The federal deficit and the cost to service that debt are rising at the same time. This historical anomaly is putting the U.S. on a “suicide mission,” according to Jeffrey Gundlach.
Gundlach is the founder and chief investment officer of Los Angeles-based DoubleLine Capital. He spoke via a webcast with investors on June 12. His talk was titled, “Push Me, Pull You,” and the focus was on his firm’s flagship mutual fund, the DoubleLine Total Return Fund (DBLTX). The slides from his presentation are available here.
“The federal debt is exploding,” Gundlach said.
He showed the Congressional Budget Office (CBO) projections, illustrating that our federal debt-to-GDP ratio will be 125% by 2030, and it is accelerating at a very steep slope. It is now approximately 80%.
It is very unusual to see this deficit expansion so late in the economic cycle, according to Gundlach. Historically, the deficit expands when the Fed funds rate is being cut, which is typically during or following a recession.
“This is almost like a suicide mission,” he said. “At some point, with debt and its service cost increasing, there will be a collision. There could be a solvency problem.”
Gundlach did not elaborate on what he meant by a solvency problem. It is generally accepted that the U.S. can effectively print as much money as it needs. A federal bankruptcy is impossible. But excessive debt could lead to other problems, such as high inflation or, like Japan, an extended economic slowdown.
The other problem, he said, is that the deficit is not expanding for a “great reason.” There has been no extra spending on infrastructure like there was, for example, in the 1950s and 1960s, he said. “We are way behind on investing in infrastructure,” which he said is obvious when you look at our airports compared to those in China.
Let’s look at Gundlach’s comments on the global economy, the likelihood of a U.S. recession and the bond market.
Slowing global growth and the next recession
The title of Gundlach’s talk was a play on the name "pushmi-pully" (pronounced "push-me—pull-you"), a character originally from the Doctor Dolittle series of children’s books, and featured in movies since. The character has two heads, and only one is used for speaking, reserving the other one for eating. The metaphor applies to the macro environment, according to Gundlach, which is being pulled in two directions. Both real and nominal GDP are going up in the U.S., but economic growth is slowing elsewhere.
Nominal GDP growth has been pushing the 10-year Treasury yield higher, he said. But the German 10-year yield, which is at 50 basis points, is pushing it down.
If the Atlanta Fed’s forecast is correct, Q2 will be one of the strongest quarters for nominal GDP growth since the financial crisis, according to Gundlach. Annual GDP growth is projected to be as high as 5.6% for the 12-month period ending June 30, 2018. Gundlach illustrated his point that the 10-year Treasury yield is being driven by two forces: GDP growth and the German 10-yield. He said the average of the 5.6% GDP growth and the 50 basis point German 10-year yield is 3.1%, which is close to the U.S. 10-year yield of 2.95%.
Gundlach said the leading economic indicators (LEIs) are a very good way to see if a recession is coming; they need to go negative year-over-year to signal a recession. “It doesn’t have the right look at all,” he said, to be predictive of a recession. The LEIs are still rising, he said. “Clearly, there is no recession coming.”
The ISM purchasing manager index (PMI) provides confirming evidence that there is no imminent recession danger, according to Gundlach.
“Those are the two best indicators of oncoming credit risk in the bond markets,” he said.
All sentiment indicators – such as consumer, CEO and home builder confidence levels – are strong and not signaling a recession, he said.
The most important indicator of credit risk is the high-yield spread to Treasury bonds. Prior to the 2001 and 2007 recessions, that spread increased by approximately 400 basis points. Over the last few years the spread has moved around “a little bit,” Gundlach said, but is still close to its lowest level over that period. “There is no recession signal from the high-yield bond market,” he said.
The slope of the yield curve, based on the spread between 2-year and 10-year Treasury bonds, doesn’t always invert going into a recession, Gundlach said. It is now 42 basis points, a low for this cycle.
“We are pretty much in the clear for the next six and probably 12 months,” Gundlach said, in reference to recession risk.
But global growth is not as strong as it looked in the beginning of the year, he said. GDP growth data is much softer than its 12-month average in Europe, the U.K. and Japan, he said. But favorable data is being reported by Canada and the U.S.
Fed policy and the markets
The Fed, which is meeting June 13, will raise rates for the sixth time in this interest rate cycle, according to Gundlach.
The Fed’s “dot projections” for 2019 and 2020, which show the Fed funds rate forecasts of the various governors, are “comical,” he said. Because they have such a high degree of dispersion, he said, about 425 basis points from lowest to highest. “It questions the utility of the exercise,” he said.
The Taylor rule expresses the Fed funds rate as a function of unemployment and inflation. It worked very well until the post-crisis period, Gundlach said. But now it is at “great odds” with the data, which says that the Fed funds rate should be 4.8% versus the 1.875% that is expected after the Fed hike. Gundlach questioned why the Fed thinks it will stop at 3.25, as the dot projections indicate. “The Taylor rule suggests it will go higher,” he said.
Until recently, one of the great arguments for owning stocks was that they yielded more than Treasury bonds. That is not true anymore, Gundlach said. The yield on the one-year Treasury is 2.27%, which is higher than the S&P dividend yield, which is 1.79%.
The “FANG” stocks may be in a bubble, Gundlach said. The price increase of the Dow Jones eCom index – which consists of Facebook, Amazon, Netflix and Google – has the same slope and magnitude as other bubbles, including the dot-com and housing bubbles. It is up 617% over roughly the last eight years.
Gold has resistance between 1,370 and 1,400, he said, and has now “lost its momentum,” Gundlach said. “I would be a buyer of gold at around 1,200.” Part of that weakness, he said, is due to the strength of the dollar, which has been up about 4% in “recent weeks.”
“I like the setup with commodities,” he said, especially given the strength of the dollar.
The dollar began a multi-year down cycle in 2017 and will continue to be weak, Gundlach said.
Italy and the European Union
The Italian 10-year “blew out of its resistance level,” he said, based on the outcome of its election. “This does not look like a good situation,” Gundlach said. Only the ECB is buying Italian bonds. “People are getting worried there are too many rabble rousers in the building,” Gundlach said, in reference to the new Italian government, which represents an anti-establishment movement, like the election of Trump and vote for Brexit.
“The Italian bond crisis has kept German and U.S. yields down,” he said, through a flight-to-safety.
But the European Union (EU) will stay together “longer than you think possible,” Gundlach said. “Think about how high housing prices got in 2006 and 2007 before that bubble eventually collapsed.” He compared the new Italian government to a combination of Rand Paul and Bernie Sanders, a tax cutter and a supporter of universal income.
“There will be many steps in the game before an EU break-up will be a serious consideration,” he said. “The situation will calm down.”
Gundlach showed this cartoon, ridiculing the idea of a universal basic income:
Universal basic income is highly inflationary, he said. “Anyone who does menial labor will be incented to charge high prices.”
Markets haven’t figured out whether tariffs pose a threat to the economy, he said, in part because the threat is not clear yet. Indeed, Gundlach said trade could increase if tariffs go away.
Gundlach reiterated his forecast that the 10-year yield would reach 6% in 2020 or 2021. “We are right on track for that,” he said, “exactly on pace.”
If the German 10-year “frees itself,” Gundlach said, which could happen if quantitative easing (QE) in Europe ends, “rates could rise.”
Read more articles by Robert Huebscher
The federal deficit and the cost to service that debt are rising at the same time. This historical anomaly is putting the U.S. on a “suicide mission,” according to Jeffrey Gundlach.
