Though he missed the torrid rebound in stocks during the first six weeks of 2019 (US stocks have, by at least one measure, experienced their best start to a year since 1991, when Gundlach didn’t expect the rebound to start until later in the year), Doubleline Capital founder Jeffrey Gundlach’s warnings about the risks endemic to the US corporate debt market (and the ballooning deficit) still resonate with thousands of investors, who are warily approaching the end of the business cycle with a mounting sense of paranoia. His warnings about how the deficit blowout has generated “artificial” growth are particularly poignant in light of the growing signs of an economic slowdown in Europe and China (though, as we pointed out yesterday, the PBOC appears to be doing everything in its power to change the narrative), as well as some weak indicators in the US (think retail sales and business sentiment).
And in an interview with Yahoo Finance, Gundlach once again expounded his view that, though the typical recessionary leading indicators are still only flashing “yellow-to-green”, and though the Fed’s promise to “pause” its QT program has soothed the equity markets worries – for now at least – there are still plenty of risks lurking beneath the surface.
And the most immediate of these, as Gundlach has previously explained (and as we have also pointed out in our own analysis), is the state of the corporate bond market, which, Gundlach believes, could tilt the next recession into a full-blown debt crisis. The corporate bond market has $700 billion in bonds maturing this year alone. What Gundlach is most worried about is the combined effect of this bonds rolling over alongside the Fed’s balance sheet runoff, which he said could lead to a flood of issuance, particularly in the long-end of the curve. As the next recession begins, we could see short term rates fall, but long term rates blow up, leading to a punishing steepening of the yield curve (leading to the type of “bear steepener” trade about which Nomura’s Charlie McElligott has also warned).
With the Fed’s QE exhausted, and the federal budget deficit already blown out to a staggering degree, Gundlach warned that policy makers will have little recourse. To illustrate just how precarious the corporate bond market risks have become, Gundlach cited research by Morgan Stanley which showed that after nearly a decade of rock-bottom interest rates, corporations have binged on debt to such a degree that, if one were to base their credit analysis solely on leverage ratios, then nearly half of the investment grade corporate bond market would be relegated to junk.
Heavily leveraged US corporates could endure mass downgrades, as investment-grade angels plummet from the sky, and just like that – the next debt crisis will have gone from contained to systemic.
Just like in 2006, the long-term, big picture risks could be the most consequential. All other short-term risks would be merely trivial details. “Like back in 2006, the only thing that mattered was you understood there was a credit crisis coming. I think this time the only thing that really matters is this problem with the corporate bond market and the national debt issue when the next recession comes.”
And when the next recession finally comes “there’s going to be a lot of turmoil.”
Compounding the risks from the corporate bond market, the US’s fiscal situation is growing increasingly dire. Once one factors in all “off-budget” expenditures like the costs of fighting the US’s “Forever Wars” in the Middle East and cleaning up after natural disasters, the US budget deficit is, in reality, expanding at a rate of 6% of GDP. With 3% real growth, this suggests that, if it weren’t for the fiscally stimulative stance embraced by the Trump administration, we could be in a recession already. But once the inevitable slowdown finally arrives, the budget deficit would need to expand to 10% of GDP merely to maintain. Which would suggest that the floor is much closer to falling out than many realize.
With that being said, here’s a quick rundown on Gundlach’s comments on whether markets are accurately forecasting the likelihood of a rate cut by the Fed this year, what the legendary bond investor’s favorite recession indicators are telling us, his two cents on the burgeoning blowback to corporate buybacks, and his outlook for interest rates.
Gundlach – whose Total Return fund outperformed nearly all of its peers last year – believes that long-term rates will move higher in 2019, though he admits that he didn’t think the 30-year Treasury would dip back below 3% in the latter half of 2018. But if the 30-year rate crosses over 3.50%, it could go all the way to 4%.
Meanwhile, even if long-term rates climb, Gundlach believes short-term rates could move lower if “they’re manipulated by the Fed.”
JULIA LA ROCHE: OK, Jeffrey, before we’ve sent us back to New York, let’s get a prediction from you. Where do you think the 10 year will end this year?
