The history books will document that U.S. interest rates hit their secular bottom in July 2012, according to Jeffrey Gundlach. Although bonds prices have rallied in the first half of this year, he said they will continue to fall.
Gundlach is the founder and chief investment officer of Los Angeles-based DoubleLine Capital. He spoke to investors via a conference call on June 13. The focus of his talk was DoubleLine’s flagship fixed-total-return income fund, DBLTX. The slides from his presentation can be found here.
“Bond prices are not going up,” he predicted. “Yields have been rising since July 2012 in a certain sense,” he said, “and they have certainly been rising in a significant way since July 2016.”
“I wouldn’t buy bonds now,” Gundlach said.
Rates will go up this summer, but they won’t hit 3%, he predicted. He said the consensus is “probably right” that the 10-year will finish 2017 at approximately 2.8%.
In January, Gundlach correctly predicted that interest rates would rally to between 2% and 2.25%, and then would head higher. He said that is “still a good road map for 2017.”
Stocks, he said, will “level off” over the remainder of this year.
The title of his talk was “Small Change,” signifying the recent market environment where stocks have been “grinding upwards” while bonds have been “mostly in a trading range.” It also characterized the political environment, where he described the response to President Trump’s agenda as “rope-a-dope,” which is how Muhammad Ali tried to wear down his boxing opponent, George Foreman, in a title match in the 1970s.
Let’s look at his other comments about the economy and the market.
Diversify global equities
Central bank policies outside the U.S. are restraining the rise in Treasury rates. Gundlach said that Mario Draghi and Haruhiko Kuroda in Europe and Japan, respectively, are in “full-on Kool Aid drinking mode” with low interest rates and quantitative easing (QE). With rates elsewhere in the world being artificially repressed, it is pushing investors into U.S. Treasury bonds.
Gundlach said it was odd that Draghi and Kuroda are so much more dovish, given similar economic conditions in Europe, Japan and the U.S. He said the Eurozone PMI (an indicator of the health of the manufacturing sector) is “booming,” as is consumer spending and loan growth.
He said that in January, and throughout the last couple of months, he advised that investors “peel off a portion of their S&P 500 exposure” and move it to Europe or, even better, emerging markets. Gundlach said that this strategy has worked, and that he still recommends it because it has “has long-term legs.”
“Non-U.S. stocks will outperform U.S. stocks,” he said.
But stay in U.S. bonds, Gundlach advised, because bonds elsewhere have a poor risk-return tradeoff.
Beware the low-volatility market
Gundlach said volatility is at its low point over the last 12-plus years. Specifically, he said, that is true of gold, U.S. stocks and interest rates. The exception is commodities broadly, which have been at about average volatility.
But, according to Gundlach, that doesn’t imply that the future will lack volatility.
The VIX (a measure of U.S. equity volatility) is at a 24-year low, but he said it went up 25% in a single day after it hit that previous low a quarter century ago. Volatility is not an indicator of market direction. Gundlach said that prices can go up steadily 5% a day and not be volatile.
Volatility was similarly low in 2007, before the global financial crisis.
“When you live through a low-volatility period,” Gundlach said, “it’s a poor idea to believe this is a new paradigm.”
Indeed, he said low volatility should be “a cause for some concern.” There is a “massive” amount of money shorting the VIX, he said, because it has been a “money machine” with a “huge positive carry, at least since the election.” But being short the VIX is a “very crowded trade” which he doesn’t expect to continue over the remainder of this year.
The economy and the recession watch
Gundlach made a number of observations about the health of the economy, inflation and fiscal policy.
Real GDP growth over the 10 years ending at the end of last year was 1.33%, he said, which was at the same level during the depth of the Depression in the 1930s, although economic volatility was much higher then.
Approximately $10 trillion of debt has been added to the deficit over the last decade, according to Gundlach. If that had not been the case, GDP growth would have been only 0.7%. He concluded that about half the economic growth has been debt-fueled.
