2016 Midyear Roundtable

JEFFREY GUNDLACH

Gundlach: The Fed wants to raise rates. It has basically said so repeatedly. It doesn’t want to be at zero when the next downturn comes. Fed policy makers are looking for a level place in the markets, and hopefully some stability in the economy, before they act. They talked about tightening credit when two goals were met: a specific level of unemployment, and a specific level of inflation. First, they kept lowering the unemployment target as each level was approached, although with unemployment now below 5%, it would strain credulity to move the target again. So, that box is checked.

What about inflation?

For many years, the Fed said its preferred inflation indicator was the core index of the personal-consumption expenditures gauge. When that didn’t move up to 2%, they shifted focus to core CPI [the consumer price index]. That is now above 2%, setting another parameter for tightening. The Fed also talked in the past about targeting the five-year inflation rate, but you don’t hear much about that now because it is in freefall. Also, employment data are weakening. After the May jobs report, it would be impossible for the Fed to raise rates in June. And it is too early to tell if they will hike at the July 27 meeting, since they flip-flop so much.

So, the mystery remains.

When the Fed hikes, the markets won’t like it. We are also attuned to the possibility of a recession. We look at two things in that regard. One is the unemployment rate moving above its 12-month average. When it does so, you’re on recession watch. It doesn’t guarantee there will be a recession, and there have been plenty of false signals. But there hasn’t been a recession without that happening. This indicator isn’t flashing a warning yet, but it probably will do so with the September jobs report. The second thing is Donald Trump’s candidacy.

You predicted at the January Roundtable that Trump would become president. Are you sticking with this forecast?

I am. Trump beat out 16 candidates, including establishment candidates, despite all the scary things the establishment has said about him. Once he begins campaigning against Hillary Clinton, the media, which is also an establishment institution of sorts, will put out all sorts of pieces about protectionism, a coming recession, and other things that could happen to the economy under Trump. If you combine weakening employment data with poor corporate earnings, a Fed rate hike, and a barrage of scary headlines about Trump, the stage could be set for a global growth scare. Then, to put the cherry on top, summer is a seasonally weak time of year for the market.

When Trump talks about bringing jobs back from overseas, people hear “tariffs.” But he will do what Ronald Reagan did. He is Ronald Trump.

What are you talking about?

Reagan massively increased the debt-to-GDP ratio. It was stable through the 1950s, ’60s, and ’70s. Reagan started massive deficit spending. It had the appearance of working to stimulate the economy, and it will have the appearance of working again. Trump has done a lot of things with debt. He likes playing around with it. If the economy turns south, he could make a deal, repay bondholders less than they are owed. That doesn’t sound good for a bondholder. But if you borrow a lot of money to build bridges or airports or walls, it stimulates the economy.

There is a big downside to all that debt.

There are several reasons why this approach might be bad for bonds. First, higher GDP tends to be negative for bond yields. Second, there will be a big supply of bonds. And third, the guy says he might haircut you on your payback. I don’t think he means it seriously; he kind of walked it back. In a way, though, it might make sense. If interest rates rose and 30-year Treasury bonds fell to 80 cents on the dollar, perhaps he would launch a fourth round of quantitative easing and buy bonds in the market, which would mean paying holders less than 100 cents on the dollar.

Turning to equities, this has been called the bull market everyone loves to hate. When you look at the charts, it is hard to call it a bull market.

Emerging markets have been down for nine years. They are down sharply from 2007, and from more recent highs in 2015. Japan is about 22% below its high, and Germany is down about 18%. The S&P 500 has been flat for 18 months.

Among individual stocks, Delta Air Lines [DAL] has fallen 20% this year. Toll Brothers [TOL], the home builder, was $42 last August. It is $29 now. While some stocks have risen, there is a lot of rot beneath the surface.

Viewed positively, many stocks are cheap.

I recommend lower-than-normal exposure to equities, but if you are going to take a risk, buy the high-beta stuff [stocks that tend to move more than the market]. If the S&P 500 is going to break out and rally to 2500, that is what will do well.

We talked in January about getting a buying opportunity in stocks during the year. It happened on Feb. 11, when the stock market bottomed. We could get another opportunity later this year. Whether the market turns up again before year end will depend on how it is interpreting the economic reality of a Trump presidency.

I don’t like the idea of adding trillions of dollars to the national debt. But it will help in the near term.

Could Donald Trump end up being a good president?

Sure. Why not? People thought Reagan had a room-temperature IQ. They thought he was a buffoon and a B-movie actor pretending to be someone running for president. Now, all these years later, people want to wrap themselves in the mantle of Reagan in the Republican Party.

What is different now is that Trump isn’t supported by the Republican establishment. The establishment doesn’t like the fact that Trump has made them irrelevant.

What they don’t like is that he has said troubling things.

They don’t like that he treats them with blatant disregard. They don’t seem to get that they are playing checkers and he is playing chess.

Let’s get back to the interest-rate outlook.

The Treasury market has been range-bound for a long time. One reason is because it is pegged to rates in Europe and Japan, which are controlled by central banks. We will continue to see much greater volatility in the credit market than the Treasury market. The volatility has been head-snapping this year. The junk-bond [high-yield] market fell by 25% to 30%, and then rebounded by 12% to 13%. Much of this relates to the oil market.

I predicted that oil’s move from $28 a barrel to $40 would be easy, but the ride from $40 to $50 would be harder. With oil near $50 a barrel, frackers will start fracking wells [extracting oil via hydraulic fracturing] that had been drilled, but not fracked. Inventories are high in the U.S., and supply could remain an issue. The secular argument against oil, oversimplified, is electric cars. We are one innovation away from Elon Musk [founder of Tesla /TSLA] or someone else, but probably Musk, developing a battery that will give drivers a much larger range per electric charge. If that happens, electric cars will gain a huge share of the auto market.

