Jeff Gundlach, CEO of DoubleLine Capital, covered his outlook for the markets in his annual webcast on Tuesday. The webcast covers a wide range of topics including the economy, inflation, interest rates and fixed income and equity market outlooks. He presents dozens of slides to illustrate and back his convictions. I’ll highlight his key forecasts and comments.

Key Themes

A key theme for the presentation was ‘magic’. Gundlach commented on the strong market returns across most all of the major equity markets, both US and international. He noted strong GDP growth results along with nearly universal positive outlook. With respect to the question on future returns, he noted that, ‘what is obvious is obviously priced in’. For the US equity markets, he is forecasting a down year for 2018, after a positive first half. He likes emerging market equity, commodities and 2Y government bonds. He doesn’t see any indications of a recession in the next 6 months, but expects that within 2 years we could see a downturn. He puts us in the ‘late stages’ of the business economic cycle.

Economic Outlook

Gundlach showed that world growth is largely in synch with most all economies showing positive growth that some would call ‘magical’. PMI survey data is showing many countries at or near all-time highs. Citigroup’s Economic Surprise Indicator looks particularly strong for the US. US nominal GDP growth is 4.1% and Europe is picking up steam. He noted that there has been a high correlation in the balance sheet of the major central banks and equity markets. He then noted that by mid- 2018 the total balance sheet for US and ECB will turn negative. This is one of the indicators he points to as a cause for concern regarding future stock market returns. He did note that the ECB continues to talk about easing even though their growth forecasts have been rising recently. They have taken growth estimates for the EU up from 1.7% to 1.9% in 2019. He suggested that if the ECB were to surprise to the more hawkish side, this could result in Euro currency strengthening vs. the dollar. The current recovery is on track for one of the longest sustained growth periods, in terms of real GDP, on record.

Recession Outlook

Next Gundlach covered a wide range of indicators used to predict inflation. All of the indicators are green for the economy. None is predicting inflation in the next six months. It is important to note that the indicators he is using are considered to have a predictive horizon of about 12 months, so these things have to be monitored constantly.

Leading economic indicators are currently high and on an uptrend. Unemployment rates typically tick up in the months leading up to recession, currently we are at a low and could see the unemployment rates drop even further. PMI numbers are very positive. Both the services and manufacturing survey numbers are well above 50, the point considered to be ‘expansionary’. Small business optimism measured by NFIB is near its all-time peak of the early 80’s, possibly driven by the recent tax reform passage. Early signs of wage inflation were noted in the same NFIB survey. Factory orders are at a 14 year high. Consumer confidence is very robust. With so much positive news, Gundlach asks rhetorically, ‘It is obvious.  Is this obviously priced in to the markets already?” Gundlach also noted that high-yield interest rate spread usually shows a large gain just prior to recessions, something on the order of 200 basis points. High yield spreads appear to be on a down trend. Again, this does not signal recession on the short term.

Equity Markets

Every little thing is magic. We have had nine up years in a row for the US stock market. We have had 387 days without a 5 % correction. This is just 3 weeks short of the longest streak on record. We had 52 days last year with the VIX (fear indicator) below 10.  There is very little fear in the market at this point.

Valuations are a big concern. The Shiller PE is at near record highs. The forward PE ratio for the S&P 500 is above 19. This has happened only twice in history, before 1929 and in 1998 leading up to the 2000 dot com market crash. Gundlach sees parallels with the current market and the market of ’98 – ’00. The PE ratio can stay elevated for some time and we ‘continue to watch things very carefully’. We have had strong earnings growth and for now earnings growth looks like it will be strong in 2018.

As noted above, Gundlach is calling for a negative year for the US stock market. He continues to like emerging market equities, given that the Shiller PE is ‘about half’ of what it is in the US. He considers developed market Europe a ‘value trap’ as the European markets do not seem to be able to rally and the trend vs. the US is negative. Last year he noted that he liked India and China and for the year these emerging markets were among the best performers for 2017. Our view and tactical portfolios are somewhat aligned with Gundlach. Our model portfolios overweight emerging markets and underweight in international developed equities. Our models do include European equities based on relative value analysis and dollar outlook. We previously discussed international valuations in detail here.

The Dollar

Gundlach showed long-term trend charts for the US dollar. He noted that the dollar tends to trade in 7-8 year cycle and from the charts looks to be on a potential downtrend. He noted again that the ECB could surprise the market by getting more ‘hawkish’ and that could drive the dollar down further. Gundlach sees a weaker dollar in 2018. This appears consistent with the forecasts we use from JP Morgan. As a result, international equities could surprise to the positive on further dollar weakening.

He noted that he likes commodities at this point. He showed charts that demonstrate large commodity price increases just prior to economic recession (this is somewhat counter intuitive). He posted that we are likely in the late stages of the business cycle and he recommended holding a small portion in commodities.

Inflation

Gundlach spent a brief amount of time on this topic. Essentially he noted that inflation ‘seems to be subdued’ and at the same time ‘some leading indicators suggest inflation may rise 16-18 months out’. He highlighted the NY Fed indicator Underlying Inflation Gauge (UIG). The indicator relies on the ‘persistent’ common components of the monthly core inflation components. In any case, he put up a slide that showed that it may be signaling up to 3% inflation 16 months out. He showed a similar slide with US GDP growth 18 months forward being correlated with inflation. The details go beyond the scope of this write up. The take away is that we really don’t have strong evidence of inflation yet but need to watch closely.

Interest Rate Outlook

We are 2.54% on 10Y treasuries and 2% for the 2Y. The yield curve flattening seems to have slowed. He spent a good deal of time discussing the 10Y rates. Last year, he predicted 3% by the end of 2017 and that ‘we could see 6% by the next presidential election’. We ended flat last year. He still seems to hold to the idea that we could get to 6% on the 10Y by 2020 – 2022.

In the shorter term he sees 2.63% as a critical level for rates. He said that if the 10Y breaks through the 2.63 level we are likely to see an acceleration of interest rates. This analysis is largely based on technical analysis of support and resistance. He said that if interest rates go above 2.63%, ‘it will spell trouble for the stock market’.