Gundlach – Headline Inflation Could Top 4%
Headline CPI inflation is almost certain to rise above 3% in June and July, according to Jeffrey Gundlach. It could even top 4%, he said, which would “really spook the bond market.”
Gundlach spoke to investors via a webcast, which he titled, “Looking Backward.” The focus was on his flagship total-return fund (DBLTX). Slides from the webcast are available here. Gundlach is the founder and chairman of Los Angeles-based DoubleLine Capital.
Gundlach’s co-presenter was Andrew Hsu, a portfolio manager for the total-return fund.
Looking Backward was a novel by Edward Bellamy, published in 1888, that predicted a utopian society would emerge in the U.S. in 2000. It created a political movement at the time of “Bellamy clubs” advocating, among other things, the nationalization of private property. It was driven by themes in late-19th century America, including a revolt against monopolies and a resentment of immigration from Europe that was driving down wages.
Those forces parallel many facing America now.
When the novel’s protagonist wakes up in 2000, the U.S. has been transformed into a socialist “utopia” with an economy based on the equal distribution of wealth and government-controlled business.
On the 100th anniversary of its publication in 1988, The New York Times wrote of the “appalling implications of its prophecies,” Gundlach said, and added that the newspaper would not be likely to say the same things today.
In the webinar, Gundlach addressed the issue of the government’s role in economic growth, but a central focus of the capital markets is inflation, so let’s start with his comments on that topic.
Inflation and the bond market
There is no inflation in core CPI, Gundlach said, but headline inflation will increase significantly and will be greater than 3% in June and July. The Fed is aware of this and is telling the bond market it is unconcerned, according to Gundlach, and welcomes that level of inflation along with the accompanying negative real interest rates. This allows the deficit to be financed with cheaper dollars, he said.
Headline CPI could even go above 4% over that time, he said, based on ISM data, which could trigger a bond selloff.
The yield curve has steepened by approximately 160 basis points this year based on the two- to 10-year spread, showing that the bond market anticipates more inflation. The five-year breakeven inflation rate has risen, he said, in part because the Fed has bought a lot of TIPS, depressing those rates.
The yield curve can steepen quickly, he said. The question is how steep the Fed will allow it to get.
The Fed is not close to implementing yield-curve control, at least until the 10-year goes above 2%.
The N.Y. Fed’s gauge of underlying inflation, which serves as a 16-month leading indicator, has bottomed, Gundlach said.
He noted that this is the one-year anniversary of the low in 10-year bond yields, which has driven poor returns across most bond classes over that time.
To get inflation, Gundlach said we need to give everyone a “Bellamy credit card,” which was portrayed in Looking Backward. It would essentially be a stimulus handout to Americans that must be spent over a fixed time or returned to the government.
“It’s shocking that households with $150,000 of income and three children will get $6,000 from the government,” he said, in reference to the $1.9 trillion stimulus. “This looks a lot like a monetizing experiment.”
The struggling economy
Inflation typically accompanies economic growth, but Gundlach was not sanguine.
GDP, employment, and the stock market have diverged, he said. Technology is 6% of GDP but only 2% of employment, yet it is 38% of the S&P 500’s market capitalization. Monopolies are taking a large share of wealth, he said, but not benefiting a proportional number of Americans.
GDP was growing at 2.5% until the pandemic, and he says we are, “still in a recession,” until we get back to trend growth in GDP. The Fed is buying $120 billion per month in securities to support economic programs. Those programs have cost $6.1 trillion, versus $1.8 trillion for programs during the global financial crisis (GFC). That does not count the pending $1.9 trillion stimulus package.
Government transfer payments made up 32% of personal income at its peak during the pandemic, versus 18% during the GFC.
Our trade balance is still in deficit and rose 1.5% due to the stimulus. Gundlach said much of those trade dollars went to China. Freight-container shipments from China to Los Angeles spiked once the pandemic began.
The budget deficit, a frequent topic in Gundlach’s webinars, is 16% of GDP. But that does not count some “one-off” items, and 54% of government spending is being financed by the deficit.
The dollar may appreciate in the short term, he said, but the growing deficit means it is likely to be lower over the long term.
Unemployment is down to 6.2%, but continuing claims for unemployment benefits show that employment is nowhere near its pre-pandemic levels, because about 10% of the labor force is still getting unemployment insurance.
