On January 9 at 11am ET, this article was corrected to indicate that Gundlach predicted a weaker (not stronger) dollar in 2019. On January 11 at 11am, this article was corrected to show that the German bund yield was 0.2%, not 2.2%.
Jeffrey Gundlach said that 2019 will mark the start of a period when bond markets must reckon with the rising federal deficit. In his most passionate comments ever on this topic, he said the exploding national debt and liabilities involving pension funds, state and local government governments and Social Security have reached a stage that is “totally unthinkable.”
Gundlach is the founder and chief investment officer of Los Angeles-based DoubleLine Capital, a leading provider of fixed-income mutual funds and ETFs. He spoke to investors via a conference call on January 8. Slides from that presentation are available here. This webinar was his annual forecast for the global markets and economies for 2019.
Before we look at his 2019 predictions, let’s review his forecasts from a year ago.
His top prediction was that emerging markets and commodities were the best opportunities for 2018. The MSCI emerging market index was down 14.58% last year. But, in fairness, when Gundlach has recommended emerging markets it has always been in the context of a long time horizon – seven years or more. Commodities also did not fare well in 2018. The two largest broad-based commodity ETNs, Shares S&P Commodity-Indexed Trust (GSG) and Dow Jones-AIG Commodity Index (DJP), were down 13.9% and 13.1% respectively.
Related to his commodities prediction, he said the dollar would go down in 2018. It did not; it was up approximately 4.7%.
Gundlach said to avoid the S&P 500, which he predicted would show a loss for the year. It did – the ETF SPY was down 4.45%. He also correctly predicted that stocks would go up in the first half of the year and retreat in the second half.
He predicted economic growth for virtually all countries in 2018. This was accurate; only 14 of the 193 countries tracked in this database had negative GDP growth. He correctly predicted that the U.S. would not enter a recession in 2018.
He said that by the middle of 2018, the Fed and ECB will be shrinking their balance sheets, and potentially Japan will as well. The Fed did contract its balance sheet last year, but those of the ECB and BOJ grew.
He correctly advised investors to short bitcoin. It was down 73.3% in 2018.
He said it was a “horrible time” to buy investment-grade bonds. Indeed, the ETF LQD was down 3.79% for the year.
On the fixed-income side, one of Gundlach’s most-cited prediction was that if the 30-year Treasury yield closed at or above 3.22% on two consecutive days – and, related to that, the 10-year closed above 3% – it would mark the end of the 30-plus-year bond bull market and would trigger a selloff in stocks. According to the official Treasury data, the 3.22% level was breached on October 3 and 4, precisely when the stock-market selloff began. The 10-year yield first hit 3% on April 24.
Let’s look at what he said will happen in 2019.
A recession is unlikely in 2019
Don’t expect a recession in 2019, Gundlach said, although a number of key economic variables are “flashing yellow,” warning that a recession is more likely than it has been in the recent past.
According to a Merrill Lynch survey done in December, over 80% of fund managers don’t expect a recession. Yet there is a lot of pessimism. Those same fund managers who expect real global growth was at its lowest level since 2008.
Gundlach also noted that 90% of asset classes had negative returns in 2018, the largest such percentage since 1901. Once the Fed started its quantitative tightening (QT) policy, he said the stock market responded with negative returns.
The Conference Board leading economic indicators (LEIs) have dropped sharply in last couple of months, he said, but are a “long way from going negative,” which has always happened prior to past recessions. The market has priced in the fact that the LEIs have dropped but are not at recession-predicting levels.
“Recessionary ideas are not priced in the market,” he said.
The manufacturing PMIs are “looking bad,” he said, and the most recent data had its biggest drop since 2008. This “bears watching,” he said, and the next observation will be extremely important.
Industrial production data looks similar to the PMI data, according to Gundlach, and both of those metrics can deteriorate rapidly. “The market will be on pins and needles looking for whether this data stabilizes,” he said.
Business and consumer sentiment data is “not bad,” he said, but worse than it has been in 2018.
Ominous signals are coming from the housing market. Gundlach said it was “really shocking” that mortgage applications are at their lowest level in 18 years. Construction layoffs are the highest since 2006 which, he said, shows how interest rates are affecting the economy and housing industry. Incomes have not kept pace with home prices, which are up a lot more than incomes.
The employment data released the prior Friday was “pretty good,” Gundlach said,, with 320,000 new jobs. But many of those gains were among old people, presumably reentering the workforce. This was not a sign of sustainable growth, he said. The 3.9% unemployment rate is above its 12-month moving average, which is an early warning sign of a recession, according to Gundlach.
Consumer expectations have been reasonably good predictors of recessions, according to Gundlach. This is one of those “flashing yellow” indicators, but he said the timing of its recession prediction is uncertain.
Junk-bond spreads “blew out” prior to the last couple of weeks, Gundlach said, nearing recession levels. They “kind of” look like spreads approximately six months prior to a recession, he said.
Another of the flashing yellow recession indications is whether Treasury bill yields exceed global bond-market yields. They just reached the same level, Gundlach said; Treasury bills had been lower since the end of the financial crisis.
Headline and core CPI are at 2.2%, slightly above the Fed’s 2% target. Headline CPI will fall as the crude oil price decline makes its way into the inflation data, according to Gundlach. Core inflation won’t come down, he said, based on the data from the N.Y. Fed UIG indicator, which has a very high correlation to core inflation 18 months hence.
Businesses are reporting problems getting quality labor, he said, which is predictive off higher wages. Average hourly earnings have been rising this year as well.
