If Jeffrey Gundlach is to be believed, U.S. stocks now have a 76.8% chance of taking out their March 2020 lows, caused in part by a new wave of unemployment, this time among white-collar workers.

In a freewheeling presentation yesterday in which he painted Federal Reserve Chairman Jay Powell as “Superman” and regaled listeners by playing—in its entirety—the Fifth Dimension’s 1967 bubblegum pop hit “Up Up and Away” as a metaphor for unprecedented monetary and fiscal stimulus leading to ever-higher levels of debt, Gundlach, the CEO and CIO of DoubleLine Capital, stuck to a familiar theme: Investors should remain cautious because prices across several asset classes are likely to decline.

Especially stocks. According to Gundlach, stocks are up more than 40% from their March lows and the Nasdaq 100 is at record highs, though the rally in the S&P 500 and the Dow Jones Industrial Average has taken a breather in recent days. Like the record-breaking bull market that ended in March, the current rally is built upon debt-driven stimulus.

“We are not up, up and away in terms of economic growth, though,” said Gundach

Gundlach’s sarcastic video rendition of “Up Up and Away” included scenes from the Albequerque, N.M., hot air balloon festival, hundred-dollar bills falling from the air, and Powell’s head superimposed on Superman’s body. The U.S. national debt will cross $25 trillion for the first time this week, according to Gundlach. Public debt grew by $3.5 trillion this year even as the GDP has shrunk due to the economic shutdown caused by Covid-19.

The rally—and almost all of the gains of the past 11 years—have been fed by increasing levels of debt created via monetary and fiscal policy. Likewise, all of the jobs created since the global financial crisis and then lost in the coronavirus-caused downturn were largely an illusion and many will never come back, he said.

“Ever since the global financial crisis supposedly ended, the growth was just an illusion,” said Gundlach. “All the jobs that were created in that huge run were lost in a six-week period. Will it be temporary? Some of it. But will all of it be temporary? Of course not, and we will not get all of it back quickly.”

Gundlach argued that historically, with Japan as an example, increasing the debt to over 100% of GDP has been destructive to economic growth. In 1998, Japan’s debt reached 120% of its GDP and since that time the country has had no GDP growth in real dollar terms, said Gundlach.

Now, the U.S. is growing its national debt at a higher rate than Europe or Japan as a recession continues to weigh on tax receipts, creating a deficit that will lead to a “big blowout,” he said.

Superman To The Rescue
But there’s still little evidence of recessionary forces impacting financial markets, said Gundlach, largely because Fed action has helped markets ignore the likelihood of continued credit downgrades in the near term and potential defaults over the long term.

“Superman comes to the rescue and things have started to improve, but we’re still having a hard time getting back to where we are,” said Gundlach.

The next market drop could mark the end to a type of “American exceptionalism,” said Gundlach, who noted that U.S. equities have massively outperformed their global peers across several recessions and downturns and are now trading at huge multiples to the rest of the world.

Gundlach also said that most of the American exceptionalism in the period following the dot-com crash of the early 2000’s was caused by a narrow “super six” selection of stocks. If Microsoft, Apple, Amazon, Netflix, Google and Facebook were excluded from U.S. stock indices, their performance would roughly mirror that of the rest of the world.

“One cannot maintain this kind of trajectory,” said Gundlach. “It almost seems like the last five years was nothing but an illusion.”

Without the “super six” included, earnings growth across the world’s equities since the 2009 global financial crisis bottom approaches zero, he said.

The recent rally, noted Gundlach, has occurred with most institutional money on the sidelines and was instead driven by retail investors.

“There’s something unnerving going on in this rally. It seems to be driven by a lot of rampant speculation,” said Gundlach. “It sounds like the big, experienced smart money is skeptical of this little-guy created rally. ... I’m happy to watch other people push it higher on these valuation levels.”

An Unemployment Fire Looms
With some fiscal stimulus programs scheduled to end in July, including the massive Paycheck Protection Program that has accounted for 75% of small-business financing during the outbreak, Gundlach says that there will likely be another period of rising unemployment. Thus far, the majority of layoffs have been from very low-paying jobs in the services and hospitality sectors, said Gundlach.

White-collar unemployment will occur as employers consider whether workers who make more than $100,000 a year are pulling their weight.

The stay-at-home, work-from-home reality of the Covid-19 pandemic is exposing the ineffectiveness of many white collar and middle-management workers, even at DoubleLine, said Gundlach. Thanks to the shutdowns, management is able to get a better idea of who is actually doing the work, he said.

“I kind of learned who was really doing the work and who wasn't really doing as much work as it looked like on paper that they might have been," he said, adding that after assessing the middle-managment staffing at his company, "I’m starting to wonder if I really need them.”

Gundlach likened it to Warren Buffett’s famous investing quip, “when the tide goes out, you find you who’s swimming naked.” This time, the tide may be going out on middle management.

Congress acted to protect low-wage workers during the onset of the pandemic in their fiscal stimulus, but no such safety net is in the works for higher earners should a second round of layoffs occur, he noted.

A turnover in white-collar jobs will lead to wage deflation, which will be exacerbated by the shift towards more employees working from home. Tech companies will balk at paying a higher salary for workers in Silicon Valley when they may pay less for an employee of similar education and skill set in a lower-cost-of-living area in Idaho or Arkansas.

Gundlach also questioned the level of unemployment benefits being paid to American workers, noting that in previous downturns, no more than one in four unemployment claims ended up being approved. Today, over 75% are approved, suggesting that up to two-thirds of the unemployment benefits being paid would not have been justified prior to the crisis and that much of the stimulus is being “wasted.”

