The first third of 2016 has been good for bond investors, but don’t expect that performance to continue for the remainder of the year, according to Jeffrey Gundlach. It has left many sectors of the bond market overvalued. In particular, junk bond investors should be wary of pending defaults and lower recovery rates.
Gundlach spoke to investors on April 12 to provide updates on the DoubleLine Total fixed-income asset-allocation funds. He is the founder and chief investment officer of Los Angeles-based DoubleLine Capital.
The slides from his presentation are available here.
The AGG index is up 3.4% year-to-date and on pace for a 10% gain for the year, Gundlach said. “There is no way that will happen,” he said. “If the bond market were on that pace, there would be problems in the global economy that would torpedo that rally.”
Some sectors, like mortgage-backed securities, are still undervalued, according to Gundlach. But many parts of the bond market are rich, and Gundlach fears that high-yield investors may be in trouble.
In Gundlach’s prior webcast, he said that investors in “risk assets,” such as the S&P 500, were exposed to 20% downside risk versus only 2% upside potential. Equites have risen 4% since then. He did not comment on them in this webcast.
I will review Gundlach’s outlook for the fixed-income market and its asset sub-classes, but first let’s look at his views on monetary policy and economic growth.
Monetary policy
On March 29, while speaking at the New York Economic Society, Fed Chairwoman Janet Yellen said there wouldn’t be a rate hike in April. Following that, Gundlach said, the probability of a rate hike in June (when the Fed would next meet) decreased rapidly and is now about 18%; the September probability is approximately 38% and for December, it is almost a 50/50 proposition. All of these probabilities are significantly lower than when Yellen spoke in March, according to Gundlach.
In every other country, Gundlach said, rate decreases are ongoing and expected and, in some cases, those rates are already negative. Rates in most countries are down about 50 basis points year-to-date, he said. The exception is Greece, where rates have risen. In the peripheral countries – Spain, Italy and Portugal – rates may have stabilized, Gundlach said.
Many central banks have tightened prematurely, according to Gundlach and, in all of those cases, they have had to reverse and lower rates.
With forecasts for GDP growth near zero for this year, it’s unlikely the Fed will raise rates, according to Gundlach.
In all likelihood, he said, the Fed’s rate hike will be “one and done.”
Inflation and the risk of recession
Core CPI is now about 2.3%, he said, and CPI growth has been zero over the last eight months. Gundlach predicted that the CPI might be the same or lower over the next four months.
“I really question whether the inflation trade makes sense,” Gundlach said, in response to some investors who have shifted allocations in anticipation of spiking inflation.
Gundlach said that he turned negative on the dollar in December, at the beginning of Fed tightening. It has weakened by about 6% since then. “I don’t have much of an opinion about the dollar now,” he said. He added that emerging-market currencies have rallied a fair amount this year versus the dollar.
One area that has been bullish for the U.S. economy has been labor conditions. The leading economic indicators from the U.S. Conference Board have been weak, he said, but don’t indicate a recession. In recent webcasts, Gundlach has been following a new metric – the U.S. unemployment versus its 12-month moving average; when the former drops below the latter, it is indicative of an oncoming recession. For the past eight months, unemployment has been between 4.9% and 5.1%, and Gundlach said if it moves up a couple of tenths in the next couple of months, “we will be on recession watch.”
Nominal GDP growth is approximately 3%. He said that is consistent historically with recessions over the past seven decades. Gundlach suspects that Yellen has been following nominal GDP, and it is guiding her dovish stance. As long as nominal GDP is falling, it puts pressure on Treasury bond yields, he said. “But we are going sideways now, which explains the lateral move in 10-year Treasury prices.”
Commodity prices have had a small but insignificant bounce up recently, he said, but “it is not a base case for building exposure in your investment portfolio.” He said he is bullish on gold and on gold miners, which have been up about 60% this year. He is sticking with his previously stated $1,400 target on gold prices.
Economic forecasters have been persistently optimistic, according to Gundlach, particularly with respect to GDP and S&P earnings. For 2016, he said, earnings forecasts were heavily downgraded starting last summer, from about 13% to about 2% in year-over-year growth. Much of the decrease has been pushed forward to 2017 increases, he said. “Earnings just keep getting downgraded,” he said, “which explains the sideways but volatile movement in stock prices in the U.S. and abroad.”
