Friday, August 14, 2015

The Bond King's Dire Warning?

Myles Udland of Business Insider reports, Gundlach: If oil goes to $40 a barrel, something is 'very, very wrong with the world':
West Texas Intermediate crude oil is at a six-year low of $43 a barrel.

And back in December, "bond king" Jeff Gundlach had a serious warning for the world if oil prices got to $40 a barrel.

"I hope it does not go to $40," Gundlach said in a presentation, "because then something is very, very wrong with the world, not just the economy. The geopolitical consequences could be — to put it bluntly — terrifying."

Writing in The Telegraph last week, Ambrose Evans-Pritchard noted that with Brent crude oil prices — the international benchmark — below $50 a barrel, only Norway's government was bringing in enough revenue to balance its budget this year.

And all this as the Federal Reserve makes noise about raising interest rates, having some in the market asking whether these external factors — what the Fed would call "exogenous" factors — will stop the Fed from changing its interest-rate policy for the first time in over almost seven years.

On December 9, WTI was trading near $65 a barrel and Gundlach said oil looked as if it was going lower, quipping that oil would find a bottom when it starts going up.

WTI eventually bottomed at $43 in mid-March and spend most all of the spring and early summer trading near $60.

On Tuesday, WTI hit a fresh six-year low, plunging more than 4% and trading below $43 a barrel.

In the past month, crude and the entire commodity complex have rolled over again as the market battles oversupply and a Chinese economy that slowing.

And all this as the Federal Reserve makes noise about raising interest rates, having some in the market asking whether these external factors — what the Fed would call "exogenous" factors — will stop the Fed from changing its interest-rate policy for the first time in over almost seven years.

In an afternoon email, Russ Certo, a rate strategist at Brean Capital, highlighted Gundlach's comments and said the linkages between the run-up, and now collapse, in commodity prices since the financial crisis have made, quite simply, for an extremely complex market environment right now.

"There is a global deleveraging occurring in front of our eyes," Certo wrote. "And, I suppose, the smart folks will determine the exact causes and translate what that means for FUTURE investment thesis. Today it may not matter other than accurately anticipating a myriad of global price movements in relation to each other."
Oil prices (OIL) keep plunging and while new reports from the IEA, OPEC, and EIA point to a rebalancing between supply and demand, I prefer to listen to Pierre Andurand of Andurand Capital who has weathered the rout in commodities when his peers are being obliterated and doesn't see a substantial recovery in oil prices until 2017.

So, who is Jeff Gundlach and why should you listen to him? As mentioned in the article above, he's the undisputed bond king, displacing the great Bill Gross whose Janus bond fund is seeing more outflows lately despite posting decent returns. Gundlach's DoubleLine Total Return fund, which marked its five-year anniversary in April, has delivered a total return of 1.94 percent year-to-date as of July 31, surpassing 98 percent of its peers in the Morningstar intermediate-term bond category.

When it comes to bonds and the global economy, I always pay attention to managers like Jeff Gundlach and Bill Gross (I ignore their stock market calls). The latter is now publicly stating that a weakening Chinese yuan will bring slower inflation worldwide, exporting deflation everywhere, and making Treasurys a winner.

It sounds like Mr. Gross is right on board with my comments on the Fed's deflation problem and what China's big bang means for bonds (TLT) as deflation creeps into the global economy.

Importantly, the risks of global deflation are rising, not falling, and this is where the Fed has to start acknowledging this time is different and raising rates will be a monumental mistake because it will exacerbate global deflationary headwinds and risk importing deflation to America.

Bond traders are now pricing in a 50 percent chance that the Fed raises rates at its September meeting. Former Dallas Fed President, Richard Fisher, appeared on CNBC Friday morning stating a rate hike is much ado about nothing.

My friend, Brian Romanchuk of the Bond Economics blog thinks the first Fed rate hike is not the issue, but the followup is. Interestingly, he concludes his excellent analysis by stating: should not be surprising that the 10-year yield will shoot up to at least 2.5% if and when the Fed hikes rates. This will provoke considerable excitement in the business press, and "I told you so!" comments by bond perma-bears. But once that initial surge has passed, the market would revert to rather boring range-trading around a slowly rising trend. In particular, analysts who use fair value models based on a regression of 10-year yields versus the Fed Funds rate (with a regression beta around 1), may be shocked by the lack of movement in the long end relative to the policy rate.

Bonds might underperform cash (or equivalently, short duration strategies outperform), but it will be a game of inches, not a fixed income apocalypse.
I agree with Brian, there won't be a fixed income apocalypse and hedge fund gurus claiming bonds are the bigger short are out to lunch.

