Jeffrey Gundlach: An Unprecedented Opportunity in Bonds
Sell stocks and buy opportunistic bonds, according to Jeffrey Gundlach. “The capital gains potential is the best in the last 15 years," he said. Bonds are “the place to be.”
Bond yields are up 300 basis points this year, creating opportunities that “blow away” the stock market on a risk-adjusted basis. There are many ways to achieve an income stream far in excess of the stock market, according to Gundlach.
Gundlach spoke to investors via a webcast, which he titled “Rehab,” 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 referred to a song performed by Amy Winehouse, released in 2006.
“The U.S. needs to get into rehab,” he said, and recounted some of the societal problems we face.
There are 1,250 IRS agents who are not paying taxes, yet another 87,000 agents are about to be added.
Most Americans think the U.S. is on the wrong track. The 31% who do are about the same percentage who think Elvis is alive and living on the Moon.
The border is not secure, he said, with two million new immigrants. Budget deficits came down during COVID, but are back to the level (3.2%) that most people think is disturbing.
“Maybe we should save money and run a balanced budget,” he asked rhetorically.
Real GDP growth accelerated in the 1950s until the global financial crisis and decelerated after that.
“We are accelerating our addiction to debt,” he said. “We need to go into rehab. Debt is decelerating our growth.”
The student loan debt-to-income ratio went from 31% in 2007 to 44% four years ago to 54% now.
In response, politicians want to cancel that debt, but he questioned whether that is constitutional.
Starting in January 2022, households have had to draw down savings due to inflation, driving the savings rate negative. Consumer credit is up 10.9% year-over-year. “Consumers are borrowing for the future to eat today,” Gundlach said.
“We need the economy to get off of this credit-debt binge that has been going on for 40 years.”
Consumer delinquencies are up from 2.5% a year ago to 5%, where it was three to five years ago. A year ago, the two-year yield was 15 basis points. Now, he said, the Fed funds rate may go to 4%, along with the two-year.
“The U.S. will not go into rehab until we accept that the negative GDP growth is unacceptable.”
Despite that dour litany of problems, Gundlach said investors have unprecedented opportunities in the bond market. First, however, let’s look at what he said about the economy.
We are not in a recession, he said, despite the two-quarter negative-growth threshold we passed this year. But the U.S. may still face a recession.
Gas prices are still up substantially since last year. The leading economic indicators (LEIs) are at zero through July, which is a precursor of a coming recession.
“It looks like we are getting close to the front end of a recession,” he said, and 2023 could be a “recessionary year.”
When monthly employment (which is 4.07%) goes below its 12-month moving average (which is 3.7%), it signals a recession. If unemployment goes up in the next couple of months, it will signal a recession.
Real average weekly earnings growth went negative starting in the second quarter of 2021. “The addiction to debt and stimulus is having consequences with inflation that is hurting consumers,” he said, causing poverty and hurting the middle class.
But it helps those in power, he added, “at least that is what it feels like.”
Consumer sentiment is declining. The consumer won’t help the economy, according to Gundlach. Durable goods spending is way above its pre-pandemic trend and will ultimately be reversed over the coming years. Non-durable is way above trend as well.
“There is no area where there is underspending and pent-up demand,” Gundlach said.
Mortgage rates are about 6.25% (up from 2.75% in early 2021), which is a tremendous headwind for the housing market. The monthly mortgage payment on the median home was $1,000 two years ago, but is now $1,816, which he said may not include the most recent mortgage rate data.
Unsecured personal loan delinquencies are up sharply since early 2021.
Gundlach has said for a long time that the Fed follows the two-year Treasury. The Fed funds rate is 2.5% and the two-year yield is 3.87%. The Fed will assuredly hike by at least 75 basis points at its next meeting. That means the two-year Treasury yield may go above 4% and remain higher than the Fed funds rate.
The yield curve has flattened, and the market expects the Fed funds rate to peak at 4.4% in March of 2023, after which it will ease into 2024. But Gundlach doubted that would happen. He said a 25-basis point increase would be more appropriate.
The Fed is getting too aggressive, he said, and will drive the economy “into a dumpster.”
The dollar has been going up over the last year, he said, because the expectation of Fed tightening went from “none” to “very high.”
Inflation is 9.4% globally and headline inflation is 8.3% in the U.S., as it is in the emerging markets. The U.S. CPI is the same as it is globally (except for China, which has low inflation). Core CPI is 6.3%
Export and import prices are both up about 9%, he said. Nominal wage growth is up 8.4%, but that is for job-switchers. Overall, wage growth has been 6.7%.
Rents are up 13.2%, but owners-equivalent rent (OER) is up only 6.3%. Gundlach said OER will gradually catch up to rent.
The yield on the Bloomberg AGG index went from 1% in mid-2020 to 4.25%, about a 350-basis point “painful” rise, Gundlach said. “But once bonds sell off a lot,” he said, “they become really attractive.”
There are plenty of bonds priced attractively in the high-yield and mortgage markets, according to Gundlach.
Using data from the AGG index, he showed that the bond yields accurately predicted total returns over the subsequent three years. As of three years ago, the forward return was about 1%, he said, which is what investors will realize. But now the yield of 4% implies a 4.5% return, he said.
The copper-gold ratio is also bullish. It is signaled an increase in 10-year yields starting in early 2021. Now it signals a 2% yield on the 10-year.
Real yields have been increasing since the pandemic, he said, and that is a problem for stocks. Earnings growth is slowing, which is a “double whammy” with rising real yields, he said.
“The bear market in stocks is not over.”
The Nasdaq stopped outperforming the S&P two years ago, presaging a repeat of the dot-com era. The S&P is probably a better investment than the Nasdaq for “years to come,” according to Gundlach.
The S&P had outperformed Europe until a couple of years ago as well, but that trend has not yet fully reversed.
Emerging markets are not yet cheap, he said, but retirement accounts with a long-term focus should buy them.
The liquidity in the Treasury market is terrible, he said, based on the bid-asked spread. That benefits those funds not based on short-term trading. That, he said, is why many total-return bond funds are lagging in performance this year.
Investment-grade and high-yield spreads have tightened since the start of the year. Defaults (at 0.8%) are very low in the high-yield market. Bank loan defaults are also historically low at 0.6% but have started to increase. The CCC spreads are wide at nearly 1,000 basis points, but that is historically not where spread widening has stopped.
Agency mortgage spreads are high, with yields of more than 5%. To get that yield a year ago, he said, you would have had to leverage the high-yield index by 50%.
Quantitative tightening (QT) is just getting started, he said. In the fourth quarter of 2018, there was QT that weakened the equity markets, causing the Fed to reverse, lower rates, and go back to quantitative easing (QE).
“QT is clearly a negative sign for equities.”
The Fed will raise rates to 4% and maybe a little above that, he said. But that is already discounted by the market, he said. The two-year yield is already near 4%.
Gundlach said that when the Fed stimulated the economy after COVID, it wanted the CPI to go to 4% to “make up for historical undershooting on inflation.” But it went too far, and inflation went to 9%
“They overshot, so they have to tighten aggressively,” he said.
But economists and the bond market believe the CPI will go down faster than it went up, he said. They believe inflation will go from 9% to 2%, and then go sideways.
“That is ridiculous,” Gundlach said.
Long-term Treasury bonds make sense because the Fed will try to get that 700 basis points, according to Gundlach. “It will overshoot again on the downside. You might get a negative 3% CPI. The bond market will rally.”
“You want to own Treasuries mixed with risky credit.”
Robert Huebscher is the founder and CEO of Advisor Perspectives.