Last week, we took a look at why zen master Ray Dalio’s All Weather fund has had a tough time riding out the series of violent thunderstorms that have shaken the market of late.
In short, “the historical relationships between asset classes (volatilities and correlations) that are used to construct optimal "risk-parity" funds in order that 'risk' is balanced and hedged across bonds and stocks (for example) broke down dramatically.”
Or, visually:
Fresh off a -4.2% performance for All Weather in August, Dalio sat down Wedensday with Tom Keene and Michael McKee for an interview on Bloomberg TV.
After concedeing that last month was indeed "lousy", Dalio went on to discuss the outlook for asset prices and the global economy ahead of an expected Fed rate hike cycle. The arguments will be familiar - especially to those who frequent these pages - but are worth recapping nonetheless.
First, there's the familiar idea that central banks are effectively out of ammunition and even if the will to ease is there (and make no mistake, in today's centrally planned world where every central banker from Washington to Tokyo has gone Keynesian crazy, we imagine that the will to ease will always be there), actually having the scope to do so is another matter. From Bloomberg:
“I don’t care whether they raise 25 basis points,” Dalio said Wednesday in an interview with Tom Keene and Michael McKee that was broadcast on Bloomberg radio and television. “What scares me, or what worries me, is what the next downturn in the economy looks like, with asset prices where they are and a lesser ability of central banks to ease monetary policy.”
He predicted that returns across asset classes over the next decade will only average 3 percent or 4 percent. Narrower spreads will make it much harder for asset purchases to have a big effect on the market, he said.
And then there's the argument - which we've been making for longer than we can rememeber - that paradoxically, because ultra accommodative monetary policy hasn't proven effective at engineering a robust global recovery by resuscitating demand, but has instead served to perpetuate a global deflationary supply glut, any move by the Fed to hike rates will almost invariably trigger a dramatic meltdown in already beleaguered emerging markets and that meltdown will in turn feedback to advanced economies causing the Fed to reverse course and launch QE4 at which point any semblance of credibility will be lost as will any hope that the world will ever be able to normalize without suffering through the worst collapse modern capital markets have ever witnessed:
Dalio, who manages the world’s biggest hedge fund, is among a small number of prominent money managers who have urged the Fed not to raise interest rates. Jeffrey Gundlach, co-founder of DoubleLine Capital, has said the Fed would have to reverse course if it raises rates prematurely.
“We will have a downturn,” Dalio said in the interview.
As the U.S. Federal Reserve meets Thursday to decide whether to raise interest rates, Dalio said a big increase in the near future is impossible because the global environment requires lower borrowing costs. He reiterated that the central bank will eventually return to quantitative easing.
If and when the Fed does finally move to hike, it will be interesting to watch not only Dalio's All Weather fund, but also the rest of the risk-parity crowd to see how the "rebalancing" works out in what are sure to be chaotic markets. On that note, we close with the following from Deutsche Bank:
A “policy error” rate hike might well result in positive correlations among equities, commodities and bonds, due to a combination of risk off and higher rates. In this case it is not entirely clear how risk-parity funds would rebalance: A potential candidate for inflows would be currencies, and in particular the dollar, which could be the only game in town. Of course, this would only put additional upward pressure on the dollar, reinforcing the “policy error” nature of the hike via additional traded goods price deflation (including commodities), weakness in net exports, and exacerbating pressure on dollar peggers.
