Recession-- No, It's a D-Process, And It Will Be Long

7/31/2019 Recession-- No, It's a D-Process, And It Will Be Long

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MONDAY, FEBRUARY 9, 2009

Recession? No, It's a D-process, and It Will Be

Long Ray Dalio, Chief Investment Officer, Bridgewater AssociatesBy SANDRA WARDAN INTERVIEW WITH RAY DALIO: This pro sees a longand painful depression.

NOBODY WAS BETTER PREPARED FOR THE GLOBAL market crash than clientsof Ray Dalio's Bridgewater Associates and subscribers to its Daily Observations. Dalio, thechief investment officer and all-around guiding light of the global money-managementcompany he founded more than 30 years ago, began sounding alarms in Barron's in thespring of 2007 about the dangers of excessive financial leverage. He counts among hisclients world governments and central banks, as well as pension funds and endowments.

No wonder. The Westport, Conn.-based firm, whose analysesof world markets focus on credit and currencies, has producedlong-term annual returns, net of fees, averaging 15%. In theturmoil of 2008, Bridgewater's Pure Alpha 1 fund gained 8.7%net of fees and Pure Alpha 2 delivered 9.4%.

Here's what's on his mind now.

Barron's : I can't think of anyone who was earlier indescribing the deleveraging and deflationary process that hasbeen happening around the world.

Dalio : Let's call it a "D-process," which is different than arecession, and the only reason that people really don'tunderstand this process is because it happens rarely.Everybody should, at this point, try to understand thedepression process by reading about the Great Depression orthe Latin American debt crisis or the Japanese experience sothat it becomes part of their frame of reference. Most people

didn't live through any of those experiences, and what they have gotten used to is therecession dynamic, and so they are quick to presume the recession dynamic. It is very clearto me that we are in a D-process.

Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?

Both of those words have connotations associated with them that can confuse the fact thatit is a process that people should try to understand.

Matthew Furman for Barron's "The regulators have to decidehow banks will operate. Thatmeans they are going to have tonationalize some in some form."-- Ray Dalio

INTERVIEW


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You can describe a recession as an economic retraction which occurs when the FederalReserve tightens monetary policy normally to fight inflation. The cycle continues until theeconomy weakens enough to bring down the inflation rate, at which time the FederalReserve eases monetary policy and produces an expansion. We can make it morecomplicated, but that is a basic simple description of what recessions are and what we haveexperienced through the post-World War II period. What you also need is a comparableunderstanding of what a D-process is and why it is different.

You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what's essential to combat deflation and adepression?

The D-process is a disease of sorts that is going to run its course.

When I first started seeing the D-process and describing it, it was before it actually startedto play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or

any central bank, exploded like it has? When was the last time interest rates went to zero,essentially, making monetary policy as we know it ineffective? When was the last time wehad deflation?

The answers to those questions all point to times other than the U.S. post-World War IIexperience. This was the dynamic that occurred in Japan in the '90s, that occurred in Latin America in the '80s, and that occurred in the Great Depression in the '30s.

Basically what happens is that after a period of time, economies go through a long-termdebt 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 pricesthat the cash flows they produce aren't adequate to service the debt. The incomes aren'tadequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debtrestructuring. General Motors is a metaphor for the United States.

As goes GM, so goes the nation?

The process of bankruptcy or restructuring is necessary to its viability. One way or another,General Motors has to be restructured so that it is a self-sustaining, economically viableentity that people want to lend to again.

This has happened in Latin America regularly. Emerging countries default, and thenrestructure. It is an essential process to get them economically healthy.

We will go through a giant debt-restructuring, because we either have to bring debt-servicepayments down so they are low relative to incomes -- the cash flows that are beingproduced to service them -- or we are going to have to raise incomes by printing a lot of money.
http://online.barrons.com/public/quotes/main.html?type=djn&symbol=gmhttp://online.barrons.com/public/quotes/main.html?type=djn&symbol=gm


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It isn't complicated. It is the same as all bankruptcies, but when it happens pervasively to acountry, and the country has a lot of foreign debt denominated in its own currency, it ispreferable to print money and devalue.

Isn't the process of restructuring under way in households and at corporations?

They are cutting costs to service the debt. But they haven't yet done much restructuring.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 itis 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-makingmechanism is going to be tested, because different people will have different points of view about what should be done.

What are you suggesting?

An example is the Federal Reserve, which has always been an autonomous institution withthe freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat andchairman of the House Financial Services Committee] is talking about examining theauthority of the Federal Reserve, and that raises the specter of the government andCongress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.

So where do things stand in the process of restructuring?

What the Federal Reserve has done and what the Treasury has done, by and large, is totake an existing debt and say they will own it or lend against it. But they haven't said they

are going to write down the debt and cut debt payments each month. There has been littlein the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.

The Federal Reserve, in particular, has done a number of successful things. The FederalReserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that isgood, too.

However, the reason it hasn't actually produced increased credit activity is because the

debtors are still too indebted and not able to properly service the debt. Only when thosedebts are actually written down will we get to the point where we will have credit growth.There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece -- banks and investment banks and whatever is left of the financial sector --that will need to be restructured. There is a corporate piece that will need to berestructured, and then there is a commercial-real-estate piece that will need to berestructured.

