WCM Educational Recap #2: The Economic Cycle

Recapped by Naveed Pirouzmand

The Economic Cycle

Welcome back to the Western Capital Markets Blog! This week, we dive Ray Dalio’s economic template to understand the economic cycle. Remember to sign up for week in reviews and topic spotlights for an opportunity to present and learn about markets in the coming weeks. More details can be found here: https://tinyurl.com/2p8z6sjk

Ray Dalio

Ray Dalio is the founder and former CEO, CIO, and Chairman at Bridgewater associates. Bridgewater is one of the world’s largest hedge funds at $140B USD AUM. He focuses on global macroeconomics and is a “big picture thinker”.

• This week’s educational focuses on Ray Dalio’s economic template, which was created to generate investment theses for Bridgewater
• It is a combination of productivity growth, short term debt, and long-term debt
• Click here to learn more about Ray Dalio’s economic template

Introduction to Economics

An economy encompasses all activities related to production, consumption, and exchange of goods and services.

Transactions

In How the Economic Machine Works, Ray Dalio explains that all cycles forces in an economy are driver by transactions. Individuals, corporations, and governments all engage in transactions which drives the economy.

• An example of a simple transaction is using money or credit to purchase goods, services, or financial assets
• Every time something is purchased, it is a transaction
• Money + Credit = Total Spending
• Price = Total Spending / Total Quantity
• The government is the largest buyer in the economy

Markets

A market is the aggregate of all transactions from buyers and sellers for a single type of good or service.

• Examples of markets include the wheat market, the car market, and the stock market
• The aggregate of all markets is the economy

Central Banking

Some of the most influential players in the economy are central banks.

• A central bank is an independent national authority that conducts monetary policy, regulates banks, and maintains alignment with the nations long term economic goals
• Central banks affect economic growth by influencing the liquidity in the financial system through controlling interest rates on loans and bonds and the supply of money
• The goal of central banks is to keep unemployment low and prevent inflation
• They can regulate member banks through cash and reserve requirements and act as an emergency lender to distressed commercial banks and government

Interest Rates

Central banks control interest rates by setting the FFR (Federal Funds Rate).

• The FFR is the interest rate that commercial banks are permitted to charge when loaning cash to each other for short periods of time
• Commercial banks charge their customers interest rates higher than the FFR to generate a spread (return)
• Banks will never issue a loan at an interest rate lower than the FFR because they could loan the cash to another bank and earned the FFR instead

Money Supply

• To increase the money supply, central banks print money and purchase government bonds.
• To decrease the money supply, central banks sell bonds and remove the cash from the economy
• When central banks purchase government bonds, the government has new cash to use at its discretion
• This process is called an OPM (Open Market Transaction)

Lenders and Borrowers

Borrowing occurs when a buyer/borrower promises to repay a seller’s cash, creating credit.

• As soon as credit is cleared, it turns into debt
• Borrowers promise to repay the entire amount they borrow (principal), plus an additional amount (interest)
• A creditworthy borrower can repay their debt and has collateral if they are unable to repay
• Lenders make funds available to the borrower with the expectation that the principal and interest will be repaid
• Lenders are individuals, public or private groups, and financial institutions

Interest Rates and Spending

Think about the interest rate on a loan as the price of the loan

• By the law of demand, when the price rises, the quantity demanded falls, and when the price falls, the quantity demanded rises
• So, when the central bank raises the target interest rate (the price of debt), demand for debt falls
• When demand for debt falls, spending on productive assets falls and growth slows
• When the central bank lowers the target interest rate, demand for debt rises, spending on productive assets rises, and growth increases
• Because one individual’s spending is another individual’s income, taking out a loan has a ripple effect throughout the economy as incomes rise and more productive assets are purchased

Why Debt is Important

When debt is leveraged to make proper economic decisions, businesses and individuals can accelerate growth.

• Without credit, spending results in no GDP growth
• Credit increases productivity and can generate economic growth
• Economics with credit can accelerate consumption today at the expense of consumption in the future

Short Term Debt Cycle (5–8 Years)

Expansion

As economic activity accelerates due to credit, we see expansion.

• When increased spending is fueled by borrowing, that means spending and incomes are growing faster than production
• Credit is widely available in times of expansion with it being cheap to borrow and easy to access
• There is increasing spending income and an optimistic economic outlook
• At peak, there is a high standard of living with high inflation and devaluing of currency
• The central bank wants to avoid excess inflation (>2%) because of issues like devaluing of currency
• To control inflation, the central bank raises interest rates which reduces borrowing and spending while increasing saving

Recession

As economic activity slows down due to higher costs of borrowing and increasing returns of savings, we see a recession.

