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Dalio says everything is a transaction – every good, service, or financial asset, someone is buying with money or credit.
Credit is promised to deliver money.
Credit grows a lot faster than money and income, and when that happens, it can’t go on for long – at some point, you can’t service debt, because it’s a promise to deliver money.
Then, there is a deleveraging.
So, there are four things you can do. You can transfer money (e.g. from Germany to Spain). Or, you can write down the debt. But one man’s debt is another man’s assets.
The third thing you can do is spend less money. And the fourth option is printing money to cover the debt.
Dalio says the bubble was obvious because the debt growth relative to income just couldn’t continue.
Dalio says the capacity of lenders to meet borrowing requirements has largely been adjusted. Italy’s and Spain’s borrowings have collapsed – and with them, the collapse of their economies.
Even still, there was not enough money to service the debt. In Spain, the ECB came in and put in about 450 billion euros worth of money. There was an unbridgeable funding gap. So now we have a situation where the debt funding needs and rollover needs are approximately in line.
Dalio says in Spain, we have a lost decade.
Dalio says there will be a long period of adjustment, and the key question is whether Europe will raise productivity. The fundamental thing Europe needs to do most is make sure the nominal interest rate is below the nominal growth rate, or else the debt will compound faster than the economy grows.
Dalio says Europe came right to the edge of chaos because there was no ECB backstop, but we moved past that point.
Dalio says the question now for markets is how events transpire relative to what the market has discounted.
Dalio says the most common mistake in investing is not looking ahead and considering the transaction – who is going to be the buyer and who is going to be the seller (of a particular asset)?
Dalio says 2013 is likely to be a transition year, where large amounts of cash will move to stock and all sorts of stuff – goods, services, and financial assets. People will spend more with the cash, they will invest in equities and gold – the cash will move.
Dalio says this will make the Federal Reserve’s concerns begin to change. It’s probably something that won’t happen immediately, but later in the year, Dalio thinks we are going to see more of that.
Dalio says the way he looks at any market is to look at who is buying, who is selling, and the motivations behind that.
Dalio says gold is generally something that large buyers would like to accumulate over a very long time, very slowly, and build that diversification. However, gold is a very small market compared to that. Dalio says the behaviour of gold makes perfect sense in that light.
Dalio says the most important thing as an investor is to have a good strategic allocation – a balanced, structured portfolio that does well in different environments.
Dalio says there is a certain discounted growth rate in equities and other assets. So, a good portfolio has assets that do well when growth is higher than expected, assets that do well when growth is lower than expected, etc.
Dalio says he has two basic portfolios – the first is an all-weather, strategic allocation mix, which has nothing to do with making “bets.”
Dalio says the one thing you can be most confident of is that assets on average will outperform cash.
The second portfolio is the bets – and those are zero-sum. One person wins, another loses.
Dalio says it’s very important for investors to know when not to make a bet – because if you come to the poker table, you have to come prepared to beat the reigning champ.
Dalio says everything is a transaction – and politics won’t have any effect on prices unless it plays into motivations behind buyers and sellers in transactions.
Dalio says if policy changes, it has to have an effect on productivity to be really significant.
Then, there are times when policy is critical, like Mario Draghi and the ECB’s actions in 2012. If you understand the cause and effect, that’s what it’s all about.
Dalio says if you put 50 per cent of your money in stocks and 50 per cent in bonds, the problem is that you have 80 per cent of your risk in stocks and 20 per cent in bonds (due to relative volatilities).
So, in structuring a good portfolio, you have to have comparable risks. If there were a law that said you couldn’t leverage, then the return of equities would be a lot like that of bonds.
Dalio says the European economy will be terrible, and gradual restructuring will go on for a while. In the United States, there will be a move out on the risk spectrum. Japan will be awash with liquidity given its recent monetary and fiscal policies.
That concludes Ray Dalio’s interview on CNBC.
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