By Robert Huebscher of Advisor Perspectives
Stimulative measures drive growth, and the U.S. economy and stock market have benefited from quantitative easing, lower rates, less regulation and tax cuts. But Jeffrey Gundlach admonished investors that too much stimulus can backfire.
Gundlach, the chief investment officer of Los Angeles-based DoubleLine Capital, spoke via webcast with investors on September 11. His talk was titled, “Miracle Grow,” and the focus was on his firm’s flagship mutual fund, the DoubleLine Total Return Fund (DBLTX). The slides from his presentation are available here.
Gundlach, an amateur gardener, said that he often uses Miracle Grow fertilizer to help his plants.
“But if you dump Miracle Grow on plants long enough it burns them out,” he said.
The growth of the deficit has been disconcerting. The deficit growth has been at levels that have historically been used to counter recessions, even though we have been in a nine-year-long period of growth.
The U.S. total debt outstanding and the total S&P return have moved up in tandem. That has been “miracle growth,” he said.
What’s going to happen when the next recession happens? The deficit could “explode,” Gundlach said.
Let’s look at what Gundlach said the future holds for the U.S. economy and stock and bond markets.
A recession ahead?
Tax cuts, deficits and debt have been responsible for the surges in U.S. growth – as are the threats of tariffs, which accelerated growth forward, according to Gundlach. Real GDP growth, he said, is at 2.9% and may be as high as 3.8% for Q3. Nominal GDP has accelerated as a result of higher inflation.
The last time nominal GDP grew at this rate was in 2004, which led to Fed rate hikes.
Is there trouble ahead? The year-over-year leading economic indicators (LEIs) are growing at 6.9%, matching the level at their peak in 2012-2013. “It’s very likely they will turn negatives,” and there is “no sign of a recession,” he said.
Sentiment surveys are “off the charts” and “have never been higher,” he said. This is the result of decreased regulation, according to Gundlach.
The PMI surveys are extremely strong (manufacturing is at 61.3 and at its highest level in 20 years). This, he said, is the result of “extraordinary” dovish central bank policies from the Fed and other central banks.
But the Fed is now in quantitative tightening (QT) mode. “We’ll see what happens as $60 billion/month of debt is retired, starting in October.”
There are also trillions of corporate maturities in the next five years, both in the U.S. and globally, according to Gundlach. Along with QT, that will lead to a lot of “interesting things” as all that debt needs to be re-floated, he said.
As debt has grown, it hasn’t been reinvested smartly, he said. Net government investment hasn’t grown. One of the positive things is that government capital spending has grown faster than consumption when compared to prior years, according to Gundlach.
Among households, student and auto loan debt has grown at alarming rates, he said. Millennials have been trapped into “lifelong debt problems” as a result of tuition increases, he said, which have been fueled by debt accessibility.
Home prices are up and home affordability is down, he said, so there has been a slump in housing growth. More than two-thirds of sentiment-survey respondents have said that it is not a good time to buy a home.
Countering Trump’s rhetoric
Gundlach generally stays out of politics in his webcasts. But this time he refuted some of President Trump’s claims.
This is not the “greatest jobs economy of all time,” Gundlach said, contrary to Trump’s claims. Wages growth has not kept up with inflation, except briefly in 2017, according to Gundlach. Wage growth is slowing down, according to data from the Atlantic Fed. Real average earnings growth is negative, with the CPI at 2.95%.
“It’s inflation that’s growing,” Gundlach said.
For the first 20 months of the Trump presidency, there have been 190,000 of new jobs per month. But under the last 20 months of Obama’s tenure, there were 211,000. Not only is this not the greatest jobs economy of all time, it is actually slightly worse than Obama’s presidency, and both periods were late-cycle in the economy, Gundlach said.
Since 1939, despite the huge increase in the population, there were “many, many” times when job growth was vastly higher than under Trump’s presidency, Gundlach said. But, Gundlach acknowledged, a lot of that historical growth happened when demographics were much more favorable than it is now.
The response to the next recession will be some form of universal basic income (UBI), he said. Gundlach cited a program like this in Sweden and noted the recent calls for UBI among socialist Democrats.
The miracle growth markets
Miracle Growth has been thrown at the markets, Gundlach said. As global central banks have pursued aggressively dovish policies, foreign stock market returns have responded in a similar way to those in the U.S.