Consumer confidence has not rebounded, he said, showing that the consumer is “far from fully recovered.”’
Overvalued equity markets
Compared to the MSCI European index, the S&P has started to underperform this year. “You just want to go with it,” he said, and expects Europe to outperform the U.S.
High-beta stocks, including the “super six” (Facebook, Amazon, Apple, Alphabet, Netflix and Microsoft), have stopped outperforming.
Flows to equity funds globally have seen “unheard of spikes,” he said and have been the fuel for stock price growth.
The P/E ratio for U.S. stocks is the highest of all time, and the forward P/E ratio was exceeded only in 1999. He reminded listeners that President Biden campaigned on raising the corporate tax rate to 28%, which means that P/E ratios would have to be adjusted even higher. The Schiller CAPE ratio is 35 and was exceeded only in 1999. The ratio of the S&P 500 to GDP is also at an all-time high.
Hotel occupancy rates are lower than in 2009 and are very depressed yet travel and leisure stocks are 20% higher than pre-pandemic levels, which Gundlach called, “almost inconceivable.”
The outperformance of mega- versus micro-cap stocks has been completely reversed in the last few months.
“I expect the VIX will hit its highest level in the next correlation and will go over 100,” he said. That will be driven by retail trading activity fueled by stimulus checks, even among low-income Americans.
The Nasdaq index looks “pretty dicey,” he said, and exceeded its top in 1999. He referred to some technical analysis that bodes poorly for the Nasdaq.
Commodities prices tracked the S&P from 1995 to 2010, until quantitative easing (QE) began. Then the S&P left commodities “in the dust,” he said. Commodities have started to perform modestly well this year, and he is bullish on them in the long term in connection with his prediction of a weaker dollar. A weak dollar is highly correlated with strong commodity prices.
Gold may have hit its low at its current price of $1,681, and he said it looks “likely to bounce.”
Based on a model of gold using 10-year real rates, he said gold is “fairly valued” and the decline in the gold price is “unlikely to continue.”
Are bonds fairly valued?
Based on a comparison to the German 10-year sovereign rate and GDP, the U.S. 10-year bond is also fairly valued, Gundlach said. That valuation is supported by the 10-year history of the CPI. “But a rising CPI will change that,” he said.
Other indicators differ in their message for 10-year valuations. The copper-gold ratio indicates that the yield on the 10-year should be about 150 basis points higher than it is now, suggesting that the Fed is holding down rates, he said. The 10-year yield is also too low relative to the rise in commodity prices. The PMI is correlated to the 10-year yield, and it also suggests that the 10-year should be at least 3%.
Gundlach said there has been a “blood bath” at the long end of the yield curve, but those bonds are now “oversold.” He expects a moderate decline in yields at the long end of the curve.
Fund flows have gone from Treasury to corporate bonds, but for investors that was a “bad idea,” he said. The longer duration of corporate bonds is hurting their returns.
The only net buyer of Treasury bonds has been the Fed, causing a lack of robust and normal organic demand. There was a bad auction in seven-year Treasury bonds last week due to a lack of foreign demand.
Corporate bonds have a real yield slightly below zero and a yield-to-worst of 4.3%. The yield is the same for BBB-rated and Treasury bonds for 30-year maturities. Corporate bonds have half the duration but carry default risk.
The corporate downgrade cycle appears to have bottomed out, he said, and with the fiscal stimulus and support measures, the upgrade cycle has begun.
Bank loans have been one of the better performing sectors, emphasizing the value of capital preservation, he said, despite outflows from funds that own them.
Residential housing and stimulus addiction
Hsu had some good news for homeowners, highlighting the effects of the pandemic.
In 2010, he said, homes spent an average of 140 days on the market; now it is only 25 days. In 2006, before the GFC, there were four million homes on the market; now there are only one million. This is very bullish for housing and, even if demand falls off, it is unlikely there will be price depreciation.
But Gundlach’s greatest fear is centered on the deficit.
“We’ve become totally addicted to the stimulus programs,” he said. “We will see interesting trends based on the belief that they are permanent, which will force the government to continue them. I worry that we could see a need for endless stimulus, which would prevent interest rates from remaining low.”
“We are in a speculative bubble in government debt and equity valuations,” he said. If there is a collapse in stock prices, it will not be 10 or 15%, but a “large number. There will be a tremendous unwind of stock positions.”