Gundlach’s Warning for “Risk Assets”
So-called “risk assets” – securities, like equities, that offer the greatest opportunity for returns but the highest exposure to risk – are priced at levels that are eminently unattractive, according to Jeffrey Gundlach. Indeed, he said that investors in risk assets should expect returns of only 2% versus potential losses of 20% – an ominous 10-to-1 tradeoff.
Gundlach spoke to investors on March 8, to provide updates on the DoubleLine Total Return Fund (DBLTX). He is the founder and chief investment officer of Los Angeles-based DoubleLine Capital.
The slides from his presentation are available here.
“Risk markets are a lot like the attitude toward Ted Cruz,” he said. “People think they are stronger than they really are.”
Richard Russell, the venerable market analyst who recently passed away, once said, “bear-market rallies look better than the real thing.” Gundlach noted that in reference to the recent rally in U.S. equities, which advanced further in the days following his talk.
“The S&P may have 2% of upside and 20% of downside,” Gundlach said. “The setup for risk assets from a risk-reward perspective is quite poor.”
I’ll look at the reasons for Gundlach’s bearish forecast, starting with his take on monetary policy.
The Fed, monetary policy and the potential for recession
Gundlach said the Fed will not be able to follow through on its calls for further rate hikes this year and beyond.
The Fed still says that it will raise rates by 100 basis points in each of 2016, 2017 and 2018, according to Gundlach. But, he said, that is not a “wise idea” because of the divergence with other central banks, as well as weak GDP growth. All other central banks are cutting interest rates, and some have established negative rates, Gundlach said. He said that the market-implied probability is one rate hike of about 25 basis points, versus the Fed’s statements of four hikes in 2016.
At the start of 2016, Gundlach said there was a 50% chance of raising rates in March, and that went to zero when markets crashed at the start of the year. The probability is now 4% of a rate increase in March, despite unemployment less than 5% and inflation – by some measures – of nearly 2% and a market recovery. The probabilities of rate hikes later this year are June (43%), September (55%) and December (70%).
“Remember that the market collapsed after the Fed raised rates in December,” he said. It would be “really dicey” to raise rates again. The market would be “ill-prepared” for a rate hike in March, Gundlach said.
When markets behave differently to the same news, it is ominous, according to Gundlach. He cited the market’s recent reaction to announcement of QE in Europe. The dollar had rallied in the past after similar announcements, he said. But recently, the euro rallied with announcement of Eurozone QE. Negative interest rate policies explain this, he said. “Markets are reacting differently to announcements of monetary policy and stimulus,” Gundlach said.
Negative interest rates are bad for banks, he said, and have been especially for the stock prices of Deutsche Bank and Credit Suisse; The Bank of America’s stock is down 30% from where it was a year ago. “The banking system and markets don’t want NIRP,” Gundlach noted.
“Investors are victims of extrapolating the recent past into the future,” Gundlach said. Inflation went from 2% to 0%, and rose recently to nearly 2%. As a result, people now believe the Fed won’t raise rates and are consequently buying stocks. Gundlach said there are “some signs” that core inflation is moving higher because of wage gains (although wages went down in the most recent monthly report). But, he said, those gains were mostly concentrated in low-wage jobs.
Gundlach said there is “no traction at all in real or nominal GDP” to support a rate hike.
The manufacturing ISM is below 50, he said, consistent with prior recessions, although it improved slightly lately. Services, however, have been plummeting similarly to how they plummeted prior to the last recession, he said.
According to Gundlach, one reliable indicator for a recession starting has been the 12-month moving average of U.S. unemployment going above its monthly level. This has been “incredibly consistent,” but it is not signaling recession now. “There will be no recession unless unemployment moves higher later this year.”