«The dollar has already topped. It may lose a lot of its value during the next downturn.»
Central banks are easing, and stocks have reached a record high. But that doesn’t mean that everything is okay. Jeffrey Gundlach sees big trouble ahead. The CEO of the investment firm DoubleLine is worried about the development of corporate debt. But also the levels of government debt and the US equity markets are not sustainable. According to Gundlach, investors have to brace for significant disruptions.
Mr. Gundlach, what would you recommend to investors?
They need to position themselves for the next global downturn because it will lead to substantial changes in the markets.
About Jeffrey Gundlach
Jeffrey Gundlach is the Chief Executive Officer of DoubleLine, an investment firm with $147 billion in assets under management at the end of the third quarter of 2019. The company is based in Los Angeles and focuses mainly on fixed income. Before founding DoubleLine, Gundlach was Chief Investment Officer and head of fixed income activities at TCW.
He is recognized as an expert in bond and fixed income investments. 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.
Gundlach 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 and collector of art.
When will the downturn come?
It doesn’t matter whether it comes in one year or four. If you don’t start preparing now, you will maybe do better while the economy continues to do okay, but whatever gain you get from that will be overwhelmed by problems with your investments in the downturn.
How do you have to be positioned?
Investors should systematically reduce risk. They have to be highly diversified, and that doesn’t just mean financial assets. You should own your house free and clear if you can. People should not own stocks if they have a mortgage.
Do you see any historical parallels?
It feels like 2006 when people realized that there was tremendous over-leverage and that it would lead to an extraordinary collapse in credit.
Why do investors need to prepare now?
It’s difficult to make those adjustments while the decline is underway because the liquidity won’t be there. This time the liquidity is going to be very challenging in the corporate bond market.
What is the problem with the corporate bond market?
The corporate bond market in the United States is rated higher than it deserves to be. Kind of like securitized mortgages were rated way too high before the global financial crisis. Corporate credit is the thing that should be watched for big trouble in the next recession.
How big is the problem?
Morgan Stanley Research put out an analysis about a year ago. By only looking at leverage ratios, over 30% of the investment grade corporate bond market should be rated below investment grade. So with the corporate bond market being vastly bigger than it’s ever been, we’ll see a lot of that overrating exposed, and prices will probably decline a lot once the economy rolls over. Furthermore, central bank policies have forced investors into asset classes that they usually would be a little bit more hesitant to allocate to.
Is it better to own stocks then?
The US equity market will be the worst performing equity market in the world if you look at the past three major economic downturns, globally. Before each of those three downturns there was one segment of the global stock market that outperformed in a noticeable way, and the economies related to that stock market were perceived as to be invincible.
Which ones were they?
The late 1980s saw Japan as invincible with the Nikkei tremendously outperforming every other market to the point where there was incredible overvaluation of Japanese real estate when the recession came in the early 1990s. The Japanese Market was the worst performer. It never made it back to that level. In the advent of the Euro, there was a lot of enthusiasm about the economic prospect of the Euro area, and the stock market in Europe was incredibly strong in 1999, outperforming every other market. When the recession began, it was the worst performing market and never made it back again, broadly speaking.
And now it is the US?
This time US stocks are crushing every other area. It’s due to some fundamentals like the better economy, but also due to tax cuts and share buybacks. In the next recession, corporate bonds will collapse, and buybacks will stop. The dollar has already topped. It may begin falling in earnest during the next downturn and US equities will lose the most. They will probably not make it back to the peak for quite a while. When the US market drops, it will drop a lot.
What about gold?
I’ve been an advocate of gold since it was at 300 $ per ounce. I’m not positive in the short term. But I think it might be worth it to buy gold at 1400 $.
Is there any place where you find value?
Outright value? No. I don’t think there’s anything in the world of financial assets that one could call value, because the policies of the central banks have pushed valuations to levels that historically are associated with avoidance rather than allocation.
How low will the Federal Reserve go with interest rates?
The Fed will follow the bond market. It’s all they ever do. The reason they started easing this summer was that the bond market was pricing 2-year Treasuries so far below the Fed Funds Rate. They couldn’t really sustain the level where it was. Ultimately it depends on what the market does. The Fed doesn’t know what they’re going to do.
