Jeffrey Gundlach: We've Crossed to the Hard Side of the Street

You're going to have fallout and losers in the AI race for the holy grail. And that's going to be what leads to the next very significant drawdown in the risk assets. I think we're close enough to there that I want to be out of the epicenter, but I would be surprised if there wasn't some sort of a shock. Maybe it's an inflation shock, maybe a supply shock sometime in the next year.

Yeah, I'm glad it worked out. Thanks for having me.

Was that just 6 months ago?

Wow. 6 months. Time is flying, I'm telling you.

Well, the valuations of the markets are pretty high. In fact, the Shiller CAPE ratio for the S&P 500 is at 42 point something. And any time that it has been 35 or higher, every single time, the forward 10-year return in real terms, so versus inflation adjusted, has been negative. And the most common one has been about -5% real per annum. So if inflation is going to be 2%, if Kevin Warsh is going to guide us to 2% and stay there, that would mean you should expect negative returns on a nominal basis for the next 10 years and there are no exceptions to it.

When you know the numbers have been reported and looking back now it's fairly clear that the numbers that were reported a year ago were not accurate which means that the performance reported for the last few years is not correct. And so it shows that sort of the negative side of things is starting to appear in the news. Kind of reminds me of the Buffalo industry. I grew up in Buffalo, New York.

And there was this steel mill that was moved from Scranton, Pennsylvania, and it was moved to South Buffalo by a guy who was from Scranton. And it got tremendous publicity as being this wonderful thing. It created thousands of jobs and it had a building that was the biggest steel mill in the world. It was over a mile long and everything's great until about 6 years later when the depression of 1907 showed up and nothing had changed at the steel plant except the press went from isn't this wonderful to reports on injuries, deaths, limbs lost, people crushed, burned to death at the steel mill. It's kind of a social mood thing. It went from let's all look at the bright side of things to wait a minute, it isn't all perfect. And that's sort of where we are, but we're doing it at a very high valuation and a valuation that continues to go up even though the competing interest rates in the Treasury bond market have been rising. They've risen a fair amount since we first met 6 months ago.

