Gundlach: Bonds are Much Cheaper than Stocks
The bond market is much cheaper than the stock market, according to Jeffrey Gundlach. Investors should abandon the traditional 60/40 stock/bond allocation in favor of a 40/60 split.
“Bond allocations will prove to be much more rewarding this year than last,” he said. Gundlach can justifiably be cited for “talking his book,” since he oversees one of the world’s largest pools of actively managed bond funds. But, as I will discuss, a year ago he (correctly) made the opposite call, favoring stocks over bonds.
One year ago, bonds were above par, he said, which is not a good starting point. Now bonds that were priced at $102 are going for $60 to $75. They can easily appreciate back to par, even if they are losses due to defaults.
“Bonds are not rich to stocks,” he said, and have less downside risk. They can act as a diversifier to equity allocations, especially if there is a recession.
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 10. Slides from that presentation are available here. This webinar was his annual forecast for the global markets and economies for 2022, and its title was, “What’s Going On?”
The title was from a song Marvin Gaye recorded in 1970, after witnessing police brutality in Berkeley, CA. It was the first single that used his three distinct vocal styles. Gaye was tragically shot and killed by his father in 1984, at the age of 44.
Before we look at Gundlach’s predictions for 2023, let’s look at how his forecast from last year held up:
- U.S. equities were overvalued, but “cheap” relative to bonds – U.S. stocks, based on the S&P 500, were down 18.6% and bonds were down 13.7%, based on the Vanguard total bond index. That was a bad year for stocks, but the worst among the last 97 years for bonds. (Correct)
- European stocks will outperform U.S. stocks – European stocks were down 16.01% based on the Vanguard European Stock Index Fund ETF. (Correct)
- Emerging markets will outperform U.S. stocks in a down market – Emerging stocks were down 18.04% based on the Vanguard FTSE Emerging Markets ETF. (Correct, but barely)
- Headline CPI inflation will be 7% for 2022 – Headline CPI-U was 7.1% for the 12 months ending in November. (Correct)
- He did not predict a recession – The was no recession in 2022. (Correct)
- He was “neutral” on the dollar in the short term – The dollar was up approximately 7.5% in 2022, based on the DXY (“Dixie”) index. (Tie)
- He was “neutral” on the gold in the short term – The GLD ETF was down 0.77% in 2022. (Correct)
- The Fed funds rate “could get to 1.5%” in 2022 – The effective Fed funds rate was approximately 4.3% at the end of 2022. (Incorrect)
That is six correct, one incorrect and one tie – a stellar record for the “bond king.”
Reflections on a remarkable year
Last year was the third worst for stocks since 1976, Gundlach said, but by far the worst year for bonds in that period. It was also the worst for the 60/40 allocation.
Since the Fed’s June meeting, the S&P is up 4%, and markets stabilized. Commodities were the best performing asset class for 2022, although they lost money in the second half of the year.
The Treasury yield curve was normally sloped, with a two-year to 10-year 150 basis point spread, at the beginning of 2022. But now it is heavily inverted.
The market-implied Fed funds rate shows that the Fed will raise rates to just less than 5% by May or June, and it will be 4.23% (40 higher than it is now) at the end of this year.
The Fed will hike in February, Gundlach said, but will not make it to a 5% funds rate. “The economic data is encouraging the Fed to stop,” he said.
U.S. government interest payments are going “virtually vertical,” Gundlach said, and will represent $500 billion in excess spending just from interest payments. Interest rates will be less than 4%.
The Fed’s balance sheet increased through quantitative easing (QE) and contracted with quantitative tightening (QT). Those changes have correlated closely with the up and down movements in the prices of U.S. stocks. Even more highly correlated, according to Gundlach, have been global balance sheet movements and the price of the FANG+ index.
Why the Fed won’t get to 5%
A weakening U.S. economy will stop the Fed from raising rates to 5%.
Supplier delivery problems are over, he said, and backlogs are at their best level in 30 years. But some of those reduced delays are due to lack of demand, Gundlach said. “The consumer is getting much more stressed,” he said, now that fiscal support measures are over.
Housing is at its least affordable level since 1990, and that is due to interest rate increases. The monthly payment on the median home doubled since the first quarter of 2020. Gundlach said that home mortgages are unlikely to default because there is equity in housing values, due to price increases during the pandemic.
