“What Will We Be Talking About This Time Next Year” – Here Is Jeff Gundlach's Answer
Over the weekend, Barron’s published its annual roundtable in which prominent investors previewed what they expect out of 2017: “a year of seismic shifts for the markets and, quite possibly, the world. Or, as Goldman Sachs strategist Abby Joseph Cohen said at this year’s Barron’s Roundtable, “We are breaking a lot of trends.” As Barron’s dubbed it, “this could be the year the movie runs backward: Inflation awakens. Bond yields reboot. Stocks stumble. Active management rules. And we haven’t even touched on the coming regime change in Washington, which will usher tax cutters and regulatory reformers back to power after an eight-year absence.”
While there were many insightful observations by the group of participants – whose sentiment was decidedly more bearish than during last year’s event – which included Scott Black, Felix Zulauf, Mario Gabelli, Meryl Witmer, Brian Rogers, Oscar Schafer, and Abby Cohen, we will focus on the predictions of Jeffrey Gundlach, if only due to his track record from the similar Barron’s roundtable one year earlier, in which he turned out to be far more prescient than most of his peers, not least of all because he “made the greatest prediction at last year’s Roundtable—that Trump would win the presidency.”
The first question posed to Gundlach was also the broadest one: what are you predicting now?
People have forgotten the mood regarding stocks and bonds in the middle of 2016. Investors embraced the idea that zero interest rates and negative rates would be with us for a very long time. People said on TV that you should buy stocks for income and bonds for capital gains. This is when 10-year Treasuries were yielding 1.32%. Someone actually said rates would never rise again. When you hear “never” in this business, that usually means what could “never” happen is about to happen. I told our asset-allocation team in early July that this was the worst setup I’d seen in my entire career for U.S. bonds. It occurred to me that the bond-market rally was probably very near an end, and fiscal stimulus would soon become the order of the day.
Based on a comparison in July of nominal Treasuries to Treasury Inflation-Protected Securities, or TIPS, the bond market was predicting an inflation rate of 1.5%, plus or minus, for the next 30 years. Now, that is implausible, and kind of proves the efficient-market hypothesis is wrong. More likely, the inflation rate would increase not in five or 10 years, but one year, because commodity prices had already bottomed. The Federal Reserve Bank of Atlanta’s wage-growth tracker is now up 4%, year over year. Oil prices have doubled since January 2016, to around $52 a barrel, which likely means that headline CPI [the consumer-price index] will be pushing 3% in April.
I expect the history books will say that interest rates bottomed in July 2012, and double-bottomed in July 2016. At some point, the backup in rates will create competition for stocks. Bonds could rally in the short term, but once the yield on the 10-year Treasury tops 3%, which could happen this year, the valuation argument for equities becomes problematic. When the long bond [the 30-year Treasury] was at 2%, bonds had a P/E of 50. Compared with that, a P/E of 20 on stocks didn’t look all that bad. But if the 10-year yield hits 3%, you could be talking about 4% on the 30-year, which implies a P/E of 25.
Something else happened in 2016: The Fed capitulated, as I predicted a year ago. The Fed gave up on its forecast for higher interest rates and lowered its dot projections for 2017, just when it might have been right. [The Fed’s so-called dot plot shows the interest-rate projections of the individual members of its policy-setting committee.] In December, the Fed had to reverse itself and raise rates.
Is an inflationary spike possible?
Fed Chair Janet Yellen suggested a few months ago that running a “hot” economy might not be such a bad idea. But when unemployment is low, wages are rising, and significant fiscal stimulus is likely, inflation could exceed consensus expectations. Jim Grant, the founder of Grant’s Interest Rate Observer, wrote a fantastic article a few years ago likening the current environment to the 1940s and ’50s. Short-term interest rates were at 3/8s in the late 1940s, and long rates were around 2%-2.5%. Inflation was running at 2%. Everyone had been predicting higher inflation rates, but after a long period of 2%, they gave up. Then inflation spiked to 8%. It came out of the blue.
His take on the strong dollar:
A strong dollar keeps inflation lower. It is helpful to the bond market. A weak dollar isn’t helpful to the bond market. However, I brought along a quote from President-elect Trump today because it makes me think. He said, “While there are certain benefits to a strong dollar, it sounds better to have a strong dollar than it actually is.” Is it really a given that Trump will bring us a strong dollar if he is supposed to be helping the forgotten middle class?
His view on market risk at this moment
People are underestimating the risk of loss right now.
On Germany being the big winner currently in Europe:
The German population doesn’t quite understand this. According to ,a poll by Pew Research Center, 38% of Germans disapprove of the EU’s handling of economic issues. In France and Italy, two-thirds-plus of the population are dissatisfied with the EU. In polling terms, that is enormous. Those countries have almost maxed out on dissatisfaction.
What worries, and excites, Gundlach about 2017:
The shift in sentiment to positive from negative, regarding the efficacy of Trump is one of the biggest I’ve seen in my career. I wonder if sentiment can swing just as quickly the other way. Many people who voted for him think something is going to change for them. They expect their wages to rise, and America to be “great again.” What will happen by July or August if nothing has changed? Put that together with the timing of an interest-rate rise, and we potentially could see a very different psychological environment.
Are bonds in a bubble:
People say bonds are in a bubble, that they are over-owned. I agree with that. But anything that is momentum-driven is in a bubble. This passive stuff is in a bubble.
On portfolio construction for the next 12 months, and what may be the “best trade” of the year:
Some things should be avoided in a major way because they have risk without rewards. One of the greatest trades of the year could be shorting German Bunds... Portfolios need to diversify away from deflation-oriented trades, which worked for a long time.
On the trajectory of the stock market over the course of the year.
Zulauf: Stocks could easily rise another 10% into the middle of the year. But after a soft period, bond yields will rise again, with the 10-year Treasury yield hitting 3% or going a little above it. That will trigger a big correction in equities, just when everyone is fully invested after buying into the Trump rally. I expect the S&P 500 to be slightly negative for the full year.
Gundlach: Did I give you my notes? That is almost exactly my view.
Where will the S&P close the year?
Gundlach: GDP growth has been unbelievably stable at 2% for the past six or seven years, despite quantitative easing and other nutty interest-rate policies. At last year’s Roundtable, I said the easiest forecast was that the Fed wouldn’t raise interest rates four times during the year. We are going to break out of the land of stability this year, and certainly by 2018, and there will be an inflation surprise. That isn’t going to be helpful for equity valuations.
I look for the stock market to make new highs in the first part of the year, but when rising interest rates bite, stocks will fall. I see a single-digit decline for the full year.
Finally, Gundlach was asked “what will we be talking about this time next year.” His simple answer: “Trouble in the euro zone.“