«It is interesting how you’ve starting to see signs of investor concern around the edges about the health of the economy and about the financial system», states Jeffrey Gundlach.
In the worlds’ financial markets things are coming thick and fast. Oil prices are spinning down, the Rubel is collapsing, and the Swiss National Bank is introducing negative interest rates. At the same time, the Federal Reserve is getting ready for the first interest rate hike in over half a decade. Jeffrey Gundlach worries that this could be a severe mistake. The outspoken and highly influential CEO of the investment boutique DoubleLine was one of just a few contrarians who, at the end of last year, were correctly predicting that long term U.S. interest rates would decrease in 2014. Now, he spots warning lights in the bond market signaling the growing risk of a severe setback for the American economy that even could turn into a recession.
About Jeffrey GundlachJeffery Gundlach is the Chief Executive Officer and Chief Investment Officer of DoubleLine. He was formerly associated with TCW where he was Chief Investment Officer and head of fixed income activities. He is recognized as an expert in bond and fixed income investments. His investment strategies have been featured in leading publications including The New York Times, The Financial Times, The Wall Street Journal, USA Today, Barron's, Forbes, and Fortune. In 2010, Mr. Gundlach was named to the SmartMoney Power 30. In 2011, he was featured as «The King of Bonds» in Barron's, and named one of «5 Mutual Fund All-Stars» by Fortune Magazine. In 2013, he was named «Money Manager of the Year» by Institutional Investor. He is a graduate of Dartmouth College summa cum laude holding a BA in Mathematics and Philosophy. He attended Yale University as a PhD candidate in Mathematics. Beyond his achievements in the investment industry he is also known to be a profound connoisseur of art.Mr. Gundlach, on Wall Street you are well known as an influential bond investor. But you are also a connoisseur of art and even tried to start a career as a drummer in a rock band. What tune comes to your mind when you look at the financial markets these days?
I have kind of lost track of music. I do not know any songs that have been written since about 1997. People around here, they all hear Radiohead and that stuff – I do not know a single song. But there is an old record by Led Zeppelin called «The Song Remains the Same» – and that is kind of what is going on: Basically all over the world, we have continued accommodative policies, to put it mildly.
Sounds almost a little bit monotonously.
What has changed in the financial markets is the strength of the Dollar. When the Dollar started strengthening, a lot of things started to change. The Japanese stock market started to go up again. Also (ALSN 88.4 1.26%), the Chinese stock market started to go up finally. In the United States, the junk bond market started to weaken. Now, junk bonds are at the low of the year whereas treasury bond prices are close to the high of the year. In the equity market, for two years, weak balance sheet companies were doing better or outperforming. Starting in this year, strong balance sheet companies were beginning to outperform. This is exactly consistent with the weakness in junk bonds.
And what does this mean?
It is interesting how you have been beginning to see signs of investor concern around the edges about the health of the economy and about the financial system. Historically, when junk bonds give up the ghost and treasuries remain firm, it is a signal that something is not right.
So what is wrong?
I think that certain things are starting to concern investors and maybe it is all tied around speculation on the Federal Reserve raising interest rates. As prospects for a Fed tightening have increased over the year, the Dollar has strengthened and the treasury bond market has been declining in yields. It is almost as if the treasury market and the junk bond market are projecting that the Fed raising interest rates will cause a recession. I am not going to predict that myself. I am just reading what the market’s message is. How could you explain all these markets acting this way? Well, it seems like as if it had something to do with a policy mistake.
That raises memories of 1937. At that time, the Fed prematurely tightened monetary policy and the economy fell back into a recession. Why would the Fed risk to repeat the blunder of 1937?
The Fed has never kept rates stable for six years, let alone at zero. I just believe that the Fed may want to raise rates simply for that reason. They must be aware that the longer they keep rates at zero the more distorted investor psychology and behavior becomes. The best friend of risk assets and basically all none income paying assets is zero interest rate policy. That is why Ferraris are up 500% in the past few years and Picassos at the very high end are shattering records. I just think the Fed realizes that if we go on with zero, people’s psychology will be even much more distorted. So they want to raise interest rates largely just to see what happens.
