Ray Dalio (Trades, Portfolio) came out with gloomy predictions for stocks and the economy. In a post on LinkedIn, the billionaire investor and co-Chief Investment Officer of Bridgewater Associates predicted that interest rates will have to rise more than expected and offered his projections on the impact this could have on stocks. .
Here are my main takeaways from this very informative article.
From Inflation to Interest Rates, Stock Markets and the Economy
The first part of Dalio’s article is devoted to explaining the cycle of inflation, interest rates, equity markets and the economy.
In summary, inflation kicks off the cycle, and inflation occurs because the productivity of society increases over time. All other things being equal, when money and credit rise, demand and economic growth will be strong, unemployment will fall, and these factors will combine to produce inflation. Since some inflation is a sign of a growing economy, the Federal Reserve targets an average inflation rate of 2%.
Dalio doesn’t explain why the Fed generally doesn’t want inflation above 2%, but the short version is that high inflation destroys economic growth because rapid price increases are unevenly distributed based on societal power imbalances. . As a result, most people’s purchasing power declines, as does their quality of life, leading to lower productivity and thus a shrinking economy. However, even though wage inflation does not follow price inflation in this scenario, it still occurs somewhat, which further increases price inflation. It can quickly spiral out of control.
So when inflation moves well above 2%, the Fed needs to tighten monetary policy, which involves raising interest rates as well as buying and selling bond assets with the money she creates.
Dalio writes that once tighter monetary policy is enacted in light of inflation, it “depresses the prices of equities, stock markets, and most income-generating assets due to a) the effects negative effects it has on earnings, b) the need to lower asset prices to provide competitive returns, i.e. the “present value effect”, and c) the fact that it there is less money and credit available to purchase these investment assets.
In addition to the effects on stock markets, the tightening of monetary policy has an impact on the economy by making it more expensive to borrow.
I would like to add that while limiting the flow of money and making borrowing more expensive, they also hinder economic growth, but they do so in a controlled way that is more likely to limit growth rather than destroy productivity as does rapid inflation.
Next, Dalio explores possible mathematical outcomes for the stock market. It tells the reader to pick a base number based on what they expect inflation to be. According to Dalio’s calculations, current stock prices (at the time of the article’s publication on Tuesday) indicate that the market expects inflation of 2.6% over the next 10 years.
Dalio believes that inflation is likely to be closer to 4.5% or 5% in the long term, unless there are new shocks such as “the worsening economic wars in Europe and Asia, or more droughts and floods.” In the near term, he writes that he actually expects inflation to ease slightly as past shocks such as the energy price spike unwind.
The next estimate needed for the Dalio calculation is the average interest rate over the next 10 years. The guru says markets are currently pricing 1%, which he considers a high estimate, setting his target range between 0% and 1%.
“Put the inflation estimate and the real rate estimate together and you’ll have your projected bond yield,” Dalio writes. This gives him a projected bond yield between 4.5% and 6%.
There is a difference between the real interest rate set by the Fed and the interest rates for different types of credit. After all, nobody got a 0% interest mortgage just because the real rate was 0%. Interest rates and availability of credit will depend on supply and demand.
Given that the issuance of new US government debt and the unloading of its balance sheet by the Fed will drive about 8-9% of all US government debt gross domestic product into credit markets, Dalio estimates that interest rates will have to increase within the range of 4.5% to 6%. This will reduce credit growth to the private sector and, therefore, the stock market and the economy.
Assuming an interest rate of 4.5%, the effect of present value discounting (i.e. devaluation of equities due to inflation and higher interest rates) and an assumed 10% drop in earnings, Dalio estimates that these factors combined will create a 20% drop in stock prices on average, with longer duration assets being hit the hardest.
Following this same extrapolation, if we were to get an interest rate of 6% (remember, this is not the actual rate but the rate imposed by supply and demand, which the Fed cannot control ), then stock prices could fall by 30%, although Dalio thinks that scenario is unlikely.
So far, the negative effect of inflation on wealth has been delayed due to relatively high levels of cash and wealth, as evidenced by the fact that large debt-dependent purchases like housing have declined while consumer spending remains strong. However, this will eventually be removed.