Jeffrey Gundlach: Preparing for the Coming Crisis

Revenue and spending: Two pieces to the debt problem

“The whole concept of revenue and spending is actually central now to investing,” he argues.  “I think the 2012 election will be the most important one in our lifetimes in terms of determining the direction the debt problem is going to take.”  Gundlach said the upcoming election will be a decision between “the taxes are too darn low party” and “the spending is too darn high party.”  If either party gets a mandate, we are “looking at very significant economic decline,” as GDP growth will be slowed by the consequent changes in government spending.

Using federal spending as an example, Gundlach divided the 2012 federal budget into mandatory and discretionary spending, noting that over 60% of the budget is mandatory spending.  “If you want to significantly balance the budget … clearly you go to where the big slices of the pie are.”  The largest expenditures, he explained, “are either in entitlements and unemployment benefits … or else they are in defense.”  Even if the government cut all defense expenses, “you wouldn’t even be halfway to balancing the budget,” he said. Thus, he concluded, it is “absolutely necessary” to cut entitlement spending.

Decreasing entitlement spending, however, poses a major problem for the national psyche, Gundlach said, as do potential tax increases.  He noted that once World War I began, income taxes were instituted and overall taxation increased.  “Income tax was supposed to be temporary,” he said.  “Of course, a temporary tax is almost an oxymoron, and you ended up having taxes increase a lot, particularly in the wake of the Great Depression and World War II.” Looking back to the debt situation in 1940, which helps to understand how the history of this problem, he pointed to a time when federal receipts represented 10% of the country’s federal debt.  This meant that debt was 10 times higher than total receipts, a multiple Gundlach said was too high to be sustainable, and led to tax increases that began at the outset of the war.   As a result, federal tax receipts increased to 20% of GDP.

Beginning in 1980, Gundlach said that there was a societal shift, which has led to many of our country’s current fiscal problems.  “All of a sudden total direct revenue started to drop, not because of policy, but because of economic weakness.”  In order to pump stimulus back into the economy, deficit spending was instituted.  Although only intended as a temporary solution, “somehow, it became embedded as kind of a permanent policy.” The ratio of revenue to the budget went all the way back down to 10%, he said, like it was in 1940.

According to Gundlach, this debt experiment also led to a tremendous polarization of wealth.  With a stable tax policy from 1940 to 1980, the wages earned by the top 0.1% of the population also remained stable at approximately 2%.  Once deficit spending began, however, the top 0.1% of wage earners earned 8% of the national income.  If capital gains are added to other forms of income, the 0.1% of top wage earners accounted for 12% of income. 

Ultimately, “we have 1% of the population getting 25% of the national income, while we have an unemployment rate close to 16-17%.”  That figure includes part-time employees who are seeking full-time jobs.  If long-term discouraged workers are included, who were defined out of existence by the government in the 1990s, Gundlach said the unemployment rate reaches over 20%.  This creates a “tremendous barbell that causes friction in society, and friction in society causes unrest.”

Investment advice for a bear market

“One of my highest themes in investing,” Gundlach said, “is that bull markets are about cooperation; bear markets are about divisiveness.”  For instance, the euro “came into existence as the most heroic experiment in cooperation” at the global peak of high-risk asset valuation.  Within the first year, all countries began violating the constructs of membership; thus, “it is not surprising that the euro is teetering and will fail.” 

While Gundlach was unclear about the future of the euro, he advised against any European investments – from banks to stocks to currencies.  Instead, he is bullish on the dollar.  “At DoubleLine, we are 100% dollar-denominated in our investments. All of our international exposure is dollars.  It’s all in emerging markets.  We have no exposure outside of the U.S. dollar.”

Gundlach advocated owning U.S. government bonds as a hedge against credit.  Despite yields being “painfully low at 2% on a 10-year government bond and an even smaller fraction on a 30-year government bond,” it makes some sense to own these bonds in case of a deflationary outcome, where losses could occur in default-exposed credit.  “One of the main reasons that most bond funds are up only 2-4% this year, with an index fund up 7%, is that they owned credit and they don’t have a hedge against it,” he said.

Furthermore, Gundlach said that gold is a risky investment in the current deflationary environment, as the strength of the dollar should be inversely related to the strength of gold.  While he understands the attractiveness of owning investments outside of the financial system, like gold, he argued that this is only realistic for very wealthy investors, who should keep 50% of assets outside of the financial system. “For simply high net-worth investors, that is difficult.”

Given our deflationary environment, Gundlach said that return on commodities will also be discouraging.  Current commodity returns are being propped up by gold and metals, he cautioned.  “If you took those away, you would have massive declines,” he said.  He was also cautious about “risk assets,” such as equities, using the Shanghai Index as a predictor for the S&P 500.  Unless the Shanghai Index shows significant increases, Gundlach said he would avoid risk assets.

Next, he said that investors should take advantage of low volatility in the bond market. Investment-grade corporate bonds have done very well, he said, while prices on those below investment grade have nearly collapsed since May.  Despite previous volatility, municipal bonds are nearing highs, as they have done very well with the drop in Treasury yields. Gundlach, however, would not invest in maturities shorter than a five-year municipal bond.

Finally, the housing market remains relatively stable, Gundlach said, “grinding along” without significant increases in housing price.  “Rates of home ownership are incredibly high.  It is ridiculous that 70% of households owned their own home in a society where you have 25% in unemployment or underemployment.”  Several years from now, there may be definitive evidence to show that housing prices are increasing, but Gundlach does not think it will happen anytime soon.  With stable housing prices, Gundlach is bullish on the investment of rental properties.

Stepping back, Gundlach said that the upcoming presidential election will play an important role in dictating the future of our current debt problem and subsequent investment implications.  Until then, he remains bullish on the U.S. dollar and bearish on all European investments, taking a conservative approach to other asset classes. 

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