Is a restructuring of the banks a starting point?


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If you think that restructuring the banks is going to get lending going again and you don'trestructure the other pieces -- the mortgage piece, the corporate piece, the real-estate piece-- you are wrong, because they need financially sound entities to lend to, and that won'thappen until there are restructurings.

On the issue of the banks, ultimately we need banks because to produce credit we have tohave banks. A lot of the banks aren't going to have money, and yet we can't just let them goto nothing; we have got to do something.

But the future of banking is going to be very, very different. The regulators have to decidehow banks will operate. That means they will have to nationalize some in some form, butthey are going to also have to decide who they protect: the bondholders or the depositors?

Nationalization is the most likely outcome?

There will be substantial nationalization of banks. It is going on now and it will continue.But the same question will be asked even after nationalization: What will happen to the

pile of bad stuff?

Let's say we are going to end up with the good-bank/bad-bank concept. The government isgoing to put a lot of money in -- say $100 billion -- and going to get all the garbage at aleverage of, let's say, 10 to 1. They will have a trillion dollars, but a trillion dollars' worth of garbage. They still aren't marking it down. Does this give you comfort?

Then we have the remaining banks, many of which will be broke. The government will haveto recapitalize them. The government will try to seek private money to go in with them, butI don't think they are going to come up with a lot of private money, not nearly the amountneeded.

To the extent we are going to have nationalized banks, we will still have the question of how those banks behave. Does Congress say what they should do? Does Congress demandthey lend to bad borrowers? There is a reason they aren't lending. So whose money is it,and who is protecting that money?

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 higherand their asset values were higher. Now net worths have gone down.


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Let me give you an example. Roughly speaking, most of commercial real estate and a gooddeal 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 theirdebt when the cash flows were up, and now the cash flows are a lot lower. If you shouldn'thave lent to them before, how can you possibly lend to them now?

I guess I'm thinking of the examples of people and businesses with solid credit records whocan't get banks to lend to them.

Those examples exist, but they aren't, by and large, the big picture. There are too many nonviable entities. Big pieces of the economy have to become somehow more viable. Thisisn't primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The '30s were very similar to this.

By the way, in the bear market from 1929 to the bottom, stocks declined 89%, with sixrallies 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. TheHoover administration had the equivalent of today's TARP [Troubled Asset Relief Program] in the Reconstruction Finance Corp. The stimulus program and tax cuts createdmore spending, and the budget deficit increased.


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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 getdollars because of the slowdown in exports, and there was a dollar shortage, as there isnow. 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 majordevaluation and reflation that marked the bottom of the Depression in March 1933.

Where is the U.S. and the rest of the world going to keep getting money to pay for thesestimulus packages?

The Federal Reserve is going to have to print money. The deficits will be greater than thesavings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in theGreat Depression. We are in a position where that will eventually create a problem forcurrencies and drive assets to gold.

Are you a fan of gold?

Yes.

Have you always been?

No. Gold is horrible sometimes and great other times. But like any other asset class,everybody always should have a piece of it in their portfolio.

What about bonds? The conventional wisdom has it that bonds are the most overbought and most dangerous asset class right now.

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 isproduced, 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 andliquidity. 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 goodportfolio, because I imagine gold could go up a whole lot and Treasury bonds won't godown 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 theproblems that we have -- and they have surpluses. They can pull in their assets fromabroad, 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.


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And China?

Now we have the delicate China question. That is a complicated, touchy question.

The reasons for China to hold dollar-denominated assets no longer exist, for the most part.However, the desire to have a weaker currency is everybody's desire in terms of stimulus.China recognizes that the exchange-rate peg is not as important as it was before, becausethe idea was to make its goods competitive in the world. Ultimately, they are going to haveto go to a domestic-based economy. But they own too much in the way of dollar-denominated assets to get out, and it isn't clear exactly where they would go if they did getout. But they don't have to buy more. They are not going to continue to want to doubledown.

From the U.S. point of view, we want a devaluation. A devaluation gets your pricing in line. When there is a deflationary environment, you want your currency to go down. When youhave a lot of foreign debt denominated in your currency, you want to create relief by having your currency go down. All major currency devaluations have triggered stock-market

rallies throughout the world; one of the best ways to trigger a stock-market rally is todevalue your currency.

But there is a basic structural problem with China. Its per capita income is less than 10% of ours. We have to get our prices in line, and we are not going to do it by cutting our incomesto a level of Chinese incomes.

And they are not going to do it by having their per capita incomes coming in line with ourper capita incomes. But they have to come closer together. The Chinese currency and assetsare too cheap in dollar terms, so a devaluation of the dollar in relation to China's currency is likely, and will be an important step to our reflation and will make investments in China

attractive.

You mentioned, too, that inflation is not as big a worry for you as it is for some. Could youelaborate?

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.

Given this outlook, what is your view on stocks?

Buying equities and taking on those risks in late 2009, or more likely 2010, will be a greatmove because equities will be much cheaper than now. It is going to be a buyingopportunity of the century.

Thanks, Ray.

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Recession-- No, It's a D-Process, And It Will Be Long