When DoubleLine CEO Jeffrey Gundlach talks to large institutional investors and high-net-worth individuals, he says the degree of illiquidity in their portfolios these days is surprising. This was evidenced back in March when Harvard University’s endowment sold $750 million in bonds.
Interviewed yesterday by David Rosenberg of Rosenberg Research, his Toronto-based independent research firm, Gundlach voiced skepticism about the health of asset classes ranging from private credit to 30-year Treasury bonds. Both Gundlach and Rosenberg agreed the boom in private credit represented a “bubble.”
Gundlach said that private credit often enjoys a boom “when public credit is not financeable.” Though he didn’t elaborate on that, he said the way in which private credit is sold is misleading—he called it a “scam”—because the marketers use a Sharpe ratio calculation without “marking it [private credit assets] to market properly.”
With so many big institutions and wealthy individuals flocking to private markets, Gundlach raised the issue of a liquidity crunch if there were a financial crisis. He mentioned a conversation he had with the head of Stanford University’s multibillion-dollar endowment 15 years ago during the great financial crisis.
Gundlach was presenting the chief of the endowment with a sound investment that was offering a fairly certain return of 24% (it would eventually return 35%). The endowment chief acknowledged he couldn’t argue with the investment's underlying logic; he just didn’t have the money. Gundlach asked him about a relatively small (for Stanford) $10 million investment and he said he didn’t even have that sum.
Why? Because so much of the endowment assets were locked away in private vehicles that were finding distressed opportunities and calling in their capital commitments. Today, many more affluent investors with portfolios a fraction of Stanford’s size are invested in these funds, raising the issue of how they’ll deal with the next downturn.
Gundlach wasn’t entirely negative on the corporate credit market. He said that “double B bank loans won’t default” and added that he likes three- to five-year corporate bonds yielding about 6.5%. But parts of the bank loan market where borrowers who were paying 4% several years ago are now being charged 10% are “a disaster.”
Moreover, he and Rosenberg agreed that there are more apparent signs of financial trouble than the markets are discounting. For example, Rosenberg noted that bankruptcies in the U.S. were up 35% in the last year.
When it comes to the U.S. Treasury market, Gundlach said he was avoiding 30-year Treasurys because he fears a possible restructuring of government obligations. With the federal budget deficit running at 6% of GDP, Gundlach estimates it could approach 12% in the next recession. “We’ll end up with a deficit the size of the entire discretionary [federal] budget,” he said, questioning the sustainability of the U.S. financial structure.
Rosenberg noted that restructuring Treasury was “illegal’ and would devastate many pensions. Gundlach responded that it was illegal for the government to restructure mortgage debt in the financial crisis and also “illegal” to forgive $7 billion in student loan debt, but the government found ways around the laws and did it anyway.
Other prominent thinkers like hedge-fund investor Stanley Druckenmiller have also raised questions about the government's ability to service its burgeoning debt obligations. Druckenmiller made a cogent argument addressing these concerns last October, and Gundlach noted Druckenmiller's reasoning relied on highly optimistic data from the Congressional Budget Office.
Even before soveriegn debt exploded during the pandemic, other observers like commentator John Mauldin were discussing the idea of major economies coordinating a debt elimination program. And in one month late in the previous decade, both Rosenberg and Pope Francis threw out the idea of a debt jubilee.
Gundlach conceded that the potential for a Treasury restructuring informed his investment philosophy in favor of low-coupon government issues. “I have this crazy idea that I want to buy only the lowest coupon Treasurys because they won’t be modified,” he said.
The problem for the larger economy is that many 10-year Treasury bonds yielding 1% or 2% that were sold in the previous decade are coming due and being replaced by bonds yielding 4% or more, dramatically increasing debt service costs. “In the next recession, inflation will go down and bond yields will go down,” Gundlach said. But he expressed concern that Fed Chairman Jay Powell has said that one reason he is reducing the Fed’s balance sheet is to enable the central bank to “gun it” during the next recession.
The question investors are most frequently asking Gundlach these days is why the recession he and others have been forecasting for more than a year has failed to materialize, despite many usually reliable indicators pointing towards a downturn. Gundlach explained that growth in the money supply was rising at a ‘linear’ rate before the pandemic exploded to the tune of $7.2 trillion and the effect of this liquidity continued long after the Federal Reserve’s monetary stimulus programs ended.
In the last two years, growth of M2, or cash and checking account deposits, has gone negative, which is usually sufficient to trigger a recession. But this time the net effect of unprecedented pandemic liquidity injections has kept the money supply above trend lines, though it is finally approaching the pre-2020 linear rates. As the real economy reopened in 2021, it managed “a baton pass” from the manufacturing to sector to services like travel and leisure, he said.
This doesn’t mean all is well in the U.S. economy, he said. Credit cards are charging 23% interest rates on average and “we are now seeing delinquencies,” Gundlach said, adding that rates that high “should be illegal.”
Other signs of pain are apparent in housing. Rosenberg noted that last month mortgage applications were down 12%, but home refinancing loans were “booming.”
That’s because people “need the money,” Gundlach said. Americans who became accustomed to living beyond their means thanks to the pandemic stimulus are reluctant to cut back their lifestyle, he noted.