The world’s hedge fund king has turned more upbeat about the economy. But it’s not all good news for investors

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The U.S. economy exceeded expectations in the final quarter of last year, and Ray Dalio, the hedge fund king, has turned more upbeat about the outlook. So is it up, up and away for Wall Street?

Sadly, no. While the latest reading, announced Thursday, showed the U.S. economy expanded at a solid 2.6 per cent clip in the fourth quarter, slightly above forecasters’ estimates, the pace of growth slowed.

Gross domestic product was racing ahead at an annualized rate of 4.2 per cent in the second quarter of last year, subsided to 3.4 per cent in the third quarter, then decelerated further in the final three months of the year. The slowing trend is likely to continue as the fiscal stimulus unleashed by Congress in early 2018 dwindles.

“Growth is settling down to more normal, sustainable levels as the tax-cut impacts fade,” wrote Joel Naroff of Naroff Economic Advisors in Philadelphia. He expects a further gearing down in the first quarter of this year, with annualized growth likely to come in around 2 per cent.

The longer-term outlook is for even further deceleration, according to Paul Ashworth of Capital Economics. He sees the U.S. economy expanding at 2.2 per cent for all of 2019 before subsiding to 1.2 per cent growth in 2020.

The good news for investors is that a slowing economy is likely to keep the U.S. Federal Reserve on hold when it comes to raising interest rates. As rates climb, bonds become more attractive in comparison to stocks, so a do-nothing Fed amounts to good news for shareholders.

A more cautious Fed also means less chance of an unforced policy error. In the last few months of 2018, the U.S. central bank had seemed determined to keep raising interest rates. Its apparent commitment to putting rate increases on autopilot stoked fears that it might inadvertently tilt the United States into a recession.

In recent weeks, Fed chairman Jay Powell has done his best to signal that will not be the case. His more dovish language has apparently had an impact, judging from the reaction of Mr. Dalio, the billionaire founder of Bridgewater Associates, the world’s largest hedge fund.

On Wednesday evening, he announced in a blog post on LinkedIn that he had lowered his estimate of the chances of a U.S. recession before the next presidential election in 2020 to “about 35 per cent” – not exactly an all-clear signal, but considerably more chipper than his position 18 months ago, when he put the odds of a pre-election recession at more than 50 per cent.

Mr. Dalio’s change of heart has occurred precisely because economic growth is plunging: Policy-makers at the Fed and other central banks are now more inclined to reduce interest rates than to raise them, he wrote.

“I still expect there will be a significant slowing of growth in the U.S. and most other countries,” he averred, but he said the Fed has the ammunition to fight a recession – at least, a modest one – by lowering interest rates a couple of percentage points. His concerns are mostly focused on Europe and Japan, where central banks have less room to cut rates in response to economic weakness.

If Mr. Dalio is correct, investors may want to proceed cautiously. Slowing economic growth is not good for corporate profits. Stocks, which move in reaction to those profits, may come under pressure despite flat or lower interest rates.

On the other hand, any sign of impending rate cuts is likely to be good news for bond holders because bond prices move in the opposite direction to rates. Even if a U.S. recession is marginally less likely, investors may still benefit from a fixed-income cushion.