And yet the stock market is probably a little higher than it was then. And so you're getting more and more stretched valuations. Also what I'm focusing on more recently is looking at the various tiers of credit ratings. So for a few months ago everything was on, it was all tight even the lowest rated triple C's and now you're starting to see erosion in triple C's. For example, the weakest bond market sector, and we're slicing them very thin, is triple C bank loans, which are down several percent in price and down about 5 or 6% in total return, while higher rated bank loans are still doing fine. They're up about 4%. So when you decompose the triple C sector you start to see things like, just take the high yield sector broadly forget just the triple C's. If you look, if you split into two pieces, AI related borrowing in the bond market and everything in the junk bond market and the bank loan market other than the AI sector, you're starting to see the non-AI sector is still strong. Spreads have barely widened on the junk bonds and their prices are near their peak on the bank loans. But when you look at the AI component, they've visibly, noticeably widened. The junk bonds are out about 50 basis points from their tights on the AI and the bank loans are out more like 130 basis points from their tights. And that hasn't bled to the single B category so far. So that's what we're kind of waiting to see. We're starting to see that the market doesn't believe the ratings of some of these companies. It's like when SpaceX borrowed a bunch of money, the bonds widened out to levels about three notches lower in credit quality. Interestingly, they got rated triple B minus, the lowest rating of investment grade. And I have a feeling that that rating was encouraged by some persuasion of the rating agencies because the bond market isn't buying it at all. And the same thing happened with, there was another IPO, Oracle, where it got a junk bond rating but the bonds widened out tremendously right after it was issued. What the bond market is saying is these ratings don't make sense to us. And we've seen that in particular in growing strains in the private credit market where it's become, people are becoming aware that there are seven or eight rating agencies and they are the private credit firms and the insurance companies that they own, they're able to arbitrage these ratings. So you can get a rating from a few companies and pick the highest one for example. Or if you're more cynical about it, and I think at this point given the shenanigans that have been going on, it's worthwhile to be cynical about it. It might be that you just get a price list. You want a triple C rating, it's a dollar. You want a double C rating, it's $5. You want a triple C rating, it's $10. You want a double B rating, it's $1,000. You want a triple B minus, it's a million dollars. And because that way you could able to get better capital treatment and therefore have more leverage at the insurance companies, which is then amplified by what I perceive to be extraordinary leverage at the reinsurance companies, which isn't even funded. So, as these developments start to develop, not just like in paper losses, but in actual losses, I think we're going to start to see the end of all of the enthusiasm for all of these things. And it has a lot to do with AI and it has a lot to do with AI adjacent types of situations. Personally, I recommend, I do a thing now where every quarter I do a webcast called Gundlach Unlocked. I do it because I had so much demand from investors, there are investors in DoubleLine products who say why don't you tell us what funds of DoubleLine to buy and I couldn't do that in conjunction with my typical podcast webcast because you're not allowed to talk about your funds if it's kind of ironic if you're doing a presentation about your fund you can't talk about your fund at least you can't make any kind of forward-looking statements or anything like that. So I just called it Gundlach Unlocked and saying all I'm going to do is put down portfolio recommendations using sectors or DoubleLine funds or ETFs. And sometimes we'll use things that aren't DoubleLine, but it's primarily to give people the answer to that question that was being answered all the time. And so I break the recommendations into four pieces. The first one is equities. And I was at 40% equities for the first two times I did this. And now I'm at 30%. And I was in exposures that were more, I would say typical. But what I'm recommending now is 30% in one thing, equal weighted index. It's a Fortune 500 index and it's equal weighted. It takes the, there's about 400, they call it 500 but I think there's less than 500 companies in it. They just take the ones with the highest revenue. It's not based on earnings. It's revenue and they equal weight it. So you get, if it's 440 that are in this you get one 440th of each one. So you don't have 40% of your portfolio in AI. You have almost nothing. You're being as far away from that as you can. So everything that I'm recommending is completely separate from AI exposure. So that's the equities. In fixed income, I have 30% as well, but I say put half in my total return fund, which is very low risk. There's no corporate bonds in it, let alone AI bonds. There aren't any corporate bonds in it. So, you're getting exposure that's extremely high credit quality and it's got a decent yield on it so it's been around a long time and people are familiar with it. And then for a barbell for the other 15% of the fixed income I go way the other way to basically the riskiest thing which is local currency emerging market debt. So you're buying emerging market debt which yields over 7% if you buy it in a non-dollar. So buying in local currency and since I believe the dollar is heading lower you're going to make money on the currency too. So you make money on the bonds hopefully. And they've done well. It's the best performing fixed income sector. Where you're not parsing it down to single letter ratings, but I'm talking about just a traditional set. So you would compare high yield to bank loans, to treasuries, to corporates. The highest one is local currency emerging market. And I think that that will continue to do well. It was the best performer last year. And I've only allocated to local currency emerging markets once in my career. That's this time when I did a year ago June and by pure, that sometimes you get lucky. This time it was exactly the right timing. So I have that and then I have 20% in real assets which I'm now up to 10% gold again.

Yeah. I had been 25% gold about a year ago, but I paired that back to 5% when it was up over $5,000, but now it's down to 4,300 and so back to 10%. And then the other 10% I'm just using our commodity strategy. It's an ETF, DCCMT. DCCMT for commodity. And it rebalances. It's rules-based. At the end of every month, it rebalances. That's up 38% year-to-date. So that's doing awfully well. And what's left I'm calling dry powder. It's 20% of a portfolio. But I don't just buy cash. I don't like cash. I think you can get a spread above cash. So we have two funds that we're splitting that between, that 10% each to DCRE which is commercial real estate ETF before everybody says it breaks out into hives when he recommends something like that. It's very carefully managed. It's also very high quality top of the capital structure duration of two but it yields basically 6%. So it's a lot better than buying a T-bill. And then the last one is DLEX, my flexible fund, which has an interesting dual mandate that we've actually succeeded at 1, 3, 5, 10, and since inception, we're trying to beat cash and the Bloomberg bond index. And when you have volatile markets, which we've had over the past 14 years, it's no small trick to be able to do that. But it's my favorite fund to manage because you have so many moving parts to it trying to outperform cash and a six-year duration benchmark. But that continues to do well. And so you put that together and you get about a six and a quarter yield and a duration of two, which one that we like to think of the Sherman ratio where you take the yield and divide it by the duration. So if the yield and the duration are the same, you're going to get basically zero. If rates go up 100 basis points in a year, you'll get the income, but it'll be offset by a price loss of the same magnitude on a mark-to-market basis. But if you have a yield of six and a quarter and a duration of two, rates would go up 200 basis points and you'd still be positive.

