Bridgewater Associates: Approaching The Seismic Shift - April 2011

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Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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  • 1. Bridgewater ® Daily Observations is protected by copyright. No part of the Bridgewater ® Daily Observations may be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the US Federal copyright law (T 17, US code). 1 Bridgewater ® Daily Observations 04/25/2011 Bridgewater® Daily Observations April 25, 2011 © 2011 Bridgewater Associates, LP (203) 226-3030 Ray Dalio Jake Bornstein Approaching the Seismic Shift As you know, we believe that the world can be divided into 1) developed debtors and 2) emerging creditors, that each of these groups can be divided into a) those with linked currencies and b) those with floating ones, and that those with linked currencies will have to delink them or they will crash. In other words, we believe that those at either end of the continuum shown below will experience their existing problems with an increasing intensity that will become severe in 2012. For this reason, we expect big changes to occur then or before. WHAT THE WORLD LOOKS LIKE Developed Debtor Countries with Linked FX Rates Developed Debtor Countries with Flexible FX Rates Emerging Creditor Countries with Flexible FX Rates Emerging Creditor Countries with Linked FX Rates Developed Debtor Countries with Linked FX Rates Developed Debtor Countries with Flexible FX Rates Emerging Creditor Countries with Flexible FX Rates Emerging Creditor Countries with Linked FX Rates MOST GROWTH & INFLATION LEAST GROWTH & INFLATION (INTEREST RATES & CURRENCIES SHOULD BE HIGHER) (INTEREST RATES & CURRENCIES SHOULD BE LOWER) Big changes will have to occur because policymakers in these countries have waited too long to make these changes in smaller doses. As is typical, they failed to make these changes because senior policymakers don’t have an appreciation for problems until they are upon them and because politics stand in the way of effective decision-making. As a result, the imbalances that have accumulated into these large debts/assets will be troublesome for many years to come, and the shifts that will have to take place to reduce them will have to be very large. We continue to believe that the longer policymakers wait to make these shifts, the greater and more traumatic they will have to be when they inevitably come. The good news is that, now that the problems are upon policymakers in these countries, they generally recognize that these shifts will have to occur, so the questions have progressed beyond "if" to "when" and "how" the adjustments should be made. The bad news is that the rate of progress will probably be too slow. Policymakers in countries on the left side of the continuum (i.e., the European debtors), who have given up their own currencies, don't have the option of devaluing their currencies and printing money to ease their debt problems because they abandoned their own currencies and going back to them is not a viable option. As everyone knows, the only reason that they would create new currencies is to devalue them, few people would want to hold them, so capital markets would not function effectively
  • 2. 2 Bridgewater ® Daily Observations 04/25/2011 and hyper-inflations would ensue. As a result, we believe that debtors of these countries are destined to have to restructure their debts and will have many years of difficulty. We also believe that European creditor countries and the ECB are destined to share these burdens, print money and cheapen the euro at a rate that keeps the deleveragings orderly. We also believe that surplus countries like China will be lured into providing support, though the amounts of support they will provide is unlikely to be game-changing. In contrast, those on the right side of the continuum have more choices, though gradually changing their currencies is no longer one of them. Though there is a strong preference for gradual changes, gradual changes won't work because of the undesired effect they would have on interest rates and money/credit growth. That is because, when currency changes are expected, the interest rate differences have to move to levels that compensate borrowers and lenders so that they are relatively indifferent to the currencies they borrow and lend in. If these interest rate changes are allowed, interest rates will move in the opposite direction than desired given domestic conditions, and if these interest rate changes are not allowed, capital flows, money growth and credit growth will be in the opposite direction than desired. For example, if China would like its currency to appreciate by a steady 7% per year against the dollar (all else being equal, which it isn’t), China would have to have its interest rates about 7% below US interest rates (which is something to ponder as US interest rates are near 0%) or borrowers will borrow dollars and lenders will lend yuan. Because of this reality, capital controls are being explored further; however, for reasons previously explained, we believe that they won’t work and will have bad effects. For these reasons, surprise and abrupt currency changes that get currency values and interest rate differentials to levels that make sense for both the balance of payments and desired domestic conditions are preferable to gradual changes. We won't go through our exact calculations because they're proprietary, but to convey the point we will give an example. Let's say a country like China (Country C) has an interest rate of 5%, an inflation rate of about 5% and a nominal growth rate of about 15%, and let’s say that it should have an interest rate of 8%, and let's say its currency is linked to a currency like the USD with an interest rate of 1%, then the abrupt currency change should be to a high enough level that it is reasonable to expect Country C’s currency to depreciate by something like 7% per year so that this difference is properly priced in both the currency and interest rate markets. That would require quite an appreciation. How much of an appreciation depends on what Country C’s balance of payments and inflation targets are. For example, if Country C is targeting 1% reserve growth and an inflation rate that's 2% higher than the US, then it will have to raise its interest rates and currency levels by less than if it is targeting no reserve growth and an inflation rate that is the same as the US. This is of course an overly simplistic example provided just to make the point that there are different levers that can be pulled to balance the alternatives. WHAT THE WORLD AS A WHOLE LOOKS LIKE The charts below are meant to help show what the world as a whole looks like, and how the parts differ. The first charts show the world as a whole. As shown, after the global economy’s 2008 dip, it has grown quickly. Growth remains strong. Inflation rates are rising. Interest rates are extremely low in relation to nominal GDP growth. So, if this was one economy, it would be pretty obvious that central banks are behind the curve and should tighten significantly.
