by Robert Huebscher, 5/15/19
A collapse in the corporate bond market could rival the sub-prime debacle a decade ago, according to Jeffrey Gundlach.
Corporate bonds are not as overvalued as sub-prime mortgage debt was prior to the financial crisis, according to Gundlach. But because the corporate market is so much larger than the sub-prime was, the overall exposure to investors could be of the same scale. Indeed, “We could easily see $400 billion in losses,” he said.
Gundlach is the founder and chief investment officer of Los Angeles-based DoubleLine Capital. He spoke to investors via a conference call yesterday. Slides from that presentation are available here. The focus of his talk was DoubleLine’s asset-allocation mutual funds, DBLFX and DFLEX.
Gundlach’s fear is rooted in the excessive amount of corporate debt, particularly bonds that are rated BBB, the lowest investment-grade rating, just above high yield.
Corporate bonds have been rich by one standard deviation for most of the last three years, he said, and now are at an “outright sell” level. A massive amount of corporate debt is weighing on the corporate bond market, and a lot of bonds are “complacently owned.”
Gundlach cited a Morgan Stanley report that showed the oversupply and weak ratings standards that could lead to downgrades. Based on corporate leverage ratios, 38% of the corporate bond market should be rated junk, according to Gundlach. That’s actually an improvement over the last time he cited this data, when the corresponding metric was 45%.
“This could mirror what happened to the sub-prime market during the financial crisis, in terms of the mis-rating of bonds,” Gundlach said.
He added that the corporate bond market is five-times the size of the sub-prime market prior to the crisis, although it is neither as mis-rated nor as misunderstood.
The high-yield market is just as expensive as the investment grade market, Gundlach said, and spreads are totally inconsistent with corporate debt levels.
Elsewhere during the webcast, Gundlach warned of excessive fiscal indebtedness, uncertainty surrounding Fed policy, exposure to a weakened dollar and the risk of a recession. Let’s look at those comments.
The global economy
Quantitative tightening has stopped. Gundlach said investors are left with a confusing picture of Fed direction.
The S&P has outperformed the rest of the world by a factor of two since the financial crisis. The reason, he said, is that earnings in the U.S. have grown at an even greater rate than the doubling of the stock market performance. Since last summer, however, the markets have had similar performance.
World stock market performance has been pressured because the European banking system is a “basket case” due to negative interest rates, according to Gundlach. Deutsche Bank’s stock is at its all-time low and Credit Suisse is flirting with its low.
GDP growth is not as great as Trump claims, Gundlach said. Real GDP is in “okay shape” at 3.2% growth. Some of that is due to the deflator that adjusts nominal to real GDP growth being “kind of screwy,” he said, due to a time lag in reporting. Manufacturing PMI has fallen sharply, he said, but not to recession levels.
Fiscal debt worries
Gundlach repeated a theme he has covered in previous webcasts – that excessive fiscal debt will reduce economic growth.
Everyone seems to fail to understand that GDP growth is based almost exclusively on government, corporate and even mortgage debt, he said. “That’s what is really responsible for the growth in nominal GDP.” He showed a chart depicting the gap that “nobody seems to care about” between what the government spends and what it takes in with revenue (taxes). There has been a gap since the early 1970s, except for just prior to the dot-com crash, and the gap has grown since 2018.
“We are juggling and expanding all this debt,” he said.
Total public debt has risen even faster than nominal GDP, at least in the last 13 years. He claimed that nominal GDP growth would have been negative had it not been for deficit spending. Government debt is now 105% of the GDP, so the “growth in the economy is simply the growth in the debt,” Gundlach claimed.
As the debt keeps growing so does the interest expense on it. Interest expense as a percentage of GDP came down a lot since the mid-1980s, Gundlach said. But, according to the Congressional Budget Office (CBO), it is expected to grow from 1.25% to nearly 3% of GDP in the next six or seven years.
“That is a big deal because it decreases growth,” Gundlach said.
The potential for recession
The probability of a recession in the next 24 months is “extremely high,” Gundlach said. Over the next 12 months it is a 50/50 proposition, and over the next six months it is about 30%.
The Citibank “surprise index” is highly correlated to changes in GDP growth, and it is at its lowest reading in the post-crisis era, Gundlach said. It actually leads GDP a little bit, he said, but not in the last 18 months. Economic data has been generally declining, but GDP has been strong over that period.
The yield curve, based on the difference between the five- and 30-year yields, has flattened from the beginning of 2014 until mid-2018. It could be an indication that the 30-year yield could go up in the next recession, due to the “mountains and mountains” of Treasury debt, Gundlach said.
“It’s a very dangerous time for fighting the next recession,” he said, “The markets can’t handle the current Fed fund rate,” in reference to the fact that the two-year Treasury yield is less than the Fed funds rate.
“The market is so addicted to Fed stimulus that it was foolhardy enough to think the Fed would cut rates to stave off a recession,” Gundlach said. The Fed pivoted at the end of last year and became much more dovish. Now the bond market is not predicting any rate hikes for the next five years. The Fed, however, is forecasting a “cosmetic” single hike over the next year, he said.
Long rates may rise if the economy is strong. But the Fed should be worried about higher rates amid massive bond supply, Gundlach said.
Gundlach was very critical of modern monetary theory (MMT), which he said is neither modern, monetary nor a theory. “It is a rationale for fighting recessions with debt,” he said.
MMT can be implemented by pegging rates, as is the case in Europe and Japan, he said. Anything can happen under those circumstances, according to Gundlach. “We might not get market-priced yields as a result of MMT, as was the case during quantitative easing (QE) and QT.”
Pegged rates are hurting European and Japanese investors, who have negative yields if they buy Treasury bonds and hedge their currency exposure, he said. As a result, some of those investors are buying Treasury bonds unhedged, which, he said, “could trigger a massive dollar demand.”
Foreign holders have been net sellers of Treasury debt for the last five years, Gundlach said. Domestic investors have been buyers, absorbing approximately one-eighth of the supply.
The bond market is extremely exposed to a downturn in the dollar. If that happened, foreigners would stop buying and sell some of the Treasury bonds they bought on an unhedged basis. “The Fed won’t move to extraordinary policies unless there is a crisis such as this,” Gundlach said.
“One has to be extremely open minded about the direction of interest rates, given the possibility for market-pegged rates,” Gundlach said.
The volatility risk
We are headed to higher volatility in stocks and bonds, Gundlach said.
At the Ira Sohn conference on May 6, he recommended a straddle on TLT (the iShares ETF that tracks the 20-year Treasury bond) because volatility was “ridiculously low,” he said. But volatility has risen in the last week, and that trade is no longer as attractive.
The VIX is also very low, he said, but not as low as it was in 2017.
Gundlach said his top trade was to go “long volatility,” but acknowledged that idea is a little late. “Volatility is going to continue to go up,” he said, and will not retreat to its 2017 level.
“Buy volatility whenever it is relatively cheap,” he said.
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