Jeffrey Gundlach on the End of Secular Norms

In his Dec. 5, 2023, webcast, DoubleLine CEO and Chief Investment Officer Jeffrey Gundlach (0:06) tours a global environment undergoing a sweeping breakdown of norms that for decades conditioned the behavior of different assets, financing of the U.S. government and performance of the U.S. economy. Mr. Gundlach begins with the dilemma of the U.S. debt cycle (1:07), “something that is barreling right at us.” He presents a series of charts on federal expense (3:25) interest on U.S. Treasury debt outstanding and adjusting Congressional Budget Office deficit projections for the change in the federal deficit following previous recessions. By 2028, the deficit could swell to between $3.5 trillion and $4.8 trillion (7:08), equal to 20% of gross domestic product.

Mr. Gundlach turns to the question of whether a recession is coming (7:58). This discussion begins with the Treasury yield curve, as measured by yields on the 10-year and two-year Treasury. True to the form of its behavior leading into past recessions, the curve inverted for an extended period and has been de-inverting from a maximum inversion this cycle of negative 108 basis points. By this metric, he suggests that, if the Fed stands pat on rates while the 10-year continues to rally, the completion of the curve’s de-inversion, signaling imminent recession, could occur in “2Q or so of next year.” Another metric (13:10), the backup of the U-3 unemployment rate, “looks remarkably like the front edge of a recession.”

With respect to markets, Mr. Gundlach disagrees with observers who see record asset levels in money market funds as bullish for risk assets such as stocks (17:47). Moving from Treasury bills into stocks, he says, would be a “monumental change in risk appetite”; rather, he sees the size of assets in money market funds as “bullish for Treasury bonds and other high-quality bonds.”

Looking at mortgage rates and the housing market (19:20), Mr. Gundlach says a decline in mortgage rates to 5.5% to 5.25% “might unlock supply” and, contrary to expectations, cause a fall in housing prices. “Ironically, we might have housing prices deteriorate along with falling mortgage interest rates – the opposite of most of our 40-year experiences.” The Agency mortgage-backed securities (MBS) market (20:25) is down to 87 cents on the dollar. In place of prepayment risk, a concern from the 1990s into the 2010s, Agency MBS offer prepayment reward. “In fact, defaults on mortgages help you in Agency-guaranteed mortgage index type of investing because you would get 100 back more quickly from today’s market value of 87.”

Another norm that has changed, Mr. Gundlach notes, is visible in the Treasury market (21:24): The yield on the 30-year Treasury, for three decades contained within two standard deviations of its trend line, “has completely broken out” of that channel. He adds that he doubts the “Pavlovian bond rally” that he has called for will last given the debt dilemma confronting the U.S. government.

Mr. Gundlach covers a variety of inflation gauges (23:08), including headline and core PCE; headline and core CPI; CPI owners’ equivalent rent; super core inflation; and his favorite price series, import and export prices. The upshot is, DoubleLine’s outlook for inflation will be in the 3% neighborhood for the next few months to come and, assuming stable energy prices, falling to mid-2% in midsummer 2024.

Returning to the housing market (32:13), Mr. Gundlach notes the extremely challenging affordability of owning a home. Whereas in most parts of the U.S. it was cheaper to buy than rent a home at the end of 2020, now it is cheaper to rent in most parts of the country. As evident by extreme lows in the U.S. Pending Home Sales Index and the MBA U.S. Mortgage Purchase Index, “the home market has been greatly distorted by the interest rate movement and by the home price appreciation.” On a positive note, he points to an unusual divergence between U.S. homes under construction, with homes being built for sale shrinking but rental homes under construction expanding. Those multifamily units becoming available for renters should be disinflationary.

A key reason Agency MBS have faced headwinds has been the fact that “two of the buyers are gone”: the Federal Reserve and commercial banks (35:50). On a positive note, MBS spreads are positively correlated with interest rate volatility. With volatility in bonds coming down, Mr. Gundlach says, “we should go from headwinds to tailwinds for these types of assets.” The gap between new mortgage rates and the effective rate on mortgage debt outstanding is at an all-time high of 361 basis points. “This is the lock-in effect” preventing homeowners from selling, he says.

On commercial real estate (39:26) and commercial mortgage-backed securities (CMBS), Jeffrey Gundlach reminds investors that CMBS is “not really a sector. It’s a sector of sectors. There’s multifamily, office, retail, industrial and the sort of catch-all ‘other’ category. The point here is they behave very differently during different economic cycles.” While BBB CMBS are priced for defaults and nonpar payback, he says that with “underwriting in the right way,” skilled investors in CMBS can pick up 7% yields in AA securities while avoiding defaults.