Liquidity, Leverage and Their Looming Risks

Ray Dalio, Chief Investment Officer, Bridgewater Associates

By SANDRA WARD

But this cycle is lasting a lot longer than usual.

RAY DALIO HAS BEEN AT THE FOREFRONT OF CHANGE in the hedge-fund and investing world since he started Bridgewater Associates of Westport, Conn., more than 30 years ago. A culture that rewards innovative and pioneering work has resulted in powerful long-term performance. The dedication to excellence fostered by Dalio has made Bridgewater a global powerhouse, with $160 billion under management and clients that range from central banks and foreign governments to pension funds and endowments.

Barron's: The market has been at odds with some of your longer-term themes.

Dalio: Our bets on currencies and bonds have for the most part been flat. The yen has been weak and we expect it to be stronger.

How would you describe your overall outlook?

Bond yields are going to go up by 75-100 basis points [0.75 to one percentage point], and credit spreads will widen. There are three really big forces driving the markets and driving the global economy, and if you could imagine those forces moving through time and interacting with themselves and each other, you will understand my view of the world. There is an economic market cycle, there is the China and oil factor, and there is leverage. We are in the early stages of the late part of the economic cycle. The late part of the cycle is when inflation begins trending up, and the tradeoff between inflation and growth becomes more acute, and central banks tighten monetary policy.

Ray Dalio

One thing that is different is China and India have essentially doubled the world's labor supply, and that has had the effect of producing a lot of disinflationary or deflationary pressure that has necessitated the creation of much more liquidity to prevent labor deflation. That's allowed the business cycle to go on longer. Business cycles end when inflation emerges and central banks have to tighten monetary policy. The economy is made of three main things: labor, raw materials or commodities, and capital. When you lower the price of one -- say, labor -- it exerts an upward pressure on the other two. We've not had a high level of general inflation because of all the production that is taking place. But the China factor and the large wave of liquidity have resulted in 100% of the countries in the world showing economic growth.

What about the debt factor?

The fixed exchange rate with China has created a system in which to keep the exchange rate in balance, the Chinese have to buy dollar-denominated assets, principally bonds. We've seen their reserves go up as we have been lent a lot of the money. That leads to debt and leverage. There has been a great leveraging up in the classic form of debt. Look at the mortgage market. But there's been a lot of leverage in financial assets as well because of all the liquidity in the hands of institutional investors all around the world. So the booms we are seeing in asset values, the art market and high-priced real estate are occurring as a result of a lot of money coming from foreign investors and passing through the hands of investment managers who are bidding up risky investments and using their fees to buy up luxury goods.

Everybody's problem is to try to get money invested, and that has resulted in a big shrinking of risk premiums. Anything that has an interest rate higher than another interest rate is probably going to be bought. Most people are not worried about price volatility, so, therefore, yield is the more important factor. Whatever has the highest yield gets bought against short positions of that which has the lowest yield. Also, when volatility goes down, investors believe they can have larger positions with the same amount of risk, and so that has resulted in much more leveraging up.

Financial leveraging has been going on at a rate and an intensity that is unprecedented. Look at the pricing of private-equity-fund investments. Now private companies are actually selling at higher multiples than public companies because of the demand for capital. Even more ominously, some of these firms are going public, and there'll be even more pressure to maximize assets under management to enhance how they look when they are going public.

We've had a few instances in the past two years when the market went through wrenching corrections only to rally to new highs. Are we ignoring warning signals at our own peril?

I don't think of them as warning signals. They were hiccups. When you have liquidity flowing like this, when you have no tightening, you aren't going to have major problems. The first correction you refer to was in May and June of '06 as a result of concerns that there might be more tightening by the Fed. This past February there was a little hiccup related to the subprime-lending problems. But when you consider the Chinese are setting up an investment company for the purpose of investing some of their surplus in a broad array of assets, and you consider the necessity to recycle other countries' surpluses, there is going to be lots more liquidity coming. There is no reason to expect a very fast tightening by central banks because there are not yet severe inflation pressures to produce a very fast tightening. However, this is all creating more embedded risks, which down the line means we'll have a lot of volatility.

Do you see any risk of a U.S. recession?

No, not now. There is plenty of money washing around. There has been an adjustment in housing, but does that mean that your income level is going to drop much because of it? As I have said, 100% of the countries in the world are growing. Americans are focused on the housing market, but while that's meaningful, there has not been a collapse of incomes and a collapse of household cash flows. Everybody is flush with liquidity, and it would be shocking to me if this little subprime problem essentially spread and sank the economy. Recession isn't a risk until we get later in the cycle and we start to see an emergence of concerns and a desire to tighten monetary policy, which will happen simultaneously probably around the time of the presidential elections, I suspect. My guess is also that the second most popular political topic after Iraq will be jobs in China and protectionism. And emerging-market countries will find the risks greater.