  • 3. 3 Bridgewater ® Daily Observations 04/25/2011 Global Growth -8% -6% -4% -2% 0% 2% 4% 6% 8% 00 01 02 03 04 05 06 07 08 09 10 11 Global Output (% pre-crisis peak) 70% 75% 80% 85% 90% 95% 100% 105% 110% 00 01 02 03 04 05 06 07 08 09 10 11 0% 1% 2% 3% 4% 5% 6% 00 01 02 03 04 05 06 07 08 09 10 11 Headline Inflation Core Inflation -4% -2% 0% 2% 4% 6% 8% 10% 12% 00 01 02 03 04 05 06 07 08 09 10 11 World Nominal Grow th World Nominal SR Tightening Needed It’s not surprising that central banks are generally beginning a tightening cycle. We believe that will put strain on the linkages underlying growth over the next 18 months. To convey how this cycle is beginning and how these cycles go, the next chart shows the “world short rate” with the shaded areas showing each upward cycle, and the chart that follows it shows the percentage of countries tightening. As shown in the first chart, on average, these upward cycles lasted 27 months and interest rates increased 3.8%; and the last one lasted 41 months and interest rates increased 3.0%. Of course what’s new this time is that, with interest rates near 0% in some developed debtors, QEs were an alternative way of changing monetary policies so the tightening will begin with that being withdrawn and won’t show up as soon in interest rate hikes. 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 World Short Rate Typical tightening has lasted just over 2 years
  • 4. 4 Bridgewater ® Daily Observations 04/25/2011 Percentage of Countries Tightening in Last 6mos 0% 10% 20% 30% 40% 50% 60% 70% 80% 80 85 90 95 00 05 10 Tightening becoming more broad-based WHAT THE DIFFERENT PARTS LOOK LIKE The following charts show what the previously described parts of the world look like and convey the need for them to have different monetary policies. A) WHAT THE DEVELOPED WORLD LOOKS LIKE As shown below, developed economies are generally recovering slowly, with the fastest recoveries in the countries that a) produced the most monetary and fiscal stimulation and/or b) are least indebted. In all cases, these recoveries are relatively fragile and will be increasingly at risk as monetary and fiscal policies will be tightening later this year and next year. For these reasons we think it’s likely that growth rates in these economies will slow significantly late this year and in 2012. 82% 87% 92% 97% 102% 00 01 02 03 04 05 06 07 08 09 10 11 DevWld Economic Output (GDP-Weighted) -1%
  • 5. 5 Bridgewater ® Daily Observations 04/25/2011 88% 90% 92% 94% 96% 98% 100% 102% 06 07 08 09 10 11 USA Economic Output 88% 90% 92% 94% 96% 98% 100% 102% 06 07 08 09 10 11 EUR Economic Output 88% 90% 92% 94% 96% 98% 100% 102% 06 07 08 09 10 11 JPN Economic Output 88% 90% 92% 94% 96% 98% 100% 102% 06 07 08 09 10 11 GBR Economic Output B) WHAT THE EMERGING WORLD LOOKS LIKE As shown below, the emerging economies generally only experienced a hiccup in growth in 2008/09 and have blasted on to new heights since, with those that are the most competitive creditors (China and other Asian surplus countries) and also have exchange rates linked to the currencies of the countries that printed the most money (i.e., the US) being the strongest. In these countries, credit growth and economic growth appear to have gone beyond control and, in our opinion, will not be restrained until the previously described shifts take place. For these reasons, we think it is likely that growth rates, inflation rates and credit bubbles will emerge with greater force later this year and in 2012. With growth in the developed world expected to slow, we think it is likely that the differences in conditions will become greater over the next 18 months, putting more strain on the currency linkages.
