Excellent article in this weekend’s Barrons, an interview with Ray Dalio CIO of Bridgewater Associates. Dalio simply and artfully explains the current deleveraging process and the importance of differentiating it from traditional cycles.
All things considered, we have a long way to fall. We have levered consumption to the hilt, driving a vicious cycle of unsustainable consumption. I have begun to see multiple store vacancies in Manhattan, and I know there are a lot more to come. It is reminiscent of the 1970’s. One of my take-aways from all of this is that as commerce dries up, the social order will be challenged. New York City’s urban revitalization of the last 25 years has been driven in large part by commercial foot traffic.
There are some great comments from the interview in addition to the excellent chart above.
…Basically what happens is that after a period of time, economies go through a long-term debt cycle — a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren’t adequate to service the debt. The incomes aren’t adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too….
…Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold. It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done….
…The biggest issue is that if you look at the borrowers, you don’t want to lend to them. The basic problem is that the borrowers had too much debt when their incomes were higher and their asset values were higher. Now net worths have gone down.
Let me give you an example. Roughly speaking, most of commercial real estate and a good deal of private equity was bought on leverage of 3-to-1. Most of it is down by more than one-third, so therefore they have negative net worth. Most of them couldn’t service their debt when the cash flows were up, and now the cash flows are a lot lower. If you shouldn’t have lent to them before, how can you possibly lend to them now?…
…By the way, in the bear market from 1929 to the bottom, stocks declined 89%, with six rallies of returns of more than 20% — and most of them produced renewed optimism. But what happened was that the economy continued to weaken with the debt problem. The Hoover administration had the equivalent of today’s TARP [Troubled Asset Relief Program] in the Reconstruction Finance Corp. The stimulus program and tax cuts created more spending, and the budget deficit increased.
At the same time, countries around the world encountered a similar kind of thing. England went through then exactly what it is going through now. Just as now, countries couldn’t get dollars because of the slowdown in exports, and there was a dollar shortage, as there is now. Efforts were directed at rekindling lending. But they did not rekindle lending. Eventually there were a lot of bankruptcies, which extinguished debt.
In the U.S., a Democratic administration replaced a Republican one and there was a major devaluation and reflation that marked the bottom of the Depression in March 1933….
…Everything is timing. You print a lot of money, and then you have currency devaluation. The currency devaluation happens before bonds fall. Not much in the way of inflation is produced, because what you are doing actually is negating deflation. So, the first wave of currency depreciation will be very much like England in 1992, with its currency realignment, or the United States during the Great Depression, when they printed money and devalued the dollar a lot. Gold went up a whole lot and the bond market had a hiccup, and then long-term rates continued to decline because people still needed safety and liquidity. While the dollar is bad, it doesn’t mean necessarily that the bond market is bad.
I can easily imagine at some point I’m going to hate bonds and want to be short bonds, but, for now, a portfolio that is a mixture of Treasury bonds and gold is going to be a very good portfolio, because I imagine gold could go up a whole lot and Treasury bonds won’t go down a whole lot, at first.
Ideally, creditor countries that don’t have dollar-debt problems are the place you want to be, like Japan. The Japanese economy will do horribly, too, but they don’t have the problems that we have — and they have surpluses. They can pull in their assets from abroad, which will support their currency, because they will want to become defensive. Other currencies will decline in relationship to the yen and in relationship to gold….
…A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation — and that will last for as far as I can see out, roughly about two years….
…Buying equities and taking on those risks in late 2009, or more likely 2010, will be a great move because equities will be much cheaper than now. It is going to be a buying opportunity of the century….
Recession? No, It’s a D-process, and It Will Be Long
Sandra Ward, Barrons, February 7, 2009