This week’s blog is a follow up on the Ray Dalio interview on Bloomberg, where I have added some of my own thoughts based on the balance sheet recession theory, as developed by Richard Koo. I have followed Ray Dalio and Richard Koo's work from 2010, and some of our investment performance success for the last decade was due to learning macroeconomics from these two.
In its interview on Bloomberg, Ray Dalio explains that stock market has already reached bottom in late March, giving some comfort to investors who are still anxious about their investments, and also to people who may want to invest and so far have delayed this.
Ray Dalio looked first at the effect the pandemic had on incomes and balance sheets, for both households and corporations. The reduction in households and corporates income due to the pandemic made them to spend some of their cash reserves they had on their balance sheets, and they also saw a reduction in the value of their assets. This could be anything from reduction in the value of real estate (residential or commercial property), the value of the investments, or even the value of receivables, and the inventories on companies’ balance sheets.
It is clear the pandemic has hit hard both people and corporations’ incomes and balance sheets. There are over 26 million unemployed people only in the United States. US companies issued corporate bonds to the tune of $150 billion in March to shore up their balance sheets, and this issuance of bonds is going to continue. In Ray Dalio’s words, the pandemic left huge holes for both the people and companies, in their income and balance sheets.
As he explained, this time the Federal Reserves and other Central Banks acted swiftly and provided money and credit to fill these holes. The Central Banks offered huge amounts of money to buy assets (Government bonds, highly graded mortgage loans, and investment grade corporate bonds). One exemption, as he explained, this is not possible in the emerging markets (with the exemption of China), as their debts are mostly in foreign currency (US Dollars), and their Central Banks have only a very limited ability to print high amounts of money.
The other measures available to Central Banks and Governments, like reducing interest rates, and reducing taxes are not possible anymore, because interest rates are already at 0% and taxes are already low, at least in the United States.
We will continue to have deflationary pressures for prices of goods and services, reflation for financial assets, and devaluation for currencies. Ray Dalio is not surprised to see a bull market now, once FED and other Central Banks started filling up the holes. Stock markets work mostly based on the amount of money and credit is available, and it is important to follow the money flow, and they mostly flowed to buy financial assets. As a result, the real economy lags the financial markets.
The most important question now is if we are going to go into a balance sheet recession. The Central Banks and Governments did well to prop-up asset prices, so we may have avoided an asset price collapse. However, liabilities have increased significantly this year, on the back of an increase of corporate leveraging that took place from 2016 till now. It is possible that everyone would start paying off debt at the same time. Also, most likely, households would become risk adverse and start saving more money to beef up their contingency plans. Corporates would not borrow this money, they will start repaying the amounts borrowed in March, loans that helped them go over the pandemic period.
There are premises for a balance sheet recession, and the Governments would need to keep borrow the money saved and repaid by households and corporations and use them for infrastructure projects.
As a result, I think we will have more of the same, a similar period with 2010 – 2020, a period with low GDP growth, households and corporations repairing their balance sheet. For US corporates, it may not take another 10 years to repair their balance sheets, as they entered this with better balance sheets than their European counterparts.
As always, after a crisis, there would be beneficiaries and losers. Beneficiaries could be countries and asset classes, and within asset classes, different sectors and companies. The main gains would be equity investments, companies with strong balance sheets, great net income, like the high-quality companies we invest in. There is also an expectation that countries will rebuild their health systems, and as a result this sector will offer good investment opportunities.
Ray explained that bonds and currencies are poor stores of wealth. He also believes that emerging markets would be the main losers, as they do not benefit from the flow of money and credit in US Dollars, EUR, and Sterling, so investing in countries like Brazil, Russia, South Africa, and Argentina are better avoided.
Great companies will do well, they have shown their strength in March, and would be able to pick out market share from their weaker competitors. With interest rates at 0%, investors starved for yield will also be attracted to their ‘bond proxi’ net earnings and will allocate more to this sector, pushing their stocks’ prices up.
Value companies would struggle as they are in big trouble right now, some will have to leverage up to the hilt, some may even fill for bankruptcy. To give an example, having lost its investment grade rating early in March, Ford Motor Company is going to borrow hand over fist. it is set to pay a 9.625% per annum on $1bn of 10-year debt. It is also issuing $3.5bn of five-year bonds yielding 9% per annum, and $3.5bn of three-year debt yielding 8.5% per annum. That is very costly, and those companies are better avoided as long-term investing.
If you want to learn more about high quality investing, please read this blog: https://www.n2-am.com/post/why-quality-investing
A word of caution is needed. It is not certain that we have reached the bottom. For example, there is the possibility that we may have a second spike of COVID-19 cases. Some countries seem to be a bit too quick to end the lockdown, and the probability of a second spike has increased. If this is going to happen, Central Banks and Governments would have to offer even more money and credit to help the asset prices from collapsing and avoid a deep depression. Central Banks could buy junk bonds which were investment grade before (“fallen angels”), and as Ray Dalio said they would not stop there, if there is a need to buy even risker assets.
In the words of Ray Dalio: ‘it is just a choice, and they (Central Banks) will buy practically anything, and history shown, they have bought stocks in the past, they will do practically anything in order to save the system, you ask what is systemic important, and they will probably buy it, and you too, as investor, you have a choice of what asset you own’.
Warning: Capital is at risk when investing and you could get back less than you put in.