By Robert Huebscher of Advisor Perspectives
Investors will confront excessive debt, high P/E levels and political uncertainty as they enter the Trump presidential era. In response, according to Jeffrey Gundlach, U.S.-centric portfolios should diversify globally.
Gundlach is the founder and chief investment officer of Los Angeles-based DoubleLine Capital, a leading provider of fixed-income mutual funds and ETFs. He spoke to investors via a conference call on January 10. Slides from that presentation are available here. This webinar was his annual forecast for the global markets and economies for 2017.
Before we look at his 2017 predictions, let’s review his forecasts from a year ago. His two highest conviction forecasts were that the Fed would not raise rates more than once, despite the Fed’s own predictions, and that Trump would win the presidency. Both predictions were accurate.
But he was also downbeat on emerging markets, and singled out Brazil and Shanghai as likely underperformers. Brazil turned out to be the best-performing emerging market last year, gaining 69.1%, but he was correct about Shanghai, which was the worst performing market, losing 16.5%.
Gundlach said he had a “low conviction” prediction that the yield on the 10-year Treasury would break to the upside. It began 2016 at 2.11% and ended at 2.45%. He said the probability was that U.S. equities would decline in 2016, yet the markets gained approximately 13%. Gold, he said, would hit $1,400 at some point in 2016. It began the year at approximately $1,100, hit a high of $1,365 during the summer and closed at approximately $1,150.
Let’s look at his forecasts for 2017, including the one which he called “the chart of the webcast.”
Doomed by debt?
The U.S. household debt-servicing ratio is at its lowest level since 1980, according to Gundlach, despite what he called an “explosion” in private-sector debt. That ratio would change adversely if rates rise, he cautioned, although that might be offset by an increase in income.
Public-sector debt is at 75% of GDP, not including the portion of the debt owned by the Fed, he said. Gundlach has warned of fiscal debt problems, as he has done in the past, but pointed out that since 2011 federal debt has “leveled out” as a percentage of GDP. But he warned that Trump’s policies would lead to a “steeper slope upwards” as compared to the congressional budget office (CBO) debt projections, which show a 141% debt-to-GDP ratio by 2046.
Trump may deliver the tax cuts he promised to the rich in return for infrastructure and defense spending, Gundlach said, and that would lead to structural debt problems – it would get us to the 141% level sooner than in 2046, he said. Those spending initiatives will not kick in this year, he noted, and might take as long as two years to get going.
Gundlach offered data showing that the deficit will increase faster than it has in the post-crisis period, although those projections were made prior to Trump’s victory, and that the portion of the deficit allocated to mandatory (entitlement) spending has grown steadily over the last 50 years.
The recession watch
The historical pattern has been that a recession has occurred during the first term of a new president, especially when following a two-term presidency. But Gundlach said that the leading economic indicators (LEIs) are positive, and there has never been a recession without those indicators going negative. CEO confidence is “moving up” and consumer confidence is “exploding,” he said, which further supports his prediction that a recession is not imminent.
“President Trump will lead to a breakout of the ‘forever 2% GDP growth’ we have seen for six to seven years,” Gundlach said. “Animal spirits have been stirred.” He noted that a small-business sentiment report released that day was the most bullish it had been in a long time.
“I guess optimism is infectious,” he said.
He also relies on comparisons of the unemployment rate to its moving average as a recession warning. He said those metrics are not signaling a recession either. He added that the PMIs are saying that the “pattern of recession is being avoided.”
Inflation
Investors should brace for moderately higher inflation. Inflation indicators, other than the PCE, are in an uptrend, he said. The internet-based PriceStats gauge is exactly in line with the CPI, and the ECRI inflation metric corroborates the rise in inflation. In response to some analysts who recently predicted a bond-market rally, Gundlach said, “A forecast of a 1.5% 10-year yield looks awfully shaky.”
The inflation break-even rate, based on the difference between nominal Treasury and TIPS yields, is at 2%, its highest level since late 2014. That seems like a “reasonable” price he said, and TIPS and nominal Treasury bonds are fairly valued with respect to each other.
Short term rates are heading up, including LIBOR. The 2% implied inflation forecast is for the next five years, which he said was possible but higher inflation is more likely. Average hourly earnings and overall wage growth are rising in the U.S., Europe and Japan, he said.
Commodities put in a “massive double bottom” in January of 2016, Gundlach said, and gold bottomed in December of 2015; both are rising now. He said he has advocated a “permanent” gold position since 1990, although he is not “wildly bullish” on it, particularly following the Trump victory. Copper has fallen recently, which supports the modest bond rally that has occurred since mid-December. Oil inventories are very high and that is why Gundlach thinks $70/barrel oil is unlikely. Oil prices will vacillate between mid-$40s and high-$50s, he said.
But the biggest story about inflation is in Germany. Below is what Gundlach called “the chart of the webcast”:
For a long time, German inflation was at or below the yield on its sovereign 10-year bond. But this chart shows that German CPI is now 1.7%, its highest level in 16 years. Yet the chart shows that the 10-year Bund yield is a mere 25 basis points, implying sharply negative real yields.
