Bridgewater Associates: Our View of The World and Oil - October 2004
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Bridgewater Associates: Our View of The World and Oil - October 2004

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Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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Bridgewater Associates: Our View of The World and Oil - October 2004 Bridgewater Associates: Our View of The World and Oil - October 2004 Document Transcript

  • Bridgewater® Daily Observations October 20, 2004 © 2004 Bridgewater Associates, Inc. (203) 226-3030 Ray Dalio Jason Rotenberg United States Our View of the World (and Oil): Revised 3/10/2006 As you know, our view of the world is, for the most part, driven by the: 1) The Economic/Market Cycle: We believe that the economy is a) following a pretty normal economic cycle, b) we are in the classic mid-expansion part of the cycle (i.e. where the economy and markets typically are about three years into the expansion when operating rates and unemployment rates are near their long term averages) and c) growth is relatively normal. As with all cycles, there are of course some differences. In this case, productivity growth is faster than normal and employment growth is slower than normal. The higher productivity growth and lower employment growth are due to the recent past investment boom, the increased effectiveness of these investments and the increased global supply of labor. The two charts below show real GDP and short- term interest rates this cycle in relation to the average of past cycles, in order to help convey the cyclical perspective. As you can see, this cycle is following the normal path for GDP growth and for short rates. For reasons explained, we expect this to continue – i.e. for growth to slow a bit, though be in the 2% to 3% range, and for short rates to start to rise at a more accelerated pace. -4% -2% 0% 2% 4% 6% 8% 10% -36 -32 -28 -24 -20 -16 -12 -8 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 Typical Cycle 1 StDev This Cycle Real GDP Growth Bridgewater ® Daily Observations is protected by copyright. No part of the Bridgewater ® Daily Observations can be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the U.S. Federal copyright law (T 17,U.S. code). 1 Bridgewater ® Daily Observations 10/20/2004
  • -6% -4% -2% 0% 2% 4% 6% 8% 10% 12% -36 -32 -28 -24 -20 -16 -12 -8 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 Typical Cycle 1 StDev This Cycle 3mo T-Bill Rate 2) The Long Term Debt Cycle: The economy is more leveraged than ever before and more of that debt is owned by foreign investors, especially foreign central banks, than ever before (see the following charts). That means that the U.S. economy is more sensitive to interest rate changes and foreigner’s demands for our debt than ever before. In our opinion, it would not take much of a rise in interest rates to cause a) housing prices to fall enough so that those who bought homes over the last two years have negative equity in them (therefore, could not sell them and move) and b) the economy to contract. The debt burden is shown in the below debt/GDP chart that goes back to 1915 and the foreign debt ownership figures are shown in the next two charts, going back to 1973. Total Debt as % GDP 120% 140% 160% 180% 200% 220% 240% 260% 280% 300% 10 14 18 22 26 30 34 38 42 46 50 54 58 62 66 70 74 78 82 86 90 94 98 02 2 Bridgewater ® Daily Observations 10/20/2004
  • Total Foreign Holdings of US Debt % GDP 0% 5% 10% 15% 20% 25% 30% 35% 40% 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 Foreign Public Ownership of US Treasuries and Agencies 0% 2% 4% 6% 8% 10% 12% 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 3) The Emergence of China (plus India and other big population emerging countries). Essentially, the world’s supply of labor has quadrupled. In the traditional 3-part way of looking at the economy in which the shares of the pie that go to labor, capital and natural resources vary as a function of their relative supplies and demands, we are seeing a rapid decline in the value of labor and rapid increase in the value of natural resources. This is most apparent by looking at changes in the growth rates in what China is importing (i.e. fastest in commodities) and what it is exporting (i.e. manufactured goods). It is also reflected in the amount of outsourcing that is going to China (plus India and other big population emerging countries). The United States (and other developed countries) are losing market shares to these countries. The chart below shows the market shares of imported goods that China and the U.S. have, which tell this story. Largely because of these trends, we estimate that the U.S. current account deficit as a percentage of GDP will approach 8% to 10% within 5 years if the dollar is not devalued. So, the Chinese and Japanese central banks (and other buyer of U.S. bonds) should get prepared to either buy a whole lot more of our debt or let the dollar fall a lot. 3 Bridgewater ® Daily Observations 10/20/2004
