On September 17, 2023, this article was corrected to show that the song, Peace, Love & Understanding, was written in 1974, not 2012 as originally stated.
The consensus is wrong, and the Fed has not engineered a “soft landing.” A recession is all but certain in the first half of next year, according to Jeffrey Gundlach.
Gundlach spoke to investors via a webcast, which he titled “Peace, Love & Understanding,” 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.
The title is from a 1974 song written by Nick Lowe and made famous by Elvis Costello. The lyrics are about a depressing situation, and where one can look for understanding. Gundlach’s gloomy outlook was centered on his recessionary outlook, and his response was to allocate to bonds.
The yield curve has been inverted for more than a year. When it de-inverts, he said, it is a reliable recessionary signal. That hasn’t happened. But if the economy weakens – if Fed tightening has more of an effect – there will be a recession.
“I expect a recession in the first half of 2024,” he said, “but not in 2023.”
The leading economic indicators (LEIs) have been recessionary for a year and are still recessionary, Gundlach said.
When there are recessions, bond yields fall, according to Gundlach, and this will happen next year. But he said a recession could be inflationary if there is strong Fed easing. That could lead to “real stagflation,” he said. “We could see something people aren’t used to – rising rates and slow growth.”
He cited another recessionary signal, which is when the unemployment rate crosses its 12- or 36-month moving average. The latter has been a flawless indicator, he said, and that crossover should happen in the first quarter of 2024, which would be a “full-on recessionary signal.”
When lending standards tighten sufficiently, there is a recession in about six months. The data also shows that will happen in the first half of 2024.
Apropos to the webcast’s title, Gundlach divided his presentation into three sections: understanding, peace and love.
Understanding
Gundlach’s understanding of the economic outlook was centered on the challenge posed by the mounting federal fiscal deficit.
As he has in the past, Gundlach reviewed the fiscal picture for the U.S. He attributed the economic growth in the last several quarters to deficit spending. If you factor out that spending, he said that we are facing growth akin to the depths of the global financial crisis.
The current Fed tightening cycle has been faster and steeper than any since 1987. With rates going up, so is the interest burden facing the government. Interest rates now exceed defense spending and increased from $500 to $900 billion or 3.2% of GDP over the last several years.
“We are going to get an accumulation of an incredible amount of interest expense,” Gundlach said.
Small businesses are suffering along with the government. Loan costs are up about 500 basis points and “money is not cheap” anymore, he said. There will be increased defaults if rates remain high, according to Gundlach.
Gundlach said that tax receipts have been delayed this year, since individual payments are due on October 15. (That is not exactly true, however, since estimated payments are due by April 15. Only final returns must be filed by October 15.) This delay could be negative for the economy. Consumers adjusted their spending habits given this delay, according to Gundlach, as was the case with student-loan payments. He said the reduced tax receipts could mean that the bond market will have less supply, and that would drive down rates in the next six months.
Peace
The peaceful outlook was that inflation has receded.
Inflation, as measured by headline CPI, peaked at 9.1% and is now 3.7%. It will stay at 3.5% to 4% for this year, he said, and then decrease to a “two handle” next year. Much will depend on energy prices, which have become more volatile as WTI oil increased to $90/barrel recently.
Inflation is down, but service-sector prices and wages have been sticky. Food and goods prices have “calmed down,” he said, driving lower inflation.
Shelter will go down, Gundlach said, and could go to zero. It is a lagging indicator by about 15 months. Zillow corroborates that, showing that the shelter component of the CPI will go back to pre-pandemic levels.
Core PPI is at 2.2% and headline is at 1.6%, which are in line with the Fed’s target.
Export prices were up 17% and import prices 13% earlier this year, he said, but both are now negative. “This makes one wonder why inflation is a concern at all,” Gundlach said.
Core PCE is a problematic metric, and it is still above 4%. The Fed needs it below 3.5% to end its rate increases, according to Gundlach.
The bigger problem is “super-core PCE,” which is core PCE less housing, and it has become Jerome Powell’s preferred inflation metric. It has not improved at all in the last two years. It needs to be below 4%, yet it is at 4.7%. “That is not happening at all,” he said. “That is the real-time signal people should be looking at.”
Market-based inflation break-even rates are just above 2% across all maturities. “The bond market is pretty happy with the Fed,” Gundlach said.
Commodities have been coming down steadily since the pandemic, he said, except for the recent spike in oil prices.
Gold has been “range bound” between approximately $2,000 and $1,600/ounce. “I am sort of neutral on gold,” Gundlach said.
The dollar has been falling for most of the year, he said, which is bad for emerging markets (EMs). “I would not get aggressive on EM debt unless the dollar starts to rally,” he said.
Love
Gundlach loves bonds.
It’s hard to love equities when the equity risk premium is the lowest in 17 years – “by a lot,” he said.
Equities are not priced for a recession, he said.
But bonds have twice the yield of the MSCI ACWI all-world dividend yield.
“We like the Treasury bond market for a short-term trade,” he said, “especially going into a recession.”
The 10-year yield could easily go to 2.5% in a recessionary response, he said.
In his previous webcast, which I reported on here, Gundlach was also bullish on fixed income, particularly low-risk Treasury securities and mortgage-backed bonds. At the time, the yield on the benchmark 10-year Treasury was 3.78%. He said then that we had “seen the peak in the interest-rate cycle,” but that yield has risen steadily and was 4.28% yesterday.
Gundlach has cited the copper-gold ratio as an accurate forecast of bond yields. He said it worked well in 2021, but not in the last two years. If it is accurate now, he said, rates will go down.
The 10-year yield has been greater than the core PCE for the last 53 years. Gundlach said there has been a similar relationship between the 10-year and nominal GDP growth. Both core PCE and nominal GDP are greater than historical levels, which argues for higher yields.
Investment-grade bond spreads are about 120 basis points, which he said is “not cheap.” High-yield bonds are “less cheap” at 374 basis points (and are rarely less than 300 basis points).
“I am not really that interested in high yield relative to other things like structured credit,” he said.
Gundlach said there were compelling opportunities in mortgage-backed securities (MBS).
Non-agency CMBS spreads are 893 basis points for BBB-rated bonds because the market is anticipating some defaults, Gundlach said. “It is a bond-picker’s market.”
Home mortgage rates could fall 200 basis points, and nothing would be re-financeable, he said. That has driven the lowest selling activity on existing homes in a long time, he said.
Since mortgages have no refinancing risk, they have “positive convexity,” which is extremely rare. That means that their risk is the lowest ever as compared to Treasury bonds. Yet their spread is among the highest.
“It is one of the best rewards at the least risk,” Gundlach said.
Robert Huebscher is the founder of Advisor Perspectives and a vice chairman of VettaFi.
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On September 17, 2023, this article was corrected to show that the song, Peace, Love & Understanding, was written in 1974, not 2012 as originally stated.
