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I have reprinted in total an interview between fund manager Ray Dalio and Barrons.
This is the most detailed and well-thought-out description of what is a deflation and
how it is repaired that I have seen. It echoes my thoughts and commentary almost
verbatim, but with a lot more detail and credibility. Read on to understand what is
happening and how we get out. I will put my commentary in brackets[]:
http://online.barrons.com/article/SB123396545910358867.html?page=2&page;=sp
Bridgewater Associates
By SANDRA WARD
AN INTERVIEW WITH RAY DALIO: This pro sees a long and painful
depression.
"The regulators have to decide how banks will operate. That means
they are going to have to nationalize some in some form." No
wonder. The Westport, Conn.-based firm, whose analyses of world
markets focus on credit and currencies, has produced long-term
annual returns, net of fees, averaging 15%.
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net of fees and Pure Alpha 2 delivered 9.4%. Here's what's on his
mind now.
Both of those words have connotations associated with them that can
confuse the fact that it is a process that people should try to
understand.
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
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essential to combat deflation and a depression?
The answers to those questions all point to times other than the U.S.
post-World War II experience. 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-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.
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economically healthy.
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 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.
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What are you suggesting?
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autonomous institution with the freedom to act as it sees fit. Rep.
Barney Frank [a Massachusetts Democrat and chairman of the House
Financial Services Committee] is talking about examining the authority
of the Federal Reserve, and that raises the specter of the government
and Congress trying to run the Federal Reserve. Everybody will be
second-guessing everybody else.
What the Federal Reserve has done and what the Treasury has done,
by and large, is to take 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 little in the way of
debt relief yet. Very, very few actual mortgages have been
restructured. Very little corporate debt has been restructured.
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If you think that restructuring the banks is going to get lending going
again and you don't restructure 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't happen
until there are restructurings.
That means they will have to nationalize some in some form, but they
are going to also have to decide who they protect: the bondholders or
the depositors?
Then we have the remaining banks, many of which will be broke. The
government will have to recapitalize them. The government will try to
seek private money to go in with them, but I don't think they are going
to come up with a lot of private money, not nearly the amount needed.
To the extent we are going to have nationalized banks [Citi, BAC for
sure, as I have maintained; they are already Fed controlled, if not
completely nationalized], we will still have the question of how those
banks behave. Does Congress say what they should do? Does
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Congress demand they lend to bad borrowers? There is a reason they
aren't lending.
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.
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%, [note: in 1929 the DJI stocks were very extended and
had the same kind of PEs as 2000. When stocks tanked in 2008, the
PEs were much lower because the air was already let out of the stock
market, so we will not need to see a DJI of 1400 before this is over.
We probably already has seen the DJI low] 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
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Corp. The stimulus program and tax cuts created more spending, and
the budget deficit increased.
Where is the U.S. and the rest of the world going to keep getting
money to pay for these stimulus packages?
The Federal Reserve is going to have to print money [my blog friends
who fear the printing press need to pay attention here. This point is
why I discount
what I hear from Marc Faber, Jim Rogers and Peter Schiff. They don't
know their history]. The deficits will be greater than the savings. So
you will see the Federal Reserve buy long-term Treasury bonds, as it
did in the Great Depression [this answers the question about who will
lend us the money to back the printing press]. We are in a position
where that will eventually create a problem for currencies and drive
assets to gold [which, in this context, is okay. I am long gold, but I am
also long our economy].
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Yes.
No. Gold is horrible sometimes and great other times [because its only
value is as an alternate currency or jewelry. Gold has NO inherent
value. It is an unproductive asset]. 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 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
[this is a point that changes my thinking a bit. I think in terms of either /
or; but Dalio makes the case for an overlap of the appreciation of both
asset classes].
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.
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Other currencies will decline in relationship to the yen and in
relationship to gold [hmmmm, I don't know if "less bad" is good enough
for me. I think Japan is in this with the rest of us; though recent
currency action supports Dalio's case here].
And China?
From the U.S. point of view, we want a devaluation [YES!! this is the
point I always make: we must create inflation to get out of this problem,
thereby devaluing the dollar]. A devaluation gets your pricing in line.
When there is a deflationary environment, you want your currency to
go down. When you have 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 to devalue 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 incomes to a level of Chinese
incomes.
And they are not going to do it by having their per capita incomes
coming in line with our per capita incomes. But they have to come
closer together. The Chinese currency and assets are 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
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make investments in China attractive. [this is a major thesis of mine,
and I own FXI, the China equity index fund and will buy more. This is
a long term phenomena that will last my lifetime. China will be the
major source of commodity demand for decades, so commodities are
a great investment here]
You mentioned, too, that inflation is not as big a worry for you as it is
for some. Could you elaborate?
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.
Thanks, Ray
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