  • United States Competitiveness -12% -7% -2% 3% 8% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 China Competitiveness -40% -20% 0% 20% 40% 60% 80% 100% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 For these reasons, we think that: 1) It is in the United States’ interest to be very easy and devalue the dollar. From an external, balance of payments point of view, the United States is like an emerging country with a) a large foreign debt that is denominated in its own currency and b) a balance of payments/competitiveness problem. Because our debt is denominated in dollars and we are uncompetitive, it is in our interest to devalue the dollar at least until inflation clearly is a worry. Also, from a domestic point of view, the high debt levels favor erring on the side of being easy because it would be easy to send the economy into a contraction. 2) We believe that commodity prices (particularly the oil price) can rise a lot and the dollar can fall a lot without materially raising inflation, because the increased supply of labor is causing labor rates and manufactured good prices to have very little inflation. Since expenditures on labor and manufactured goods are much larger than those on commodities and imported goods, it will take a very large increase in commodities and decrease in the dollar to push the overall inflation rate uncomfortably high. We have seen this. It is why inflation hasn’t materially risen, bonds and stocks haven’t sold off and the economy hasn’t weakened despite record high oil prices. 4 Bridgewater ® Daily Observations 10/20/2004
  • 3) We think that 2005 will be a transition year from the mid point of the expansion to the late part of the expansion (much like mid-1978 to mid-1979) during which the economy will continue to grow, the dollar will continue to decline, commodity prices will continue to rise and interest rates will rise grudgingly. In late 2005 and early 2006, we expect an environment of much greater risk. Oil at $100 to $120 dollars As you know, when we imagine the world oil market, we think of lots of oil in an oil drum (i.e. the oil in the ground) that is pulled through a straw (i.e. the production and refining capacities) at a rate that is commensurate with the speed of the engine (i.e. the growth rate of the global economy). When the rate of sucking oil through the straw equals the capacity of the straw, the price of oil skyrockets until either it or something else (usually tightening monetary policy) slows the engine. As you know, we believe that it will take much higher oil prices (over $100 to $120/brl.) to ration demand because that is what it would take to get to the same price in real dollar terms ($100) as past cycles and a price ($120) at which oil consumption as %GDP went to in past cycles. The reason that we think these price estimates are in fact conservative is that it was not these high levels that slowed the economy and oil consumption – it was the very tight money policies that accompanied these oil price shocks (to fight inflation) that had these effects. Said differently, if the Fed and other central banks did not tighten aggressively, oil prices would have risen much higher than $100 to $120 (in current dollars) to have slowed the economy and rationed oil demand. To help convey this picture, the first chart below shows oil consumption as a percent of GDP, the second chart shows the inflation adjusted oil price and the third chart shows the tightness of monetary policy (measured by the slope of the yield curve). The bars on the first two charts designate recession periods, and in these charts note that the oil price could double before hitting old highs. Now look at the third chart. Note the severe tightenings that occurred during the first two oil shocks and look at how easy monetary policy currently is. In our opinion, without a much greater tightening in both developed countries and China (which we do not think will occur soon), the engine will not be slowed enough to prevent a move in oil prices to over $100 to $120/brl. 0% 2% 4% 6% 8% 10% 12% 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 Recessions Oil Consumption % of GDP Priced In 5 Bridgewater ® Daily Observations 10/20/2004