  • 6. 6 Bridgewater ® Daily Observations 04/25/2011 50% 60% 70% 80% 90% 100% 110% 120% 00 01 02 03 04 05 06 07 08 09 10 11 EM Economic Output (GDP-Weighted) +15% 70% 80% 90% 100% 110% 120% 130% 06 07 08 09 10 11 CHN Economic Output 70% 80% 90% 100% 110% 120% 130% 06 07 08 09 10 11 EMAsia ex China Economic Output 70% 80% 90% 100% 110% 120% 130% 06 07 08 09 10 11 LatAm Economic Output 70% 80% 90% 100% 110% 120% 130% 06 07 08 09 10 11 EMEurope Economic Output
  • 7. 7 Bridgewater ® Daily Observations 04/25/2011 As we see it, there are two important points of stress arising from currency/monetary policy linkages - - 1) those existing between the developed debtors and emerging creditors, and 2) those existing between the European debtors and the European creditors that share the euro as their currency. The charts below contrast them. LINKED CURRENCY PROBLEM #1: DEVELOPED DEBTORS VS. EMERGING CREDITORS As shown below, a) the debtors and creditors have very different levels of indebtedness, b) are experiencing very different levels of debt problems, c) the debtors have lots of slack in their economies while the creditors have very little slack, and d) the imbalances have not improved much so that the debtors are still getting deeper into debt and the creditors are continuing to build their holdings of it. Difference in Indebtedness… …Leads to Credit Problems… …And Difference In Growth… Total Debt % GDP 100% 150% 200% 250% 300% 350% 400% 00 02 04 06 08 10 Developed Debtors Em erging Creditors Current Accounts (% NGDP) -6% -4% -2% 0% 2% 4% 6% 8% 10% 00 02 04 06 08 10 Developed Debtors Emerging Creditors …But The Imbalances Are Still Large Output Gap -5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% 00 01 02 03 04 05 06 07 08 09 10 11 Developed Debtors Emerging Creditors Total Credit Market Delinquencies 0% 1% 2% 3% 4% 5% 6% Pre-Crisis Current Pre-Crisis Current Developed Debtors Emerging Creditors
  • 8. 8 Bridgewater ® Daily Observations 04/25/2011 LINKED CURRENCY PROBLEM #2: CREDITOR EUROPE VS. INDEBTED EUROPE As shown below the countries of Europe that are linked by the euro and the same monetary policies a) have very different levels of indebtedness, b) are experiencing very different levels of debt problems, c) the debtors have lots of slack in their economies while the creditors have very little slack, and d) the imbalances have not improved much so that the debtors are still getting deeper into debt and the creditors are continuing to build their holdings of it. Difference in Indebtedness… …And Difference In Growth… Euroland Total Non-financial Debt (%GDP) 140% 160% 180% 200% 220% 240% 260% 280% 300% 320% 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Core Periphery …Leads to Credit Problems… Output Gap -8% -6% -4% -2% 0% 2% 4% 6% 00 01 02 03 04 05 06 07 08 09 10 11 12 Core Periphery Banking System NPLs (GDP W eighted) 1% 2% 3% 4% 5% 6% 7% 8% 00 01 02 03 04 05 06 07 08 09 10 Core Periphery …But The Imbalances Are Still Large Current Account (% EUR GDP) -3% -2% -1% 0% 1% 2% 3% 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 Core Periphery Pre-Euro CAs never got too far out of line transfer
  • 9. Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, LP and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any of the recipients. Additionally, Bridgewater's actual investment positions may, and often will, vary from its conclusions discussed herein based on any number of factors, such as client investment restrictions, portfolio rebalancing and transactions costs, among others. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Bridgewater research utilizes data and information from public, private and internal sources. External sources include International Energy Agency, International Monetary Fund, National Bureau of Economic Research, Organisation for Economic Co-operation and Development, United Nations, US Department of Commerce, World Bureau of Metal Statistics as well as information companies such as BBA Libor Limited, Bloomberg Finance L.P., CEIC Data Company Ltd., Consensus Economics Inc., Consumer Metrics Institute, Credit Market Analysis Ltd., Ecoanalitica, Emerging Portfolio Fund Research, Inc., Global Financial Data, Inc., Global Trade Information Services, Inc., Hewitt Associates, LLC, Intex Solutions, Inc., Markit Economics Limited, Mergent, Inc., Moody’s Analytics, Inc., MSCI, RealtyTrac, Inc., RP Data Ltd., Standard and Poor’s, Thomson Reuters, TrimTabs Investment Research, Inc. and Wood Mackenzie Limited. While we consider information from external sources to be reliable, we do not assume responsibility for its accuracy. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues.