• Gundlach thinks recession signals are close, but not signaling recession right now.
• Interest rates are a wild card as the Fed switches from ‘pragmatic’ to ‘put’ mode.
• Gundlach thinks European equities are a value trap. He likes emerging markets (still).
• His strongest warning was to avoid junk bonds and beware of huge debt crisis.

Jeff Gunlach, the CEO of Doubline held his annual ‘Just Markets’ webcast on Tuesday, January 9th. It was a long call with many nuggets. It seemed to lack bold forecast that seem to be a hallmark of Gundlach’s calls. He doesn’t always get the calls right but, the data and the thorough process is pretty interesting for analysts. I’ll try to summarize the key points.

Gundlach Recap of 2018

The core to his 2018 forecast for why we would see a down year was that all of the good news of global coordinated growth was priced in, that interest rates would exceed 3% and the market would come under pressure. I thought the most interesting slide he showed was the decline in growth estimates in Europe in the first half of 2019. That along with the large dollar rise really put the hurt on international stocks last year. He did say he liked emerging stocks last year based on valuation. They were hit much harder than US stocks.

Economic Outlook

Gundlach covered a good deal of indicators that are widely used as recession signals. Most all of his indicators suggested that the trend and levels of the indicators were close to but not quite to the level of predicting recession. He did make an interesting comment on the ‘two ten spread’. He argued that, although history has shown that the US has never gone into a recession until the two year exceeds the ten year interest rates (yield curve becomes inverted), he said he believes there is the possibility that we could go into a recession before the yield curve crosses zero because we are in such a low interest rate environment. He showed a slide with Japanese interest rates not inverting but recessions occurring, supporting his idea.
He didn’t make a firm prediction on recession. He concluded, “we’ll have to keep a close eye on the data and wait and see’. He did seem to favor the ‘sentiment’ type indicators of the PMI and CEO and homebuilders sentiment. CEO sentiment is trending down but still above zero.

Interest Rates

He spent a considerable amount of time talking about the Fed rate hikes and the large change in the Federal Reserve’s stance in Q4. He said Powell blew his press conference in Q4 and then subsequently other members had to come out and walk back the comments. His view is that, Powell has gone from ‘pragmatic Powell’, to a ‘Powell Put’, and the reversal caused the market to recover from the December slide.

He didn’t have a clear position on where rates go from here. He thought we could actually see continued back and forth on rates, adding uncertainty to the market. Zig zag.

Corporate Bonds

Gundlach showed some data from Morgan Stanley that graphed current debt ratings and what the debt should be rated if we only focused on corporate leverage. Essentially, he was arguing that corporate debt is way lower in quality then we all think. Given corporate leverage, he recommended focusing on companies with strong balance sheets. He thought these companies would hold up better if we have a ‘zig zag’ market this year. He was very negative on junk bonds. He said the recent rally in prices might be a good opportunity for people to get out.

Equity Markets

As noted, Gundlach didn’t have a firm forecast for the US. For Europe, given the drop in forecasted growth he suggested people should stay away. He called Europe a ‘value trap’. He continues to like emerging markets based on equity valuation relative to the US.

What Should Investors Do?

If you are persuaded by Gundlach line of thinking, bond portfolios should be adjusted toward quality issues (away from BB and below corporate bonds). For equities, as noted Gundlach, would seem to favor Quality stocks in the US along with some emerging markets.

This will be a year where watching the data on the economy could pay dividends. US valuations are more attractive than last year and risk-reward continues to favor holding a diversified portfolio of stocks and bonds. Increasing the bond quality toward government bonds and investment grade bonds should provide a better margin of safety if the economy did deteriorate into recession.