By Robert Huebscher
So-called "risk assets" - securities, like equities, that offer the greatest opportunity for returns but the highest exposure to risk - are priced at levels that are eminently unattractive, according to Jeffrey Gundlach. Indeed, he said that investors in risk assets should expect returns of only 2% versus potential losses of 20% - an ominous 10-to-1 tradeoff.
Gundlach spoke to investors on March 8, to provide updates on the DoubleLine Total Return Fund (MUTF:DBLTX). He is the founder and chief investment officer of Los Angeles-based DoubleLine Capital.
The slides from his presentation are available here.
"Risk markets are a lot like the attitude toward Ted Cruz," he said. "People think they are stronger than they really are."
Richard Russell, the venerable market analyst who recently passed away, once said, "bear-market rallies look better than the real thing." Gundlach noted that in reference to the recent rally in U.S. equities, which advanced further in the days following his talk.
"The S&P may have 2% of upside and 20% of downside," Gundlach said. "The setup for risk assets from a risk-reward perspective is quite poor."
I'll look at the reasons for Gundlach's bearish forecast, starting with his take on monetary policy.
Gundlach - The Fed, monetary policy and the potential for recession
Gundlach said the Fed will not be able to follow through on its calls for further rate hikes this year and beyond.
The Fed still says that it will raise rates by 100 basis points in each of 2016, 2017 and 2018, according to Gundlach. But, he said, that is not a "wise idea" because of the divergence with other central banks, as well as weak GDP growth. All other central banks are cutting interest rates, and some have established negative rates, Gundlach said. He said that the market-implied probability is one rate hike of about 25 basis points, versus the Fed's statements of four hikes in 2016.
At the start of 2016, Gundlach said there was a 50% chance of raising rates in March, and that went to zero when markets crashed at the start of the year. The probability is now 4% of a rate increase in March, despite unemployment less than 5% and inflation - by some measures - of nearly 2% and a market recovery. The probabilities of rate hikes later this year are June (43%), September (55%) and December (70%).
"Remember that the market collapsed after the Fed raised rates in December," he said. It would be "really dicey" to raise rates again. The market would be “ill-prepared” for a rate hike in March, Gundlach said.
When markets behave differently to the same news, it is ominous, according to Gundlach. He cited the market's recent reaction to announcement of QE in Europe. The dollar had rallied in the past after similar announcements, he said. But recently, the euro rallied with announcement of Eurozone QE. Negative interest rate policies explain this, he said. "Markets are reacting differently to announcements of monetary policy and stimulus," Gundlach said.
Negative interest rates are bad for banks, he said, and have been especially for the stock prices of Deutsche Bank (NYSE:DB) and Credit Suisse (NYSE:CS); The Bank of America's (NYSE:BAC) stock is down 30% from where it was a year ago. "The banking system and markets don't want NIRP," Gundlach noted.
"Investors are victims of extrapolating the recent past into the future," Gundlach said. Inflation went from 2% to 0%, and rose recently to nearly 2%. As a result, people now believe the Fed won't raise rates and are consequently buying stocks. Gundlach said there are "some signs" that core inflation is moving higher because of wage gains (although wages went down in the most recent monthly report). But, he said, those gains were mostly concentrated in low-wage jobs.
Gundlach said there is "no traction at all in real or nominal GDP" to support a rate hike.
The manufacturing ISM is below 50, he said, consistent with prior recessions, although it improved slightly lately. Services, however, have been plummeting similarly to how they plummeted prior to the last recession, he said.
According to Gundlach, one reliable indicator for a recession starting has been the 12-month moving average of U.S. unemployment going above its monthly level. This has been "incredibly consistent," but it is not signaling recession now. "There will be no recession unless unemployment moves higher later this year."
Although the yield curve has flattened this year as the Fed raised rates, Gundlach also dispelled a bit of conventional wisdom. Recessions can happen without an inverted yield curve, he said. Consider Japan, which has had six recessions without an inverted yield curve.