• Credit is limited during times of recession and expensive with barriers to access
• Spending and incomes quickly decrease, despite production of goods and services remaining relatively stable
• This results in decreasing prices, also known as deflation
• Trough results in stable currency prices, decreases in the wage gap and lower standard of living
• When a recession becomes severe (a depression), the central bank will then lower interest rates to spur economic activity again

Long Term Debt Cycle (75–100 Years)

Causes

Long term debt is caused by people being inclined to borrow and spend more

• Credit is easily available more than it is not
• Over a long period of time, debt rises faster than income creating a debt burden (i.e., The Great Depression 1929)

Deleveraging to Reduce the Debt Burden

Cut spending

• Demand decreases, asset prices fall, the value of collateral drops, stock market crashes and gets squeezed, borrowers are no longer creditworthy and stop taking on new debt
• People, businesses, and governments cut their spending to pay down debt
• Debt burden grows (deflationary period)

Redistribute wealth

• Central government collects fewer taxes due to lower incomes
• Increases to spending due to unemployment and creates stimulus plans to increase spending
• Needs to raise taxes or borrow money to fund this deficit

Reduce Debt

• Many borrowers unable to repay loans
• Banks are squeezed as they are not paid back by borrowers, but depositors attempt to withdraw their capital in panic
• People and banks default on debt (fail to repay)
• Restructuring of debt occurs, with lenders getting paid back in a longer period at lower interest rates

Print money

• Central Banks use printed money to buy financial assets and government bonds
• Inflationary and stimulates spending throughout the economy
• Drives up prices making owners more creditworthy
• Central government essentially borrows from central bank and increases spending
• The recovery phase of the long-term debt cycle lasts approximately 7 years to 10 years and is known as a “lost decade” (i.e., decade after the 2007–08 global financial crisis)

Previous Economic Cycle (2008 to 2022)

Drivers of Rapid Expansion (2009 to 2015)

Quantitative Easing (QE)

• Central bank printing money to purchase government and private securities
• A form of open market operations

Low interest rates over prolonged period

• Hovered near 0% until 2015
• Made borrowing attractive for consumers to make purchases and businesses to make investments

Corporate Tax Cuts

• Boosted equities further, decreased burden for struggling firms

Drivers of Slower Expansion (2015 to 2022)

Issue

• Huge US. Government budget deficit combined with overleveraged corporations and increasing inflation
• Inflation exacerbated by quantitative easing

Solutions

• Begin raising interest rates in 2015
• Fed selling off previously acquired debt
• Decreased government spending

Macroeconomic tools

Monetary and fiscal policy are macroeconomic tools used to manage or stimulate the economy.

Fiscal policy

• Goal is to target the total level of spending and the total compensation of spending
• Taxation can affect people if different income levels in varying ways
• Government spending can be stimulus or deficit spending

Monetary policy

• Goal is to incentivize individuals and businesses to borrow and spend, spurring economic activity
• Restrict spending and incentivizing savings to “cool down” the economy
• Interest rate impacts the cost of borrowing and saving
• Supply of money in circulation matters because it is one of the most liquid asset classes

Macroeconomic Tools

Monetary Policy

• Central Bank incentivizes or reduces borrowing and spending by manipulating interest rates and supply of money (i.e., Bank of Canada’s Response to COVID-19)
• Lowered interest rates (current: 0.25%) so people and businesses are more willing to borrow and spend
• Launched liquidity facilities and purchase programs (involving buying different assets) to help struggling businesses
• Open market operations to continue purchasing long-term debt
• As a result, inflation increased rapidly (peaked 8.1%) and the house market soared (21% price growth in 2021)

Fiscal Policy

Government targets the total level and compensation of spending by manipulating taxation and government spending (i.e., Government Response to COVID-19)

• Policies like Families First Coronavirus Response Act; Coronavirus Air, Relief, and Economic Securities Act; Paycheck Protection and Health Care Enhancement Act to stimulate economic activity
• Consumer spending rebounded from -30% in April to -13% in the first weeks of June
• Few loans were distributed for the first round of assistance; loans were paid out to large businesses, but small businesses faced the brunt of COVID-19 detriment

Future Growth Estimations

Many factors aside from credit affect growth.

• Productivity (education, resource utilization) is highly correlated with future growth (i.e., high government spending, but low impact of spending leads to less growth)
• Value of a dollar and inflation
• Culture: How society views work and contribution to public goods
• Credit (country’s debt): Large debt hampers growth in the future as the country must pay it back

Key Takeaways

• Don’t have debt rise faster than income because large enough debt burdens will eventually be crushing
• Don’t have income rise faster than productivity, it will eventually render a business uncompetitive
• In the long run, the most important thing is raising productivity