New Paradigm:

Ray Dalio describes the current economic environment as a new paradigm shaped by three big forces, which haven’t existed together in anyone’s lifetime. These forces are the long-term debt cycle, wealth and political gaps, and the rise of a great power challenging U.S. dominance.

Long-Term Debt Cycle:

Dalio talks about the long-term debt cycle, stating that it reached a point where interest rates hit zero. Monetary policy, a key driver in this cycle, has evolved through three stages since 1945. The world moved from a gold-backed dollar to a system where central banks could create demand by producing credit. When interest rates hit zero in 2008, monetary policy shifted to printing money and buying financial assets, which in turn increased liquidity and asset prices.

Wealth and Political Gaps:

The second force is related to the long-term debt cycle and refers to growing wealth and political gaps. Dalio points out that the wealth gap is the largest since the 1930s and this contributes to political divisions. These gaps often develop during periods of peace and prosperity, driven by the expansion of credit and technological development.

Rise of a Great Power:

The third force is the rise of a great power that challenges the existing world leadership of the United States. Such cycles have happened historically and include various types of wars, including trade wars. This is another major influence affecting the global situation.

Monetary Policy’s Influence:

Dalio suggests that understanding where we are in the long-term debt cycle is crucial for comprehending the overarching influence of monetary policy. This also has implications for the value of money and market behavior. Before the advent of the coronavirus, these three forces were already significantly shaping the world economy.

Central Banks’ Role:

Ray Dalio mentions that central banks now control the capital market, indicating a shift in economic dynamics, further emphasizing the importance of monetary policy in the current paradigm.

Shift in Monetary Policy:

Ray Dalio identifies a transformation in the financial world, emphasizing that central banks are now the principal drivers of economic cycles rather than being mere facilitators. He observes that central banks are purchasing a significant number of financial assets and government securities, which directly influences market behavior.

From Credit Expansion to Centralized Control:

Dalio explains that in a typical financial cycle, central banks would supply money, which banks would then lend. This money would flow through the credit system, enabling financial assets to compete with each other. However, Dalio argues that this classic model has changed. Central banks and central governments have now become coordinators that manage the entire economic system, making them the de facto market makers.

Systemically Important Economy:

According to Dalio, the scope of what is considered “systemically important” has expanded from merely the banking sector to the entire economy. Central banks are now willing to lend to a broader range of entities, including “fallen angels” (companies that have recently been downgraded from investment grade), to prevent economic collapse.

Value of Money:

Dalio delves into the topic of the value of money in this new paradigm, citing examples like the European Central Bank lending at negative interest rates. He suggests that the central banks are operating with a political agenda rather than a purely economic one, which influences when loans need to be repaid based on broader economic conditions.

Central Banks’ Willingness to Act:

In response to a question about how far central banks are willing to go to support the economy, Dalio states that central banks will do whatever is necessary to “keep the system afloat.” He believes that due to the substantial amount of existing debt, central banks’ balance sheets will “explode” to prevent economic collapse.

Historical Context:

Dalio brings in historical perspectives, mentioning that he has studied the rise and decline of reserve currencies like the Dutch guilder and the British pound. He claims that when faced with political disruptions, central banks will supply “enough money,” but the critical question will be the value of that money.

Central Banks Driving Capital Markets:

Ray Dalio emphasizes that traditional market forces are no longer the key drivers of the economy; instead, central banks and their coordination with central governments play a pivotal role. Central banks like the Federal Reserve have the power to set interest rates and purchase financial assets, thereby affecting market behavior and even the value of money itself.

Shift from Banking System to Whole Economy:

Previously, central banks focused on stabilizing systemically important banks, especially during crises like the 2008 financial crisis. Now, Dalio argues, the entire economy has become systemically important. Central banks must provide liquidity to various sectors to prevent economic collapse, thus broadening their role as market makers.

Asset Valuation in a Central Bank-Dominated World:

Traditional asset valuations like P/E ratios are no longer applicable in this central-bank-driven environment. Asset prices are influenced more by the risk-free return set by central banks and the risk premium, rather than supply and demand in the real economy. With central banks able to inject liquidity, the risk premium and, consequently, P/E ratios can fluctuate significantly.

Limits on Central Bank Interventions:

When asked how far central banks are willing to go in influencing the market, Dalio states they will go as far as necessary to keep the system afloat, especially in an era characterized by high levels of debt.

Implications for Wealth Storage:

Dalio also tackles the issue of where to store wealth in this new economic landscape. With low or negative interest rates making cash and bonds unattractive, investors may seek storeholds of wealth like equities and gold. These become more attractive as central banks continue to put liquidity into the system.

Role of Money and Alternative Assets:

Finally, Dalio notes that the value of money is changing, leading people to consider alternative storeholds of wealth. He suggests that equities, gold, and other assets can serve as counterbalances to the diminishing value of money, particularly when central banks are actively pumping liquidity into the financial system.

