this is what I believe the holy grail of investing is. If you can do this, you will make a fortune. You'll be very successful. And it's simple, really. Maybe not simple to pull off, but simple concept. If you can get 10 good, uncorrelated investments, 5 good, uncorrelated investments, 15 good, uncorrelated investments, you can substantially improve the return-to-risk ratio. And this just shows how it works and why diversification is more important than being good, even, in picking the best investments. And most people think, give me the best investment, and let me put all my money in what I think is the best investment. Wrong. Find your best 10 uncorrelated investments, and put your money in that, and you're going to do a lot better. And this just gives you an example. So this is the standard deviation. Let's call it the risk of 10%. And just imagine I put in an asset, I'll use a simple example, that has 10% return and 10% standard deviation. So let's say it's 10% return, 10% standard deviation. And let's say I put in a second investment that is 60% correlated with that. Third, fourth, fifth, and sixth, and so on. This is how my risk in my portfolio would change. That means if you have a diversified portfolio of stocks, average stock is about 60% correlated with average other stocks. And you can put in 100, you can put in 1,000, and you are not going to materially reduce your risk relative to putting in just 5% to 10%. And you could see that that'll lower your risk by 10% or 15%. If you have an uncorrelated return stream, and you can get actually better than uncorrelated, because you could have negatively correlated. But let's say I put in an uncorrelated return stream. This is how the line goes. So you could see, like at 5, you've more than cut your risk in half. Five uncorrelated return streams. If you have down to 15, you're going to reduce your risk by nearly 80%. That means you've improved your return to risk ratio by a factor of 5. So you can reduce your risk a lot without reducing your return. And that is the key to it, right? So when I look at this, I think that there are two types of assets. What's your strategic asset allocation mix? What is your beta? In other words, what portfolio do you normally have? And in my opinion, it should be highly diversified, but with along those lines in terms of half and growth, half inflation, rising or declining. And then alphas. You have to have a lot of different alphas. Like in our case, we have well over 100 different types of alphas, about 130 different kinds of markets, actually, in terms of trading. So that's it. Thank you for your patience. Let's have a conversation about it.