And so that way you can think if rates go up 200 basis points, I'll outperform cash or in line with cash perhaps, but I'll tremendously outperform the Ag index because that will have a loss of six and a yield going in of five. So it'd be negative 1 and we would be under this scenario, we'd have a return of about four. So you have to think in these terms of how the price and the yield and how the credit pieces fit together. I use the analogy of loading the dishwasher after a big dinner party. You have to make it all fit together. And that's, I enjoy doing that. So that's one of my favorite funds to run. So you'll notice that nothing in this mix has any like AI. There's nothing here. And I was perfectly fine owning some AI by using other types of equity vehicles. But starting last week, I just want out. If you're in there, have fun. I hope you enjoy yourself. I hope it works out well for you. But we're past that point where everything's viewed as beautiful.

They might be going to that. Plus, there seems to be perhaps some ulterior motive of why does a guy go from one company to another and then quit right before that other company left trying to IPO and you know who knows what's really going on here.

Yeah, 2020.

Yeah. I felt like, I think when we last spoke I said you were talking about $4 gasoline was a psychological level and I said you know I think the $40 trillion deficit will be a psychological level.

And we crossed that. Well, it was really interesting because I was monitoring it and I noticed a few months ago where the pace of the growth of the debt was going and I said we'll be over 40 trillion by Halloween. And then I recalculated about a month later and I said it's going to be above 40 trillion by Labor Day. And amazingly the next day they announced it had gone over 40 trillion. And interestingly the day after they announced it went over 40 trillion, the day after Bessent announced Operation Twist, he didn't buy anything. He didn't do it. He says he may have started by now, but he signaled that there was a concept that was being considered of issuing tons of T-bills, which you can manipulate through the Fed. I don't know if the Fed will cooperate, but at least it's possible to do that and buy long-term treasuries. Now he says that it's about improving liquidity for off-the-run treasuries. It doesn't make any sense because the bid-ask spread on an off-the-run treasury is probably about 3/8 of a point worse at most than the bid-ask spread of the on-the-run. So it's like a couple of basis points. What difference does it make if an off-run treasury trades at 5.33 or 5.35? How does that change anything? So, I think there's something else going on there. And I think it might be just, you know, a full-on Operation Twist is what they really want to do to control long-term rates. I've said in the past that rates will naturally go up if they're left to market forces, and that certainly has happened. And at some point, they will reach a level where it's decided that some extraordinary measure has to be taken. And when you're dealing with a deficit that's headed towards 50 trillion, you know, and maybe headed to 10 or 12% of GDP in the next recession, what are you going to do? You're going to inflate the deficit away by printing money or devaluing the deficit therefore or are you going to restructure the Treasury debt by extending maturities and or reducing coupons? Those are really the only two methods that you can do it. Even cutting entitlements isn't going to do it because you've already got all that debt. It would slow it down obviously, which would be a good thing, but it's not really going to change the trajectory. And during recessions, the deficit typically goes up by 4 to 6%. So, we might have a deficit that's 12% of GDP, and we can't finance that. And meanwhile, the hyperscalers and the AI guys, they have an insatiable demand now for borrowing money at today's rates. The spreads went wider and they didn't care. And they won't care. They won't care if the rates go up 200 basis points. They're not thinking about making 7 or 9% IRR if they're successful at these enterprises. They're hoping to get what did SpaceX say that their addressable market is one quarter of global GDP. I mean, how many companies can have one quarter of global GDP as their market? Four. So, you can't, it just doesn't work. You're going to have fallout and losers in the AI race for the holy grail.

And that's going to be what leads to the next very significant drawdown in the risk assets. Are we there yet? Well, I think we're close enough to there that I want to be out of the epicenter of that. I'm not selling everything. I'm not short anything, but I want to be further and further away from the areas that are going to suffer the most. And we've been at this process of moving shorter maturity on the yield curve, moving up in credit, getting out of a lot of things for a couple of years now. And you know so you never can time it precisely but I would be surprised if there wasn't some sort of a shock, maybe it's an inflation shock, maybe a supply shock sometime in the next year. You know these oil prices have gone back above $100.