On which levels do you expect US long-term rates to be?
Rates should rise a lot in the next recession because the bond issuance will be in the multiple trillions of dollars, but maybe the Fed will suppress them as the European Central Bank has done. The Fed is already doing quantitative easing. But they don’t admit it. They are injecting liquidity in the repo market. It seems to me that the Fed is suppressing long-term interest rates.
How is the Fed suppressing long-term rates?
Jerome Powell says this is not quantitative easing because quantitative easing was designed to bring down long-term interest rates. Still, in a sense, he’s abetting the enormous issuance of T-bills. If the Treasury were issuing 30-year and 10-year bonds instead, yields would be rising already. So they are in a weird way suppressing long-term interest rates through the management of the debt issuance. What I find fascinating is that you don’t get natural demand for 1,85% T-Bills today. Do you think you’re going to get natural demand for 1,5% 10-year treasuries if you’re issuing five times the amount you are issuing now? I don’t think so.
So the Fed will keep long-term rates low?
Rates will rise first. Because it would be strange for the Fed to announce one day out of nowhere that they were doing a massive quantitative easing program buying 10-year and 30-year Treasuries. There would have to be a catalyst for that to happen. And the catalyst would probably be similar to what happened in the repo market, where the whole thing unraveled in a day, rates went up to nearly 10% and the Fed came in and rescued everything. Maybe you could get a «taper tantrum» type of move on the long end. That might lead the Fed to announce this vast program. Powell said he’s going to use large scale asset purchases to fight the next recession. That’s what he said at his last press conference.
What else could he do?
He could introduce negative interest rates, but I think Powell understands that the US cannot introduce negative interest rates without the entire global financial system collapsing. Because where’s all that capital going to go? Which markets are big enough? Negative rates are the worst thing that could happen in the US.
Why is that?
You can see what negative rates have done to the banking system of Japan and Europe. All you’ve got to do is look at the relative performance of bank stocks. The underperformance of European banks is correlated to the yield of the 10-year German Bund. I don’t know if the politicians understand that negative rates are fatal. It’s fatal to Deutsche Bank and insurance companies in Switzerland.
Will Europe leave negative rates behind?
It doesn’t seem so. They certainly don’t seem to want to. They concluded that negative interest rates are a short-term boost for the economy, yet for the long term, they are fatal. So how many short terms do you need to glue together before you get the long term?
It has been going on for quite some time.
So has the US budget deficit. But that doesn’t mean that it’s irrelevant. It just means that it hasn’t happened yet.
Nobody seems to worry in Washington about debt and deficits.
They don’t worry because they think that the Fed will monetize it. Maybe they’re right. People have given up on the idea that we’re going to pay our debt back. I don’t think anybody believes it. I don’t see how. The US debt is so high that to pay it back, we would have to retrench so much.
What will happen instead?
You could create inflation through universal basic income. That would debase everything. Or you could default on Social Security benefits and welfare benefits. These are the options. We’ll do some combination, maybe raise the eligibility age from 65 to 75. I don’t know what’s going to happen, but what we have now is unsustainable. The debt is unsustainable. Interest rates are unsustainable. The wealth inequality gets worse every minute. It’s already beyond the point of sustainability, and when the next downturn comes, there will be a lot of anger and unrest.
Will the downturn be the tipping point for these changes?
Yes, because the misery is going to be apparent for a considerable fraction of the population. It’s going to be pretty intense, and the response will be money printing. When Ben Bernanke said, we’ll never have deflation because we have the printing press and when he used the word helicopter money, people thought it was some euphemism, some joke. People thought that that could never happen. Now we have candidates running on it. Kamala Harris has a version of it, Cory Booker has a version of it. And for Andrew Yang it’s the centerpiece of his campaign.
How soon do you expect a recession?
I don’t see a recession in the next few months. The indicators aren’t pointing in that direction strongly enough. They are a lot weaker than they were a year and a half ago. But they’re not universally corroborative. Unemployment is still too low for a recession.
Where would you see negative signs first?