But global stock markets are down this year, with some real “disasters” in the emerging markets, he said, due to the trade war.
“One of the things we will remember most about 2018 is that incredible divergence between the U.S. and global stock market returns,” Gundlach said.
Inflation has been picking up in the U.S. and internationally. Across the globe, 80% of countries have had rising inflation during the last three months. “We can clearly see that inflation has bottomed out and is heading higher,” Gundlach said. Both goods and services prices have been rising over that period.
We are not having problems getting inflation to the 2% level, according to Gundlach. There is good reason to believe the core CPI will go higher, according to DoubleLine’s proprietary models, the New York Fed’s Underlying Inflation Gauge (UIG) and the ISM PMI (which also is a leading indicator of inflation). Money growth (M2) supply also suggests a move above 3% for inflation, according to Gundlach.
A suicide mission
“It’s bad enough that deficits are increasing this late in the cycle, but we are increasing taxes and raising interest rates,” Gundlach lamented. It is a “suicide mission,” as Gundlach had called it in a previous webcast. If rates are hundred basis points higher, with $7 trillion of debt, there will be $140 billion of additional interest costs, according to Gundlach.
“This will put further pressure on the deficit and create a self-reinforcing cycle of higher debt and higher rates,” he said.
The Treasury could get overwhelmed by a “supply fear” that could lead to much higher inflation, with a tough economy and rising rates, Gundlach warned. “That would be the gateway to universal basic income. Americans would think they were getting something, but it would really be a devaluation of the dollar.”
The dollar’s next big move will be down and it will be lower than it is now by year end, he said. It has recently weakened versus the euro. That will help non-U.S. stock markets. But the dollar has strengthened relative to emerging markets, which has hurt those stock markets.
“The market is telling us the trade war is very bad for emerging markets, especially those with dollar-denominated debt,” Gundlach said.
But, he said, President Trump wants the dollar to be weaker and wants the Fed’s help to make this happen.
U.S. valuations, according to the CAPE ratio, are near 1929-levels. Emerging markets are at half the levels of the U.S., based on the CAPE ratio. It’s really hard to believe that equity markets will hold up. If it gets worse in the emerging markets, then it “has to be a global situation.”
That will happen if the dollar weakens.
Advice to investors
Since May, global markets are down 10% and the U.S. is up 7%. Emerging markets are down 20% over that period, which “looks like a bear market,” Gundlach said. But he does not expect this divergence to continue.
Commodities are at historically cheap levels, but are not going lower, according to Gundlach. “They are a late-cycle play and highly volatile” and they should “stay in the portfolio,” he said.
Gold, at approximately $1,200 per ounce, will increase in price as the dollar weakens. It is a “really good buy” at its current price and has “exhausted its downside,” Gundlach said.
The U.S. 10-year yield (at 2.97%) has been remarkably stable over the last several months. But if nominal GDP growth or the German 10-year yield moves higher – the two have historically been closely tied to U.S. 10-year rates – then it would lead to higher rates. But Gundlach said he does not have high conviction about the future direction of rates.
There is an extremely large speculative position against the Treasury market. Gundlach said that if rates head down, even a little, it could lead to a “stampede” and possibly to a 10-year rate as low as 2.25%. He called this scenario “conjectural” but not impossible.
The 30-year yield (at 3.12%) is nearing the 3.22% level, which Gundlach has previously cited as a threshold that would lead to higher rates, provided there are two consecutive closes above that rate.
Across sectors of the bond market, Gundlach said he is not a big fan of corporate bonds, which are two standard deviations rich, according to the DoubleLine models. Junk bonds are “very highly valued,” he said, but not in imminent danger. Corporate-debt-to-GDP is “horrifically” high, he said, and is inconsistent with tight option-adjusted spreads. Corporate bond yields are also suffering from historically high levels of supply.
With convertible bonds, investors are “basically owning stocks” he said. They are more of an equity investment.
Non-agency mortgage-backed (MBS) securities and floating rate bonds are his favored bond sectors.
Don’t buy Chinese stocks, he said. The financial problems there are “scary” and investors are better off in other Asian markets.
The S&P 500 will end the year modestly lower, he said.
“You want to be globally diversified,” Gundlach said. The U.S. market is sensitive to “just a few stocks.” If you want to increase beta, invest outside the U.S.
“I would not invest in e-commerce stocks,” Gundlach said. “I would rather sleep at night.”