JEFFREY GUNDLACH: I’ve long ago learned not to fall into that trap. There was one year when I said the 10 year would end at x, and it actually ended five days before year end exactly at x. And then there was a big move the last five days. And so, [? ended up being ?] off by like, 35 basis points or something. And I remember people saying I was wrong because I was off by 35 basis points when in fact, I was only off by five days.
I think- let me put this way. I’m not going to put a number on it. But I think long term interest rates are headed higher. I think what we had in response to the weakness in risk assets in the stock market– I think we had the Pavlovian reaction of oh, I’ve seen this movie.
When stocks get weak, you buy long term treasuries. And we had a decent rally, about 50 basis points, in long term treasuries. But now, we’re basically drifting higher again.
And I think that what I said earlier is going to start finding its way into people’s psyche, which is when the next weakness comes, there’s going to be so much debt, so many bonds, that it’s possible that short term rates drop if they’re manipulated by the Fed, and flight to safety leads people to find a 250 2 year to be OK. But I’m not really sure if people will find the 280 10 year to be OK when you’re staring down the barrel of trillions of dollars of bond issue.
And so I think interest rates are headed higher. I really didn’t think they would get back below 3% on the 30 year treasury. They did for a minute. And now they’re back above 3%. But I think when and if long term interest rates move up towards about 350 on the 30 year, I think you could see them accelerating higher. And so a nice round number to think about would be around 4% on the long term sort of treasury as we move towards the latter part of this year.
Gundlach believes the growing popularity of “Democratic socialism” is nothing short of dangerous, and the idea that lawmakers would try to tell corporations how to distribute their profits is equally absurd.
Socialism didn’t work out for the Soviet Union, Gundlach said. And it won’t work out for the US.
MYLES UDLAND: Jeffrey, Myles Udland here in New York. I want to ask you about share buybacks, which has gotten a lot more play among a number of politicians recently. You were just talking a moment ago about leverage ratios in the corporate bond market. Does anything about the conversation about buybacks concern you, just in terms of politicians I suppose, being a little bit more hostile towards corporate America?
JEFFREY GUNDLACH: Well, it’s pretty clear that the rhetoric from presidential hopefuls for 2020, on the left side anyway, has gotten very, very hostile. Obviously, to have legislators telling privately companies or public companies in this case, what they should be doing with their profits is a little bit disconcerting, to say the least.
So on the margin, you have to take legislation prohibiting or limiting buybacks as a negative for the stock market. It’s pretty clear that the leverage ratios in the corporate bond market have driven– have been hand in glove with buybacks. And the corporate economy is very leveraged. So I think what the politicians want is– their thought processes stop enriching the wealthy who are already disproportionately– wealth inequality is pretty bad– stop enriching them with boosting up stock prices. The idea might be to have more money for workers wages, which is obviously part of the wealth inequality problem.
So I can kind of see how all this– all different parts of the same picture viewed from different angles. But the politicians clearly are talking about socialism, democratic socialism. Just puts the word democratic in front of the word socialism, because it sounds good, that at least you’re voting for it, instead of being forced into it. But you know, socialism is not a very good way of building wealth, as shown by millennial– you know, hundreds of years of history, most recently down in Venezuela. That’s all you have to look at. I remember there was a thing called the Soviet Union, which had five year plans, and I don’t think they’re around anymore. So not a really good idea.
The National Debt
Gundlach isn’t a fan of high taxes. But the notion that the US total taxation rate has fallen to just 15% of GDP, its lowest level since 1949, while the national debt has ballooned past $22 trillion, is ridiculous. If politicians don’t have the temerity to reduce the size of government, they should at least be willing to pay for what they’re spending.
To illustrate the distortions caused by deficit spending, Gundlach caluclauted that, If we had a balanced budget in 2018, economic growth would have been negative.
JEFFREY GUNDLACH: Well, there’s always some people somewhere in the government that are doing things right. But the biggest problem is that we have a growing economy, and yet, we have decided that debt doesn’t matter one bit. You know, Dick Cheney was famous for saying Ronald Reagan proved that deficits don’t matter. But the national debt just went over $22 trillion dollars yesterday, and it’s growing at over a trillion dollars a year during a growing economy.