  • $10 $20 $30 $40 $50 $60 $70 $80 $90 $100 $110 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 Recessions Real Oil Price (2004 Dollars) -80% -60% -40% -20% 0% 20% 40% 60% 80% 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 $10 $20 $30 $40 $50 $60 $70 $80 $90 $100 $110 Tightness of Monetary Policy (SR/LR - LTA) Real Oil Price (2004 Dollars) That is not to say that we do not expect the energy price rise to be more noticeable over the next few months, because we do. However, we do not expect it to have a material impact on either energy consumption or GDP growth. On average, oil prices flow through to gasoline pretty quickly, in around 9 days. As shown below, refinery margins had blown out to historic highs, and the contraction has kept gasoline down relative to oil. That has cushioned the gas price spike and this will not continue, though current gas prices pretty much reflect current oil prices. Also, gasoline consumption will slip seasonally. 6 Bridgewater ® Daily Observations 10/20/2004
  • $0 $5 $10 $15 $20 $25 99 00 01 02 03 04 Gasoline Crack Spread (Refinery Profit Per Barrel) While gasoline prices typically reflect oil price changes with a 9-day lag, the real effect of energy price hikes come in the winter because usage of both heating oil and natural gas will increase then. The first two charts below shows household petroleum and household natural gas usage, both in the past and as projected. Since we pretty much know the usage, we can apply current prices to it in order to see the extra costs. 80 100 120 140 160 180 200 1/1/01 7/1/01 1/1/02 7/1/02 1/1/03 7/1/03 1/1/04 7/1/04 1/1/05 Houshold Petroleum Consumption (Trillions of BTUs) Expected Expected petroleum consumption 100 200 300 400 500 600 700 800 900 1,000 1,100 1/1/01 7/1/01 1/1/02 7/1/02 1/1/03 7/1/03 1/1/04 7/1/04 1/1/05 Houshold Natural Gas Consumption (Trillions of BTUs) Expected 7 Bridgewater ® Daily Observations 10/20/2004
  • We showed you oil prices before, so we will just show you natural gas prices in order to convey the broader picture. $1 $2 $3 $4 $5 $6 $7 $8 $9 $10 92 93 94 95 96 97 98 99 00 01 02 03 04 05 Natural Gas 1nb Expected Close to highest natural gas prices ever In all, we estimate that households will have to spend about $7.6 billion more on energy this January (the peak demand month) than they did a year ago, totaling 1% of disposable income for that month. If usage is as we estimate it, and prices of oil and natural gas stay as priced in the futures market, we estimate that households will spend a total of $56 billion on energy over the next 12 months, compared with the $41 billion that they spent in the last 12 months. In other words, they will spend about an extra $15 billion, or $144 per household ($413 more than in 1999). This is not a big number and it is much smaller than the tax impact. 0.0% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2% 1.4% 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 Annual Household Energy Expenditures (Oil + Natural Gas) As % of Disposable Income Estimate While there are other energy costs that will increase, they are not so big that they change this basic picture – (i.e. that current energy costs are not excessively burdensome. Further, as households will probably borrow the money and either foreigners will lend it to us or we will print it, it won’t bite. 8 Bridgewater ® Daily Observations 10/20/2004
  • Weekly Sentiment: Below is our updated weekly sentiment. Composite Sentiment Index 44% 9% 14% 49% 26% 47% 78% 60% 44% 58% 7% 22% -100% -50% 0% 50% 100% T-bonds Euro$ Stocks Euro B-Pound S-Franc J-Yen C -dollar G old Silver C opper O il This Week Last Week 3-Month High/Low High OB Mod OB Neutral Mod OS High OS Composite Sentiment Index (avg of raw numbers) Market This Week Last Week 3 mth high 3 mth low T-Bonds 64 58 67 53 Euro$ 53 50 58 31 Stocks 50 57 65 42 Euro 70 65 70 45 B-Pound 57 45 66 45 S-Franc 57 50 65 50 J-Yen 64 57 67 47 C-Dollar 80 80 80 51 Gold 73 75 75 49 Silver 64 67 67 39 Copper 50 71 71 49 Oil 78 80 87 58 Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, Inc. 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. 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 is based primarily upon proprietary analysis of current public information from sources that Bridgewater considers reliable, but it do not assume responsibility for the accuracy of the data. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. The views represent Bridgewater's outright views in these specific markets, but not all markets that Bridgewater trades. 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. 9 Bridgewater ® Daily Observations 10/20/2004