Eighteen percent of high-yield energy bonds are already in default. The percentage could go higher. Volatility will remain elevated in credit. Junk bonds are correlated to equities. If the stock market goes down, there could be a buying opportunity in junk.

What do you recommend in the meantime?

I am recommending a lot of cash. It is dry-powder time in the markets. Treasuries will probably be a buy when stocks drop. I would buy the 10-year if the yield goes into the low-2% area.

I also like gold-mining stocks. The GDX [ VanEck Vectors Gold Miners exchange-traded fund] is up about 80% on the year, but there is more to go. Gold is around $1,220 an ounce. It could rally to $1,400. If it does, you will make a lot of money in gold miners’ shares. The miners are notoriously badly run, but there is room for the stocks to go up.

Thank you, Jeffrey.

FELIX ZULAUF

Barron’s : How does the world look to you, Felix?

Zulauf: Equity markets haven’t done much in the past 12, 18, or even 24 months. In the U.S., the Dow Jones industrials and Standard & Poor’s 500 have moved up and down like a yo-yo, but without much change in price. The MSCI World index is unchanged in U.S. dollars since early 2014. It is almost at the same level as at the 2007 peak. The MSCI Europe index, in dollars, is at the same level as in 1999.

You’re looking backward, not forward. Nonetheless, why have stocks performed so poorly?

Business fundamentals are weak. World markets sold off in January and early February. Then the major central banks made a secret pact at the G-20 meeting in Shanghai that saved the markets. The U.S. said it wouldn’t hike interest rates. The ECB [European Central Bank] and the Bank of Japan agreed not to weaken their currencies further, and the Chinese agreed to keep their currency stable. Once this happened, stocks and commodities rallied.

Who let you in on the secret?

I can’t tell you my secrets, but the agreement seems to have ended. The Federal Reserve is contemplating a rate hike again, and currencies in Asia have started to weaken. The market is wrong in assuming that economic growth in China is reaccelerating, and will help the world economy to reaccelerate. Rather, things are going the other way. The global economy could decelerate in the second half from today’s already low growth rates

Why do you say that?

Credit data are pointing downward. Inventories are high in the U.S., China, and Asia’s major exporters. The next step is to adjust production downward. Also, the automobile cycle, which has been an important driver for the world economy, is peaking. In the U.S., car-loan delinquencies are creeping up.

In Europe, there are political uncertainties about a British exit from the European Union. The vote will occur June 23. Polls in other nations, including Portugal, Italy, France, and Spain, show that 50% of the population would like to leave the euro today. What company wants to make long-term investment commitments in Europe if it can’t be sure of the institutional and regulatory framework?

Do you expect a global recession later this year?

We are moving toward one, but I don’t know when it will hit. Almost all asset prices are high historically, due to extremely low interest rates. All forms of carry are compressed. Also, the business cycle has been distorted by the manipulations of the authorities, central banks in particular. The risk is high and rising that something will go wrong in the world economy.

The biggest imbalances exist in China and the emerging markets, especially Asia. The private sector in the emerging world is more levered than in the developed world. Return on equity in the EM [emerging market] universe is below the level of 2009, and those countries are highly indebted in U.S. dollars. I expect a balance-of-payments crisis to occur in those economies. Large capital outflows, rising interest rates, and depressed asset prices could mean big problems for several financial institutions in Asia, probably requiring government bailouts. I foresee a deep crisis in that part of the world. It could begin by mid-2017, at the latest.

What will the catalyst be?

The Chinese corporate sector is running a financial deficit equal to 20% of China’s gross domestic product, something previously unseen. At some point, China will run out of lending capacity. Also, its bond market can’t grow much bigger. At some point, the bubble will burst.

How should U.S. investors prepare?

I am bearish on equities and constructive on high-quality bonds. Also, I expect gold to rally this year to $1,400. U.S. Treasury bonds are considered the highest-quality paper in the world. Yields on 30-year Treasuries could fall a hundred basis points [one percentage point] in the next 12 months. Global bond indexes have outperformed the MSCI World Equity index on a total-return basis for more than 12 months. They have slightly outperformed stocks since 1987, and with much less volatility.

Have you other investment picks?

In the next year, there will be an investment opportunity in Argentina, where there has been a fundamental political change after 70 years of a combination of socialism, conservatism, nationalism, and corruption. This change could be as important as the Reagan presidency was to the U.S.

Mauricio Macri, Argentina’s new president, is open-minded, with an international view. He has a great team of experts in place in finance and economics, and at the central bank. He lifted export sanctions and currency controls. That’s why the dollar/peso ratio shot up to almost 16 from nine. It pushed inflation rates up, but inflation is expected to decline next year as the impact of the one-time devaluation disappears. Argentina also has settled its problems with foreign creditors, and has come back to the capital markets. In addition, Macri has announced a tax amnesty that will bring in more tax revenue.

What is the best way to invest in Argentina’s progress?

I’m bullish on the Argentine peso. You can buy it against the dollar on a one-year forward basis. The interbank forward rate is 17.31 pesos to the dollar, versus the spot rate of 13.95 pesos. This gives you a carry of 19.4% for 12 months if the spot price stays unchanged.

Argentina has recently issued $16 billion of dollar-denominated bonds with maturities of three, five, 10, and 30 years. I bought the three-year, which carried a coupon of 6.25%. The yield has already fallen to 4.5%. If you are more adventurous, you can buy five-year debt.

In the near term, things aren’t easy in Argentina. The economy is in recession. The inflation rate is 40%. There are demonstrations and strikes. The next nine to 12 months is critical, until people see that inflation is normalizing. But Argentina has little government debt. It couldn’t tap the capital markets for a long time.