Investors face many concerns as the new year approaches, but a recurrence of May’s “taper tantrum” should not be high on their lists, according to DoubleLine’s Jeffrey Gundlach. With the majority of Fed governors staking a dovish position, “quantitative stimulus is likely to remain with us longer than people think,” Gundlach said.
“Like it or not, we have to deal with this,” he said.
Gundlach spoke via conference call with investors Dec. 10. He is the founder and chief investment officer of Los Angeles-based DoubleLine Capital. Copies of the slides from his presentation are available here.
Gundlach stressed that presumptive Fed Chair Janet Yellen has said it is “imperative” not to prematurely take away the central bank’s stimulus. He said that quantitative easing (QE) and “meddling with the economy” will last a lot longer than consensus expectations.
I’ll review what Gundlach said about a number of trends related to the deficit and entitlement spending, the impact of Obamacare (including some claims that I didn’t agree with) and the outlook for a number of fixed-income asset sub-classes. First, here are a few more predictions he laid out in regard to the Fed’s actions.
Papering over tapering
In previous talks, Gundlach has asserted that the Fed’s bond-buying program effectively funded the growth in the federal deficit. This year, however, the deficit has shrunk. Gundlach said the Fed could have reduced its bond buying by 30% this year and achieved the same level of deficit funding.
The increase in bond buying, relative to the deficit, explains why at least some markets performed well in 2013, according to Gundlach.
Gundlach said that approximately 70-75% of all Treasury bonds are owned by central banks, with the Fed having the largest holding – $2.1 trillion of a total $16.8 trillion. The Japanese and Chinese central banks each own about half of what the Fed holds.
A fear that weighs on the markets is a lack of bond-market liquidity. A spike in rates, some fear, would trigger selling by mutual funds and other institutional investors. With banks constrained by regulations and unable to purchase riskier debt, rates could spiral upwards. Gundlach allayed this fear, noting that mutual funds own a very small percentage of government bonds.
“People are worried about mutual funds selling government bonds,” he said, “but it’s not really much of an issue relative to the total flow of U.S. government bonds. “
Another fear among bond-market participants has been the ramifications if China (and, in earlier years, Japan) refuse to buy Treasury bonds. But Gundlach said both countries have already reduced their purchases in the Treasury market, and the Fed has been the main buyer of new bonds.
Indeed, the Fed is now buying about 70% of all Treasury market issuance. Gundlach called the Fed’s subsidy of that market, the housing market and the federal deficit a “pretty incredible undertaking.”
The question of whether the Fed can taper its bond-buying without triggering a liquidity shortage in an environment with lower foreign purchases hinges on the composition of the Fed board, according to Gundlach. He said the Fed members fall into two camps: doves who worry about financial stability, and hawks, some of whom would cease bond-buying immediately because of the financial instability it creates.
Yellen is a dove. Her camp presently outnumbers the hawks. The doves’ decision as to whether to taper is data-dependent.
The doves’ waiting game
Two metrics guide the thinking of data-dependent doves: unemployment and inflation. Under Chairman Ben Bernanke, the Fed set targets for the nation of reaching 6.5% unemployment and 2% inflation before the central bank would initiate tapering.
Gundlach offered a bleak outlook for unemployment. He did not say when the 6.5% target might be met, but he noted that the primary problem has been people dropping out of the labor force. If the labor-participation rate had not changed since the financial crisis, Gundlach said unemployment would be 11.5%, versus its current rate of 7%. Adjusting for demographics and an aging population, Gundlach said unemployment would still be 9.3%.
“While the headline numbers is now 7% unemployment,” he said, “we all know that’s a little bit rosy of a picture when you normalize the statistics.”
Other problems plague the labor market. Disability payments are up, and median household income has been dropping since 2009. Gundlach said unemployment is higher, and labor-force participation lower, even for those with college degrees. Real income for those with advanced degrees has declined over the last decade. Those trends are problematic for the nearly $1 trillion in student debt now on the books.
As unlikely as it is that the Fed will meet its unemployment target, the prospects of achieving 2% inflation seems even more remote, based on what Gundlach said.
“Inflation is hard to find in the reported numbers,” Gundlach said. Inflation in the U.S. looks like it is headed to zero, he said. He reiterated that low inflation would keep the Fed from easing its policies.
In response to skeptics who claim the Fed has manipulated its numbers to report lower-than-actual inflation, Gundlach offer a piece of bad news: If inflation were lower, real GDP growth would be negative. “If you really think inflation is understated,” he said, “then there is no economic growth.”
