Debt-to-GDP levels around the world have been rising for two generations. In a December 2018 report, Ray Dalio comments, “It appears to me that we are in the late stages of both the short-term and long-term debt cycles.” What are the investment implications?
According to Dalio, credit cycles are “nothing more than a logically-driven series of events that recur in patterns.” Big debt crises occur when the scale of debt reaches a level where interest rate cuts alone are insufficient to prevent a depression.
Principles for Navigating Big Debt Crises provides a framework for understanding the mechanics of these crises. Dalio sets out six stages, from the seeds of the crisis to its resolution. He analyzes 48 historical episodes of debt crises when GDP growth fell by 3% or more. These episodes cover both developed and emerging economies. Dalio categorizes big debt crises into two types — deflationary and inflationary — and provides economic and market data for both.
Deflationary debt cycles typically occur when the majority of debt is denominated in a country’s own currency. Dalio believes it is possible for policymakers to manage these crises well, but even a good outcome will be extremely costly to some people.
Inflationary debt cycles occur when most debt is denominated in foreign currencies. This situation makes it harder for a country’s policymakers to “spread out the harmful consequences,” a key part of resolving the crisis. They must decide who will benefit and who will suffer — to what degree and for how long — “so that the political and other consequences are acceptable.” This process often entails a need to recapitalize systemically important institutions.
In an inflationary cycle, “at the top, people are so invested in the optimistic scenario, and because the optimism is reflected in prices, even a minor event can trigger a slowing of foreign capital inflows and an increase in domestic capital outflows.” Major currency depreciations typically follow. Once policymakers give up the fight against devaluation, losses from holding the currency average 30% in the first year.
Policymakers have four levers to bring down debt — and debt servicing costs:
- Debt defaults and restructurings
- Money printing by the central bank
- Transfer of money from those who have more to those who have less
Each policy has a different effect on the economy and thus on markets. Austerity and defaults are deflationary. Money printing is inflationary and stimulates growth. Transfers of money, by definition, produce winners and losers. Austerity, defaults, and wealth transfer are all politically challenging. Inevitably, therefore, countries choose to print.
A successful resolution occurs when policymakers use the right mix of these four levers. The best outcome is a “beautiful deleveraging”: “In this happy scenario, debt-to-income ratios decline at the same time that economic activity and financial asset prices improve.”
Government actions to reduce the fundamental imbalance are well received by markets. During the Great Depression, there were six large rallies in the stock market, each triggered by a policy response.
Effective approaches require coordination of monetary and fiscal policy, which can ensure that the money provided through printing is actually spent. By contrast, a lack of coordination can leave policymakers “pushing on a string,” as expansionary policies fail to generate economic activity. The risk for investors in this scenario is that excessive money printing can lead to severe currency devaluations.
The worst-case scenario occurs when authorities lose control of an inflationary cycle, triggering a hyperinflationary episode. Dalio uses his framework to provide a detailed explanation of the 1918–1924 German debt crisis.
All of the crises that Dalio explores share common characteristics. They “eventually led to a big wave of money creation, fiscal deficits, and currency devaluations (against gold, commodities, and stocks).” Equity market declines averaged around 50% across all 48 episodes. Currency depreciation exacerbated the losses for overseas investors, particularly in inflationary debt cycles.
The book is organized into three parts (each of which is available as a free download). The key lessons are held in Part One, consisting of 64 pages on “the archetypal big debt cycle.”
Part Two provides detailed analysis of three major crises to illustrate Dalio’s framework: Germany’s hyperinflation, the Great Depression, and the recent global financial crisis. Part Three provides a brief overview of all 48 episodes. This is where investors will find, for each episode, charts on equity prices, nominal long-term interest rates, the yield curve, real exchange rate moves versus trade-weighted indexes, and the gold price.
Big debt crises can be career-defining events for investment managers. Outstanding examples include the success of John Paulson in the 2008 global financial crisis and the 1998 failure of hedge fund Long-Term Capital Management, which was triggered by a debt crisis in Russia. Dalio gives investors confronting a big debt crisis a framework to understand the possible economic scenarios that lie ahead, backed by empirical evidence. In addition, he tells investors what information they need to obtain in order to determine the investment implications.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Robert N. Farago, ASIP, is head of thought leadership at Aberdeen Standard Investments. He was previously head of asset allocation at Schroders Private Bank. Robert has over 30 years of investment experience, including portfolio management roles at Schroders and Bankers Trust. He is an active member of the CFA Society of the UK.