Gundlach on Donald Trump, China and Fed Policy

Gundlach cited an article that appeared in Bloomberg earlier this year, which showed that the Fed has raised rates 118 time since 1948. The average nominal GDP growth at the time of those hikes was 8.6%, more than twice today’s rate. Only two of those hikes occurred when growth was less than the current rate of 3.7%.

Lack of inflation argues against a rate hike. Gundlach said that commodity prices, measured by the CRB index, are at the lowest point in the past 10 years. The Fed’s preferred inflation indicator, the core PCE, is at the lowest level since 2011 and 50 basis points lower than when QE3 begin three years ago. The core CPI has risen slightly in the last three months, and Gundlach said the disparity between it and the PCE is due to a difference in the weighting of medical-care expenses.

Inflation expectations, as measured by the TIPS market, have also been declining. Low inflation has been driven by weak oil prices, which Gundlach said may go lower. Production of oil exceeds current global demand, he said.

Weak credit conditions are an ominous sign for the Fed. The price of the junk bond ETF, JNK, is at a four-year low, Gundlach said, and the price of the investment-grade ETF, LQD has also been performing badly.

Emerging-market equity prices are at a six-year low, he said, and are sending a “dangerous signal” to the Fed. The warnings from the IMF and the World Bank were based, at least in part, on fears that a rate hike would trigger instability in those markets.

In March, Janet Yellen said she was fearful about raising rates because of the strength of the U.S. dollar. It has stayed strong, Gundlach said, giving the Fed another reason not to raise rates.

Gundlach said the ISM and PMI manufacturing indices, which he usually doesn’t mention in his webcasts, are also lower than when QE3 began.

Hourly wage earnings have been stable with a very gradual increase since 2011, Gundlach said, which is one positive sign that would argue for Fed tightening. But that is belied by the employment cost index, which Gundlach said is now at its lowest point since 1982 when the data series began.

Gundlach reiterated a comment he made on July 15, the day that Yellen was appearing in a congressional testimony. He said that if you looked at charts of emerging market stocks, junk bonds, commodity prices and nominal GDP and you flew in from Mars, you would say, “My goodness I hope the Fed is easing.”

“All of these things seem to be screaming fairly loudly, ‘Dammit Janet, don’t raise rates,’” he said.

What’s going on in China?

Aside from his comments about Trump’s trade policy recommendations, Gundlach expressed clear concern over recent developments in China.

Gundlach cited arrests of individuals by Chinese authorities over on-line rumors and other types of crackdowns. “This type of thing usually comes along simultaneous with tensions and unrest broadly speaking,” he said. Those actions are driven by weak economic growth, which Gundlach said is less than China’s publicly stated target of 7.5%.

Weak growth is being driven by the strength of the Yuan, which has appreciated by more than 10% relative to China’s trading partners, according to Gundlach. He said that other Asian currencies have been “systematically weak” since 2012, while China’s has been relatively strong.

Problems are clearly evident in China’s equity markets. Gundlach compared the massive gain in the Shanghai index and the subsequent crash earlier this year to the U.S. stock market movement in 1929 at the start of the Great Depression.

“In 1929, the U.S. had been promoted to the engine of global growth and we know that what happened when the Dow Jones industrial blew off in 1929, the crash was followed by some pretty rough economic time periods,” he said. “This is metaphorically similar.”

Another similarity between China today and the U.S. in 1929 is the amount of margin debt. Gundlach said Chinese margin debt went up five-fold from the middle of 2014 until the crash this spring, and now that leverage has completely unwound.

Real-estate construction, which had been a driver of Chinese growth, is waning, according to Gundlach. The floor space of new buildings was growing at between 10% and 15% since 2009 – until this year, when it contracted by 11%, he said.

Gundlach did not offer any forecast for China’s growth or for what will happen with its political unrest. But he expressed clear concern for what slow growth in China will mean for the rest of the world. It’s already fueling lower commodity prices, he said, given China’s outsized needs. For example, China represents 73% of the demand for iron ore, Gundlach said.

If China’s growth is 1% or 2% instead of the 7% or 8% many believe, then Gundlach said he fears that global growth could be as low as 1% to 2%. That would mean some countries would face negative growth. Besides fostering popular unrest, Gundlach said those conditions would force countries to attempt to stimulate growth through currency devaluations, which would be systemically unstable.

Gundlach mostly dismissed fears that China would sell some of its U.S. Treasury holdings to support its currency. He said those holdings have been mostly stable for the last several years and have not been a source of recent volatility in the U.S. bond market.

“I don’t really think selling pressure from foreign central banks, particularly the Chinese, has anything to do with U.S. rate markets movement in August,” he said. “Rather it is the long bond wants the Fed to tighten.” His latter comment means that long-dated maturities would react positively (increase in price) if the Fed were to raise short-term rates.

Asset class valuations

Gundlach reiterated his forecast from previous webcasts – that yields in the Treasury market will be unchanged over the course of 2015. He noted that, thus far this year, that forecast has been accurate not just in the U.S. but in many global markets.

German bund yields, which were negative earlier this year, are converging with Treasury yields, he said. That means bunds are a “much worse investment” than Treasury bonds.

For the U.S. corporate bond market, Gundlach said the credit cycle turned in the first half of 2014 when yield spreads bottom and credit conditions were the most relaxed. Since then, he said, spreads have widened in the high-yield market, which is consistent with the price of JNK at a four-year low. In 2013, high-yields were the most overvalued in history; now, Gundlach said, they are fairly valued.

The high-yield market includes a substantial number of issuers in the energy and mining industries, he said, and those bonds are unlikely to perform well, given his forecast for continued weak prices in oil

“The amount of time that we are spending below $50 and certainly below $60 a barrel has started to become protractive and companies will start running out of money,” he said. Default rates have not yet spiked, he said, but they will if the price oil remains below $50 for another year.

His fund, DBLTX, has been one of the top-performing intermediate-term bond funds this year. Gundlach corrected a misconception that his performance was due to holdings in “esoteric CMOs,” including interest-only securities. He also noted that his holdings of non-agency residential mortgages are priced to provide a “cushion” against further defaults that he “fully expects.” More on this topic can be found in this APViewpoint discussion.

The driver of the performance of DBLTX, he said, has been the overall mix of corporate and government credit along with its interest-rate positioning (the duration of the fund).

Many economists changed their views when the S&P 500 bottomed earlier this month, predicting that the Fed would not tighten. Since then, commodity and stock prices have risen.

But even if there were a 10% increase in stock prices and a move to $55 oil, Gundlach’s position would be unchanged.

“If that happened, then maybe the Fed would feel more emboldened to tighten,” he said. “But markets being where they are here September 8, I think the Fed is not going to raise rates nor should they.”

Read more articles by Robert Huebscher