Maybe the weak dollar will help earnings, he said, but he doesn’t think it will move enough to make a difference.
Bond market valuations
As is his practice in these asset-allocation webcasts, Gundlach looked at various sectors in the bond market to discuss his firm’s assessment of their relative valuations.
“The bond market remains range-bound across the yield curve,” he said. Yields could move higher and provide a better entry point, he said. The benchmark 10-year Treasury is down 49 basis points this year.
GNMAs are about one standard deviation cheap to Treasury bonds, he said, and have a low duration, so it is a good “buy point” for funds. Mortgages generically are cheap, he said, particularly CMBS and RMBS.
Corporate bonds were their richest in history in June 2014, Gundlach said, and now are one standard deviation rich. “This is a good time to sell corporate bonds and buy mortgage bonds,” he said.
Junk bonds were their most overvalued in history at the end of 2013, after which they underperformed Treasury bonds by 30%, Gundlach said. “Once Fed aborted its suicide mission of four consecutive rate hikes,” he said, “they rallied.” Junk bonds look a little cheap now, according to Gundlach, because the rally already happened in conjunction with the rise in oil price. They will hold their value in the near term, he said, but he advised selling funds like the ETF JNK. Long term, there are problems with default rates and the “lousy” quality of issuance, he said. “Spreads are in a rising secular trend that may last several years,” Gundlach said.
Leveraged loans are not cheap either, he said.
The problem with speculative-grade debt is that the percentage of issuers in distress is rising, Gundlach said, but the default rate has been stable. The upgrade-to-downgrade ratio is similar to 1998 and 2007-2008, which he said were periods of “great prolonged stress.” Gundlach expects to see downgrades ahead that will force certain investors to sell because they are required to maintain minimum credit levels in their portfolios.
When high-yield defaults start, as they did in 1996-1998 and 2004-2007, the recovery rate is about 55%, according to Gundlach. But he said when the default rate heats up, then recovery rates “absolutely collapse,” as they did in 1999-2002 and 2007-2009. Recovery rates are now about 40%, he said, with a moderate rate of defaults. He said that the recovery rate will collapse below 25% like it did in 2007-2009, and could be as low as 10-15%. Analysts who predict a 55% recovery rates should be ignored, Gundlach said.
EBITDA in the high-yield market is collapsing, he said, and is down approximately 60%. Many companies are losing money, but even if you exclude the energy sector, he said earnings are falling. “This is a fundamental that should not be ignored,” he said. “The easy money has been made in the high-yield market.”
Crude inventories have come down a tiny bit from their “skyrocketing” levels in 2015, he said. “Oil will lumber along toward $45/barrel with setbacks along with way. This is not the time to turn bullish on oil at $42/barrel.” He added that the move from $30 to $40 was “short covering.”
Municipal bonds are a “little bit overvalued,” he said. He owns some Puerto Rican bonds in risky portfolios and bought some last week at 65 5/8 with an 8% coupon. “If you’re going to take a risk on something, why not take it on something that could give you a 12% after-tax yield,” he said.
TIPS have outperformed nominal Treasury bonds by 70 basis points this year, he said, and look a little expensive now.
Gundlach said he is “much less positive” on dollar-denominated emerging-market debt now that they have rallied this year.
Negative interest rates?
Gundlach dismissed fears that policymakers would implement negative rates in the U.S.
“Negative interest rates are one of the dumbest and most dangerous ideas,” he said. “People thought they were a surefire way to devalue currencies and prop up stock markets.” But, he said, in Europe bond yields are marginally higher and the euro has strengthened since rates went negative. European stocks have been a disastrous investment over that time period, according to Gundlach.
When Japan went negative, he said, its currency strengthened “massively” and its stock market went down precipitously.
“The last thing you want to do to prop up stocks and depress your currency is to go to negative interest rates,” he said. “It’s fatal for the banking system.”
“Thankfully, we don’t appear to be going toward negative interest rates in the U.S.,” he said. “If so, I would recommend you don’t own government bonds in the U.S.”
Read more articles by Robert Huebscher