Consumer confidence is probably the best indicator. It ties it all together. Consumer confidence drops with falling employment, leading to a reduction in spending. Recessions are highly psychological.
CEOs are already pretty pessimistic.
CEO confidence is really low, like during a recession. And CEO confidence usually drops first. It tends to lead to slower hiring and less investment. So it’s easy to paint the case for a recession next year. However, there are levers that the Trump administration will probably pull – or try to pull – to push it out a little bit.
Either by dumb luck or by planning, Trump is doing just about everything he can to push a recession out. Tariffs are hurting retail sales right now. They’re delaying people’s buying decisions, particularly when he says «there’s a 25% tariff, but we’re gonna have a deal». That makes people wait for the deal. So one way to sculpt consumer behavior is by talking tough and putting on tariffs in 2019 and then taking them off. I don’t know if he’s going to do that, but he certainly put them on. What if he took them off in March or April and suddenly the delayed buying decisions might get pushed forward? Maybe the softness in the economy that we saw this summer is based partially on the tariffs. Perhaps all that this is doing is putting in some softness that can be reversed.
That will help the economy enough?
The administration has talked about a payroll tax cut as well. They might roll that out during the campaign which would increase consumer spending almost one-to-one. That’s a potent economic stimulus, and by weakening the economy in mid-2018, he achieved the goal of getting the Fed to do a complete U-turn – from quantitative tightening and sequential rate hikes to quantitative easing and rate cuts. Those cuts work with a lag. That could help too. And so you’ve got all these things working, and the three of them together could potentially stave off the recession. If you did nothing, then you probably would have a downturn before the election.
Will Trump get reelected?
The only thing that could derail him is a recession.
What about the Democrats?
If Trump is not impeached, none of them have a chance. The strongest candidate is Pete Buttigieg, but I think he’s just too young. And I think his identity is probably a little bit ahead of its time in certain parts of the country.
What about Elizabeth Warren?
She can’t win. She could maybe win the nomination. But Medicare for All is a losing policy in the general election. She says that 160 million people that have private insurance are going to accept inferior health care to what they have now so that other people can have an improvement in their health care. That’s a tough sell. Maybe she can pivot back, but I don’t think she can pivot back on Medicare for All. And she shot herself in the foot by refusing to answer the question of whether she will raise taxes on the middle class to pay for Medicare for All. Everybody knows that the answer is yes. She could tell a story «yes, we will raise taxes on middle class, but don’t worry, over several years, you’ll see that the savings you get with no deductibles and no premiums will overwhelm the tax». That’s kind of what she’s trying to say, but she refuses to answer the question. That hurts her authenticity.
But she has a considerable following.
In the political cycle in the United States, it’s prevalent right now to trash capitalist ideas – trash markets, trash corporations, trash wealthy people, and call for solutions to wealth inequality. That trend is inexorable. These are all massive issues that will lead to some pretty significant changes when the downturn comes, including wealth confiscation or free money programs.
Will the Modern Monetary Theory be part of that new system?
Probably. I think that it will be part of the transition to a new system – an attempt to forestall the unhappiness by giving money to people.
In your time as an investor, have you ever been in a situation like today?
Of course not. This situation has taken since 1945 to develop. And it really got going with US-President Ronald Reagan. So I started in this business when the scheme was starting. And we used to think that 8% interest rates were set to last forever, and it was unthinkable that the Fed would buy bonds, inconceivable! And now it’s normal. And free money used to be unthinkable. What people got themselves fooled by was feeling somehow that there’s real stability to societal institutions because they’ve experienced it most of their life. Some still think they’re experiencing it. But they’re not.
Will we ever go back to normal monetary policy?
No, we’re going to have a new normal long-term policy. That’s going to be different. We have to figure it out. Look: In 1970, there were no credit cards. In 1970, there were no car loans. People saved money and bought things. That was normal. The debt-to-GDP ratio was stable. Economic growth was real. It really happened.
In 2018, the dollar growth of nominal GDP was less than the dollar growth of the national debt. That means that there is no growth. We’re having an illusion of growth. It means that we’re issuing IOUs and spending it, and it shows up in the calculations as growth. But spending is not growth.