In fact, despite record low yields, I don't find the 'scary' bond market to be that scary after all. Why? I touched upon five structural factors which I think are very deflationary and bond friendly in my comment on China's big bang:
  • The global jobs crisis: Jobs are vanishing all around the world at an alarming rate. Worse still, full employment jobs with good wages and benefits are being replaced with partial employment jobs with low wages and no benefits.
  • Demographics: The aging of the population isn't pro-growth. As people get older, they live on a fixed income, consume less, and are generally more careful with their meager savings. The fact that the unemployment rate is soaring for younger workers just adds more fuel to the fire. Without a decent job, young people cannot afford to get married, buy a house and have children.
  • The global pension crisis: A common theme of this blog is how pension poverty is wreaking havoc on our economy. It's not just the demographic shift, as people retire with little or no savings, they consume less, governments collect less sales taxes and they pay out more in social welfare costs. This is why I'm such a stickler for enhanced CPP and Social Security, a universal pension which covers everyone (provided governments get the governance and risk-sharing right).
  • Rising inequality: The ultra wealthy keep getting richer and the poor keep getting poorer. Who cares? This is how it's always been and how it will always be. Unfortunately, as Warren Buffett and other enlightened billionaires have noted, the marginal utility of an extra billion to them isn't as useful as it can be to millions of others struggling under crushing poverty. Moreover, while Buffett and Gates talk up "The Giving Pledge", the truth is philanthropy won't make a dent in the trend of rising inequality which is extremely deflationary because it concentrates wealth in the hands of a few and does nothing to stimulate widespread consumption (I know, we can argue that last point but for the most part, you know I'm right).  
  • High and unsustainable debt in the developed world: Government and household debt levels are high and unsustainable in many developed nations. This too constrains government and personal spending and is very deflationary.
Keep these five structural factors in mind as you keep reading my blog to understand the "bigger picture" and why I think we're on a collision course with a major bout of global deflation and why bonds will likely continue to do well, defying Wall Street economists (and a few well-known pension fund managers) once again.

Having said this, there will be backups in yields even if the secular low in Treasuries is still to come. The reflationistas might be right, global growth might come in stronger than expected in the months ahead, giving the Fed wiggle room to raise rates and that is why some rightly note the time to sell the mighty U.S. dollar is now, before the Fed rate hike.

How can global growth surprise to the upside? The drop in crude prices is a pain for emerging markets (EEM) but it's a boon for Europe. Also, the decline in the euro will help boost eurozone exports, temporarily boosting growth there. Moreover, China's big bang will reinforce the ongoing Euro deflation crisis, placing more pressure on the ECB to ramp up its quantitative easing (QE) operations. This too will stimulate growth in Europe for a little longer before the next crisis hits them.

As far as stocks, my thinking hasn't changed much since writing my Outlook 2015. I continue to buy the big dips in biotech (IBB and XBI) and tech (QQQ) and steer clear of energy (XLE), mining and metals (XME) including gold (GLD) and pretty much anything related to commodities (GSC), emerging markets (EEM) and China (FXI). You can trade these sectors but be nimble and TAKE profits.

As far as dividend plays like utilities (XLU), REITs (IYR) and other dividend plays (DVY), I would be careful there too. They have all bounced back strongly since China announced its devaluation, mostly because this heightened deflation fears and makes a September rate hike less certain, but dividend plays are very vulnerable to an increase in rates.

Below, an April, 2015 interview on Wall Street Week featuring bond king Jeffrey Gundlach of DoubleLine Capital, Liz Ann Sonders of Charles Schwab and Jonathan Beinner of Goldman Sachs Asset Management. Listen closely to Gundlach's dire prediction on the high yield bond market (HYG) for 2018. The doomsayers on Zero Hedge are sounding the alarm way too early (also read this comment on why high yield is not sounding the alarm on equities yet).

[Update: Gundlach recently warned that it might be premature for the U.S. Federal Reserve to raise interest rates next month, given junk-bond prices are hovering near four-year lows.]

Second, technical analyst Walter Zimmermann explains why the commodity cycle suggests the space will not find a bottom until October 2016. He might be right but pay attention to the U.S. dollar because if it starts depreciating before the Fed rate hike, commodity prices and emerging markets will get a temporary boost.

Third, former Dallas Federal Reserve President Richard Fisher, says we have a strong dollar, in discussing China's impact on U.S. monetary policy. Eli Lilly Chairman, President and CEO John Lechleiter, is the guest host.

Lastly, Raoul Pal, Global Macro Investor, discusses what investors should be concerned with in regard to the latest global markets. Excellent discussion, listen to the points he is raising and why he thinks the U.S. economy is heading for a recession.

Hope you enjoyed reading this comment. As always, please remember to click on my ads and more importantly to donate or subscribe to this blog via PayPal at the top right-hand side. Have a great weekend! 

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