Don’t sell your bonds just yet, according to Jeffrey Gundlach. Global economic growth is slowing, he said, and the U.S. will be competing for a larger slice of a shrinking worldwide pie. A weaker economy dims the prospects for higher interest rates. The benchmark 10-year Treasury yield – currently 2.08% – will be 1.70% by the end of the year, according to Gundlach, providing profits for holders of long-term bonds.
“I like bonds more now with prices down and yields up,” he said. Yields on the 10-year have risen by about 40 basis points in the last month.
“It is a horrible time to be exiting bonds at this moment,” Gundlach said.
Gundlach spoke with investors via a conference call June 4. He is the founder and chief investment officer of Los Angeles-based Doubleline Capital. Copies of the slides from his presentation are available here.
Japan’s aggressive quantitative easing (QE) initiative and Europe’s recession will dampen growth in the U.S., he said. Inflation is not a threat, according to Gundlach. The Fed may slow its QE efforts, but it won’t back away from its zero-interest rate policy.
Let’s look at Gundlach’s forecast for the economy, outlook for Fed policy and preferred sub-classes of bonds.
A shrinking global pie
“The big problem that exists in the world today is declining world GDP growth,” he said. “Basically you are increasingly playing a market share game, trying to steal exports from other countries.”
Most of the growth, he said, is coming from the BRICs (Brazil, Russia, India and China) and other developing markets. Developed markets are contributing very little, despite QE efforts, which Gundlach does not expect to go away.
China is not contributing the 6% growth its reported statistics claim — Gundlach said its numbers are “fabricated.” Indeed, China is unlikely to support global growth to the degree it has over the last decade – Gundlach said it may face bigger problems. He cited a recent talk by the hedge fund manager Stanley Druckenmiller, who said that conditions in China are alarmingly similar to those of the U.S. in 2007, just prior to the financial crisis.
Gundlach said there is a worldwide trend of countries trying to protect their exports, with Japan leading the way. Its program of yen debasement, he said, is aimed at stimulating Japanese exports. Gundlach is concerned that Japan’s policies could escalate and lead to tariffs, which would destabilize the global economy.
Speculators on the plight of the yen should be patient, though. Gundlach said it might take more than five years for it to exceed 200 yen to the dollar. It is currently just over 100. He said the Nikkei stock market index may go a bit lower in the near term, but investors should not exit that market.
Growth forecasts by economists have been steadily decreasing, based on a survey by The Economist. Gundlach said projections for virtually every country decreased between October 2012 and April 2013. The sole exception was Japan.
The eurozone is in a “small recession,” Gundlach said, and investors should expect no contribution to global economic growth from it.
Anticipating the next policy moves
With growth slowing across the globe, Gundlach doesn’t expect a big shift in Federal Reserve policy.
He said that the Fed might slow its QE efforts – “tapering,” in today’s parlance – in response to lower unemployment. But the Fed’s overriding goal, according to Gundlach, is to match up the size of its bond purchases with the budget deficit. Although the Fed has never stated this to be its explicit goal, Gundlach said it is trying to use QE to match the budget deficit as closely as possible.
The Fed “greatly overestimates” its ability to achieve such fine tuning, Gundlach said, making the chances of unintended consequences very high. One of those consequences is already manifest in the U.S., he said: Older people have stayed in the workforce because their savings can no longer earn an acceptable rate of return.
The expansion of the Fed’s balance sheet has been highly correlated to the performance of the S&P 500, Gundlach said, with an r-squared of approximately 0.87. But he said it’s unlikely the Fed will taper its QE efforts to a degree that would jeopardize equity market returns. Indeed, he said if 10-year yield increased above 2.35%, the Fed might increase its QE efforts, because Treasury yields above that level would cause a weakening of the economy, and higher interest payments would pose a dangerous threat to the deficit.
Gundlach presented a hypothetical calculation showing that if interest rates were to “normalize” and increase by 100 basis points annually over the next five years, the federal interest expense would increase from $360 billion last year to $1.51 trillion.
“This really is unthinkable,” he said. “It is one of the reasons why quantitative easing is likely to be in place, particularly should interest rates start to cause problems by rising more than I think they are going to rise.”
The need for more federal revenue also makes it unlikely that corporate profits will increase significantly, Gundlach said. Profits are already significantly above their mean value relative to GDP, and they are likely to revert, although he did not say how long that reversion would take.
Another factor weighing on profits is the fact that tax revenue from corporate profits have been coming down steadily – as a percentage of GDP – since World War II, despite the U.S. having one of the highest corporate tax rates among developed economies. Some of that is due to income that is recognized offshore. Gundlach also noted that profit margins have been highest in industries dominated by lobbyists, such as healthcare and pharmaceuticals.
Inflation is low, whether measured by the Consumer Price Index or by the Personal Consumption Expenditure index, as the Fed does, according to Gundlach. Median household income hasn’t increased since 1994. Average hourly earnings are not increasing either. Unemployment, when measured – as Gundlach said it should be – by the employment-to-population ratio, is not improving.
“I just don’t think you are going to get away from zero-interest-rate policy,” he said.
Gundlach offered a few thoughts on selected asset classes.
Doubleline’s funds hold only dollar-based assets, and he recommended that investors do the same. He said he is short the yen and the Australian dollar.
If you want to bet on the Japanese market and own the Nikkei, he said to hedge currency exposure to the yen. He said investors should take their profits if the Nikkei reaches between 14,000 and 15,000 again.
Gundlach does not own any European investments.
The performance of gold and silver will continue to be “soft,” he said, but investors should prefer silver as part of a diversified portfolio as a way to hedge against inflation. Gundlach doesn’t think sliver is inherently a good investment, but he said it has a high beta and will rise strongly if inflation strikes.
As he has said in the past, Gundlach was not upbeat about the prospects for mortgage real-estate investment trusts (REITs). Expect their dividends to drop, he said, and “brace yourself for continued negative volatility.”
Emerging-market bonds are attractively priced, according to Gundlach, specifically those that are dollar-denominated. Those bonds yield 6.5% to 7%, he said, which compares favorably to U.S. high-yield bonds rated DD or DDD.
He also likes “relatively safe” (good credit quality) bank loans and non-agency mortgages.
Investors should “think about” buying long-term Treasury bonds at today’s prices, although he said those yields are likely to rise before the end of this year.
Treasury inflation-protected securities (TIPS) are unattractively priced, Gundlach said. Treasury bond yields are likely to increase in anticipation of inflation before actual inflation shows up in the CPI. Investors are better served buying Treasury bonds, rather than waiting for TIPS to produce a return through changes in the CPI, according to Gundlach.
Markets are becoming more volatile overall, Gundlach said. He recommended that capital preservation be a priority. “Interest rates are going to peak out in the fairly near term and hit their high for the year,” he said, “and many risk markets have already have hit their high for the year. Those two ideas go together.”
As for his flagship Total Return Fund, which holds mostly mortgage-backed securities, Gundlach stood by his forecast that it would return 6% this year.
Read more articles by Robert Huebscher