Bracing for a deleveraging economy – Discovery

Well, first off, I am not an expert in investment, finance, nor economy. I am just a humble developer who is entering the workforce in a month’s time. It will be the first time in my life that I will be earning thousands of dollars per month. Besides being able to eat less instant noodles and cut my hair more frequently, I will have some extra cash sitting around.

The common way is to invest this extra cash and let it compound with interest. Over time, I will be rich… Right?

Honestly, I don’t know. And that is precisely the reason why I am learning about investment and finance.

Though, along the way, I realize that many such “common knowledge” isn’t commonly known. So, in this article, I will document down what I have learned so far – The economic cycle, a common investing strategy called dollar cost averaging, the long-term debt cycle, and some possible light at the end of the tunnel.

Hopefully, by the end of this article, you will have a clearer idea. And then you will be the judge of what to do with your money.

The Economic Machine

From the coffee shop, I often hear about the “economic cycle”. The cycle of the bullish and bearish market. “What comes up must come down” and vice versa. But I don’t really like analogies, especially when trying to understand an unfamiliar domain.

That’s when the “Economic Machine” comes in. I first hear about it from reading Principles by Ray Dalio. It serves as a rough framework of how the economy works and it gives a macro view of the economic cycle. And there is much credibility to this framework especially when everything is explained with a reason, and that it comes from one of the largest hedge fund manager – Ray Dalio.

You can find the video on How the Economic Machine Works here.

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The general idea is very simple – One’s spending will become someone’s income. As we earn more money, take out more loans, and have more disposable money, we also consume more.

When we increase our spendings, the producers earn more. This action creates an inflationary effect on the economy. Note that this effect will drive up the demand and prices of assets causing the rich to get richer.

However, when debt piles up faster than what we earn, we become pessimistic. We control our spending, take out fewer loans, and try to pay off our current debts. In such a time, it only makes sense for the banks to be more prudent when it comes to giving loans.

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Remember, our spendings is someone’s income.

When our spending drops, someone’s income drop. This creates a cycle and a deflationary effect on the economy. Prices of assets take a dip together with the economy.

These effects, in the short term, are met with fiscal policies introduced by the government. This can come in the form of increased money supply (print more money), lowering interest rate to encourage more loans and thus stimulating consumption. When done effectively, the economy will be stimulated back into an inflationary economy. This is the short-term debt cycle.

However, in the long run, during an inflationary economy, people get wealthier and accumulate more leverage through debts. As the debt piles up (with interest) faster than the increase in wages, it becomes difficult for us to pay off our debt – Even for companies and nations.

Distrusts breeds. Loans become harder to get. The economy is driven into a deflationary period.

When the effect is so strong such that lowering interest rate and printing more money cannot recover the economy anymore, the economy continues to deflate. This is the long-term debt cycle.

Looking at the past century, this cycle has proven to be true. And as I mentioned earlier, from my perspective, this line of reasoning has strong credibility.

A recession is overdue

The short-term debt cycle is easy to follow because it happens more frequently than the long-term cycle (duh!). We can easily look back in the past few decades and realize that the economy indeed works that way.

So, with some spare time on hand, I did a little bit of research. This Wikipedia shows the list of recession US faced in its economic history. There are two columns of interest to me here – Time since last recession and duration.

Looking at the time since last recession, it ranges about 2 – 6 years with the longest of 10 years happening in the 2000s recession. The last recession ended in 2009. It has been 9 years since we had a recession. We are well over average.

The duration of recession ranges from 1 – 2 years, with the longest being 3 years 7 months during the Great Depression (1929 – 1933).

This information gives me the idea to save up cash to prepare for a recession and then invest in the market when the price is low during the recession. This brings me to the next two concepts – Dollar cost averaging and a deflationary period.

Dollar Cost Averaging

If you are planning for your finance, you have most likely heard about this term.

The market is unpredictable. Even the legendary Warren Buffett agrees. So, the common strategy for a conservative and defensive investor is to invest a specific sum of money on a regular basis into an index fund. By doing so, the buy-in price is averaged out over a period of time (thus the term dollar cost averaging).

This eliminates any form of speculation and prediction. The money is sure to grow as long as the economy becomes more productive – Which we will due to advances in technology and people getting more educated.

