Gundlach – Inflation Will be Above 4%, Making Treasury Bonds Overvalued
Inflation will stay above 4% for 2022, according to Jeffrey Gundlach, which makes Treasury bonds at yields of 1.5% to 2% overvalued.
The Fed thought inflation would last only a few months, but Gundlach thinks it will be longer-lasting.
The CPI may stay elevated as the effects of increased housing prices (which show up as owner-occupied rent in the CPI) will seep through into next year. But inflation in the prices of cars, lumber, and other goods affected by supply-chain issues may go away, he said.
But labor and housing inflation will stay.
Gundlach acknowledged that he failed to predict the recently announced 6.2% CPI inflation. But he now thinks there is a chance of hitting 7% at some point in the next year.
The Fed will fight inflation, but we will see economic problems with just a few rates hikes. That could “break the economy,” Gundlach said. The bond market is sniffing out a weaker economy with problems sooner rather than later.
He said the economy will weaken in the second half of 2022.
A key issue is shelter inflation; core is 58% and shelter is 32.4% of the CPI. Reported housing inflation is only 3.5%, but it is “way more than that,” according to Gundlach. Supplies of homes for sale are at a historically low level. Existing home prices have risen 24% since the onset of the pandemic and are now rising 13% year-over-year. The Case Shiller index is at its highest level in 20 years, increasing about 19% higher year-over-year. Since the start of the pandemic, rental vacancies went from 7% to 4%, and the nationwide median monthly rent rose from $1,100 to almost $1,300. “This could easily add 1% to the CPI,” he said, “and offset the resolution of supply-chain issues.”
If we used home prices instead of owner-occupied rent in the calculations for the shelter component, the CPI would be up 12.3% instead of 6.2%.
Gundlach spoke to investors via a webcast, which he titled, “In Our Time.” The focus was on his flagship total-return fund (DBLTX). Slides from the webcast are available here. Gundlach is the founder and chairman of Los Angeles-based DoubleLine Capital.
Gundlach said he chose the title because many of the fears he has expressed over the last 15 years about the challenges facing society, the markets and the economy are accelerating and need to be resolved “in our time." Hemingway wrote a semi-autobiographical book with that title based on the character Nick Adams. That book was set in World War I and contained a passage of a soldier praying for survival, in which case he would be forever grateful to God. He did survive, but never lived up to his promise. That relates to the promises the government has made to Americans, which Gundlach said will not be fulfilled.
The title also relates to the infamous Neville Chamberlain, who falsely claimed to have achieved “peace in our time” after negotiating with the Nazis. It reminded Gundlach of the fate of Afghanistan, and potentially that of the Ukraine and Taiwan.
Gundlach focused on things that were highly unusual “in our time.”
That begins with the fact that yields went up during each episode of quantitative easing (QE). Now that the Fed is tapering – and accelerating that tapering – it would be natural for yields to fall, according to Gundlach.
The Fed’s QE regimen is responsible for rising stock prices, but tapering will be over by March. He said it will turn into “rougher waters” for markets. Most believe Fed Chair Jerome Powell has turned more hawkish and will raise rates next year, potentially to 3% or higher.
Historically, the economy has buckled when rates rose, most recently in 2018. “We are likely to see much more uncertainty and stress as the Fed turns more hawkish,” Gundlach said.
As a result of high inflation, the real (inflation-adjusted) Fed funds rate is -6.14%, the most negative it has been since the 1970s. The Atlanta Fed has a theoretical calculation showing that the real Fed funds rate would be -7.92% including the effects of QE. But once the taper is complete, those two rates will converge.
“There are lots of things that resemble the late 1970s,” Gundlach said, “including geopolitics and inflation.”
The federal debt has passed $29 trillion and unfunded liabilities have surpassed $160 trillion. “We have to deal with these in our times,” he said.
The consequence of that spending is “wildly stimulative economic growth,” he said. Since the second quarter of 2020, government spending went up 46%, rising by the same amount as it did from the start of the financial crisis to 2020.
Much of that stimulus went into the stock market. The ownership of U.S. equities among households went from $5 trillion in 2009 to six-times that level now.
“The stimulus will be less of a tailwind at relatively high valuations,” Gundlach said.
All the growth in the U.S. economy has been debt-based, as has been the case in the corporate economy, he said. There have been few corporate bond defaults because of refinancing.
Markets and the dollar
U.S. equities have outperformed the rest of the world by an “outrageous” amount since 2006, Gundlach said, and the gap was especially large for the emerging markets. This year alone, emerging markets have suffered approximately a 40% underperformance relative to the U.S. That has been due to economic outcomes, health systems, pandemic recovery, and the strength of the dollar, he said.
“We are on watch for the dollar to reverse,” Gundlach said. He predicted a strong dollar for the second half of 2021, but he is long-term dollar bearish on the dollar.
“The dollar will go down thanks to the twin deficits in the U.S.,” he said, in reference to the current account and budget deficits.
The emerging markets will be a very strong performer when that happens, he said, but it is too early to buy those stocks now.
The dollar has been in a broad declining pattern over 40 years, according to Gundlach.
Gold has been “shockingly stable,” he said, despite bitcoin volatility and commodity inflation. “You need the dollar to roll over to see gold prices rise.”
Gundlach said that the run up in “go-go” stocks and funds resembles the dot-com era. It’s a similar pattern to the U.S. outperformance relative to the emerging markets, he said. The emerging markets can do very well, which happened following the dot-com bust.
The yield curve is flattening, and the bond market is “sussing out trouble,” Gundlach said. The steepness of the yield curve matters at low rates, he said, and the signal of a possible recession is twice as strong as compared to when rates are high.
“Nobody wants deeply negative, long-term bonds,” he said. “You have to believe there is deep economic trouble coming.”