Gundlach – U.S. Stocks Have Not Bottomed
From its all-time high on February 19, the S&P 500 hit a bottom of 2,237 on March 23. But it will go lower this year, according to Jeffrey Gundlach, and only then will he buy stocks.
Gundlach spoke to investors via a webcast, which he titled “A Tale of Two Sinks.” Slides from that webcast are available here. Gundlach is the founder and chairman of Los Angeles-based DoubleLine Capital.
Compared with prior market crashes, Gundlach said, this one most resembles 1929. Typically the market goes to a “crash low,” he said, and then there is a snap back, followed by another move down and then an enduring low.
“The low from mid-March will get taken out,” he said, and he will be interested in buying at that time.
He compared U.S. equities to Japan in 1989, Europe in 1999 and the emerging markets in 2006. Like those markets, “the U.S. will be a poor performer and it will not get back to its high on a real basis,” Gundlach said.
The economy faces deflation. The drop in oil and copper prices has “devastated U.S. industries,” he said. Based on historical patterns of commodity prices, Gundlach said, there is no hope to think the economy will rebound in Q3.
Will the stimulus cause inflation? It is like a titration exercise in chemistry, Gundlach said, where you drop a colored liquid slowly into a jar until the correct color is observed. “We’ve been doing titration by drip with QE,” he said. “Now we are letting it rip. Sending money people directly is the easiest way to create inflation.”
Gundlach waded into the controversial topic of stock buybacks. He said that the airline industry spent $45 billion in buybacks over the last five years, but got $58 billion in support from the federal government. “Let them go bankrupt,” he said. “The planes won’t disappear.” The airlines drained the liquidity that they need now, he said.
“The government is effectively buying back shares for more than the airlines paid for them,” he said. “The buybacks are obviously are going away.”
Airline usage is down 94% year-over-year, he said, based on Bank of America data.
The title of the talk relates to the two sinks that Gundlach has in his kitchen. He said he never used one of them, until the other started leaking. Then he started using it and found he liked it better than the original one. The plumbers came and fixed the original one, he said, but he didn’t go back to using it.
“When we go through this stay-at-home period,” Gundlach said, “we start to change our habits. The lessons we learned about commuting, working from home and not polluting the air sink in, and we may never go back to where we were, particularly the longer it drags on.”
The title is also derived from a 1985 sculpture, The Ascending Sink, by the modern artist Robert Gober:
Those sinks symbolize the daily human war against dirt, Gundlach said, “with an obvious message to our regimen of washing our hands.”
Let’s look at Gundlach’s assessment of the global economy and the capital markets.
A depression-like scenario
Global GDP growth forecasts are now negative, he said, following the announcements of massive layoffs. There could be 10 million initial claims for unemployment in the next two weeks.
Gundlach showed the epidemiological data from various countries. The United States is seven times larger than Spain, but both have the same number of cases. The same ratio applies to reported cases and deaths.
He derided comparisons of the economic collapse to a “snowstorm,” which he knows well since he grew up in Buffalo. He expects another four weeks of shutdown, for a total of 15% of the year. Even as a temporary setback, he said it looks like a “depression scenario,” with double-digit unemployment.
The silver lining is that vehicle traffic has been drastically reduced, based on data from Los Angeles, where DoubleLine is based. There has been an incredible drop off in pollution as a result, he said, which is especially true closer to the ocean.
There will be changes to the global economy
Our economy will be less globalized, he said, because manufacturing will come back to the U.S. The biggest winner will be the American economy, as it moves from outsourcing to self-sufficiency. Inventories will move away from “just in time” levels, he predicted.
He compared the fiscal stimulus bill to one of Gober’s sinks, with the other being monetary policy. There is talk about doubling the size of the fiscal sink, Gundlach said.
GDP growth was projected to be 1.8% at the beginning of the year. Projections now from major investment banks show a huge “divot” in Q2 and a “snap back” in Q3, he said. But he doubts that the recovery will be as robust as those projections, some of which he called “outrageous.”
It is a myth that there are non-essential businesses, he said. “There is no such thing as a non-essential business. They are all essential to their owners and those businesses are interconnected to one another.”
James Bullard, the St. Louis Fed president, has predicted 30% unemployment, Gundlach said. “I don’t see how we can crawl out from under that.”
“We are looking at a massive, massive reduction in GDP,” he said.
Economic weakness was foreshadowed in the JOLTS survey in the second half of 2019, according to Gundlach, but not to the degree that it unfolded.
The jobs at risk are 35 million “low-quality” ones, he said – the people who work in shoe stores, barber shops, nail salons and gas stations, and in the amusement, recreation and restaurant industries.
The Fed is talking about taking its balance sheet to $7 trillion, Gundlach said, “but $10 trillion is possible. Here we go with a massive increase in the Fed balance sheet and the national debt.” He said the Fed is doing things that are “quasi-illegal,” like buying ETFs.