Gundlach asked, rhetorically, how German yields can stay at that level with this much inflation. Bunds, he said, are vulnerable.
The Fed
Gundlach predicted that the Fed would not raise rates in March, but would in June and probably again later in the year. He assigned a 50% probability to a third rate increase.
Since 2014, the Fed has been systematically reducing its projections of where short-term rates would be in 2017, according to Gundlach. Late last year, when inflation was starting to increase, the Fed was at its lowest projection.
As a result, a narrative is developing that the Fed is “behind the curve” with respect to raising rates, but Gundlach doesn’t think so. He said that lower rates will help finance the big infrastructure bill that is coming.
Gundlach cited academic research that claimed to show that the Fed Funds rate would have needed to be at -3% to achieve the same effect as the quantitative easing (QE) programs it followed in the post-crisis period. Since it is no longer engaged in QE, it is effectively tightening at approximately that 300 basis point rate, and that policy has led to recessions in the past. But he cautioned against making too much of an inference from that research, because rates are at a different (lower) level that at the time of prior recessions.
Bond market projections
The 10-year closed at 2.38% on the day he spoke. He said it will go below 2.25% but not below 2% in the current rally. Analysts’ forecasts for the 10-year yield have been consistently too high over the last five years. Now forecasters are predicting a flat year, but Gundlach had a different view.
“I think rates are going to rise in 2017,” he said. “For sure rates are going to rise.”
Moreover, as he said in his prior webcast, if the 10-year yield surpasses 3%, “the bond bull market is over from a classic chart perspective.” He said that would also mean “trouble” for equity markets.
Gundlach noted that another prominent bond manager had made the same prediction, but said the threshold was 2.60% instead of 3%. But Gundlach pointed out that the yield had already reached 2.64% last year. He did not name this manager, but it almost certainly was Bill Gross.
In the short-term, though, he said, “We are going to see another leg up on bond yields after this rally.”
Over the medium term, Gundlach said the 10-year yield could hit 6% in four years, about the time of the next presidential election. He noted that inflation and economic growth are already at levels similar to 2006, when interest rates were at 6%. A move to 6% would not be bad for bond investors, he said, given the opportunity to reinvest coupons at higher yields, and returns might be similar to what investors would have received on a stagnant 1.5% yield.
Junk bonds are “way off their highs,” Gundlach said. They did great until mid-December but now are “muddling along.” Many investors think that because high-yield debt ended 2016 at a high price they are not vulnerable to an interest rate increases, he said. But that is incorrect, according to Gundlach; if rates move higher, high-yield bonds will not go up in price because spreads have already tightened. The high-yield ETF JNK tracked the S&P 500 in 2016, but that will not repeat in 2017, he said. In 2016, credit spreads drove prices; now it will be interest rates.
Gundlach said he is neither bullish nor is he bearish on the dollar. The dollar will be supported by Fed rate hikes, but Gundlach doubted that the dollar (based on the DXY index) will go above $120 (it was at $102 on the day he spoke). Trump understands that a strong dollar sounds better than it actually is, Gundlach said, and that influences his dollar forecast, which is in opposition to the consensus, which favors a stronger dollar.
The ratio of copper-to-gold prices is a “fantastic” coincident indicator of the economy and interest rates, Gundlach said. If copper keeps softening or gold goes up, it will support a bond rally in the short term.
Investment recommendations
Diversify outside of the U.S., Gundlach said. Usually analysts call for this following rallies outside the U.S., he said, which has not universally been the case. But the U.S. is “richly valued” and Gundlach said now is the time to look at other markets.
U.S. stocks are at a high level relative to earnings, he said. Analysts are expecting a 20% increase in earnings, which would be helped by Trump’s proposed tax cuts, according to Gundlach. But there is a lot of anticipated profit margin expansion in analyst earnings projections, he said. “Unless earnings really pick up,” he said, “there will be a problem.”
Wages have picked up and the gross operating surplus across corporations has gone down, he said. The Shiller CAPE is getting near its 1929 levels, fueling his believe that that the U.S. is richly valued.
Gundlach noted a few markets that he liked – and a few he didn’t.
He favors India, which has been one of his picks for the last several years for long-term price appreciation
Mexico is “massively exposed” to a potential tariff increase, he said, since 80% of exports are to the U.S. “I am not fond of Mexican investments given that uncertainty.”
Given his neutral outlook on the dollar, he recommended an allocation to emerging markets. He noted that the S&P 500 has been outperforming emerging-market equities over the recent past, and that a reversal of that trend is coming.
Gundlach also likes the Nikkei. He said that Abenomics is supportive of Japanese equities through automatic buying by the Bank of Japan. That policy is shrinking the Japanese market by 6% annually, he said. The yen will weaken more, so investors should hedge their currency exposure, according to Gundlach.
But Gundlach doesn’t recommend Europe because of “election risks” in France and the Netherlands. “It is a bad bet to expect the populism trend to change,” he said. “There will be trouble in the next year.”