“It is absurd to think there will be a rash of defaults,” he said. “People will just sell their houses,” to get their equity.
But housing is not going to rescue the economy in 2023.
The consumer savings rate spiked in 2020 due to the pandemic but is as low as it was just before the global financial crisis. Households were net savers until late 2021, but the savings rate shrank and became negative since. “Consumers don’t have money,” he said. Food and gas prices are elevated, and there is “all kinds of evidence” consumers are using credit to cover necessities, Gundlach said.
Indeed, he said, consumers are “desperate.” Their high credit card usage is a sign of stress.
Consumer sentiment is at one of its lowest readings in the last 40 years.
The unemployment rate is near its 12-month moving average and might go below it in the next few months. That has been a strong indicator of a recession, he said. The LEIs are negative and heading very sharply into recessionary territory. One LEI metric suggests a recession is a month away, Gundlach said.
The ISM PMI has the same pattern it had two months prior to entering the last two recessions.
The yield curve is “screaming recession,” Gundlach said. Fed rate hikes and a rally in 10-year bond prices have driven its slope to a recessionary level based on the last six recessions. The same message is coming from the 2-year to 10-year slope.
“Sustained, inverted yield curves have always led to recessions in short order,” Gundlach said.
Investment-grade and high-yield spreads widened going into 2022 but are still not at recessionary levels. It is the best indicator that a recession is not imminent, Gundlach said.
But spreads at the lower tier of high yield (CCC bonds) predict there will be some defaults in the next few years. Lending standards have been tightening “a lot” and “look recessionary,” he said. High-yield default rate could be 9% in a year.
Headline CPI was in a tight range for a decade up to 2020, then it spiked to 9.1% during COVID. Now inflation is declining at the same pace it accelerated.
The market and economists expect inflation to decline to around 2% and then go “dead sideways,” Gundlach said. “That will not happen.”
If the Fed gets inflation to 2% by the end the of the year, he said it will go below that level, and will go negative on a year-over-year basis.
Money supply growth, as measured by M2, historically has been a leading indicator of inflation. It crashed in 2022 to its slowest growth level in 50 years. “That presages low inflation,” Gundlach said, if the Fed stays aggressive.
Export prices spiked about a year ago, but are coming down, similar to import prices. Both are falling rapidly. Both are signs of lower inflation, Gundlach said.
“It is absolutely clear inflation is coming down,” he said, and predicted that May it will be approximately 4%, which supports bond valuations.
Car and home prices are depressed and will not drive inflation, he said.
Asset class predictions
Commodity prices will not drive inflation and have been falling over the last six months. “I would not broadly buy commodities until they go above their 200-day moving average,” he said. “That will need a weaker dollar.”
Over the past two and a half years, gold has moved sideways. “It is a reasonable and good time to buy gold,” he said.
Real yields have stopped going up, which Gundlach said is good for “risk assets.” “That will remain the case for the first half of 2023, which is a reason to be positive. “
Until the Fed relents on its inflation-killing policy, he said P/E ratios will be depressed. The deflating of the Nasdaq bubble “has not played out,” Gundlach said.
Gundlach said he “tremendously favors” non-U.S. to U.S. stocks, starting with European and especially with emerging markets.
“The European trade has significant legs,” he said.
There is a lot of opportunity in emerging markets. Once a recession shows up, he said, the dollar will drop. “It is heading lower from its level of 103.1,” he said, and that movement will be fueled by rising deficits from a recession.
“There is a massive tailwind in the works for emerging markets because of a weakening dollar,” he said.
The copper/goal ratio shows that the 10-year yield is going lower. It should be closer to 2.5% than its current level of approximately 3.6%.
“There is tremendous potential gain for Treasury securities at the long end,” Gundlach said.
What is really cheap?
Commercial mortgage-backed securities (CMBS) rated AAA are exceptionally attractive. They have very little default risk, he said.
Ratings on securitized products are “overstated,” Gundlach said, and are less risky than their ratings indicate. CMBS are comparable to investment-grade bonds and are “as cheap as they ever have been,” he said.
“The cheapest in 10 years.”
“That is where you want to be,” Gundlach said.