April 20, 2023
Bridgewater is one of the world’s most successful hedge fund managers. Founded by Ray Dalio but now firmly under the purview of co-CIOs Bob Prince, Greg Jensen, and Karen Karniol-Tambour, their thoughtful research notes are always worth reading.
Last year’s historically large and rapid tightening is starting to constrict the financial system and slow the economy. This is necessary and will need to be sustained to restore equilibrium conditions.
Our Co-CIOs describe how the US and other Western economies are in a bearish disequilibrium driven by the high level of nominal spending, which, when compared to the ability of the economy to produce more, leads to inflation rates that are significantly above target. Central banks have been tightening to correct these imbalances and slow demand—and this tightening is starting to bite. But there is more work to do, and restoring equilibrium will be painful for the economy and markets.
The operative words are “starting to bite” and “will be painful.”
Overspending by the US government and the Fed’s excessively long Quantitative Easing policy led to the imbalances, which Bridgewater indicates will take many years to correct.
They explain why capital markets and the US economy will not be the goldilocks we hear daily from Financial TV personalities.
In brief, we believe that there are three major equilibriums and two major policy levers that interact to drive markets and economies. As outlined in previous research, we see the three equilibriums as:
Spending and output in line with capacity, which roughly translates into something like 2% real growth with 2% inflation, 4-5% nominal spending growth consistent with that, and an unemployment rate that’s around average.
Debt growth in line with income growth, meaning credit growth that’s not too high and not too low, with interest rates that act as neither a major incentive nor disincentive to borrow.
A normal level of risk premiums in assets relative to cash, meaning bonds provide an expected return above cash, and equities an expected return above bonds, commensurate with the risks of those assets.
If these conditions don’t exist, intolerable circumstances will ensue that will drive changes toward these equilibriums being reached. For example, if an economy’s usage of capacity (e.g., labor and capital) remains low for an extended period of time, that will lead to social and political problems as well as business losses, which will produce further changes until these equilibriums are reached.
The two levers are monetary policy and fiscal policy. Monetary policy is managed by central banks to drive money and credit changes that finance the purchases of goods, services, and financial assets. Fiscal policy is managed by the legislative and executive branches of governments to use taxes, government spending, and laws and regulations to influence economic behavior. Structural reforms are changes in laws and regulations, so they occur via fiscal policies.
As Bridgewater notes, equilibrium is a long way off.
Do I think the American people, Congress, and Federal Reserve Bank will work earnestly to correct these imbalances? The answer will be an obvious ‘No!’ every time we watch the current histrionics over a needed debt ceiling bill.