Gundlach also warned that when economic hopes begin to dim, democratic countries begin exploring anti-monopolistic actions like more stringently enforcing existing regulations or passing new, more effective anti-trust provisions.

“We called it exceptionalism, too, when there was Standard Oil and U.S. Steel and these massive tycoons who created these enterprises, but when a bear market comes, you don’t call it exceptional anymore. You call it monopoly or a trust that needs to be busted,” said Gundlach. “That kind of American exceptionalism is going to be tested.”

Gundlach noted that while considered a great American disaster, the early 1900s earthquake in San Francisco actually caused few injuries and fatalities. It was the fire that resulted from the earthquake that decimated the city. "A lot of times it's not the earthquake, it's the fire," he said. An impending second wave of layoffs and another downturn in financial markets could erode what’s left of the country’s economic stability.

“I believe there’s another fire coming,” he said, adding that rising unemployment often equates to rising levels of unrest. The employment-to-population ratio has reached 52.8%, he said. If it falls below 50%, that’s “an upside-down society where you have less than half of the population employed. That situation could get seriously out of hand from a socioeconomic point of view.”

Fed Watching
If Treasury yields continue to rise on the long end of the curve, the Federal Reserve is likely to attempt some form of yield curve control. Whether they’re effective or not is a different story. Gundlach argues that thus far, the Fed’s low- and zero-interest rate policies have not been fruitful. Nor has its monetary stimulus.

Eleven years after the fiscal crisis prompted what were then unprecedented monetary policies by central bankers, the U.S. is back in a recession with high levels of unemployment and the same zero-rate interest policy and quantitative easing programs it had engaged in before – but “on steroids,” he said.

“What strikes me as being worth pondering are two questions: What is the end-game to these policies, and two, do these policies work,” said Gundlach. “I don’t think they work. If they worked, we wouldn’t be back at them on steroids 10 years after we first used them. Once something gets embedded as policy, it works for a while, and then you have to reapply it. That means it really doesn’t work, and also, the length of time [between the use of such policies] shrinks regressively. ... it took us 10 years to have to go back to a zero-interest-rate policy and bigger quantitative easing. Next time we’ll have hyper-QE and maybe it won’t be zero-interest-rate policy, but negative interest rates.”

Thus far, policymakers have mostly focused on the 3-year to 10-year parts of the curve, but they will take action to keep long-term borrowing costs low for U.S. companies, said Gundlach.

"Obviously yield-curve control is lurking in the background of the conversation," he said. "I certainly do expect that Jay Powell would follow through on controlling the yield curve should the 30-year rate really get unhinged."

The Fed is likely to keep short-term interest rates at or near zero for at least two years, said Gundlach. He also pointed out that areas of the bond market that went without Fed support during the criisis—agency mortgage backed securities, for example—have not experienced a flood of forebearances or defaults as many had feared. Even student loans experienced higher levels of forbearance during the 2008-09 global financial crisis than they have during the pandemic, said Gundlach.

The worst performers in the bond market recently have been corporate and high-yield credits, where after a boost from the Fed buying investment-grade and high-yield bond ETFs, both sectors have fallen. in part because front-running in ETFs like LQD and HYG. Corporate bonds “are not the place to be,” Gundlach said, because Fed action turned a “drip” of outflows into an “ocean," allowing the price for LQD to rise close to its all-time high while the underlying bonds are “not performing. ... Yet money has been piling in. I think this has to be a set-up for disappointment.”

“The narrative that developed is that you want to buy what the Fed’s buying. No, you don’t,” said  Gundlach. “The results are telling,” with the LQD up around 0.5% since April 9, and the Bloomberg Barclay’s Aggregate Bond Index up about 1%, while emerging market bond ETFs are up 8%. A flood of new issuance at near-zero rates has been met with a market with little liquidity available, he said.

He also critized the Fed’s purchase of high-yield bonds and ETFs as a violation of the Federal Reserve Act of 1913.

Kryptonite
Gundlach sounded a stern warning against negative rates, which could act as a “kryptonite” to Powell’s Superman. Rising budget deficits might also act as economic kryptonite, he said, as well as a massive number of BBB-rated corporate bonds being downgraded to junk status.

“There are more BBBs than junk bonds,” he said. “You could see the junk market getting completely overwhelmed if a significant fraction of BBBs get downgraded, and you have to believe that a significant chunk of BBBs will get downgraded.”

While Gundlach was cautious on gold in prior pandemic-era webcasts, yesterday he changed course, taking a more bullish view.

“Gold has come up to a big resistance point that it hit in 2011-2012 in dollar terms,” said Gundlach. “In terms of other currencies, gold went to a record high. There are two ways of thinking about this: that gold in dollar terms has to catch up so we see new highs, or that this is a divergence. I turned neutral on gold a couple of months ago as I thought it was extended, but it hasn’t done anything since then, and you ought to be rewarded by accumulating gold. It certainly doesn’t seem to have a downside in it.”

Gundlach also expects that the dollar will weaken against other global currencies.

“Sure, the U.S. is running up debt like crazy, but so is everybody else,” said Gundlach. “Who are you going to devalue against? Maybe against everybody,” as the U.S. has become a huge outlier among the developed world in its outsized response to the Covid-19 crisis.

In fact, rising unemployment and a potentially more harmful second wave of job losses are applying new deflationary pressures to the economy, he said. While inflation should remain nearly non-existent in the near term, Gundlach also warned listeners to watch out for rising inflation expectations in the mid-term, noting that when economists begin warning about potential inflation it can become a self-fulfilling prophecy.

Politics also got a mention in Gundlach’s presentation. He argued that a win by Democratic candidate Joe Biden over President Donald Trump in November would likely lead to an increase in corporate taxes, which would slow any economic recovery from the pandemic-caused recession and exacerbate job losses.