Real GDP growth has been steady at 2% “like a rock” for the last eight years, ranging only from 1.6% to 2.6%. For the second quarter of 2017 it will be higher than that, but has been revised lower. He expects it to be approximately 3%. The downgrades to projected GDP growth haven’t been as severe as in prior quarters, he said.
In March and April, headline inflation peaked at 2.86%, and he said he is “absolutely certain” it will drop and will be 1.6% for the full year.
Nominal GDP forecasts have not reflected the cyclicality of inflation due to oil prices and commodities, Gundlach said. “This is significant,” he said, given the relationship between nominal GDP and the 10-year Treasury yield. Nominal GDP growth will be higher than 3.5% this year, he said, “so it’s hard to understand why the 10-year is about 2.5%.”
The explanation lies for this in a “relative-value argument,” Gundlach said, because rates in Europe and Japan are being held down artificially due to central bank policies, pushing investors to U.S. markets.
He noted that he recently said not a single indicator is signaling an impending recession. Now there is an exception, he said, but with a caveat. Corporate debt has peaked, he explained, in a pattern similar to previous recessions. But, according to Gundlach, corporate debt is not a leading indicator; it typically peaks after a recession, which is because corporations can’t borrow during a recession.
Gundlach is not forecasting a recession for the foreseeable future – for at least another year.
Other economic indicators are good, he said, including the Conference Board’s leading indicator. There has never been a recession without that indicator going below zero, according to Gundlach, and it is now “strong” at 3.2.
Non-housing debt has been rising rapidly over the last decade, he said, most significantly among auto loans. But he doesn’t expect them to be a problem. Student-loan debt has also grown strongly, he said. Total nominal debt has reached a new high, according to Gundlach, but as a percentage of GDP it is down, because GDP has grown. This is troubling because wage growth has not been strong relative to GDP.
Forecasting Fed policy
Gundlach expects a Fed rate on June 14, but he said the market predicts about a 50% chance of a third rate hike over the second half of this year.
A “big problem” for the Fed is the Taylor rule, he said, which has had a high historical correlation between Fed policy and the Fed funds rate. It says the Fed funds rate should be 3.91%, which Gundlach said is what’s behind the Fed’s forecast for higher rates. But, he said, the Fed is “uncomfortable” following the rule because of the “scars of the great financial crisis.”
Gundlach said he is skeptical of economic rules. “Rules and formulas don’t seem to work.”
The best example, he said, is the Phillips curve. It is supposed to be a correlation between inflation and unemployment, but he showed a graph that depicted the true relationship to be mostly random, specifically over the last eight years, when inflation has been steady despite decreasing unemployment.
Entering 2017, Gundlach said the theme was to “get out of bonds because the Fed is going to hike.” Gundlach correctly disagreed and predicted that longer term Treasury bonds would do well, as it has during most tightening cycles, when the yield curve has flattened.
He cited a study from the Atlanta Fed which showed that QE had the effect of a rate hike of approximately 400 basis points, which is historically what has brought on a recession. But that is not reliable, according to Gundlach, since a bigger rate hike is needed given the starting point of near-zero rates.
Should you buy bonds today, given the expectation of rate hikes?
Gundlach doesn’t think so, considering that the history of rate hikes has such a small sample size. Sentiment in the bond market has gotten “too bullish,” he said, and the market is “counting on this pattern to occur.”
The high-yield market and the next four years
Gundlach noted that for the first time in the last 10 years high-yield bonds have negative convexity, which is bad for investors. “But to worry about high yield you have to worry about a recession,” he said. High-yield spreads are tight, where they were in 2014.
“As a disciplined investor you should be underweight high yield,” Gundlach said. “There is a lot of room for spreads to widen. It’s okay to dance the risk dance and own some high-yield bonds, but dance near the doors.”
Stocks and bonds have risen together this year. For bond yields to break out to the downside, it will take a “negative shock in the stock market,” he said.
Gundlach stood by his prior prediction of a 6% yield on the 10-year Treasury around the time of the 2020 election.
