Ray Dalio, the Role of Credit, and the Economic Machine

Credit is the most important part of the economy. Ray Dalio, founder of the investment firm Bridgewater Associates, describes it as a transaction between a lender and a borrower, in which the borrower promises to pay back the money in the future along with interest.

Credit leads to an increase in spending, thus increasing income levels in the economy. This, in turn, leads to higher GDP (gross domestic product) and thereby faster productivity growth. If credit is used to purchase productive resources, it helps in economic growth and adds to income. Credit further leads to the creation of debt cycles.

Banks are significantly impacted by credit growth in an economy. This is because their primary business is to provide loans to customers in return for interest payments. As an economic environment improves and customers are more willing to spend, demand for credit grows. This is advantageous for banks, as it leads to more loans being provided and an increase to interest incomes.

Back in 2015, US banks were direct beneficiaries of rising credit demand backed by historically low interest rates. Year-over-year, consumer credit grew 7.02% in Q2 od 2015. And from 2013 to 2015, it grew at an average rate of 6.67%. As of 2019, though, consumer credit growth has been slowing down. It’s at about 5.2% for this year overall.

Banks like Wells Fargo (WFC), JPMorgan Chase (JPM), Bank of America (BAC), and Citigroup (C) stand to benefit from rising credit demand. Investors looking for diversified exposure to banks could invest in the Financial Select Sector SPDR ETF (XLF).

Economic cycles are broken down into four primary phases: early-, mid-, late-cycle, and recession. While business cycles are repetitive in nature, their lengths are difficult to predict.

Ray Dalio suggests that the primary cause for economic cycles is the debt cycle. Expansion of credit and debt leads to an expansion in GDP (gross domestic product), thereby leading to an expansionary cycle. Any contraction of credit leads to a recession.

The early expansionary cycle is characterized by positive economic growth, declining unemployment, and rising inflation. This usually follows a recession, so it is a move from negative GDP growth to positive GDP growth. Backed by expansionary monetary policy and low interest rates, credit markets see liquidity as demand for credit and consumer spending start to grow.

The banking industry performs extraordinarily during an economy’s expansion. An expansionary cycle is characterized by increased demand for loans and bank services and increased consumer spending. These factors help to boost banks’ earnings.

Banks perform best when interest rates are low and there is higher demand for loanable funds. This leads to higher margins. They tend to outperform during the early phase of the expansionary business cycle.

From the 2009 crisis to the end of 2015, banks like Wells Fargo (WFC), JPMorgan Chase (JPM), Citigroup (C), and Bank of America (BAC) nearly doubled their performance. Comparatively, the S&P 500 SPDR ETF (SPY) surged 116%. And in 2019, the banking sector’s profitability in the US is still trending upward. But despite signs of resilience, they haven’t returned to the sustainable 12% profitability mark.

Investors should also try to understand Ray Dalio’s economic principles and how they affect US banks (XLF).

As I’ve mentioned, Ray Dalio is the founder of Bridgewater Associates—and it’s the largest hedge fund in the world. His economic principles highlight how the economy functions like a machine. These principles cover three basic forces driving the economy: productivity growth, the short-term debt cycle, and the long-term debt cycle.

Ray Dalio highlights that transactions are the basic skeleton of an economy. Each economy is simply made up of numerous transactions between a buyer and a seller. So, while seemingly complex, an economy is really just many simple parts working together.

Transactions can be in cash or credit and can be to buy goods, services, or financial assets. The total of credit and money in the economy is useful in determining the total spending in the economy. Total spending is a major driving force of the economy.

While the amount of money in existence is controlled by central banks, any two parties who transact in credit can create that amount of credit in existence. In bubbles, more credit is created than can later be paid back, which later creates bursts.

Dalio further explains how short-term debt cycles and long-term debt cycles are created. A short-term debt cycle arises when the rate of growth in spending is faster than the rate of growth in the capacity to produce, leading to price increases. This is curtailed by tightening money supply.

A long-term debt cycle arises from debts rising faster than both income and money, until this can’t continue due to excessive debt service costs, which typically arise because interest rates can’t be reduced any further. Deleveraging is the process of reducing debt burdens. Deleveraging typically ends via a mix of debt reduction, austerity, and redistribution of wealth.

Below, we take a look at how these principles affect major banks like Wells Fargo (WFC), JPMorgan Chase (JPM), Bank of America (BAC), and Citigroup (C).

Deleveraging refers to the process of reduction in debt levels in the economy, usually following a financial crisis. It’s generally measured as a decline of the total debt-to-GDP ratio.

Ray Dalio has written extensively on deleveraging. Dalio describes what he calls “beautiful deleveraging,” which uses three tools: austerity, debt restructuring, and printing money.

In financial markets, deleveraging leads to banks tightening their borrowing levels and restructuring their balance sheets. In the United States, household debt levels are in much better shape than they were during the pre-crisis period, but they are still alarmingly high.

Despite six years of the deleveraging process, the ratio of household debt-to-GDP stood at nearly 80% in 2015. While this came down a bit from the 2009 peak of 98%, debt was still disturbingly high. Now in 2019, the situation is improving. Household debt-to-GDP stood at about 75% as of January 2019.

The US financial sector (XLF) alone has been able to decrease leverage due to the strict regulations imposed upon it. After the financial crisis of 2009, US banks were forced to deleverage. Excess leverage means an excessive debt burden. This was one of the primary reasons premier financial institutions like American International Group, Lehman Brothers, Fannie Mae, and Merrill Lynch collapsed.

To protect banks from another crisis, Basel III norms have introduced a new ratio into their regulations. This ratio expects banks to maintain a leverage ratio in excess of 3%. These regulations have had an impact major banks like Wells Fargo (WFC), JPMorgan Chase (JPM), Bank of America (BAC), and Citigroup (C) directly, as it affects their ability to lend money to borrowers.

Originally published in September 2015 by Rebecca Keats, this article was updated on December 6, 2019.