Also, because index fund represents the state of the economy and helps in diversification, we are essentially betting that the economy will grow in the long run. We are referring to a time scale of decades – 10 to 50 years long.

So with a recession overdue, I should save up on cash, wait for the recession, and then start to regularly invest an amount into an index fund… Right?

I don’t know.

I was confident until I realize a downturn in the long-term cycle is overdue too.

The dollar cost averaging method relies on the fact that the economy is growing in the upwards direction generally in the long run. Thus, by averaging it out, we are essentially drawing a best-fit line on the GDP chart – Which has been in the upward direction for the past many decades.

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However, in a long-term deflationary period, or Ray Dalio calls it a “deleveraging period”, the general direction is downwards. Wouldn’t we be making a loss until after the deleveraging period is over? That would take about 10 to 20 years generally.

If I were to wait 10 to 20 years before investing in anything, I am missing out on a lot of interest in that period of time. That should be the time I am smelling my retirement.

To gain clarity, I did a little research on the long-term deflationary period.

A deleveraging incoming

As explained earlier, a deleveraging happens when the debt level far surpassed the ability to repay them and people start defaulting on their loans. These “people” include individuals, corporations, and even nations.

To understand the situation, I look at the debt-to-gdp level in the US.

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According to TradingEconomies, the previous deleveraging period happened before the 1950s. At its peak, the debt was 120% of its GDP. Right now, we are above 100%, well within the danger zone.

“The US can just print more money”

No, they can’t.

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The graph shows that money supply has been on a steady and gentle increase from way back until in 2008, it started shooting up crazily only to be controlled within recent years. This shows that there is a limit to how much the government can print their money. Too much printing and the value of the money drops.

As a Singaporean, I am also interested in the economy of my country.

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Likewise, Singapore’s debt-to-gdp level is at an insane level. However, the saving grace is that the government claims that the high debt level is not due to loans to fund its spending, but rather accumulated through saving securities such as the Singapore Savings Bond.

You can find their official statements here and here.

Aside from the nation’s debt, we should also keep an eye on the household debts, especially in Singapore which is at a steady incline.

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At this point, it is clear that a deleveraging economy is incoming and a recession is overdue. However, I am unsatisfied with the idea to let my cash stay idle. What can I do with them to let them grow with the least risk possible?

Again, for the third time, I don’t know yet. However, so far I have a few vague ideas.

What I have learned so far

As someone who doesn’t have a father figure that I can look up to and someone coming from a poor family, finance management is an unfamiliar ground.

As such, I read books to learn about the things that beg for an answer urgently. So far, I have read business owners’ biographies to understand the considerations, operations, and financials of a business. I took up accounting classes to learn the fundamental technicalities. And currently, I am reading books that discuss investment.

One way forward in this deleveraging economy is to invest in stocks running at a discount. In The Intelligent Investor by Benjamin Graham, one example of such a bargain was given with a company having their company valued at a price lower than their net working capital.

What this means is you are essentially buying the shares for free as their current assets value already surpass the share price. As such, one way out for the idle cash in a deleveraging economy is to look out for individual stocks that have a sound bargain and a strong earning power. Or Warren Buffet likes to call it an “economic moat”. For me to be able to determine that, I have to understand more about business and security analysis (which I will talk about next time).

Another solution unique to Singaporean is the Central Provident Fund (CPF). The CPF is a pension scheme to help Singaporeans manage their retirement fund. The CPF is separated into different accounts. And the idle cash can go into two different accounts that can be converted into monthly payout after retirement. The interest rate is 2.5% for the Ordinary Account and 4% for the Special Account.

However, the average returns in the market run at about 4% for the past few decades, and many index funds have outperformed this average. As such, I might be more inclined to put my money into companies that I understand.

Also, the catch with CPF is that you cannot withdraw your money until retirement. Even after retirement, the withdrawal is in the form of monthly payout, not a lump sum (if the amount is below a minimum sum).

Finally, one thing weighing on my mind on this topic is the fact that I will never be rich if I merely invest my idle cash. I might have a comfortable retirement. But if my desires are more ambitious, then my investment should not be a means for me to get rich (as it will never happen), but rather a means for me to maintain any wealth I get from other sources. Hence, my investment style should match this intention as well.

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