Is the U.S. economy not strong enough for a moderate raise of interest rates? For instance, the unemployment rate is already down at 5.8% and closes in on the 5.2 to 5.5% range which is considered as maximum employment.
It is really a mistake to compare today’s unemployment rate to what would have been an unemployment rate around 6% roughly twenty years ago. Today, there is a great shift towards part time employment. For example Wal-Mart is very visible in this regard. They intentionally hire people for less than 26 hours a week to avoid Obamacare. Well, that means that what used to be three jobs is now five jobs. There is not more money into the economy. Also, what you have is employment growth for people who are over 55. Why is that? They cannot retire because interest rates are at zero. With interest rates at zero an infinite amount of money earns zero, let alone a finite amount of money like $300’000 or $800’000 or whatever the particular individual has saved. There is no chance that they can live off of that. Therefore, what many older people do is they work. But there is very little movement regarding young people. So it seems like the Fed, for reasons that are philosophical rather than fundamental, may raise interest rates.
What do you mean by that?
I think they are just nervous about zero interest rate policy going on this long and not having tools to fight any future weakness in the economy. What the Fed wants to do is get off of zero so at least they have the ability to ease down the line. But fundamentally, there is very little reason why they should raise interest rates. The price of oil dropping to $55 a barrel is a very strong sign that there will be perhaps no inflation at all in the United States. The only places where there is inflation is in places that are painful. It is in shelter and in food but not in wages which would help parts of the society. Raising interest rates against that backdrop seems like a poor idea. So I just hope the Fed thinks carefully about what it is doing.
The crash in the oil market is already causing jitters in the financial markets around the globe. What is your take on that?
Oil is incredibly important right now. If oil falls to around $40 a barrel then I think the yield on ten year treasury note is going to 1%. I hope it does not go to $40 because then something is very, very wrong with the world, not just the economy. The geopolitical consequences could be – to put it bluntly – terrifying.
At present, a barrel of WTI (WTI 50.74 0.57%) oil trades at around $55. What are the consequences of that?
Those who want to be optimistic on asset prices say this a tremendous economic benefit because it is a tax cut. Clearly there is some truth to that: You pay less for gasoline and you can buy more junk food. But there are some other, pretty substantial ramifications, not only on inflation. At this level oil is starting to have an impact probably on employment in the United States. The job growth and the economic growth in the fracking regions is monumental and it has to slow down with oil below $60. So you could see employment starting to drop a little bit. At some point with the global economy weakening and the Dollar strengthening, there is a real chance that the U.S. will import economic weakness and deflation. So if the Fed raises the Federal Funds Rate I actually think long rates will not even go up.
How about the risk that the drop in oil prices spills over into the financial markets?
Something between 14 and 19% of the junk bond market are energy related. So when you have oil prices staying where they are for several months – which is likely because that is a policy decision that some oil producers have made – some of these companies will start to really run into financial troubles. Now, some people are saying: «That is confined to energy, it is a pocket of the economy, everything else is OK and insulated.» But that argument usually does not work. When the housing market started to get weak in the subprime category, even Ben Bernanke said: «That does not matter, it is just subprime.» But things are linked together.
So far the stock market is still holding up. It got a little bit bumpy in October and in the last few weeks but the Fed did get out of QE3 without significant troubles.
They have not fully gotten out of QE, they are still reinvesting. Also, I suspect that raising rates would be a bigger deal than just reducing bond buying. That is because buying bonds was easy to replace. The amount of bonds the Fed used to buy was taken over by foreigners in China and Europe because of the yield differential and because there was not a lot of fear of being in the Dollar. But raising rates is different. You cannot really replace that. You cannot suddenly have some other entity lending to you at zero. So I think it will change people’s behavior and it will really start to cause volatility in the currency market.
On the other hand, investors are expecting the ECB to ease monetary policy in Europe further and to start its own QE program.
In Europe, there have been three years now of lack of concern. In Italy, ten year government bonds are yielding less than 2%. In Spain it is 1.7%, in France 0.9% and in Germany 0.6%. So it is not Japan that sticks out anymore. The outlier is actually the United States with 2,2% on the ten year treasuries. Yields in the US are too high. I do not know why anybody in France owns French bonds. You can more than double your income by buying U.S. bonds – and the Dollar is heading higher. So no wonder bond yields in the U.S. have a hard time retracing to higher levels because it is a relative value play. Sadly, in today’s world of developed bonds 2.2% represents value.