Historical Liquidity Interventions:

Ray Dalio points out that the decision to introduce liquidity into markets isn’t a new concept but has been a recurring strategy throughout history. He cites specific instances such as March 1933, August 15th, 1971, and November 2008, where liquidity was pumped into markets to stabilize them. These measures have often served as inflection points, marking the bottom of market downturns.

Different Types of Inflation:

Dalio differentiates between inflation in goods and services and inflation in financial assets. While inflation in goods and services may be what most people think of, he focuses on the inflation that occurs in financial assets when liquidity is introduced into the system. This type of inflation drives down risk premiums and fuels competition among investors seeking returns.

Impact on Asset Classes:

In this kind of environment, where liquidity is abundant, Dalio suggests that what investors should hold are “reflation assets,” not necessarily “inflation assets.” These are assets that benefit from the increased supply of money and credit, which are meant to reflate or boost the value of financial markets.

Repeating Patterns in Asset Valuation:

Dalio argues that the current economic scenario is not unique but fits into a historical pattern. In each case, the introduction of liquidity had a profound impact on asset valuations, driving up prices and changing the dynamics of risk and return. He notes that these patterns have implications for what kinds of assets should be held during such times.

Central Role of Liquidity:

The crux of Dalio’s argument is that liquidity, or the availability of money and credit, is a central issue that governments and central banks repeatedly address in times of crisis. By pumping money into the system, they change the rules of the game for investors, altering the valuation of assets and the strategies for wealth preservation.

By understanding these historical patterns and the types of assets that benefit from them, Dalio implies that investors can better navigate the financial landscape during times of economic uncertainty.

Limits Defined by Demand:

Ray Dalio discusses that the limits on central banks’ ability to print money are primarily determined by the demand for that money and the associated debt. When returns on bonds become undesirable due to excessive money printing, the central bank can step in to buy those bonds. The demand for these bonds, therefore, plays a crucial role in defining the limits.

Historical Analogs:

Dalio finds the period from 1930 to 1945 to be most analogous to current conditions. Then, zero interest rates led to money printing and large fiscal deficits, culminating in the war years, which tested the limits of central banks’ ability to manage enormous amounts of money and credit.

Risk of Alternative Markets:

Dalio asserts that the dollar could be at risk if other markets or assets become more appealing. He mentions gold, stocks, or even another reserve currency like the Chinese Yuan as potential alternatives. In such a scenario, it would become challenging for the central bank to manage interest rates without buying even more bonds.

Implications for the Dollar as a Reserve Currency:

Dalio warns that if the dollar loses its status as the world’s reserve currency, the impact would be massively disruptive, both to global markets and geopolitics. The U.S. has the ‘privilege’ of its currency being the world’s reserve, but it is pushing the limits of that privilege.

Fiat Monetary System and Dollar Dependence:

Dalio highlights the switch from gold-backed currencies to a fiat system, emphasizing the critical role the dollar plays in global economics. He cites the U.S.’ competitiveness and a considerable amount of dollar-denominated debt as props for the dollar’s current strength.

China’s Role:

Dalio mentions China’s significant holdings of U.S. Treasuries and questions the prudence of such a strategy, especially given the current geopolitical tensions and poor returns on these assets.

Multi-Faceted Risk Landscape:

Dalio suggests considering monetary and debt cycles, the wealth and values gap, and China’s role to fully comprehend the risk landscape. He hints that a shift in any of these could significantly impact the dollar and the global financial system.

Dalio’s discourse essentially warns that while money printing by central banks can be a useful tool, it has its limits and long-term risks, particularly for the dollar’s status as the global reserve currency.

Systems Over Enemies:

Ray Dalio articulates that the perception of China as an enemy is overly simplistic. He suggests that instead of labeling nations as good or bad, it’s more constructive to understand that different countries have different systems and they coexist in the same world.

The Chessboard Analogy:

Dalio likens international relations to a chessboard, where both China and the United States aim to play their hands as best as they can according to their respective strategies. The concept of an “enemy” can be emotionally neutral, simply referring to the party on the opposite side of the chessboard.

Historical Context & Thucydides Trap:

He mentions the “Thucydides Trap,” described by Graham Allison, which highlights how rising powers have historically come into conflict with existing powers. Dalio emphasizes that while history has instances of such powers going to war, the competitions can also be viewed as brutal but not necessarily martial.

Quality of Play & Internal Challenges:

Dalio shifts the focus toward how effectively each country is playing its hand in this geopolitical game. He points out that the quality of education and unity around a common purpose are fundamental to any nation’s global strategy. He expresses concern about the fragmented worldviews within the United States and questions its ability to effectively compete.

Respect for the Competitor:

Dalio finishes by acknowledging the impressive aspects of China’s system and its people. He appreciates their intelligence and historical perspectives but reiterates that they remain competitors in the geopolitical landscape.

Closing Remarks:

The conversation concludes with thanks to Ray Dalio for sharing his time and perspectives during Bloomberg’s Global Asset Owners Forum.