The benchmark 10-year Treasury bond is an attractive investment, according to Jeffrey Gundlach, although its yield is likely to stay between 2.2% and 2.8% for the remainder of the year. Despite that narrow range, Gundlach foresees pivots in other parts of the investment landscape.
“This is a pretty big moment for the markets and the economy,” Gundlach said. “Emerging markets may be breaking on the upside. The Shanghai is at a decision point. I also see gold seems to be at a decision point.”
Gundlach spoke June 10 on a conference call with investors. He is the founder and chief investment officer of Los Angeles-based DoubleLine Capital.
A copy of Gundlach’s presentation is available here.
With the recent “bounce up” in Treasury yields, Gundlach said investors should “think about bonds.” The yield on the 10-year closed at 2.64% on the day he spoke, up from its low this year of 2.44% on May 28.
“I know that everyone thinks that bonds are terrible because of the low interest rates,” he said, “but most of those people missed some significant profit opportunities in long bonds that we referenced at the beginning of the year.”
I’ll look at what Gundlach said is in store for emerging markets, China and gold. But first, I’ll review what he said about the U.S. – including his seven reasons why interest rates have trended lower.
Seven reasons why U.S. rates have declined
“Almost nobody believed interest rates could fall during 2014,” Gundlach said, yet long-term government bonds have been the best-performing asset class.
Gundlach gave seven reasons for the drop in interest rates. First was something he talked about in prior presentations: Pension plans have taken advantage of the gains in the stock market to shift allocations toward bonds, to lock in funding of projected liabilities. That trend, he cautioned, “is largely behind us.”
Lack of supply – particularly in the long-term U.S. Treasury market – has also driven down yields. Gundlach said that central banks now hold a disproportionate share of those bonds, leaving very little float for mutual funds and other investors. In fact, he said that Barclays has now eliminated bonds owned by the Fed from its calculation of its aggregate-bond index.
Slow economic growth has contributed to weakness in yields. Gundlach said that “GDP really failed to pan out versus forecast, particularly in the first quarter.” He cited data showing that the consensus forecast was 2.75% until the beginning of this year, when those expectation started to decline – but never reached the actual number of -1%.
A fourth reason is data from other parts of the world, he said – deflationary indications in Europe and slow growth in China.
A “huge short position” against the Treasury market also explained the decrease in yields. Indeed, in March he said that if yields were to drop below 2.5%, he said to expect an “incredibly painful short-covering scramble.” A popular strategy among many bond managers and leveraged exchange-traded funds over the last year has been shorting Treasury bonds as a source of cheap financing, he said at the time. Recent media reports show this is exactly what happened.
The sixth reason he cited was interest rates in other countries. Low rates in Japan and most of Europe, including its most fragile economies – Spain, Greece and France – have driven investors into U.S. debt markets.
The dollar has been strong, Gundlach noted, and he expects it to remain so and advised against any non-dollar-denominated assets. The dollar’s strength, particularly against the euro, which Gundlach expects to weaken, also explains why rates have fallen in the U.S.
Aside from those seven reasons for declining interest rates – many of which are no longer at play – Gundlach spoke about another trend which is likely to constrain growth – and perhaps rates – over the longer term: demographics. The dependency ratio, which is the ratios of people not in the working-age population to those who are, is increasing in a number of major developed economies, including Japan, Germany, Italy and France. The U.S., he noted, is in relatively good shape.
Gundlach said those shifts in demographics will accelerate over the next 15 years. Dependency ratios, he noted, are made worse by increasing life expectancies.
“This is a real problem for GDP growth looking forward for a generation in the developed world because it means there are fewer and fewer people as a percentage of society who are working or are of working age,” he said. “GDP growth will almost certainly be lower across the board in the developed world as we look forward for the next generation.”
China, emerging markets and gold
China’s Shanghai index has been weak over the last four years, Gundlach said, and its recent flat performance has been ominous. “It can’t get out of its way,” he said. “It’s put in lower highs and higher lows.”
Gundlach said he expects a “very significant breakout” to occur in this market, but he said he wasn’t sure which direction that would take.
Gundlach did not predict what the magnitude of China’s economic slowdown would be, but he said it was “crystal clear” its GDP would grow less than 7% this year. China’s government may be getting nervous about the weakening of its economy, he said, which is why the renminbi had declined – until very recently – against the dollar.
“Obviously that is supportive of interest rates globally because it means lower economic growth globally,” he said. “Maybe that would be consistent with further angst about the deflationary potential in Europe. So this is some of the things that are floating around to be thinking about the second half of 2014.”
Emerging markets have done better than most people expected this year, Gundlach said. Emerging markets are “right now at a point where maybe were going to finally start put in a new high,” he said. “That would have to be consistent with the break to the upside in the Shanghai market in my opinion.”
He said there was potential for “some significant performance” in emerging markets, which most people thought was impossible.
Gold, Gundlach said, hit the “easy money target” of $1,355 a troy ounce but failed to rise above the high $1,300s. In the second half of the year, he predicted a “higher high” for gold – one that would be above $1,400 but not much higher than $1,500.
“Gold is very unpopular,” he said. “It’s not performing very well, but I think that looking at the charts and looking at the way people are allocating money gold, gold could have another modest performance higher.”
Gundlach spoke about a couple of other asset classes. Municipal bonds are overvalued relative to Treasury bonds, he said, although their performance could remain strong if tax rates continue to increase.
Equities, he said, face a “big divergence” because their performance has been strong while margin debt has decreased. Margin debt and equity prices are strongly correlated, he said. Gundlach also said he agreed with John Hussman’s analysis, which shows “very convincingly” that corporate profitability is “very, very high and will end up mean-reverting.” This, he said, is a “dangerous signal.”
He also reiterated much of what he said about housing in this talk in May.
What will the Fed do?
For the last two years, forecasts have been that short-term rates would increase to 1% around the first quarter of 2016, Gundlach said. He said those forecasts have been very stable.
But that is highly dependent on Federal Reserve policy, which is closely tied to economic growth.
Given the potential for weakness in the economy, Gundlach said there is a reasonable chance the Fed would stop or at least slow down its tapering.
It might even reverse and ease further before the taper reaches zero, he said.
“The Fed is absolutely determined to try to get this thing down to zero,” he said. “Negative 1% GDP didn’t stop them from tapering.” The Fed, he said, is citing bad weather as a reason for slow growth, “like every other economist.”
“It’ll be highly dependent on what comes in the third quarter,” he said.
Read more articles by Robert Huebscher