The well-known analyst Martin Fridson has built a model that shows a 17% chance of recession based on the high-yield market, Gundlach said. "I think the probability is higher than that," he said.
Slow global growth underlies economic and market weakness, according to Gundlach.
Global GDP was forecast to be 3.2% for 2016, Gundlach said, but the World Bank downgraded that prediction to 2.9% in January. China's growth is now forecast at approximately 7%, he said, but considering its emergency stimulus and debt, he said, it "seems extremely clear China's growth rate is not at 7%. It may be contracting."
China is about 16% of world GDP; if it is at zero growth, then global growth would be approximately 2% or lower, Gundlach said.
"This is the problem that is plaguing commodity prices," he said.
According to Gundlach, South Korea is a big trading partner of China (23% of its exports go there). South Korean export growth is in "negative double digits," Gundlach said. Chinese imports and exports are negative, he said. "There is no way it can have 7% growth."
He added that tariffs and protectionism advocated by Donald Trump would make those matters worse, although it could be offset by the massive military spending that Trump recommends.
China needs to devalue its currency, Gundlach said, which would "not be good" for risk assets. China has pegged its currency to that of its trading partners, but at too high a level, he said, and will need to abandon this. Global stocks have historically fallen when China devalues, Gundlach said. "The correlation is incredibly high. Watch out for what's happening over there."
"This is a world without enough GDP growth globally," Gundlach said.
Commodities, high-yield bonds and the energy sector
Historically, global stocks have not had a high correlation to 10-year U.S. implied inflation rates, according to Gundlach. But lately that correlation has been very high. "Stock markets fear deflation," he said, and that is consistent with the markets needing higher commodity prices.
Oil prices have risen from their low of approximately $27/barrel. It will be much more challenging for oil to go above $38, Gundlach said. But the price of oil is too low to avoid bankruptcies and problems among banks, he said. Oil inventories are "through the roof," he noted, "and are far greater than when prices were $95/barrel." The gap between supply and demand has widened in the past three months, he added.
Gundlach said the price of oil needs to be above $45 to get a health energy sector. "Unless commodities can rally, there are about 100 companies that will face a day of reckoning," he said.
"People who buy high-yield bonds and ETFs today will sell them at lower prices," he said, "perhaps to us. They will get whipsawed." Avoiding getting whipsawed, he said, is the number-one rule of investing. Protections and covenants for bondholders are minimal in high-yield bonds, by historical standards, and the degree of leverage is very high. Earnings are negative across those issuers, even if one excludes the energy sector. "Defaults will go up," he said, given lending standards and commodity price levels.
"Time is not your friend with commodity prices this low," Gundlach said, as a warning to those who might be considering investing in, for example, high-yield bonds.
The dollar is in a long-term bull market, but it has not strengthened as a result of Fed rate hikes, he said. Gold is still going to $1,400, according to Gundlach, but in the short term it has been very volatile. "Stay long on gold for the long term but maybe trim gold-miner positions," he said.
Some final forecasts and warnings
Gundlach finished the call with several strong admonitions.
Three times the 10-year Treasury yield has gone down to approximately 1.65%, he said, but failed to go below that level. "Don't buy at 1.66% or 1.67%," he said. "Wait to see if it can break that resistance."
"It still looks like the bottom for interest rates was in July 2012," he said. "We are not about to see a big spike up in interest rates."
"Banks will fail and stocks will crash if the Fed goes to negative interest rates," Gundlach said.
He cited a "bad signal" for risk assets: CCC- and lower-rated high-yield bonds have rallied, but there is a big gap between where they are now and their prices in July 2104. But, he said, the S&P 500 is back to where it was at that time. "These lines will converge - either in the attic or the basement," he said. "Based on where commodity prices are, we suggest it will be in the basement."
Profit margins have fallen to a level that is consistent with recessions, he said, mostly because of wage gains. GDP growth at 2.2% and slowly declining and prospects of Fed tightening are inconsistent with forecasts of 10% earnings growth.
His final words: "Watch out for the idea that this is the time to be buying into risk."