(Kitco News) – It’s no surprise that central banks and sovereign wealth funds are pivoting away from Treasuries and towards gold, and history shows that the present moment is a perilous one, according to Ray Dalio.
In a candid conversation with the WSJ Leadership Institute’s Alan Murray at the World Economic Forum in Davos last week, the Bridgewater Associates founder discussed the ongoing convergence of debt, capital flows, domestic politics and international conflict.
Dalio stressed that the debt cycle works the same way whether for an individual or a country, except that a government can print money.
“When you have very little debt relative to your income, you can increase it and it's not a problem,” he said. “But the more debts and debt service you have, then it squeezes out your spending. That's when you start to get into financial problems.”
There’s also a supply-and-demand dynamic. “In other words, one man's debts are another man's assets. So when you sell the bonds and somebody's holding those bonds, they expect to have a decent, real return, otherwise they wouldn't hold the bonds.”
“The world has a lot of that debt, and then you're selling a lot more,” he added. “Do you want to buy a lot more?”
Dalio said that the increase in geopolitical conflict adds another layer of complexity – and additional risk.
“We're now talking a lot about trade wars,” he said. “You could see more capital wars, or you can understand why buyers or holders of U.S. dollar-denominated debt might feel it's risky, either because of [supply-demand] or because you have a war-like environment. If you were China, wouldn't you be worried that you could be sanctioned? And if you're the United States, then there's a risk that's not bought.”
This new risk calculus is showing up very clearly among sovereign buyers, who are passing up fiat in favor of hard money.
“What you're seeing happen now is a change in central banks’ holdings: They're moving to gold,” he said. “Gold is now the second-largest currency.”
“Why did the gold market go up? Why is it going up? You're seeing central banks and sovereign wealth funds and so on beginning to build that kind of money,” he said. “Why? Because that is the safer kind of money.”
In the current environment, Dalio said the most surprising thing is that people are still surprised.
“It's shocking to me that everybody wakes up every day, reads the news, and is shocked because of something that never happened in their lifetime,” he said. “Connect the dots. How is the money? Why did gold go up 67%? We've been through this before. Who are the buyers? What is happening domestically? Pay attention to what is happening! Is this not the real story?”
On Oct. 30, Dalio spelled out his fiat-versus-gold thesis in a detailed LinkedIn post, saying gold is better understood as fundamental money rather than a speculative asset, and investors would be wise to hold between 5%-15% of their portfolio in it - and even more in times of war or fiat devaluation.
“It seems to me indisputably true that gold is a money and it is the money that is least at risk of being devalued and/or confiscated,” he said.
Dalio said that throughout history, all money has either been “‘linked/hard-asset-backed’ currencies, meaning linked to gold or something similarly limited in supply and globally valued like silver,” or fiat currencies, “meaning currencies that are not linked/backed by anything, so they aren’t limited in supply.”
He noted that throughout history, every time gold-linked or asset-backed money had too much debt or commitments attached to it, the monetary system broke down. “This happened because the countries’ leaders either a) stuck to the commitment to back the money with gold, which led to debt defaults and deflationary depressions or b) broke their commitment to give the gold at the committed price, which allowed them to create a lot of money and credit, which typically devalued the money and led to higher inflation and higher gold prices.”
“Before the introduction of central banks (in 1913 in the US), the a) deflationary path was typically followed, but after central banks came into existence, the b) inflationary path was followed,” Dalio said. “In both cases, big debt/monetary breakdowns/crises followed and reduced debts relative to the incomes to service them, which fixed things at new, higher price levels.”
Since all currency has been fiat since 1971, Dalio said the lessons of fiat system breakdowns are more relevant to today. “In such cases, central bankers always created a lot of money and credit, which typically led to higher inflation and higher gold prices,” he said. “In all these cases, gold did well as an alternative money to ‘paper debt money.’ Over long periods of time, it was the money with the best track record of holding its purchasing power. This is why it is now the second-largest reserve currency held by central banks.”
One of the major advantages that gold has over fiat currencies is that “it has lower confiscation risks than other monies and other assets,” Dalio said. “That’s because it doesn’t depend on getting money from someone, and it’s tougher for someone or some government to take it from you.”
Because of this, “during times when there were monetary/debt crises and/or wars that increased the risks of confiscation, gold went up a lot in value (or, said more accurately, it was the money that didn’t fall in value),” he noted. “This is why gold has continued to be the most fundamental money over time, with the best track record of having its value keep pace with the cost of living over very long periods of time.”
“That’s how the debt/money/gold dynamic has worked and still works, which is especially noteworthy at times when there is a lot of debt relative to the amount of money needed to service the debt and when there are risks of confiscation,” he added.
Dalio also shared his analysis of gold as a standalone investment asset.
“I look at gold like I look at all other assets in putting together my portfolio, which is by looking at its expected returns, risks, correlations, and liquidity in relation to other assets to make a strategic asset allocation mix,” he wrote. “Then I think about what tactical deviations I want to make from that mix based on what’s happening as it affects the markets. So, I see gold as part of one’s portfolio as having a certain amount of money that has certain characteristics, just like having a certain amount of cash has its characteristics.”
Dalio said his approach differs greatly from that of most investors, who treat gold more as a speculative market.
“When I think about how much gold one should have in their portfolio, I view that as first and most importantly a strategic asset allocation rather than a tactical/market-timing decision,” he said. “I think everyone’s starting point for investing should be to know and be in the portfolio that is best to have, independent of any tactical views of the markets. Any deviations from that portfolio should only take place if the investor believes that they have better abilities to market-time, which investments are better than others. Most investors don’t have this ability, so they should just stick with their strategic asset allocation mix.”
“For this reason, when investors ask me if they should buy or sell gold based on whether I think it will go up or down, I tell them that that’s a tactical, secondary question because they should first start by asking themselves what amount of gold they should have in their strategic asset allocation,” Dalio added. “When I look at this in my own analysis, this is between 5% and 15% depending on what other assets are in the portfolio and the investor’s risk preferences.”
“As for tactically market-timing over- and underweighting gold in one’s portfolio, as explained, it should be overweighted at times of monetary system breakdowns and high risks of money confiscations and economic/monetary wars (e.g., sanctions) and underweighted at other times because, over long time frames, gold has been a relatively poorly performing asset (like cash) because it’s not a productive asset,” he concluded. “In any case, what I’m trying to get across is that you should think of gold as being a fundamental money that you should own at least some of. Most investors don’t own any.”