The markets are not in great shape, according to Gundlach. The emerging markets are “broken”; the bid-ask spreads are 10 points, he said, and that is a market that the Fed is not supporting. Similar things are happening in the corporate bond market. In the CMBS market, he said there are “real problems” in liquidity. At the top of the capital structure – AAA bonds and CLOs, for example – things are okay, but there is little liquidity in lower-grade instruments, according to Gundlach.
“We are following a pattern that is not that different from what Japan did starting in 1997 and which accelerated starting in 2008,” he said, referring to that country’s “lost” decades, despite aggressive fiscal and monetary measures. “You can’t levitate yourself back to growth” through fiscal stimulus and monetary policy. That was the lesson in Japan’s experience, according to Gundlach. It has had very sluggish GDP growth. “In the short term,” he said, “we are not getting a bootstrapped, bailout-based growth.”
Growth will come from restructuring the economy back to manufacturing and away from services, according to Gundlach.
Gold has gone up a little bit in the last two weeks, he said, but is not making much progress because we are in an “everything gets sold” market. Gold miners are well below their peaks in 2016. They are up a little very recently, he said, benefitting from their exposure to gold, but suffering from being stocks and exposed to equities overall.
There is a “real shortage” of physical gold, he warned. Too many speculative securities are not backed by the physical commodity. If gold skyrockets in price, he said, there won’t be enough metal and “something bad will happen. There could be a huge failure in the gold market.”
Telling people you don’t have to pay taxes (by extending the IRS deadline to July 15), while the government is ramping up the stimulus, he said, “could lead to a crisis.”
Negative interest rates have decimated banking stocks when they have been tried, like in Japan and Europe. Many analysts are saying they “love” the banks, according to Gundlach. But loan and credit card payments will suffer, given the forecasted unemployment, so he does not ascribe to that view.
“The future is here when it comes to the deficit,” he said. The budget deficit is going up and employment is going down. Tax receipts typically fall during recessions. But this time tax receipts fell and deficits increased over the last decade, without a recession. “Unemployment is probably going to 10%,” he said, “and the deficit will be much higher than 10% of GDP.”
“The supply of bonds will be overwhelming,” Gundlach said, “but the Fed is buying the deficit and beyond, because they are buying corporate debt.”
“We sowed the seeds of a big problem by growing the deficit over the last five years, while the economy was growing and unemployment was low.”
This is bad news for the dollar, according to Gundlach, which seems to have peaked. But the trade and fiscal deficits are highly correlated to the dollar, he said. The trade deficit will go down with the weak U.S. economy, but the fiscal deficit will accelerate and the dollar should go down “a lot.” “We are flooding the system with dollars,” he said.
The bond market
The Barclays AGG was having its best year ever until the end of February, Gundlach said. Then it was having its worst year, and then had a snap back due to the Fed’s rescue of corporate and mortgage bonds.
Once the Fed is in this mode, he said, the yield curve will steepen, “and that will remain a theme. It does not want long-term rates to go up.”
The real sign of upward pressure on rates in the developed markets would be if they went above their 2016 lows, Gundlach said. “We are long way from that in the U.S. and Germany. That would show that the supply of bonds is overwhelming the market, which would lead the Fed to increase its balance sheet.”
Rates for 30-year mortgages were rising until the Fed stepped in. Refinancing is not as attractive as many think, he said, and rates are higher than in the second half of 2019.
Credit markets have suffered across the board, Gundlach said. In the corporate markets, prices have dropped as many bonds were downgraded from BBB to BB. CCC bonds were down as much as 30%, along with the stock market.
“The Fed has chosen winners and losers without any warning,” he said. “It will need to rescue other parts of the bond market. The further you down you go in the capital structure, the worse it is.”
March was shaping up to be the worst one-month performance in the investment-grade and high-yield markets, he said, until the Fed stepped in.
This has obviously caused dislocations and illiquidity with no ability to restructure along the way, Gundlach said, because it unfolded so fast. “The illiquidity was worse than in 2008 because it unfolded so quickly.”
He has previously warned about owning BB-rated corporate bonds; their spreads relative to BBB bonds moved from 50 to 330 basis points during this crisis.
The biggest blowout in spreads was in an obscure corner of the bond market – CMBX BB sleeves – which went from spreads of 1,000 to 4,100 basis points relative to BB-rated bonds, and then back to 3,500 basis points. Gundlach said those bonds finance “a particularly undesirable segment of commercial malls.”
Mortgage REITs are at the epicenter of widening spreads, he said, and have been among the biggest losers in the equity markets.
High-yield bonds outperformed following the great financial crisis, but that is not likely to repeat because their prices are artificially supported by the Fed.
But, he said, “It is exhilarating as a money manager because it will lead to tremendous opportunities as we head into 2020.”
“We will never get back to normal,” Gundlach said. “We are using a different sink.”
“We will get to a better place after a period of sacrifice.”