Inflation in the Eurozone – which Gundlach described as “debt-logged” – is trending lower, he said, but Japan has managed to bring back “some measure” of inflation due to its stimulus policies.
“But everywhere in the developed world,” he said, “inflation is running at about a 1% rate.”
Is Gundlach correct about healthcare?
Having presented the rationale for the Fed maintaining its monetary stimulus, Gundlach next offered some comments on U.S. healthcare and the impact of Obamacare.
While the media has focused on the website failures and false promises related to Obamacare, Gundlach discussed a number of new taxes that Americans will face. For example, many firms – including DoubleLine – will pay an excise tax for “Cadillac” employer health plans. Those taxes, he said would total $500 billion over the next seven to eight years. Gundlach also cited individual- and employer-mandate penalties and other taxes tied to health-insurance premiums that will kick in over the coming decade.
The actual cost of Medicare in 1990 turned out to be three times its estimate when it was introduced in 1965, according to Gundlach, and he warned that the same could be true of Obamacare.
Health-care costs are already high, according to Gundlach. He cited data showing the U.S. has “vastly higher per-capita health-care spending” compared to other developed countries and that health-care spending in the U.S. has risen much faster than GDP growth and wages over the last 50 years.
“You would think or hope you would get some benefit out of this,” he said.
But we don’t, according to Gundlach. He cited data showing the life expectancy at birth in the U.S. is below the average of developed countries, although it has increased consistently over the last century.
Despite the data that Gundlach presented, one should not conclude that the U.S. spends disproportionately too much on healthcare or that outcomes in the U.S. are inferior to those in other countries.
As Michael Edesess and Kwok Tsui argued in their article, Why Does the U.S. Have High-Cost Low-Quality Healthcare?, other developed nations spend considerably more on a per-capita basis on social services (food, housing, clothing and heat). That spending greatly influences healthcare outcomes, and when spending is viewed on a combined basis (healthcare plus social services), spending in the U.S. is not extraordinary.
Nor is life expectancy at birth an appropriate metric for healthcare outcomes. The U.S. has a higher murder rate than other countries. When life expectancy is measured from age 30 or greater, the U.S. compares well to other countries. But life expectancy alone is too blunt a metric to compare the U.S. to other countries. As Edesess and Tsui stated, the U.S. has higher levels of poverty, drug use and violence, for example, when compared to other nations, which make it extremely difficult to determine whether higher mortality rates are due to poorer healthcare or to other factors.
Some predictions for the bond market
Gundlach will be holding another conference call Jan. 7 to discuss his market outlook, but he offered a few predictions in this call.
In his previous conference call, Gundlach compared the current bear market in Treasury bonds to that of 1994. Based on that experience, he said yields would stop rising – and they did. He said the 1994 experience is still relevant, although the correlation over the last three months has been weak. Nonetheless, he advised against being too negative on bonds.
Gundlach had positive things to say about corporate bonds. With strong corporate balance sheets, he said, “you don’t need profitability to be at an all-time record for corporate bonds to be safe.” With defaults virtually non-existent, he said it would take a recession before investors should worry about credit risk in corporate bonds.
Junk bonds, however, are priced unattractively, according to Gundlach. He compared them to 30-year Treasury bonds, which he said have similar volatility. Bonds rated BB yield 4.6%, and the spread is negligible versus 30-year Treasury bonds. Both those and B-rated bonds (which yield 5.2%) have low default rates, but Gundlach said both are at all-time overpriced levels, based on a proprietary metric used at DoubleLine.
High-yield bonds have performed well this year and are up 7%, according to Gundlach, while emerging-market debt has done very poorly. But he said emerging-market bonds are due for mean reversion. “I just don’t think it’s a good idea to be favoring high-yield bonds in the U.S. today versus dollar-denominated emerging market bonds,” he said.
Gundlach addressed a key question that confronts many bond investors: If the Fed does stop buying bonds, will other buyers step in to take its place? If rates go higher, which they are not doing now, Gundlach said the likely candidate would be pension funds.
Pension plans are having a terrific year, Gundlach said, due to the appreciation in their equity holdings and the ability to discount their liabilities at higher single-A corporate-bond yields. If stocks continue to move higher, Gundlach said many pension plans would make it to the “promised land” of fully funded status.
If that happens and if rates rise – neither of which Gundlach explicitly predicted – pensions could shift significant assets into long-term bonds to lock in their funded status. That, he said, would create a “massive demand for long-term bonds.”
Read more articles by Robert Huebscher
