Markets aren’t pricing in a political panic

Ray Dalio © Getty images
Ray Dalio: reining in his horns

The conventional market wisdom for much of the 1990s and pretty much all of the early 2000s was that “government doesn’t matter”.

Markets were in the ascendant everywhere. We lived in a globalised world, where pretty much everyone – with a few stubborn hold-outs – agreed that free-market capitalism was the way forward.

This was, of course, always delusional. But in the West in particular, it meant that political paralysis, and even apparent incompetence, was greeted with a shrug.

Not any more. Now the world’s top hedge fund manager is warning that he’s reining in his horns – not because he’s worried about markets, but because of politics.

Why this hedge fund giant is pulling back from the markets

Ray Dalio is the founder of Bridgewater Associates, the biggest hedge fund group in the markets.

Bridgewater is an odd place. Lots of hedge funds are given to displays of hi-falutin’ philosophising and eccentricity. For a lot of them, it’s nothing more than branding – a sales pitch to distinguish them from the rest of their rivals. “We’re so weird, we must know something you don’t.”

Not Bridgewater. Its cult-ish reputation might work well as a recruitment tool for both potential staff and clients, but Dalio clearly believes that his deep thoughts and radical transparency contribute something to returns.

Anyway, at the moment, Dalio is musing on history and populism. He may understand that past performance is no guide to the future, but it’s the only one we have. And looking back, he’s not too keen on the way things are going.

He posts regularly on social media website LinkedIn, and put up his latest piece yesterday. He was already fretting about the economic and social divide. You’ve heard this argument – wealth inequality has given rise to populist leaders. “We are now economically and socially divided and burdened in ways that are broadly analogous to 1937.”

Clearly, that’s a worrying backdrop. But what’s bothering Dalio now is that he doesn’t think our current leaders are capable of dealing with that backdrop in a constructive manner. Dalio is worried about conflict resolution, and the absence of it.

More specifically, he is concerned that we’re reaching a point where “the principles that divide people are more strongly held than those that bind them and when divided people are more inclined to fight than work to resolve their differences”.

In short, we’re at that point in an argument where you don’t care about the collateral damage as long as the other guy gets what’s coming to him. “Conflicts have now intensified to the point that fighting to the death is probably more likely than reconciliation… While I see no important economic risks on the horizon… I continue to closely watch how conflict is handled while tactically reducing our risk to it not being handled well.”

What’s worth noting is that Dalio was prepared to give Donald Trump the benefit of the doubt when he first came to office. So this is not an embittered Democrat talking. It’s telling that he’s hunkering down now.

Markets are precariously positioned

It’s pretty disturbing to see a big player in the financial world citing 1937 as a precedent, even if he’s largely talking from an American point of view (quite a different perspective really to a European one when it comes to this).

The specific danger to markets, I’d say, is that while Dalio says he sees no major economic threats on the horizon, this is all happening at a time when markets are priced for perfection.

The latest data point on this comes from the corporate bond markets. In the absence of many bargains in the markets, investors are looking to squeeze whatever tiny bit of “edge” they can get out of the market right now.

On Bloomberg, Lisa Abramowicz notes that bond investors are scouring the market for junk-rated (high-yield) bonds that have the potential to be upgraded to investment grade bonds.

These are attractive targets. When a junk bond is upgraded, a whole new world of potential buyers and index funds opens up to it. Institutional buyers who can’t buy junk are suddenly able to invest. So if you can get in before the upgrade, these “rising stars” (as they’re known) are nice things to own.

(Logically, and yet ironically, rising stars often start life as “fallen angels” – former investment-grade companies that have been downgraded at some point.)

It’s all a sensible-enough strategy. However, everybody’s at it. “Investors have piled into top-rated junk notes at a disproportionate pace this year.” As a result, yields on these bonds have declined (yields fall as prices rise).

So today, the gap (or the “spread”) between the yield you get on the “best” junk bonds, and the yield you get on the “worst” investment-grade bonds, is at its lowest “since before the credit crisis”.

The spread peaked at around six percentage points (or 600 basis points (bps), as the bond jargon puts it) at the height of the financial crisis in late 2008. It’s now fallen to roughly one percentage point (100 bps).

This is just one data point of many showing that markets are precariously positioned. The fact that Tesla – a company that’s burnt more money than the KLF – has just managed to get a big bond issue away at a yield of just over 5% is another one.

The 1937 parallels might be overdone. But one thing’s for sure – markets are not pricing in anything much less than perfection. And we’re a long way from that.

  • Aidan Martin

    Although I very much enjoy the journalism from MoneyWeek authors I do find the relentless focus on the negative somewhat tiresome. It’s such soft and easy journalism to write a piece that is focused on ‘fear’ and markets being overvalued.
    If markets are so overvalued and we should all be investing elsewhere how about a positive piece on the ‘where’!

    • Tony Taylor

      Several years ago a fund manager friend of mine told me (one January) that the analysts he used were all giving positive views for the year ahead but in private none of them really believed them. It’s a question of putting the client who pays you first. No company will continue employing a broker who gives out negative information on them. I get your point but sometimes the choice is good news or the truth!!

  • LG

    It does seem like the same cycle. A great financial crisis is followed by an outraged populace, rising inequality and the rise of populist demagogues inciting division. In the 30s it led on to WW2. It may not play out the same way this time but its certainly worth being aware of the similarities.