Global market predictions
Gundlach offered a few broad predictions for global markets.
The dollar will be weaker in 2019, he said, and this will lead to outperformance among emerging markets. Emerging markets are nearing a point that would suggest a “strong upswing,” he said. “This is a time to invest in emerging realistically.”
Stay out of Europe, he said, which is a “value trap.” The euro may go higher, Gundlach said, which won’t help European equities.
Gundlach called this the “chart of the year”:
It shows that U.S. stocks and non-U.S. markets moved together starting on January 26 (when U.S. markets hit a peak) until May, when the S&P started doing much better. But since December, those markets have diverged with the S&P moving higher relative to global markets. The takeaway is that they are likely to converge again, and that the S&P will retreat and/or non-U.S. markets will rally.
For those willing to endure volatility, Gundlach said bitcoin makes sense. It could make it to 5,000; it is now just over 4,000 and that would produce a 20% gain.
Commodities have been hurt by the tariff talks and the slowdown in the global economy, Gundlach said. Commodities typically move higher prior to a recession. But he is less sure of this now, because it could be overwhelmed by broader variables like inflation. With a weaker dollar, commodities have a 50%-plus chance of making money, Gundlach said.
The copper-gold ratio indicates that 10-year yield will go lower, Gundlach said.
The 10-year yield had been tracking the Fed’s Treasury bond holdings until its recent rally. But then yield fell off. Gundlach said yields could head higher, which would be problematic for stocks.
Gundlach cited an “amazing indicator” for 10-year yields: the average of nominal GDP growth and the German bund rate. For the third quarter, those figures were 5.5% and 0.2%, yielding an average of 2.85%, not far off from the 10-year yield of 2.7%. Using projected Q4 data, he said those numbers would be 5.2% and 0.2%, producing an average exactly equal to the 10-year yield of 2.7%.
He predicted the yield curve will steepen in 2019. The Fed will be slow to raise rates, according to Gundlach. “You don’t need an inverted yield curve to signal a recession,” he said, “especially when rates are every low.” The spread between the two-year and 10-year Treasury yield has been approximately 15 to 20 basis points since last August. If it steepens, Gundlach said it would be a recessionary signal.
Get out of investment-grade bonds, Gundlach said. He had less dire warnings for junk-bonds, which investors should sell “on any strength” based on the ETF JNK.
Gundlach’s warning to corporate bond investors is driven by excessive leverage across companies. He said that 45% of the investment-grade market would be rated junk based on leverage ratios. Companies have been saying reassuring things to the ratings agencies and agencies believe them, resulting in more favorable ratings from the agencies.
He said the junk-bond market would expand from $1 to $2.5 trillion dollars if bonds were rated properly.
Indeed, he said, downgrades have already started – $200 billion of the investment-grade market has already been “right rated.” That’s why spreads have widened in the U.S. and European high-yield markets.
A passionate reproach of growing deficits
In virtually every webcast, Gundlach warns that the growth of the federal deficit and other liabilities will reach crisis levels. But this webcast was different. Instead of facing a crisis five or more years into the future, Gundlach said the tipping point will arrive much sooner.
The other difference was in the tone of his voice. He saved these comments for the end of webcast, and warned listeners earlier that this would be a focal point of his comments. He delivered these remarks passionately – as a warning to investors and, presumably, as a plea to policymakers to heed his warnings.
The federal deficit is exploding, he said, and makes the U.S. bond market unattractive to foreign investors because of low yields. Those yields are already unattractive as a way to fund pension assets.
With yields rising, the Fed raising rates and deficit up, we are on a “suicide mission,” Gundlach said. The deficit is $800 billion. But he said the national debt, another measure of indebtedness, is up 50% because it includes items such as one-off military operations, natural disaster relief and some money in in the Social Security system. The national debt grew by 6% of GDP last year, which Gundlach said was “shocking.”
In the first three months of fiscal year 2019, the national debt grew by another 8% of GDP, which Gundlach said was equivalent to every U.S. household taking on another $15,000 of debt. He called this a “completely horrific” situation.
“Debt has exploded during a growing economy,” he said. “But are we really growing or is it just because we increased the national debt?”
He warned that the cost of servicing our debt will go higher as rates rise.
But he also pointed out that nearly 40% of that debt is owned by the Fed or by the U.S. government.
The Congressional Budget Office (CBO) says interest costs will rise from 1.3% to 3% of GDP, according to Gundlach, assuming there isn’t a recession over the next several decades.
“Could we be at a tipping point of the debt compounding cycle?” Gundlach asked, rhetorically.
Gundlach cited a book, Bankruptcy 1995: The Coming Collapse of America and How to Stop It, by Harry Figgie. He said that book claimed the U.S. was then at the “precipice of a disaster.” The book used what were then “absurd” tables and projections of the deficit, which were in excess of where we are now, according to Gundlach. The author hoped to shock people into action.
Now, Gundlach said, some of those tables look like they are going to happen.
State pension plans are underfunded by about 50%, Gundlach, citing well-known data. He cited data from usdebtclock.org that there are $122 trillion of outstanding liabilities, including the national debt, state and local government debt, pension fund liabilities and money owed by Social Security. This, he said, is six-times the U.S. GDP and is “totally unthinkable.”
“This not an issue 20 or even eight years from now,” Gundlach said.
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On January 9 at 11am ET, this article was corrected to indicate that Gundlach predicted a weaker (not stronger) dollar in 2019. On January 11 at 11am, this article was corrected to show that the German bund yield was 0.2%, not 2.2%. 
