Gundlach: I m Not Really Bullish on Bonds

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1 Gundlach: I m Not Really Bullish on Bonds September 13, 2017 by Robert Huebscher Jeffrey Gundlach, one of the most respected bond managers in the world with over $100B in fixed-income assets under management, fears that interest rates are going up. Gundlach is the founder and chief investment officer of Los Angelesbased DoubleLine Capital. He spoke to investors via a conference call on September 12. The focus of his talk was DoubleLine s flagship Total Return Bond Fund, DBLTX. The slides from his presentation can be found here. I m not really bullish on bonds, Gundlach said. His team uses a scale from -2 to +2 to rate their bullishness on asset classes. Gundlach said he was at a -1 for the 10-year bond, adding that he was closer to -2 than to zero. While discussing whether the yield on the benchmark 10-year Treasury would end the year at or below 1.5%, he said I m not in the 1.5% 10-year camp. Gundlach predicted that it won t go below 2%. It closed at 2.17% on the day he spoke. This is not a new position for Gundlach. On June 13, when the 10-year closed at 2.21%, he held a webcast during which he said that rates were going up. Treasury rates are being held down by a relative value argument, according to Gundlach. He explained that German 10-year sovereign debt is priced at 39 basis points, and he suggested that investors prefer the relative safety and higher yield of U.S. Treasury bonds. The rate is too low on the 10-year, Gundlach said. There will be more bias to go up. Shifting to discuss DoubleLine funds, Gundlach devoted a portion of the webcast to deride a Wall Street Journal article that he said claimed the performance of DBLTX had deteriorated in the last year. He showed that his fund had outperformed its benchmark (the Bloomberg Barclay s Aggregate Index) and a mortgage index (the Bloomberg Barclay s MBS Index) over the last year and the last five years. Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 He showed this by looking at five metrics total return, volatility, Sharpe ratio, downside risk and Sortino ratio. Indeed, he showed that its performance had been better in the last year than over the last five years, based on those five metrics. Gundlach did not dispute the claim in the article that his assets under management declined in the last year. But he showed that its percentage decline was less than that of similar funds from PIMCO, JP Morgan and TCW. The wacko world of the press has it that somehow the fund is struggling, Gundlach said. That is a crazy mischaracterization. I ll look at what Gundlach said about global markets, the Fed and other asset classes. The great policy divergence Everyone is losing their minds in the dog days of the summer, Gundlach said in regard to the divergence of policies pursued in the U.S. and in Europe. While the U.S. is raising rates and tightening its monetary policy, the European central bank (ECB) is pursing quantitative easing (QE) and keeping rates low. But Gundlach said that Europe is the healthier economy based on GDP growth, inflation, retail spending and other metrics. What explains the policy divergence? Gundlach said that Mario Draghi is worried about the fate of the E.U. and its periphery and wants to keep the experiment alive. But he will need to change his rhetoric and will have to end QE, Gundlach said, referencing Draghi s statement that its QE will be done by the end of Gundlach noted that we are already seeing this change. According to Gundlach, Draghi is no longer saying the E.U. is having a hard time and is now saying it is making progress. Gundlach also said that the German interest rate is currently being pegged (maintained at a specific yield by ECB monetary policies) and that it will need to rise. The German yield will move to 1% pretty quickly, Gundlach predicted. That would be a catalyst for U.S. rates rising as well, he said. The U.S. and German 10-year yields move together. Gundlach called it crazy that European junk bonds have the same yield as a U.S. Treasury basket (the Merrill Lynch U.S. Treasury Index). He said that spread is typically 700 basis points or more. Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 Recession watch The big question in the U.S. is whether we are heading for a recession, Gundlach said. The bond market won t be treated well by the next recession, he cautioned. But he said the economic leading indicators are positive and not looking recessionary. According to Gundlach, there has never been a recession without the leading indicators first going into negative territory. He added that the ISM indicators were looking quite robust. Junk-Treasury spreads usually widen approximately 100 to 125 trading days ahead of a recession, he said. Those spreads widened a tiny bit in the last month, but are nowhere close to a warning signal according to Gundlach. It s too early to see a recession coming from the junk-bond spreads. One pessimistic signal is in commercial lending data, which Gundlach said doesn t look good. He explained that loan growth has dropped to a point where the Fed has historically eased, but now it is still tightening. Commodities are stirring from a low level, Gundlach said. He predicted that they will go up further after a rise in the 10-year rate in the next year. This could be a precursor to a recession, he said. Since the 1970s, rising commodity prices have often been the cause of recessions, according to Gundlach. Monetary policy and the chart of day According to the WARP function, which shows the implied probability of Fed actions based on the futures market, there is a 35% chance of a rate hike in December and only a 25% chance of a rate hike in He said the Fed has been quiet because the core CPI has been disappointing it is below 2% and keeps going lower. Headline CPI may go up from 1.6% to 2%, Gundlach said, but the Fed needs core CPI to go to 2% for a December rate hike. Core CPI is 1.7% now. When Treasury bonds mature, Gundlach said the Fed will redeem those bonds at least when less than $30 billion needs to be redeemed. When it is more than $30 billion, the Fed will redeem some of the bonds. It is doing something similar with mortgages, he said. QE has been highly correlated with risk assets (specifically the S&P 500) levitating, Gundlach said. That has been true since 2009 and on a global basis, he said. The actions by other central banks have lifted the prices of non-u.s. equity markets. Gundlach said that when earnings are revised down, equity prices fall and vice versa. Except that wasn t true when QE was going on. Now that central banks are tapering globally ( quantitative tightening ), it is a bad sign for equities, according to Gundlach. Maybe we will start getting into trouble in mid-2018, as QE goes away and the German 10-year yield Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 goes up, Gundlach said. Gundlach said he is not a big fan of U.S. stocks, but is very positive on emerging-market stocks for dollar-based investors with a long-term horizon. He said that emerging-market stocks have been helped by dollar weakness this year, but he cautioned that the dollar may still go lower, so he doesn t necessarily recommend emerging markets over the short-term. Gundlach called the graph below the chart of the day : The chart shows the ratio of equity (S&P 500) to commodity prices since With the ratio at the extreme bottom, Gundlach said, the valuation of commodities, versus equities, is incredibly cheap. Alternatively, one could also infer that equities are incredibly expensive. Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

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