What are you betting on in this environment?

We have anti-carry trades. We generally have bets on wider credit spreads. We have bets on interest rates rising, not declining. We are long commodities and we are long emerging-market currencies. And we expect to increase these positions with time.

Is there a risk we repeat the emerging-market crisis of 10 years ago?

Liquidity will tighten, credit spreads will widen, risk premiums will increase. In that regard, it will be the same. But unlike a decade ago, when emerging-market currencies fell and the U.S. dollar rose, it will be accompanied by the U.S. dollar going down and those currencies rising. The positions of the emerging markets have shifted as dramatically as I have ever seen. There is usually a boom leading to increases in their current-account deficits because they become a very popular place for foreigners to invest and their currencies and their assets and their economies strengthen at the same time they have a deterioration in their balance of payments. Now they are having a boom, but they are running current-account surpluses and paying down their debts. The emerging countries today are the lenders to the rest of the world, particularly the U.S.

Our situation today is a modern-day version of the time before the Bretton Woods breakup. It is very much analogous to 1968, '69, and '70, a period in which we had large imbalances, a fixed exchange rate, and Japan and Germany bought our bonds, and then there was a rebalancing. China today is similar to Japan then, in transition from being an emerging economy, except it is about eight times as large. The imbalances are only going to increase, and there'll need to be an adjustment for that. This will lead to depreciation in the value of the dollar relative to emerging countries' currencies, particularly those in Asia. It is going to mean the Fed's tradeoff between inflation and growth is going to be more acute in the next couple of years. Given the leveraged condition of the economy and the vulnerabilities I've described because of all the private equity and other types of investments that are a skewed bet essentially on credit spreads narrowing, that creates financial risk in the system. It isn't going to happen at a very fast pace because there is so much capital coming from China and oil-rich countries, but three to four years from now this is going to be a very risky situation.

You've been making this case for some time, and it has resulted in more modest returns in your portfolios. How do you have confidence in these positions?

We haven't had negative performance or positive performance for about the last 18 months or so. We've had essentially flat performance relative to the benchmark. We haven't made money and we haven't lost money. There are always times when you are saying the world around you is doing things you think you don't want to participate in and, in fact, you want to bet against. In fact, 1998 and '99 were very much like that for us, and we made a lot of money when the stock market broke in the 2000-2002 time period. The biggest mistake in investing is almost implicit in your question. The biggest mistake in investing is believing the last three years is representative of what the next three years is going to be like. The most common mistake in the investment profession is to say, oh, it hasn't been good for me for the last 18 months and therefore I need to change what I'm doing. The real question is whether your judgment is sound or poor.

A theme of yours for the past few years is that the investment industry is undergoing epic change.

The investment business can no longer be distinguished from other kinds of businesses. And other businesses can no longer be distinguished from the investment-management business. We are in a just-make-money game in which those who can construct the best portfolios win the game. Those portfolios can include businesses and securities and lots of other things like securitized assets, derivatives and so on. We are in a period in which a sophisticated understanding of financial engineering is required.

Cerberus buying Chrysler.

That's a good example. The game is how to create an efficient investment portfolio. The use of derivatives and financial engineering allows one to break up investments into different components and different building blocks and reconstruct those efficiently. It is a technological change which in the investment business is as profound as changes in the telecommunication industry.

Who's really gaining here? It seems to me as hedge funds proliferate we are seeing more mediocre results.

Hedge funds and private-equity firms today are like the dot-coms in 2000: Ask for money and you'll get it. They bid up the prices of everything. The amount of money flowing is almost out of control, and it's making everything overvalued. A client of mine said it's like there are 11,000 planes in the sky and only 100 good pilots -- an accident is bound to happen. Just like the dot-com bust, the winners and losers will be sorted out but the technological advances won't stop. There is a greater differentiation of managers now than ever before. For example, practically all good managers are closed to new investment. And there is fee differentiation. The business has become much more technologically intensive and people intensive. It is much tougher for new boutiques to compete.

What's the likely impact of these changes on the market?

Hedge funds and private-equity investors will be affected by liquidity and they will affect liquidity. Most of these investors are holding similar positions. They are all buying the high-yielding thing and selling the low-yielding thing. When liquidity starts to dry up, there will be a compounded unraveling of debt much the way there was in 1998. Because we are in a global bubble, my bias and my positions are to hold the lower yielding securities and the lower credit spreads.

Thanks, Ray.