January 10, 2012
Watch out if you own a bond fund that underperformed its benchmark by 2% or more last year, as most did. Rather than put their careers at risk by suffering a second year of poor performance, those fund managers will turn to indexation, according to DoubleLine’s Jeffrey Gundlach. And since the Barclay’s Aggregate Index holds nearly 35% of its assets in Treasury bonds with near-zero yields, its investors will endure poor returns.
It’s “game over” for fund managers who take the same risks they took in 2011 and repeat their underperformance in 2012, he said. Investors need to understand that “there are other motives than just return maximization when you are running a huge bond-market business.”
“Firms will start couching what they are doing in strange terms that are code words for indexation,” Gundlach said. “They will say things like ‘more disciplined active risk-taking,’ ‘tighter parameters around deviation,’ or ‘more awareness of tracking error.’ All that means is a move towards indexation.”
Gundlach made those comments during a conference call with investors last week. He also criticized Morningstar’s selection of its bond fund of the year. We’ll see why, but let’s look first at the primary purpose of the call – which was Gundlach’s forecast for 2012 performance across the capital markets.
The slides from Gundlach’s presentation are available here.
Avoid all other currencies
Gundlach’s overarching theme was that investors should be purely dollar-denominated and avoid all currency risk. He warned that a number of risks, particularly in Europe, are not fully priced into the market.
According to Gundlach, a key issue in Europe is whether Italy will be able to successfully roll over its debt, as it faces many large maturities in the months ahead. A total of 300 billion euros of Italian debt matures in 2012 and another half that amount in 2013.
“There is a lot of financing pressure in Europe, and it's very likely to make the crisis accelerate and heat up further, if it is not hot enough already,” he said.
“I do not believe for second that you can say that the European bond markets are fully discounting the potential for, say, an Italian default, which is clearly nonzero,” he said. “I don't say that the debt crisis in Europe is fully priced in.”
Across Europe, Gundlach said that the banks are, to an increasing degree, “living on life support from the ECB.” He noted that ECB bond purchases, which were almost nonexistent in the late spring and summer of 2011, have reached an alarming level today. The ECB needed to step in, beginning in August of last year, since there were no other buyers of Italian bonds. Gundlach said yields of approximately 7% on Italian bonds represent de facto price fixing through ECB purchases.
Beyond the precarious position of its banks, Gundlach said Europe is also staring down the risk of a recession. Portugal’s GDP growth has turned negative, he said, and Spain may soon follow. Germany’s forecast for 2012 is 0.6% growth.
Looking ahead to 2012, Gundlach said investors should be dollar-denominated, because there is a scramble now to put money to work in US markets, in part because investors are fleeing to safety. He said the overall behavior of the US economy and markets will be roughly the same as it was in 2010 and 2011. The Q4 2011 economic indicators will “surprise on the upside,” he said, but the question remains as to whether this will prove self-sustaining.
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