«Negative interest rates are the dumbest idea ever»
Jeffrey Gundlach, CEO of the investment firm DoubleLine, expects central bankers to capitulate on negative interest rates and is bearish on US stocks.
In the global financial markets the bulls have taken over once again. In the United States, stocks are even flirting with a new record high. Nevertheless, Jeff Gundlach doesn’t trust this recovery and expects a severe setback. «The riskiest things are now stocks and other investments perceived to be safe», says the CEO of the Los Angeles based investment firm DoubleLine. The star investor, who is celebrated on Wall Street as the new bond king, is surprised that nobody seems to care anymore about the worldwide growing mountain of debt. Especially in the junk bond market, he sees a massive wave of defaults on the horizon. Mr. Gundlach likes gold and thinks the Federal Reserve has given up on its plans to normalize interest rates. Next, he expects central bankers elsewhere to capitulate on negative interest rate policies.
Mr. Gundlach, it is getting suspiciously quiet in the global financial markets. What is your assessment of the current situation? - What you see is that the same pattern has been in place since 2012: Hope for growth in the new year that ends up being revised downwards, over and over and over again. But now we have reached the point at which no one bothers anymore about the comedy of predicting 3% real GDP growth. Even nominal GDP growth isn’t probably going to be at 3% this year. Actually, nominal GDP is at a level that has historically been a recessionary level. It isn’t this time because the inflation rate is close to zero. But no one bothers anymore and the Federal Reserve has basically given up.
How serious is this slowdown? Could the US even fall into a recession? - We will be on watch for that in the coming months. But it doesn’t really matter. Recessions don’t drive financial markets. It’s the other way around. People are so focused on this «recession-yes-or-no-question». What really matters is that we are in a low nominal growth environment and global growth keeps getting marked down. It is going to be slower in 2016 than in 2015.
What does that mean with respect to monetary policy in the United States? - I have been waiting for about two years for the Fed to capitulate on their interest rate increase dreams. Now, I think they did. Federal Reserve Chair Janet Yellen basically capitulated on March 29th. So far she had been acting as if each voice at the Fed carried the same weight: One official would say this, and another official would say something different. And because there were contradictory statements being made, the markets were getting very confused. But Janet Yellen took control with her speech at the Economic Club of New York. She did a good job and said that she is not going to raise rates at the next Fed meeting in April despite all these other Fed officials saying that April is a possibility. But it’s not going to happen. We’re not going there. So you’ve gotten about as much capitulation as you can get.
But what about a rate hike at the more important Fed meeting in June? - The Fed has already reduced its forecast to two rate hikes. And that’s going to turn into one hike pretty quickly because we’re getting close to mid-year and I really doubt that they are going to do a rate hike in June. But what they are going to do is a rolling twelve month two hikes type of thing. So in June they will signal two hikes by June 2017 and then they will just keep pushing it forward. That’s a movie we’ve seen before. The Fed has pushed forward such decisions for years. We were always going to get to a Federal Funds Rate of 3% and it was always going to be starting in six months. But it never happened.
But actually, the Fed raised interest rates in December for the first time since the financial crisis. - Well, that didn’t work very well. The stock market crashed and the credit markets were a disaster. The Fed’s dots of four rate hikes this year made no sense and they’ve capitulated. The markets have humiliated the Fed into abandoning their pretty idiotic forecast.
So what’s next for the financial markets? - The capitulation of the Fed is pretty much fully priced in. But I think the next big thing will be that at some point central bankers in Japan and in Europe will have to realize that they need to give up on negative interest rates. Negative interest rates are the dumbest idea ever. It’s horrible. Look at how badly it’s been working. The day that the Bank of Japan went negative the Yen started strengthening like crazy and the stock market is down. That’s exactly the opposite of what they wanted. The same thing happened with the ECB. Around a year ago, the consensus recommendation was to sell US equities and to buy European stocks because of negative interest rates in Europe. That turned out to be the most common mistake that was made in 2015. It’s been a horrible outcome. So there is mounting evidence that negative interest rates do the opposite of what the central bankers were hoping for.
Why don’t negative interest rates work? - Negative interest rates are designed to fight deflation. But they are the very definition of deflation: Your money is disappearing. As an investor, you are going to have less money in the future than you have today with negative interest rates. That’s deflation! So negative interest rates are deflationary and they are tremendously negative for monetary velocity. For instance, in Japan they’re issuing huge amounts of high denomination Yen notes. That’s because of negative interest rates people don’t want to put their money in the bank and they don’t want to invest in Yen denominated bonds. That’s why I think eventually you are going to get helicopter money.
Are you concerned about that? - I’m not concerned about anything. My job is not to set policies. I’m not an economist or a politician or a central banker. I invest people’s money. So I’m agnostic as to what’s good and what’s bad in terms of policy. I just deal with it.
So how do you deal with negative interest rates and central bank capitulation? - It’s all about capital preservation. If you can get a few percent return in a deflationary environment you’re doing fine. Because if you invest in European government bonds your base case is that you are going to have a negative return. The same applies if you invest in Japanese government bonds. So gold is a high yielding investment. You are getting zero yield versus negative yields in the case of short term European bonds and most Japanese bonds. Gold is doing fine. It’s preserving capital in the US, it’s been making money over the last couple of years for European investors. That’s why I own gold. Because in a negative return environment anything that holds its value or makes a little is good. Also, US bonds look relatively good. You have a positive yield of 2 or 3% this year from a bond portfolio in the US. Of course, that’s not great for European investors because the dollar has been weakening.
