Gundlach – Don’t Count on “Transitory” Inflation
The Fed stated in late April that it expects inflation to be “transitory,” but Jeffrey Gundlach gives that only a 60% chance of being true. If inflation is non-transitory, markets will be “severely stressed,” he said.
Gundlach spoke to investors via a webcast, which he titled “Clampdown,” and the focus was on his flagship total-return fund (DBLTX). Slides from that webcast are available here. Gundlach is the founder and chairman of Los Angeles-based DoubleLine Capital.
“Clampdown” is the British word for lockdown, and Gundlach referenced the use of this word in a classic album, London Calling, by the rock group the Clash.
DoubleLine’s proprietary model shows the next CPI reading will be in the “high fours,” Gundlach said, “with some risk in the fives.” Consumer fear of rising prices is the greatest in 40 years and has risen steadily over the last year, he said.
The trouble with the transitory narrative, according to Gundlach, is that inflation could turn into a self-fulfilling prophecy if consumers purchase goods and services now for fear of paying more in the future.
Core and headline PCE are 3.06% and 3.58%, respectively. Core CPI is at 3% on a year-over-year basis, its highest reading in about 15 years. Gundlach said it “no longer looks like it is going sideways.”
Gundlach acknowledged that a strong argument supporting the possibility of transitory inflation is the base effect from a year ago, when inflation was exceptionally low. But, he said, that is “clouded by the effects from a few months ago.” He did not elaborate on that remark, but presumably he meant that the signs of year-over-year inflation were not limited to the low CPI readings in March 2020 relative to March 2021.
“The question is how the Fed will respond to a five-handle CPI,” he said. “That will be a big question for the market.”
The core CPI is 4.2%, he said, but it does not reflect the double-digit increase in home prices. If you replaced the shelter component used by the BLS, which is based on rental income, with home prices, core CPI would be 8.75%, more than double its reported value.
Food prices are going up, which Gundlach said could lead to social unrest. The food component of the CRB commodity index is up 6% on a year-over-year basis, and this leads the food component of the CPI by about six months. The food component of the CPI was approximately 3.5% on a year-over-year basis six months ago.
Inventories are at their lowest value in the last 20 years, according to ISM data, which supports the “transitory” argument, Gundlach said.
But prices are rising.
Used car prices have nearly doubled over the last year, and there is virtually no supply in the market. This is not sustainable, he said. Home inventories are at their lowest level since 1991. In many cities in the U.S., real estate agents outnumber homes for sale by as much as three-to-one.
“Nobody really knows the answer to whether inflation will be transitory,” Gundlach acknowledged.
Stresses in the economy
A recurring theme across America is the inability to find workers, Gundlach said, as exemplified by a Pennsylvania-based McDonalds that is offering a $500 sign-on bonus for new employees.
Real GDP grew 4.2% in the first quarter, and the next three quarters are projected to grow 9.2%, 6.8%, and 4.75%. That volatility is due to the “wash over” of federal stimulus measures, Gundlach said. Nominal GDP growth is forecast to be 10.4% for the year. In prior webinars, Gundlach has shown that the yield on the 10-year Treasury bond, which is 1.53%, has followed the average of nominal GDP growth and the German 10-year yield, which is -22 basis points. Based on that relationship, the 10-year yield should be more than 5%.
Deficit spending also causes volatility in the economy, he said. The federal deficit is 16.2% of nominal GDP, and it would be 20% if it included off-balance-sheet items like entitlements. “We are living on an unusually fueled economy,” he said.
A third of personal income is from transfer payments, according to Gundlach, and as a result, commercial-bank loan issuance is at a 50-year low. This has caused “distortion” in the overnight reverse-repo market, he said, and has led to negative interest rates on overnight bank deposits.
China is the strongest economy globally, benefitting from U.S. consumer spending and exports to the U.S. The U.S. trade deficit had been stable and declining since the global financial crisis, but it has risen since the lockdown. China’s exports and imports in dollars had tracked each other closely since 1997, but since the recovery from the pandemic began, exports are at their highest level in almost 25 years.
Based on the “Dixie” index, the dollar has been mostly in the low 90s during the last few years, but it now at a “critical juncture,” Gundlach said. There is support around 89, and he is neutral in the short term but very negative in the long term. Based on the capital account and budget “twin” deficits, the dollar could go below 70, he said, which would have “meaningful ramifications for asset allocations and investment performance.”
U.S. equities have outperformed the rest of the world since 2005, but not anymore, he said. U.S. stocks have performed in line with non-U.S. equities this year due to the weakness in the dollar.
“There are plenty of indications that the dollar should be falling over the medium to long term,” he said. “The dollar going down is the lynchpin to everything and would be the harbinger of a debt crisis.”
Gundlach said he has avoided European stocks has for the last 12 years, since the founding of DoubleLine, but is reassessing them now that they are outperforming U.S. stocks.
Employees are not returning to their offices. The office occupancy rate declined 80% following the lockdown, and it had not risen as of late May. Gundlach is considering reopening his office after the summer on a voluntary basis and will accommodate those employees who want to work from home.
The top five states that have lost residents are New Jersey, New York, Illinois, Connecticut and California. Common among them are high unemployment rates, high business taxes and lack of affordability. They are “anti-business states,” Gundlach said.
Continuing claims for unemployment insurance benefits have remained strong. If those “roll off” due to reduced benefits, there would be shocks to disposable income, he said, affecting housing and automobiles. That reinforces the transitory narrative of inflation.
Retail flows into funds and ETFs have been unprecedented, he said, and have lent strong support to equity prices.
Commodities have performed strongly since early 2020, Gundlach said, but may be due for a pullback. Commodities are strongly correlated with the dollar and do well when the dollar is weak. But there is not the same correlation with interest rates. Nevertheless, he said that commodities have risen to a level that suggests higher interest rates – more than 3% on the 10-year Treasury.
Lumber has increased five-fold since Q1 2020. It has started correcting and looks like it has “peaked out,” Gundlach said.
Gundlach does not have a short-term opinion on gold at its price of $1,895 per ounce. Ultimately, though, it will go much higher as the dollar falls, he said.
The copper/gold ratio suggests that the 10-year yield should be greater than 2.5%, but “we are in a price-fixing interest rate market.”
Investment-grade bond spreads are at their lowest in 20-plus years, he said, but that doesn’t mean they will widen. Pension plans are better funded than since before the global financial crisis and may buy bonds to de-risk their holdings. There is no room for investment-grade spreads to improve, he said.
High-yield bonds have their lowest spreads since 2007 and have very little room to contract further. Those bonds are at risk of an economic setback, he said, and are highly dependent on policymaking decisions.
Lower tiers of credit, such as CCC-rated bonds, are trading at par and there is no profit potential, he said. “This is not a good time to be in the lowest tiers of corporate credit.”
“We are in a period of very high risk at the lower edges of the credit spectrum with no reward,” Gundlach said.
Consumer delinquencies have declined since the pandemic began, except for student loans, which had a payment moratorium. New consumer bankruptcies are approaching zero. Consumers came into the pandemic with relatively strong balance sheets and paid down debt, he said. Most likely, if debt repayment continues, the economy will not recover as strongly as some expect.
Gundlach said Treasury bonds are relatively attractive, despite being artificially depressed and with deeply negative real yields. They are more attractive than corporate bonds, low-coupon mortgages and parts of the equity market.
One part of the equity market that Gundlach will avoid are “meme” stocks.
When asked about investing in AMC, he said, “I don’t want to be involved in any of these mob-running stocks. You are just playing with fire with that kind of stuff.”
Robert Huebscher is the founder and CEO of Advisor Perspectives