How the Economic Machine Works – 2016/09/18

“Only So Much You Can Squeeze Out Of A Debt Cycle… We Are There!”  … Ray Dalio explained on 9/13 that the multi-decade long period of credit fueled growth is over. Dalio explains what this means for investors in this 30 minute video on how the economic machine works. The conclusion is sobering.

 

Most folks don’t bother to try to understand how the economy works. Economists have many theories, but they usually rely on complex models and questionable assumptions like “equilibrium” and “rational behavior” that ignore rather important phenomenon like recessions and financial crises. It is therefore understandable that most folks ignore these theories. Instead, folks deciding where to invest rely on simple rules based on historical performance. For example, folks are generally (and for good reason) advised to avoid trying to time markets and instead buy and hold diversified target retirement funds. These funds allocate more stock to the young and more bonds to the old. Stocks are considered risky in the short run, but a good bet in the long run. Bonds are considered to be a safe way to avoid losing money, but with little upside. Folks believe this because for several decades that has been the case. Without a meaningful understanding of how the economic machine works, folks generally believe (again, for good reason) that these simple rules based on historical patterns, are their best hope for saving for the future.

The trouble with these simple rules is that if everyone acts on them they will necessarily cease to be true. We have gotten the message and so we invest on autopilot along with soverign wealth funds and foreign central banks that buy stocks using printed money. This despite high US stock prices relative to earnings. Those who think stocks will always beat in the long run need only look at Japan and its 25 year 70% decline in stock prices. Meanwhile, lower for longer and even negative interest rates have turned many bonds into high risk assets. Leading the way are supposedly “risk free” sovereign bonds with long maturities such as UK gilts which were up 52% in July but then lost about 10% of their value in just the past month.

A growing minority of influential investors and regulators are pointing to global debt and quantitative easing as the chief culprits for turning conventional investing wisdom on its head. The Bank of International Settlements is notable because of their prestige and role as the central bank of central banks. The BIS 85th Annual Report 2014-15  featured this disturbing chart of global debt levels marching ever higher as falling interest rates made it increasingly easy for households, businesses, and governments to increase spending beyond their means.

global-debt-and-ir-rates

 

What makes today’s market special is that this 40 year trend cannot continue. Interest rates cannot continue to drop much below zero. Debt service cannot rise above incomes. And central banks cannot continue injecting money via quantitative easing because they are already running out of financial assets to buy.

What this means is the past is unlikely to resemble the future. How we can prepare for this “regime change” and make better decisions is the purpose of these weekly observations.

Feel free to share your own thoughts on how the economy works. There is no better compliment you can give us than your thoughtful criticism. You can reach us at intuitecon@gmail.com, or follow us on Twitter @intuitecon

Sincerely,

IntuitEcon Team

Disclaimer: These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.

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