And our taxation versus GDP has gone from around 20% a few years ago to about 15%. So 15%– it’s not the lowest level ever, it’s just the lowest level since 1949. So we have decided to run a large government with huge deficits and it seems that nobody’s interested in collecting the taxes for that. I wish government were smaller. I think it’s not a problem of taxation. But once you’re going to establish the size of spending the way it is, you’ve got to pay for it. And we’ve gone very, very far away from that.
And that’s an issue that is going to get a lot of attention because the deficit is going to continue to grow, and the Fed has been ripping interest rates. They’ve stopped for now. But the debt expense, the interest expense is at 1.25% of GDP right now, but the CBO says that by the mid 2020s, it’s going to be at 3%, which is a 1.74% increase relative to GDP. Which in a very simplistic framework means that GDP, all things being equal, will be 1.75% slower in the mid 2020s.
And we’re already struggling under insufficient economic growth. Think about the nominal GDP that the most recent one that was announced, which is through September 30, which is fiscal 2018. You know, the growth of nominal GDP was 5.3%. But the growth of the national debt was 6% of GDP. And part of economic growth is the delta in government spending so with the national debt growing by 6% GDP, and nominal GDP go up by 5.3%, it means if you had a balanced budget, the economy would have been negative during fiscal 2018.
But while the Trump Administration has behaved irresponsibly with its spending, Democrats like Elizabeth Warren calling for Medicare for All won’t do any better. Gundlach said he was stunned by Warren’s willingness to lie to the American people during her speech announcing her campaign.
So everything that we’re doing is based upon debt expansion. And it is not insignificant. And it is not true when you hear politicians– I listened to Elizabeth Warren’s speech when she said she was running for president. She looked right into the camera and lied to the American people, that it is not true that we can’t afford Medicaid for all, and free college tuition, and all the other goodies that the socialists want to bring out. She says, it’s just simply not true that we can’t afford them.
And I hear other politicians say, oh, it’s just World War Ii all over again. Well, taxes were raised massively during World War II. And not just taxes on the wealthy the taxes on the middle class and the lower middle class were raised massively to pay for World War II. Going into the 1930s, the tax rate for the average American household was 1.5%. By the 1944, it was 25%. So this is a massive tax increase. Taxation during World War II went from 5% of GDP to 20% of GDP.
Despite the emergence of a narrative of a “synchronized global slowdown”, most leading indicators aren’t signaling an imminent recession – yet.
JEFFREY GUNDLACH: A little bit more than it was a year ago, what was really interesting about entering 2018 was that there was this narrative of a synchronized global expansion. That was true. Everything was really flashing green lights for the economy entering 2018. And yet, what’s interesting about that when things were flashing green light, most people don’t understand that it means it’s kind of the end of the game for risk assets. The global stock market peak January 26 of 2018. The US hung on until October, but the global stock market peaked January 26 of 2018.
Entering 2019, there was a narrative developing that is also true of some synchronized global slowdown. Yet the indicators that we look at for a recession are not even flashing fully yellow yet. It’s more of a yellowish green right now. We look at things like the leading economic indicators, kind of the granddaddy of them all that’s put out by the conference bureau. That year over year always has gone negative before the front end of a recession. And while it’s weakening from a very high level, it’s still pretty high at around 5% year over year. And the stock market being up in the last couple of months means that probably, the leading indicators will hang in there.
What is signaling recession a little bit more are sentiment surveys. The PMI surveys typically collapse in a very observable way before the front end of recession comes. They are collapsing sort of right now, but they’re still at high levels. Consumer sentiment same sort of thing. Unemployment rate is starting to flash yellow a little bit. Unemployment claims, the report every Thursday, have bottomed out and appear to be in a rising trend. And the unemployment rate now is above its 12 month moving average unemployment rate. And that’s a necessary condition to be talking about potential recession.
Watch the full interview below: