Monday, January 5, 2015

Outlook 2015: A Rough and Tumble Year?

Jonathan R. Laing of Barron's reports, Jeffrey Gundlach’s Surprising Forecast:
It has been a magnificent year for both the stock and bond markets, even with the slight wobble in equity-market results in the last two trading sessions of 2014. But with the drop of the ball on the Year of the Horse, it’s time to look ahead to 2015.

And we could think of no one better to talk to than the widely acclaimed King of Bonds, Jeffrey Gundlach, who presides over the $64 billion asset-management complex DoubleLine. He is never shy in offering his opinion on all manner of securities in the U.S. and around the world.

During an interview on the second-to-last trading day of 2014, we found him in a relaxed, expansive mood. And why not? His funds had a banner year, with his flagship DoubleLine Total Return Bond fund (ticker: DBLTX), with $40 billion in assets, and DoubleLine Core Fixed Income fund (DBLFX), with $3.4 billion, finishing in the top decile of their Morningstar groups. Likewise, the DoubleLine Emerging Markets Fixed Income fund (DBLEX) ended in the 96th percentile of its Morningstar class. Meantime, some $4 billion in the DoubleLine go-anywhere hedge fund complex scored a better than 20% annual return, say investors.

It was a much happier new year for DoubleLine and Gundlach than it was for giant rival, Pacific Investment Management Co., and its now-departed chief Bill Gross. Outflows from Pimco’s flagship Total Return fund (PTTRX) rose to $19.4 billion in December. In the midst of Gross’ messy departure from the firm, he met for three hours with Gundlach about the possibility of teaming up. Gross landed at Janus Capital, but Gundlach evinces much respect for his sterling record over more than 40 years of running bond money. “He navigated Total Return magnificently during the 2008 credit crisis, for example,” Gundlach opines.

Per usual, Gundlach has an idiosyncratic view of where markets are headed in 2015. Like virtually everyone, he expects the Federal Reserve to begin raising the federal-funds rate this year, but he predicts that the impact will be the opposite of the conventional wisdom. To wit, longer-term bond yields will, in fact, decline rather than rise as a result of a surprising flattening of the yield curve, he argues.

Where the median economic forecast tabulated by Bloomberg for the 10-year U.S. Treasury Bond yield for year-end 2015 currently stands at 3.24%, Gundlach thinks the 10-year that finished 2014 at 2.17% could potentially take out its modern-era low of 1.38% yield hit in 2012. This would particularly be the case if crude-oil prices keep falling to, say, $40 a barrel from their 2014 year-end level of about $55. This further drop from the 46% decline suffered by crude in 2014 would only accentuate deflationary forces he sees at work globally that continue to drop long-bond yields.

Gundlach says he’s constantly asked “how low oil prices can go,” and he responds that no one will know until they stop falling. “That answer isn’t meant to be cute,” he says. “When you have a market that showed extraordinary stability for five years -- trading consistently at $90 [a barrel] or above -- undergo a catastrophic crash like this one, prices usually go down a lot harder and stay down a lot longer than people think is possible.”

Likewise weighing on U.S. bond yields will be brisk foreign buying from investors in Japan and Europe, where long-term sovereign debt bond yields are mostly lower than U.S. rates and economic growth prospects are less bright. “Everybody worried about what would happen to the U.S. government [bond] market when the Fed ended [its third round of quantitative easing] last fall and stopped its heavy monthly government bond purchases,” he points out. “The answer, of course, is that foreign buying easily replaced declining government support of the market. And the strengthening dollar, which we think will continue, only makes U.S. bonds all the more attractive, for not only do foreign investors benefit from higher relative rates, but they also win on currency translation profits.”

GUNDLACH ISN’T PARTICULARLY sanguine about the prospects for U.S. stock markets. Early in the year, rebalancing of diversified institutional portfolios from stocks to bonds will create some price undertow for equities, he claims. Also, he worries that gross-domestic-product growth for next year and 2016 is unlikely to hit the 3%-plus annual targets that forecasters are assuming. That’s because the deflationary tide unleashed by a slowing world economy and excess capacity will begin to lap against U.S. shores by the middle of 2015. A strengthening dollar won’t help U.S. competitiveness.

Low oil prices will begin to wreak real havoc on employment, capital spending, loan collateral values, energy-company balance sheets, and the junk-bond market. “The boost to U.S. consumers from lower pump prices is the first shoe to drop, but the negative secondary effects from the crude-oil price collapse take longer to surface,” he says.

There’s plenty wrong globally that will eventually weigh on the stock market. He mentions the obvious. Emerging-market economies are sharply slowing. China, despite its current stock market boomlet, rests on shaky financial and economic foundations. Greece threatens to come apart again. Russia is a basket case. Sinking oil prices threaten to amp up geopolitical risks that Russia or Iran might do something dangerous out of economic desperation. Currency wars impend, led by Japan’s systematic yen-devaluation campaign.

But such factors constitute the wall of worry that bull markets typically climb. Bad news or weakening fundamentals can, as often as not, have scant impact on the course of the stock market.

For Gundlach, a mathematics whiz, some of the charts and technical indicators he religiously follows are what give him pause about stocks and the global economy. He sent us over 70 charts from a recent presentation to make various points about what is going on in the belly of the beast.

One shows U.S. CRB Index Futures -- weighted commodity prices going back five years. To the untrained eye, there’s not much to see beyond a vertiginous peak made between late 2009 and late 2010 with a series of smaller peaks saw-toothing down to present levels. But Gundlach draws another conclusion: “Look, commodity prices have fallen back to their lows of 2009, which of course was at the height of the financial crisis. Something is obviously very wrong these days in the global economy.”

Another chart, delineating the movement in yields of two-year government securities of various key euro-zone nations over the past 14 months, looks like a tangle of spaghetti. But Gundlach points to an interesting divergence that has shown up since September, when the rate on German debt sharply diverged from two-year rates on Italian and Spanish debt. The German yield turned negative, while the two Club Med countries’ yields headed the other way. This told Gundlach that trouble lies ahead for the euro zone beyond the headlines of European political unrest. “Folks in Europe are obviously losing confidence and scared if they are willing to pay Germany for the privilege of parking their funds there,” he says.

DURING OUR INTERVIEW, Gundlach reflected on his meeting with Gross, which has attracted much press coverage, largely based on Gundlach’s recollections. Some of the reports focused on Gross’ graciously passing his King of Bonds title to the latter, depicting himself as Kobe Bryant to Gundlach’s LeBron James. But as Gundlach recalls the exchange, it was something of a back-handed compliment. For Gross added that he now had five championship rings and Gundlach only two, though he might win three more some day. On to the new year.
There is a good reason why this interview has been discussed extensively in the financial press. Jeffrey Gundlach is the undisputed bond king and he has been calling rates right over the last few years when too many people underestimated the deflationary headwinds impacting the global economy.

Gundlach thinks this time it's different and investors who are ill-prepared for what lies ahead will get crushed. When discussing my outlook for markets, I always begin with interest rates and that's why I discussed Gundlach's views. More than anyone he understands the macro themes driving bond yields lower and bond prices higher (TLT).

In particular, I think he's right, the "catastrophic crash" in oil will mean that oil prices will likely stay low for a while. But not everyone is convinced that oil prices will stay low for a long time. Last week, Pierre Andurand of Andurand Capital, shared his outlook on oil with my readers, stating the following:
I think Brent will trade down to $50/bl in q1 2015 and WTI down to $45/bl. After that we should be in a $50-$60 range for 6 months or so, and then go back up in 2016 to $70-80.

The oil markets were very stable between early 2011 and mid 2014 because the growth in US shale oil production was exactly offset by an equal amount of supply disruptions. This gave a false sense of security and balance to the market but it was actually just a coincidence.
Since summer 2014, we have had less supply disruptions (some oil come back from Libya and Iran, and even Iraq), while US supply growth stayed unabated, and demand growth ended up being much weaker than the market expected (700kbd vs 1.4mbd expected earlier in the year). All that moved the global S&D by 2mbd for 2h14 and 2015. The oil market suddenly got 2mbd oversupplied for 2015, and likely to start 2015 with high inventories.
That led to prices going down to rebalance the market as there is not enough storage capacity for inventories to rise 2mbd for more than 4-6 months. In the past, every time the market would get oversupplied Saudis/OPEC would reduce production to support prices, which brought a rising floor on prices (except late 2008/early 2009 because of the severity of the financial crisis). This time the Saudis decided for the first time since 1986 to defend its market share instead of prices with a view that the swing producers should now be the high-costs producers (Pre-Salt Brazil, Canada tar sands, US Shale oil etc).
Indeed in 2008, OPEC thought they would be producing 38mbd in 2014, and in reality because of lower demand growth than expected, and higher supply growth from non OPEC, OPEC ended up producing only 30mbd in 2014. The Saudis understood that it was a lost battle to support prices every time, as it would only encourage sub-trend demand growth, and high non OPEC supply growth at the expense of their own market share. Saudis/OPEC retreating from being the swing producer means much lower prices first in an oversupplied market, and then more volatile prices. We will see very large price ranges for oil prices, which will have an effect on many other financial assets too.

Much lower prices will slow down non OPEC production growth dramatically over time (but it will take some time and will be path dependant), and will lead to bankruptcies in the less efficient producers, and the most levered ones, it will bring a lot of M&A activity in the sector, and will put a lot of pressure on countries that are major oil exporters. I believe it will be a very eventful roller coaster.

It is interesting to note that speculative length hasn’t gone down since August but has actually gone up (in number of contracts), which means that the move down came mainly from more producer hedging, and more inventory hedging. When inventories go up, this lead to more selling of futures to lock in the contango. Specs don’t need to sell or sell more for prices to go down. I think if anything too many people are trying to play the eventual rebound way too early.
I then followed up with some questions of my own which Pierre answered. You can read that comment to gain more insights on his outlook.

Apart from oil, which keeps crashing as prices are now below the $50 mark, there are other reasons to worry about the global recovery and this too is weighing down U.S. bond yields. Gunlach mentions Greece where we are preparing for another election in late January where in all likelihood the anti-austerity Syriza party led by Alexis Tsipras will win and maybe form a minority government.

Germany is playing hardball with Greece, insisting on austerity and threatening “Grexit” if it doesn't adhere to Troika's demands. But the reality is Germany and the eurozone can't afford the repercussions of "Grexit" and those who think otherwise are wrong. The best case scenario is that Syriza will form a very fragile minority government and will find it next to impossible to demand anything from Germany.

The bigger issue for the eurozone remains deflation. The Telegraph reports that German inflation hit a five-year low in December and now flirting with deflation. This opens the door for more quantitative easing (QE) from the ECB but as Sober Look rightly notes, 2015 will test the ECB's resolve and independence.

More monetary and fiscal dithering in Europe will continue weighing on the euro which has fallen to a nine-year low amid Greek woes. This means one of the most important trends of 2014, the surge in the mighty greenback, will continue weighing down commodity prices and could figure prominently into the Fed's decision to raise rates.

This is where I don't agree with Gundlach and others who think that a hike in interest rates is a foregone conclusion in 2015. The December Fed meeting was confusing, mostly owing to the twisted language of the statement, but the key takeaway for me is the Fed isn't in a  hurry to raise rates and will increasingly be looking at developments outside the U.S. to base its decision.

Importantly, if there is a crisis in the eurozone or emerging markets, there is no way the Fed will increase rates. Even if there's no crisis, as long as the eurozone, Japan and China keep slipping further into deflation, the Fed will be hard pressed to go ahead and raise rates, ignoring global deflation or worse still, adding to it.

The other disagreement I have with Gundlach is on stocks. As I've stated previously, the plunge in oil will not crash markets and stocks will decouple from oil in 2015. There will be plenty of volatility and violent corrections, but investors should prepare for a delationary boom ahead.

In this environment, investors should overweight small caps (IWM), technology (QQQ or XLK) and biotech shares (IBB or XBI) and keep steering clear of energy (XLE), Metals and Mining (XME), Materials (XLB) and commodities (GSG). And even though deflationary headwinds will pick up in 2015, I'm less bullish on utilities (XLU) and healthcare (XLV) because valuations are getting out of whack after a huge run-up last year.

One of my favorite sectors remains small cap biotechs which are going to outperform once again in 2015. The ALPS Medical Breakthroughs ETF (SBIO) debuted on the market last Wednesday, but my eyes are glued on many small biotech shares, including the ones below courtesy of the Baker Brothers, Fidelity and others (click on image to enlarge - updated 08-01-15):

But I warn you, small cap biotechs are extremely volatile and very risky, especially if all you do is chase momentum names (you'll get destroyed!). Last year, I had to stomach insane volatility but I kept my cool, carefully adding to my biotech positions during the big unwind, and had a spectacular year listening to my inner voice and knowing when to go for the kill (ie. when to buy those huge biotech dips!).

And if my prediction of another melt-up in the stock market pans out, it will be led by tech and biotech shares which were on fire in 2014. This is where I see most of the action in 2015 as a nascent biotech bubble forms.

Again, one thing we can all agree on is that 2015 will likely be a lot more volatile than 2014.  Geopolitical tensions, Greece, Russia, China,  Japan, the Fed, the ECB, etc. will all create a lot more uncertainty in 2015, which tells me hedge fund robots will keep crushing their human rivals.

It's going to be another tough year to make money but there will be plenty of opportunities in stocks, bonds, currencies and even commodities as long as you trade well in this environment and choose your spots carefully. Don't get cute, pick your spots wisely and don't forget to take money off the table.

Below, oil has fallen below $50 for the first time since April of 2009, reports CNBC's Jackie DeAngelis. Leo de Bever and I predicted all this last December when I told you all it's time to short Canada (keep shorting the loonie, Canadian stocks and real estate).

And who got the economy and markets right in 2014? Consuelo Mack introduces the economist, strategist and portfolio managers who hit home runs on WealthTrack in 2014. You can download Cornerstone Macro's 12 favorite U.S. charts here.

Third, everybody knows that leaving the euro isn't a "real option" for Greece, says Andreas Koutras, director at InTouch Capital Markets Ltd. He talks from Athens with Guy Johnson and Francine Lacqua on Bloomberg Television's "The Pulse."

Finally, insights to the debt problem the U.S. faces, with CNBC's Rick Santelli, and Lacy Hunt, Hoisington Investment Management. Listen carefully to Dr. Hunt and make sure you read Hoisington's latest economic review, one of the best free comments in the investment industry.

On that note, I will be providing you with more insights on pensions and markets but remind many of you that your financial support is greatly appreciated. Please join others and take the time to donate or subscribe using the PayPal buttons on the top right-hand side. Thank you and Happy New Year!

Update: Make sure you read my another follow-up comment, Is OMERS worried about deflation? and Prepare for Global Deflation?.

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