And what about stocks? Especially in the US, equities have staged a surprising comeback since the heavy turmoil at the beginning of the year. - The US stock market seems egregiously overvalued versus other stock markets. Emerging markets look vastly better, Japan looks better and Europe does too. That’s because they’re all down. It’s remarkable that the US stock market is within about 2% of its all-time high and every other significant stock market is down substantially. Also fundamentally, it’s very hard to believe in US stocks. Earnings and profit margins are dropping and companies basically are borrowing money to pay dividends and to buy back shares. That’s completely non-productive borrowing and just creates a bigger debt burden. So it’s likely that you are going to see declines in the US stock market and since the correlations are so high this means that probably the junk bond market will go back down, too.
There’s also a strong correlation between junk bonds and oil. What’s your take on the recent rally in crude? - I predicted oil would make it easily to $ 40 and it did so very comfortably. But now it’s having a very hard time getting to $45. It bounces up a dollar, down a dollar and I think if oil is going back down to $ 38 people are going to be very concerned.
Energy companies are playing an important role in the junk bond sector. What would oil at $ 38 mean for the credit markets? - Just like oil, the high yield market has enjoyed the easy rally. I think it’s basically over. I don’t see how you are supposed to be all fond off high yield bonds, since they are facing enormous fundamental problems. I thought people would learn their lesson but the issuance in the years 2013/14 was vastly worse than the issuance in 2006/07. Also, in the bank loan market covenant lite issuance rose to 40% in 2006/07. In this cycle it climbed to 75%. The leverage in the high yield bond market is enormous and you’re about to have a substantial increase in defaults. I wouldn’t be surprised if the cumulative default rate in the next five years were going to be the highest in the history of the high yield bond market.
What would be the consequences of that? - We are now in a culture of default. There is no stigma about defaulting anymore. During the housing crash, homeowners walked away from their mortgages. That was the beginning of a massive tolerance of default. Today, people talk about Puerto Rico defaulting like it’s nothing. But if Puerto Rico defaults why won’t some clever person in Illinois say: «Let’s default, too! » Constitutionally, Illinois is not allowed to default, but Puerto Rico wasn’t either. For Illinois it just seems impossible to pay their pension obligations. And then, what about Houston, what about Chicago, what about Connecticut? I am surprised that people have lost their focus on the enormity of the debt problem. Remember, in 2010 and 2011 there was such a laser focus on the debt ceiling in the US and we were worried about Greece. Nobody is worried anymore. People are distracted by this negative interest rate experiment.
That’s also interesting with respect to the presidential elections. In contrast to 2012, this time there is not much talk about national debt and budget cuts. - What you see this time is only child’s play. The next election is going to be much more transformative than this one. Because in this election, both parties are kind of clinging to the belief that they can keep the genie in the bottle. But we’re on the cusp of big change and, unfortunately, it’s all wrapped up in generational problems. The big problem that is coming, of course, is the unfunded liabilities that have been promised to the baby boomers. According to one calculation, the unfunded liabilities of all these entitlements on a present value basis are $ 60 trillion in the United States, just at the federal level. But in this election, nobody is talking about addressing them. Donald Trump wants to keep social security the same, Bernie Sanders says make it even bigger, while Hillary Clinton represents more of the same.
So who do you think will win the race for the white house? - Trump is going to win. I think Clinton and Sanders are both very poor candidates. I know the polls are signaling the opposite. But the polls said the opposite four years ago, too.
How would the financial markets react should Trump win? - In the short term, Trump winning would be probably very positive for the economy. He says a lot of contradictory things and things that are not very specific. But he does say that he will build up the military and that he will build a wall at the border to Mexiko. If he wins he’s got at least to try those things. Also, he might initiate a big infrastructure program. What’s his campaign slogan? Make America great again. What that means is let’s go back to the past, let’s go back to the 1960s economy. So he might spend a lot of money on airports, roads and weapons. I think Trump would run up a huge deficit. Trump is very comfortable with debt. He’s a debt guy. His whole business has had a lot of debt over time and he has gone bankrupt with several enterprises. So I think you could have a debt-fuelled boom. But the overall debt level is already so high that you start to wonder what would happen after that.
How do you explain that a guy like Trump might actually win the election? - His popularity is very similar to the popularity of unconstrained bond funds. About two or three years ago, unconstrained bond funds became the most popular thing in the United States retail market and in the institutional market probably, too. Because when investors analyzed all the bond segments they were familiar with, they didn’t like what they saw. They didn’t like treasuries, they were scared of the Fed, they didn’t like traditional strategies. So, if everything you think you know looks unattractive, you go for something that you have no idea about. And that’s an unconstrained bond fund. The thinking was: «Don’t even tell me what you are doing, I do not want to know. Because if I know, I won’t like it. » The same is true with respect to the elections: «Don’t give me a traditional candidate. Give me someone who I have no idea what he is going to do» – and that’s basically Donald Trump.
That shows that it is not easy to invest your money these days. What does it take in general to be a good investor? - I made a name for myself primarily because in March of 2005 I was convinced that there would be a complete collapse of the credit market. When it was still hypothetical, people argued with me. They said that this would never happen. But I was right. So you have to find a center piece idea that will be important in driving the market. And you have to have an intuition about how other investors will react if you’re right and they wake up to that idea. Such opportunities do not happen very often. It is not always so obvious. So you have to pick your moments. In the financial markets, 80% of the time it’s a coin flip. But the other 20% of the time you have very high confidence and it’s not a coin flip. For instance, I don’t think the stock market is a coin flip. Especially in the United States stocks are very expensive, particularly low volatility stocks.
What exactly is the problem with low volatility stocks? - The riskiest things are now stocks and other investments perceived to be safe. One of the most popular categories in US investing are low volatility stock funds. But there is no such thing! If you think that a stock like Johnson & Johnson can’t go down, you’re wrong. And if people own funds that invest in stocks which they think are immune from decline and they start to decline, all hell breaks loose.
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