And now on WTI and Brent's even higher. And the strategic reserve is almost completely depleted. You can't deplete it all the way. Once you get down to a certain level, you have to stop depleting it because the ratio of the oil to the whatever the salt or whatever is in the caves, it gets to the point where it compromises the oil. So, you can't go to zero. So, you have to stop at some point. And I'm told by my energy team that we're pretty close to that point. Meanwhile, it's not just the United States. It's the global oil reserves are at basically the all-time low. And yet, you know, of course, the population is bigger, yet we're at an all-time low. So, they're not going to have much of a cushion on oil. And in California, they have an interesting thing going on. Diesel nationwide is $8 a gallon now. And in California, there's some parts where it's $9.99 and 9/10. Do you know why that's?

They don't have enough digits on the pump.

They don't have enough digits on the pump. And so one person suggested, and I think it would be viable, but I don't know how much work you have to do. You could just sell gas by the half gallon.

Sell diesel by the half gallon. You'd have to change the machine so it spun at a different speed, you know.

But that's up there. And I don't see this energy price shock going away at all.

And it's all starting to filter in other things. I just heard today on my way over here that Costco is rationing its Kirkland motor oil because the price, they had to raise the price a lot and they were either witnessing or fearful of people hoarding it because you know if because the price went up a lot. It like doubled or something and so they doubled it and then rationed it. Well, if you double the price, a lot of people are going to say, I'm going to buy it before you double it again. So, you get that kind of, this is what causes inflation problems when people start buying in advance because they think the price will go further up. And I feel that we're on the precipice of that potentially in the energy market. And of course, this spills over into a lot of other things.

There's just all kinds of stuff that are bypassed, fertilizer and all of these things the prices are going to not go down.

Yeah. And our inflation model with inflation where the oil price was last week, so it's going to be even more severe with the higher oil. We think that the next print that comes out on the CPI will start with a four based upon the oil movement and stay above four unless something changes with the commodity complex stays above four all the way through March. And here's Kevin Warsh talking about we will get to two. And two doesn't mean 2 anything. He says two, not 2.5, two. And how now he announces on the PCE. Now that might not go to four. We don't really have a model for the PCE that's as robust, but the CPI will probably stay above four. And the Fed chair says, well, he has defined success as the Fed requiring 2.00% to be maintained and to stay there for a while. He says we're going to do it. We're not going to fail. So if he doesn't get there, he failed by his own parliament. So the inflation problem seems to be getting back on people's minds simultaneous with, you know it's interesting now it's $8 diesel and even $10 in California and now today I had a meeting somebody quoted the national debt at 41 trillion we're not even talking 40 anymore it's 41 trillion maybe that's just on a round I don't know but it's going to get up there.

So that's a kind of a problem so we want to stay at the shorter end of the curve. We think the long end continues to move higher if it's allowed to move by its own accord. And the lower dollar isn't going to help inflation either.

Yeah.

Well, I'll tell you what, it used to be that nominal GDP was a benchmark for where the 10-year should be. And then we did some work on it and we noticed that, and this is kind of data mining. I mean just admit it up front. Which you said the 7-year average of nominal GDP turned out to be a very interesting trend signal for whether it would go, when the 7-year moving average was going up. Rates would typically go up on the 7-year moving and for good reason. And it means the economy is getting better on a 7-year basis. And that became the benchmark for the 10-year. And then we had the negative interest rate regime particularly in Europe. We didn't go there in the United States, but they had it in Europe. And the US nominal GDP was no longer a good benchmark for the 10-year for that because foreign interest rates were so much lower that it was influencing US interest rates a little bit lower. So what we did is we noticed that if we use the 7-year average of US GDP and use the German 10-year, we were capturing more of the global interest rate aspect. And so in that way the influence on the 10-year of the global economy was a little bit more insightful than just the outlier US economy. And it turns out it's an amazing correlation. If we run it back for a few decades and the correlation of the 7-year moving average of US nominal GDP and the German 10-year, the R-squared is .93. That's very, very high, it's almost the same line and that line is moving up now and it says though interestingly that the US 10-year is presently about 20 basis points too high.

Too high, although you know, that's not that much, but usually they're almost on top of each other. It's uncanny. It's actually up, I use the chart the US nominal GDP 7-year moving average and the German 10-year. So, if people want to go and look at Gundlach Unlocked on the replay, you can just go skip to that slide if you want and it'll blow your mind.

How identical those lines are.

And by the way, that 0.93 correlation, it would be stronger if we didn't use the first three years of like 20 years ago. So for the past 15 years, the correlations, the R-squared rather is higher than 0.93. There's almost nothing that you can find that has that high of an R-squared, but it's a great starting point. I think people should follow it and you don't have to look at it every day because the 70 moving average doesn't change very quickly.