
Even if the Fed raises short-term interest rates as many expect it to, longer-term bond investors won’t face a decline in prices, according to Jeffrey Gundlach. Indeed, the market may have already priced in the effect of rate hikes, he said.
Gundlach is the founder and chief investment officer of Los Angeles-based DoubleLine Capital. He spoke to investors via a conference call on March 10. Slides from that presentation are available here.
“It’s more likely that the 10-year Treasury dips below 2% than it goes up as high as 3% during the course of 2015,” Gundlach said.
The 10-year closed at 2.14% on the day he spoke.
Gundlach reiterated his belief that raising rates would be a mistake due to the weak global economy and low inflation. Even if the Fed were to take that step, he said, it would eventually be forced to reverse and lower rates, as several European countries have had to do after attempting premature rate increases.
“I’m afraid that the Fed is intent on being a blockhead and raising interest rates against this backdrop,” he said, “and further strengthening the dollar, weakening the economy, weakening corporate earnings, and basically having to reverse policy.”
Demographic problems and the growth of the federal deficit will push rates higher, he believes, but that might not occur for another five years. Gundlach also boldly predicted an inglorious fate for Detroit’s automakers.
I’ll first look at his views on Fed policy and how it will play out in the bond market and then his assessments of valuation in various asset classes.
The factors driving bond prices
Weakness in Europe’s economy is driving down rates. Gundlach said that $2 trillion of global bonds now have negative yields and another $2 trillion have marginally positive yields of just a few basis points. Quantitative easing (QE) by the European Central Bank (ECB) will push yields even lower, according to Gundlach.
With the strengthening of the dollar, Gundlach said there is an “overwhelming interest rate differential” that will “put a lid” on U.S. Treasury yields, as investors favor those bonds over their European counterparts.
“These European bond yields sure are low but they are not likely to rise,” he said, because the ECB’s QE has depleted the supply of investment-grade bonds and will do the same for European sovereign debt. That, in turn, will further support the dollar against major developed-market currencies, he said.
Gundlach noted that 70% of European companies have dividend yields higher than their corporate bond yields. He speculated that companies could borrow aggressively to retire their higher-yielding stocks.
Europe’s problems may weigh heavily in the Fed’s thinking. Gundlach said that Janet Yellen devotes the third largest allocation of her time to meeting with foreign officials. “You wonder exactly what that’s about, what they are colluding over, or what sort of input is being given,” he said.
Hourly earnings are increasing modestly, Gundlach said, and that is likely a reason for the Fed’s apparent willingness to raise rates. Historically, wage increases have been a prelude to Fed rate hikes, he noted.
“As long as employment data shows up okay and oil is at least stable and not falling, I think the Fed really does want to raise interest rates,” he said.
Inflation is “not a problem,” he said, in part due to falling commodity prices. U.S. inflation is exactly the same as in Europe, according to Gundlach. The U.S. may actually be in deflation, he said, depending on the method of calculation used for consumer prices.
Demographics and deficits
The U.S. economy has benefited from low interest rates, according to Gundlach, but that may start to unravel in four or five years.
Many of the bonds owned by the Fed, which were acquired largely through QE, mature starting in 2018. Each year thereafter, he said, approximately $300 billion of Treasury bonds come due. Either the Fed will have to reengage QE to purchase those bonds or “someone else will have to buy them,” he said.
That occurs at the same time the federal deficit is projected to expand because of entitlement obligations, he said, creating a need for further debt issuance.
“This is why I think the rising interest rate crowd is on to something, but they are three or four years early,” he said.
Gundlach discussed demographic changes, which he said have been missed by central bankers. Across the developed world, the share of people over age 80 is increasing, a cohort that must be economically supported by the working-age population. This is particularly true in Japan, China and Germany, he said, but is not as bad in the U.S.
“It’s too early to be going deeply into this for investment purposes,” he said, “but as we are looking forward for the next big thing is going to be this rollover of debt, the deterioration of the U.S. deficit again, and these demographic changes.”
“This is going to be where you have to get it right to really be a successful investor looking out for the next 10 years,” Gundlach said.
Valuations
It’s a very different environment now than it was last year, Gundlach noted. A year ago, U.S. Treasury bonds were the asset “nobody wanted,” but ended up performing extremely well.
Gundlach offered thoughts on the relative valuations for a number of asset classes.
Gold, he said, will make it to $1,400 per ounce this year, but he’s “not really that bullish,” despite evidence of significant gold buying by central banks.
He did not say whether U.S. equities were over- or undervalued, but did note that share repurchases have been a “huge source of demand” over the last several years.
Gundlach said he is “long the Japanese stock market.” The Nikkei, he said, is at a local high in terms of its performance versus the S&P 500, and back to where it was nearly two years ago.
The Indian stock market continues to be one of his long-term favorites. He said its demographics are “very, very good,” and he advises owning it, even though recent performance has been strong.
U.S. investment-grade bonds are two standard deviations rich, Gundlach said, due to recent strong performance and are “very overvalued.”
High-yield bonds are fairly valued, he said, following a recent selloff. He warned that recently launched distressed energy funds have “jumped the gun” and bought bonds at prices that were too high to deliver significant returns. He said that oil will go lower but not as low as the $10/barrel some have predicted, and energy bonds will suffer further price declines.
Agency mortgage-backed bonds are also fairly valued, according to Gundlach, as is emerging-market debt.
Gundlach said he is a “buyer” of Puerto Rico’s municipal bonds at prices in the low 80s. He said he personally owns a significant amount of California general-obligation municipal bonds and is “quite comfortable” with those investments.
He stated that he would “at best put a hold” on buying mortgage REITs.
TIPS are cheap, he said, “but not convincingly cheap.”
The death knell for big auto?
Gundlach is “long-term negative on the auto manufacturers.”
The efficiency of car usage is going to explode to the upside in the years ahead, he said. The success of Uber is showing that consumers – particularly millennials – are discovering that they don’t really need a car, especially if they live in an urban area.
Most cars, he said, are parked 23 hours a day. Driverless cars will make transportation easier and more flexible, Gundlach predicted, as consumers will be able to step up to the curb and effortlessly decide where they want to go.
He believes that new car sales will fall substantially, perhaps by as much as 40%. Consumers will find that they may prefer adding other rooms to their houses or finding other uses for land space, rather than building a garage.
Those changes, he said, will not happen in the next year, but will unfold over a longer time horizon.
“It is the direction of that trend that matters,” he said. “Car sales are at an all-time high, and yet a trend underneath the demand is almost certainly going to change. The long-term future of mono-line auto manufacturers, particularly old school, doesn’t look very good.”
Read more articles by Robert Huebscher