Total Return Webcast: Jeffrey Gundlach’s Macro and Market Views at mid-2023

In a June 6, 2023, webcast, DoubleLine Capital CEO and founder Jeffrey Gundlach starts (1:16) by exploring the “dust in the crevices of our financial institutions here in the United States and perhaps the general global world order.” Exhibits No. 1 and No. 2 that the country is heading for a dust-up (2:06) are the federal debt and the United States’ increasingly vulnerable mechanism of finance, debt-financed federal budget deficits. He notes that the federal government is already running deficits as a percentage of GDP that “should be scary relative to past recessions, and we’re not even in a recession yet.” This is the situation as Mr. Gundlach will show a recession appears likely later this year or in 2024.

The “real kicker” of this thesis (6:13), Mr. Gundlach says, is the amount of interest being paid on federal debt. In the wake of Federal Reserve increases of 525 basis points (bps) in official short-term rates and many rates along the Treasury curve up 400 bps, the burden of debt service has surged higher in dollar terms and as a percentage of GDP. Interest expense, Mr. Gundlach warns, “is going to swallow all of the tax receipts in the next few years if we stay on this track.” He predicts that the need for fiscal reform, including raising taxes and perhaps restructuring entitlement programs, is “going to become a political issue as part of the 2024 presidential campaign.”

Turning to the probability of recession in the U.S. (9:02), Mr. Gundlach reviews a range of indicators. Consumer expectations of the future, one of his favorite indicators, is one of the few indicators not to have given up the ghost. A broad range of other metrics, however, are flashing red. The year-over-year and sixth-month annualized change in the Leading Economic Index is “full-on recessionary.” Another recessionary indicator is the U.S. Treasury yield curve (10:51). The curve’s inversion indicates a recession likely is ahead. Mr. Gundlach is waiting for the curve to begin de-inverting, which might have begun, as a sign that the leading edge of recession is imminent.

In a sign of the onset of the last two recessions, Mr. Gundlach observes, the U.S. unemployment rate (15:15) exceeded its 12-month moving average. “That has happened now, but only by 4 bps. I don’t think we can call this a crossover in a really definitive way, but it does put us on watch.” This indicator (15:56) sometimes flashes false alerts. So DoubleLine also looks for confirmation in the form of a crossover of the unemployment rate’s 36-month moving average by its three-month moving average. That indicator still reads green.

Mr. Gundlach points to (17:23) a Federal Reserve survey showing a large increase in adults reporting deterioration in their financial situation versus a decrease in those reporting improvement in their financial condition. A study by Bank of America of households receiving unemployment benefits shows unemployment rising faster among higher-income groups than low- and middle-income groups, confirming Mr. Gundlach’s prediction of deterioration in middle-management jobs. Citing the same BofA study, he notices higher-income groups now are experiencing negative wage growth. Wage growth for the other two cohorts remains positive but is declining.

Banks have been tightening lending standards for business loans (20:26), a phenomenon that curbs loan growth and leads recessions. Interest paid on short-term loans to small businesses has doubled from the lows in 2020. As one of the reasons behind recent bank failures, Mr. Gundlach points out that “loan growth is contracting, and also the interest rate paid on short-term loans for small business has, thanks to the Fed’s actions, clearly exploded higher.” In 2023, bank failures, while limited to “only a couple of banks,” have occurred at large institutions, to the point that their combined asset value is slightly above 2% of GDP (20:23). Over the last century, when bank failures exceeded that level, they preceded the Great Depression, the savings and loan crisis “in the late 1980s and early ’90s, and then the Global Financial Crisis. We’re pretty close to the level as a percentage of GDP as those past two experiences that led to financial distress and, of course, significant recessions.”

Turning from recession to inflation (26:16), Mr. Gundlach singles out a money supply that is “the most negative that it’s been since the Depression.” While monetary contraction spells trouble for economic growth, it suggests that “the CPI should be coming down” further. “The M2 problem is no longer stoking inflation using this correlation.” Mr. Gundlach reviews a variety of inflation gauges (27:44), among these headline and core CPI (the former falling rapidly, the latter proving stickier); the contributors to headline and core CPI inflation (the sticky cost of shelter being a big reason behind stubborn core inflation); the U.S. PCE; U.S. producer prices; and export and import prices, his favorite measurement of consumer prices.

Notwithstanding mix shifts that affect readings of the indexes of export and index prices, Mr. Gundlach prefers them (33:21) over other price measures “because they’re the most unadulterated, they’re just prices, and they don’t have all these hedonics and replacements.” With year-over-year changes of negative 4.8% on imports and negative 5.9% on exports, these levels represent “some of the lowest readings that we’ve seen in the past decade and a half. In fact, they’re in deflationary mode right now. So, I’m wondering why people are so bearish on bonds or had been so bearish on bonds.” He then cites two big factors for worrying about bonds: “A, inflation, that’s been relaxing, and B, really low interest rates.” “Clearly interest rates are a lot higher now than two and a half years ago,” he notes, “Bonds are much more attractive, and their inflationary nemesis has been in retreat. That’s why I think bonds are the superior asset class right now.”

In terms of asset class allocation (34:36), Mr. Gundlach advocates instead of a 60-40-type portfolio mix, “more like 30-60-10. So, 30% stocks, 60% bonds and 10% real assets. And that real asset that I’ve liked is gold, which has gone up this year but has a very hard time staying above ($2,000).” Commodities would not get his vote at this time for a real-asset allocation. “I like gold just because it’s kind of a real-money sort of a thing for part of your financial portfolio. But I really don’t like commodities, and I haven’t liked them for a year just because the economy is weakening, and we’re probably going into a recession sooner rather than later. Commodity prices probably won’t go up during a recession.”    

Mr. Gundlach then tours (41:07) the major sectors of the fixed income universe. He identifies credit sectors where the market is clearly pricing for defaults. The bottom line, however, is, thanks to the significant rise in yields, attractive opportunities are available for investors across a broad spectrum of risk tolerance. Investors can “play it really safe” to buying “riskier funds like closed-end funds” with yields in the high single digits, low double digits. “Back a year and a half ago,” he says (43:04), “stocks were cheap to bonds. As overvalued as stocks were, they were cheap to Treasury bonds and bonds broadly. But thanks to this increase in yields, bonds are absolutely cheap to stocks at the present moment and would be a much more relaxing way of earning returns than white-knuckling it in a stock market in an economy that’s perhaps going to a recession.”    One danger zone in fixed income, Jeffrey Gundlach warns, is lower-tier bank loans (45:09): Recovery rates in the event of default are already running at 50% (in the absence of a recession), not the 70% predicted by most models. In the high yield corporate bond market, while credit spreads “might look a little tight on a yield spread going into recession,” he welcomes one development in the sector. The share of the market that is secured has increased to 29% versus 6% two decades ago.

We should expect a decrease in volatility as the Fed is getting close to or maybe already has done their last hike. I think they already have done their last hike and so volatility should be coming down in the weeks ahead, which means mortgage spreads have a huge tailwind to be tightening in, making them even more attractive relative to the Treasury bond market.