There is a deep tension in markets as cyclical conditions, which have converged toward reasonable equilibriums, continue to confront big, interrelated paradigm shifts in geopolitics, the macroeconomy, and technology.
In our recent Q3 CIO letter to clients, we described how we’re processing these dynamics and why we prefer being balanced across assets today. Below, we share a few condensed highlights from that letter.
Bob, Greg and Karen
Co-Chief Investment Officers, Bridgewater Associates
1. Cyclical conditions remain near equilibrium in most economies, which has been good for assets. But cyclical equilibriums often don’t last long.
The acceleration of modern mercantilism and the AI revolution are reshaping geopolitics, economies, and markets with ever-increasing speed. Despite this chaotically and rapidly evolving background, cyclical equilibriums have, so far, largely remained in place. All in all, when we look across the world, we see most economies still hovering around the sweet spot today. That said, it’s important to realize that even in normal times cyclical equilibriums often don’t last long before something disturbs them, as the last chart below shows.
2. The potential for extreme outcomes exists behind the façade of market calm.
As these interrelated paradigm shifts flow through the system, it is becoming more challenging to maintain equilibrium. These are some of the risks we are watching:
- Today, with both income and spending slowing, policy makers need to find a new impetus for spending to maintain equilibrium. This is set to come via some combination of lower rates flowing through and fiscal support. When that stimulus produces spending, it will encounter an economy with a more constrained supply of labor and a rising cost of goods from the ongoing flow-through of tariffs, increasing the risk that higher nominal spending flows through to rising prices rather than real growth. And the starting condition is inflation that is still hovering above target as disinflation has stalled out, creating the risk that the system shifts from one where disinflation and normalization are tailwinds to markets to one where inflation and tightening are headwinds.
- These known conditions already create a tricky path for monetary policy to navigate. The unknowns we see today (e.g., What trade deals or escalations will we see over the next year? AI-driven capex has backstopped growth this year—will it accelerate or slow?) make it even trickier. To achieve what the Fed itself expects—a decline to 2% inflation, a slight acceleration to 1.8% real growth, all with another 100bps of easing—already requires threading a very fine needle without any of these unknowns. This is inherently a difficult equilibrium to bet on persisting.
- At the same time, the Fed must steer monetary policy with the administration increasingly trying to put a hand on the wheel, raising the risk of policy that is inappropriate for conditions.
- Fiscal policy is the other traditional lever policy makers have that influences cyclical equilibrium. And now fiscal responses are ramping up globally, often to adapt to mercantilist threats, with implications for the supply/demand for capital. For example, many US allies are now meaningfully investing in self-sufficiency. This spending is resulting in an associated “pull” for capital, encouraging money to stay home versus flow into US assets. So far, the impacts on currencies like the dollar, which was the recipient of most savings flows, have been meaningful but small in the historical scheme of things—and there’s room for much larger adjustments.
- In the longer term, rising debts and deficit spending almost everywhere raise concerns: are deficits on a sustainable path? Globally, there is little in the way of a bid for deficit consolidation—mercantilism and populism make fiscal austerity exceptionally challenging. The question is whether this will end in monetization and fiat currency debasement, as it so often has in history, or whether a more sustainable path will be found.
3. Markets are extrapolating the past into the future, not pricing in risks.
Markets, particularly in the US, are extrapolating the past and not pricing in much in the way of risks around the many threats to current equilibriums, or around the limits of the current AI wave. For example, the AI revolution has entered the resource-grab phase, with breakneck capex growth that is great for profits today but raises long-term concerns about whether these investments will produce the cash flows needed to meet high expectations.
US equities are priced as though the favorable conditions that lifted all companies, not just tech, will persist: record earnings growth, subdued volatility, and ongoing policy support. The growth expectations discounted today are about as optimistic as they’ve been in nearly 100 years, with the brief exception of the dot-com bubble.
And despite the many potential sources of volatility in the world today, market measures of risk remain unfazed. Credit spreads and implied volatility are at low levels, consistent with a continuation of current equilibriums. Combining the above chart and the below, a steep and narrow range of outcomes is what is now discounted.
4. Navigating this environment calls for diversification. We share some of the attractive opportunities we see today.
This environment brings with it an uncomfortably high probability of unknowable and extreme outcomes. There is really only one investment antidote for unpredictable and extreme outcomes, and that is diversification. Diversification means that, if and when the surprise comes, the damage is contained.
Today, we see assets as most attractive in countries that have more incentive and ability to ease and with less risk to capital flows from stretched positioning, which tend to be markets outside of the US. Asian economies, in particular, stand out as some of the most attractive destinations in the world for capital.
We also favor spreading risk much more equally across assets. Many investors today are concentrated in US equities or equity-like assets. The breadth of interrelated shifts taking place means that we can see paths across the world that lead to inflation, disinflation, strong growth, and weak growth—we prefer balance across assets for dealing with this range of outcomes, especially since diversification is still attractively priced.
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