Gundlach – When the Dollar Heads Lower, Emerging Markets will Outperform
Jeffrey Gundlach’s highest conviction investment idea is that the dollar will head lower over the long term. That will lead to a strong rally in emerging equities, and they will outperform U.S. stocks.
He is neutral on the dollar in the near term. But it is headed “much lower” in the years ahead, he said, and he has started to get “a little bit more negative on it.”
The DXY (“Dixie” dollar index) could go below 70 (it was at 92 on the day he spoke), “but that doesn’t mean it will happen this year,” he said.
Our trade deficit has grown since the onset of the pandemic. The combined budget and trade deficits (the “twin” deficits) are growing as well, which is bearish for the dollar. Gundlach is looking for the dollar to head lower, perhaps in 2022, and that will be the time for investors to allocate to emerging markets.
Emerging markets have grossly under-performed in the U.S. Over the past decade, emerging market equities (based on the EEM ETF) returned 4.84% annually, versus 16.30% for U.S. equities (based on the SPY ETF). Over the past year, emerging markets returned 18.64%, versus 33.20% for U.S. stocks.
Gundlach said he will be a “strong advocate” of emerging market equity buying when the dollar moves to the downside.
Gundlach spoke to investors via a webcast, which he titled “Johnny 7,” and the focus was on his flagship total-return fund (DBLTX). Slides from that webcast are available here. Gundlach is the founder and chairman of Los Angeles-based DoubleLine Capital.
The title was a reference to a toy, marketed in 1964, that resembled a military gun. It consisted of seven different weapons, and Gundlach said those were symbolic of the massive efforts and spending programs launched by the Fed and Congress since the start of the pandemic.
“Frankly, the toy didn’t work that well,” he said.
Let’s review Gundlach’s take on the health of the economy and how the Fed and Congress have responded.
Fake growth and a rocky recovery
Nominal GDP is approximately $2 trillion more than its pre-pandemic level, which Gundlach said was expected given the spending by the government.
“The economic growth we are seeing isn’t growth,” he said, and is the result of spending programs.
But the fiscal stimulus by the U.S., at 26% of its GDP, is in the middle among developed countries. Japan is nearly double that of the U.S. and Germany is also well ahead of our level.
Debt levels due to the stimulus rose four-times faster than in response to the global financial crisis. The debt we incurred from the pandemic is about 60% more than what resulted from the financial crisis.
“This was a much larger response in three months than during the global financial crisis,” Gundlach said
The current thinking, which he agrees with, is that tapering will start in the next few months. He said his “guess” was that $10 billion of Treasury bonds and $5 billion of mortgage-backed bonds would be tapered from the $120 billion monthly that makes up the Fed’s quantitative easing (QE) plan.
The effective Fed funds rate is now -5.16%, which is the “real” rate relative to the CPI. The last time there was such a deeply negative real rate was in the 1970s, but then it was due to inflation, not to low interest rates.
Gundlach expects the Fed funds rate to stay at zero for at least a year, and possibly two, until QE is fully terminated.
He cited academic research that calculates the theoretical effect of QE on the Fed funds rate. It showed that the effective Fed funds rate is -1.80%, which translates to a real rate of -7.05%. This is comparable to its level in 2014.
Employment has not come close to rebounding, despite the resurgence of nominal GDP. There are 5.3 million fewer employed Americans versus pre-pandemic peak. “This remains a real wound to the economy,” Gundlach said.
“Free money is negatively affecting employment,” he said. “The 5.3 million jobs will shrink when the money goes away.”
Now that the supplemental employment benefits rolled off on September 6, he said, it is possible employment will recover.
There is an unusual divergence, where 90+ day delinquencies on mortgages are very high, yet foreclosures are at historically low levels. If the eviction moratorium is allowed to lapse, he said there could be a surge in foreclosures, which portends a rocky economic recovery.
“The short term is quasi under control based on nominal GDP,” Gundlach said, “but there are lots of things out of whack.”
“The history book will not say that inflation is transitory,” Gundlach said.
The Fed will redefine “transitory” to be a longer time period, he said. It initially said transitory was two or three months; now it is approximately nine months.
Inventories are at a low level, he said, which portends that inflation is not transitory.
Consumer confidence, based on sentiment surveys, is also low as are expectations of the future, and have not recovered since the start of the pandemic. A recession is more likely than a year ago, but it would require a further weakening in consumer sentiment before one becomes likely.
Jobs are hard to fill, and workers’ compensation (wages) has gone up very substantially. Among older workers, including those 22 to 54-years old, wages have not accelerated since the lockdowns. But for the younger age group, wages have risen. That is the result of the shortage of labor in restaurants and retail, Gundlach said.
Global manufacturing delivery times are lengthening, reflecting the longest delays in three decades, which has been a driver of inflation. But trade is booming, he said, and is higher than in 2018-2019. That is the result of U.S. consumers buying imported goods. He said that there are stories of container ships coming from Asia but having to return empty. South Korea, for example, is an export-oriented economy, and it is booming.
The housing market was at its peak shortage level in April, and that shortage has eased. Home prices have gone up sharply, he said. In Phoenix, for example, prices are up 45%, as are other “destination” cities where workers are seeking a lower cost of living. The Case Shiller home price index is up 19%, the biggest increase in about 20 years.
Home prices have probably peaked, he said, because the market can’t sustain these levels.
Houses are still affordable, he said, when measured based on the monthly payment as a percentage of income. That is due to low interest rates on mortgages, which are driven by the Fed’s yield-curve control.
There has been a “stampede” to rental properties, Gundlach said. Rents will go up, he said, and that will drive the CPI higher. The CPI uses owner-equivalent rent (OER), and rents will go up when the eviction moratorium ends. Property owners will increase rents very sharply in the months ahead, once evictions resume.
Rents are increasing at a much higher rate than the 2-3% reflected in the CPI through the OER. That is true across the 100 largest cities, according to Gundlach.
The headline CPI would be 12.0%, not 5.3%, if rising home prices were used in the CPI calculation.
Both the PCE (the Fed’s preferred measure of inflation) and the producer price index (PPI) data support a spike in inflation since mid-2020.
“There is not a great reason to believe the CPI will go back to a two-handle,” Gundlach said, “as the Fed wants us to believe.”
Based on TIPS breakeven yields, the market thinks inflation will remain in the 2-3% range, but that could be due to the Fed buying TIPS, according to Gundlach. TIPS are expensive, he said, but pay well because of the headline CPI data.
Asset class valuations
Gundlach commented on the valuations in several asset classes.
Commodities have been very strong since 2020, he said, but have been moving sideways for six months.
He is neutral on gold until the dollar turns lower. “It looks cheap relative to TIPS,” he said.
The copper/gold ratio says the 10-year Treasury yield should be 3%, he said, “as does any fundamental logic.” The 10-year yield closed at 1.32% on the day he spoke.
The 30-year yield is being kept below 2% by the Fed’s yield-curve control.
Using the forward P/E ratio, the Russell 1000 growth index is at 32, but value has decreased to 17. That is the largest difference since the start of 2020. “Value is cheap to growth,” Gundlach said.
Corporate bonds have done poorly this year because of their long duration, he said. LQD, the benchmark investment-grade bond ETF, has a duration around 10. But high yield has done well due to the narrowing of spreads.
The high-yield bond market has been helped by better credits, the result of refinancing by issuers and the movement of bonds from BBB to BB ratings.
Investment-grade corporate option-adjusted spreads are very low, Gundlach said, and would be threatened by a recession. The same is true in the high-yield market.