2018 proved to be a good year for Bridgewater Associates, the world’s largest hedge fund. Even as other top-flight hedge funds turned in painful losses, Bridgewater’s Pure Alpha Fund posted one of its best performances in years. Collectively, hedge funds were down 6.7%, worse than the S&P 500’s 4.4% drop. Meanwhile, Bridgewater delivered a 14.6% positive return net of fees. That is an impressive performance at the best of times, let alone in a market slammed with volatility and uncertainty.
Given Bridgewater’s strong showing last year, one might think its boss would be gushing with optimism. But that is not the case. Indeed, Ray Dalio (Trades, Portfolio), the hedge fund's renowned founder, is increasingly fearful of the next downturn.
Recession on the horizon
According to Dalio, there is now “significant risk” of a recession in the near term. Trade conflicts, secular slowdown and tightening monetary policy may all contribute to triggering a downturn.
Because of global trade tensions and darkening consumer confidence, Dalio is sure the next downturn will be global:
"It's going to be globally a slow up. It's not just the United States; it's Europe; and it's China and Japan.”
Dalio’s money is currently on 2020 as the time when crisis will most likely hit. That is ominously close at hand. Worse still, Dalio fears the next downturn could be particularly ugly.
Few tools to fight back
While recessions vary in severity, Dalio thinks the next one could be worse than average thanks to a depleted arsenal of weapons with which to take corrective action. According to Dalio, monetary policy is “our most valuable tool” for combating the effects of recession and restoring growth, yet the current state of interest rates means the Federal Reserve will be severely limited in what it can achieve.
The long economic expansion following the Great Recession has been unusual both in terms of its length and its relatively lackluster rate of growth. Throughout the cycle, the Federal Reserve and central banks around the world have kept interest rates extremely low. The Fed has only recently started hiking interest rates, and at a laboriously slow and cautious pace. Despite that restrained pace, the market reacted violently to the most recent rate hike in December, causing many central bank observers to opine that the Fed may pursue an even more conservative approach.
Between a rock and a hard place
Speaking on a panel at the World Economic Forum in Davos, Dalio discussed the stark limitations facing monetary policy today, and how it will define the global economy over the next couple years. According to Dalio, the Fed’s efforts to raise interest rates may cause trouble for the economy, arguing that current bond yields indicate that the central bank should probably slow the pace of monetary tightening:
“If it rises faster than that, I think we're going to have another problem.”
Yet, Dalio also admits the ultra-low interest rates that have prevailed for more than a decade severely limit the Fed’s firepower to juice up the economy or combat a recession:
“Where we are in the later [economic] cycle and the inability of central banks to ease as much, that's the cauldron that will define 2019 and 2020.”
The Fed has precious little wiggle room to affect the economy through monetary policy. If rates stay low, it will have little power to intervene. At the same time, raising rates could trigger a downturn. Talk about being trapped between a rock and a hard place!
A glimmer of hope
While it might sound like Dalio is preaching doom and gloom for the economy, that is not entirely the case. Yes, he is increasingly worried a recession could start in the next year, and that such a recession would be particularly challenging to combat using traditional monetary policy tools. But he also believes prudent policy can stave off that disaster scenario:
"I think there is the possibility that you extend the equilibrium in a certain way where you have an easier monetary policy...and you grow in a fairly slower way and that you don't have a classic recession for a while."
In other words, Dalio is advocating for a monetary policy regime calibrated toward low rates, but targeting a somewhat slower economic growth rate. Of course, such actions are far easier said than done.
The global economy continues to look worryingly wobbly. We share Dalio’s fears about a near-term recession as well as his concerns that traditional monetary policy tools will be unavailable to combat it. The slow and steady tightening policy under Fed Chair Jerome Powell has seen some pushback from a market grown accustomed to near-zero interest rates, but it is vital if the central bank is to ever replenish its arsenal of monetary policy tools.
The sky is not falling, but the market very well might in the event of even a relatively minor economic hiccup. Investors should be extremely careful in these strange and volatile times.
Invest with caution.
Disclosure: No positions.
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