What happens if EZB chief Mario Draghi does not deliver?
Mario Draghi talks a lot and I think the market gets tired of the talk. What seems to be happening is Draghi fatigue in terms of the market being willing to simply accept words. There is probably going to be a test of Draghi’s promises and it will be interesting to see whether he is able to pull it off or not. Also, you are seeing things change. For instance, the anti-Euro parties seem to be polling better in Greece and Italy and even in France.
So what should investors do?
My best ideas is very pedestrian – and, unfortunately, totally noncontroversial: The Dollar is getting stronger. That is the thing I am most convinced of. Already at the year-end of 2013 the strengthening of the Dollar was the consensus viewpoint and it turned out to be right. Everybody thinks the Dollar is getting stronger – it is almost uncomfortable. But sometimes the consensus is right.
Where else do you spot opportunities?
This is a market where things are diverged. It is not all one market any more. You have things like silver that are down massively in Dollar terms while gold is almost unchanged. You have some emerging markets like India that are doing great while other emerging markets like Brazil have done terribly. It is not like it was last year or the year before where everything was up. You have divergences: There are markets that have gotten really weak and are oversold and others are near their highs. So what you have is an opportunity to diversify taking true risk. I am not talking about the S&P 500 (SP500 2141.16 -0.01%) but about true risk: Brazil or Russia.
Why should Russian securities be attractive right now?
I am not saying they are going to do well but I do not think that they are incrementally risky versus the high flying markets because they have diverted somewhat. So you end up in these funny situations where the things that are the scariest because they already lost so much value, are actually the safest. And I think that is the case today. For example, the Rubel is actually a decent speculation. It is incredibly risky but it lost so much in value that it is probably drastically oversold. The Rubel is falling like a knife so it could easily drop another 15% this month. But I would bet just about anything that the Russian currency sometime in the next six months will be at least 15% higher than it is today.
What could be the biggest surprise of 2015?
Russia starts a war and that would be very, very bad for the financial markets. The probability is still low and I am not predicting this. But with oil at $55 there is a lot of pressure on Russia. Now the question is: Is Putin suddenly going to play nice? I doubt it. It just does not seem like his personality. So if he is not going to play nice what is going to happen? It is not unthinkable that he is going to get killed by the Oligarchs who are going to get mad. That has happened before. So maybe he starts another war. Leaders often start wars when there is pain and tension. I just think the risk of Russia going off the reservation is much higher with oil at $55 than at $95.
In contrast to Russia, other countries may take advantage of lower oil prices. Where do you see opportunities with respect to that?
If oil is staying down you should probably buy the Indian stock market. I have been bullish on it the whole year. It is up almost 30% now and therefore not cheap. But India is a huge beneficiary if oils is staying where it is. And it is a very comfortable economy to invest in for the next generation because they have tremendous ability to growth – that and the fact that they have many problems.
What do you mean by that?
If there are problems they can be solved and you have potential. I learned this personally when I started my career. I worked for a guy who was probably one of the worst investors in the business. He was terrible. At first, I thought it was a curse staying in this department where the head of the department cannot shoot straight ever. Then, I started to realize it was a benefit. Because when the leader is incompetent there is opportunity. So do you really want to go working for the greatest investor in the world? No! Because he is never going away, there is no opportunity.
So that is the reason why people like working here?
You have got me there. Yes, they know that I am not the best investor.
Seriously, how does your personal portfolio look like?
Most people’s risk profile – including mine – is way too low. I have that disease as well, I do not take enough risk. That is because I just do not like to lose. I am a buy-low-person not a buy-high-person. So at present, I hold more cash than I have ever had. If you forget about art and about DoubleLine, when I look at stocks and bonds and other financial assets than I am probably at 40% cash. And I do not feel like I am losing very much. The things that are going up like Picassos I am long the market. And frankly, I was walking around my house last week and I was like: «I do not think I can put anything everywhere else. It is all so crowded.» You do not want every wall to have something on it. That is some sort of weird.