February 23, 2021

How Jeffrey Gundlach Gets Ready for Higher Rates

Check out the Bond King’s model portfolio designed to hedge against inflation and—oh, yeah—deflation, too.

Reported by Larry Light

Jeffrey Gundlach

Brash and swaggering, Jeffrey Gundlach is known for his bold calls. One reason to listen to this asset manager is that he often has been right. Examples: his 2006 prediction of the 2008 housing crisis and his 2015 one that Donald Trump would win the presidency in 2016.

Gundlach, 61, the founder and CEO of DoubleLine Capital (year-end 2020 assets: $137 billion), is a font of opinions. In particular on interest rates and inflation (going up), the economy and society (in cantankerous and worrisome flux), and asset allocation (must be arrayed to protect against both inflation and deflation). And he has a quirky model portfolio to hedge against such perils that investors may find useful. More on that later.

With his colorful and unique turns of phrase—he once likened a financial turning point to a titration experiment in his high school chemistry class—he is an arrestingly entertaining thinker. A frequent guest on financial TV shows, Gundlach is nonetheless much more than an oracular talking head.

His nickname is the Bond King, owing to his long record of fixed-income success. He won this media-bestowed moniker from its original holder: Bill Gross, who retired two years ago after pioneering a go-anywhere style of bond investing that transformed this once-sleepy investment realm. Actually, Barron’s named Gundlach the Bond King back in 2011. Gross’s retirement sealed it.

As longer-term rates inch up, bonds are hardly on fire thus far in 2021. While Gundlach’s flagship DoubleLine Total Return is down 0.63% this year as of Monday, that’s still better than the Bloomberg Barclays US Aggregate, the bond benchmark, aka the Agg, which is off 2.04%. The Total Return fund, regularly ranked near the top of all bond mutual funds, “has an enviable long-term record,” Morningstar analyst Karin Anderson wrote. Over five years, the DoubleLine fund has outpaced the Agg, 3.12% annually versus negative 0.31%.

Gundlach launched DoubleLine in 2009 after an acrimonious departure from Trust Company of the West (TCW). This followed more than two decades heading the TCW Total Return fund, where he had a stellar run. He conducted a nasty court fight with TCW that ended up with his new firm getting a $67 million jury award.

Sporting a $2.2 billion net worth, by Forbes’ estimate, Gundlach is an art collector of, among others, early 20th century Dutch abstract painter Piet Mondrian. The artist’s use of closely packed horizontal and vertical lines is the inspiration for the DoubleLine’s name and logo. Another explanation for the name is a reference to the don’t-cross double-line road marker telling motorists that passing is too risky—a play on the risk-reward calculation that investment managers routinely must make.

While he has detractors, no one doubts that Gundlach is a smart, well-read guy. The son of a chemist, he graduated summa cum laude from Dartmouth College in mathematics and philosophy, then pursued a Ph.D. in math at Yale before dropping out and entering the finance arena.

Gundlach’s wagers often are based on macro forces. He has been wrong, of course, such as in 2011 when he forecast that municipal bonds were going to tank. And after a relatively calm few years, times have gotten tougher. In 2017, he said in a recent TV interview, “we had the most stable asset market,” but no longer.

In a told-ya-so reminiscence, he warned back then, when the CBOE Volatility Index, or VIX, was at a low of about 10, that the tempo on stock transactions was going to escalate. Other commentators “called me an idiot,” he said—and then he emerged vindicated. The VIX is now at 22 and began periodically jumping above 20 in 2018; it hasn’t been below 20 for the past year.

What’s on his mind now? Although Gundlach was unavailable for an interview, in his televised appearances lately he has provided some interesting, and at times disturbing, views on three key themes:

Interest Rates and Inflation

Conventional wisdom holds that inflation will edge up in the near future, as the economy recovers and even more Washington aid—President Joe Biden wants a $1.9 trillion package atop all the previous relief funding—floods the economy.

Long-term yields are ascending in anticipation: The benchmark 10-year Treasury hit 1.37% on Monday, up from 0.5% last spring. The difference, or spread, between a two-year and a 30-year Treasury has blown out to just over 2 percentage points. Pre-pandemic, a year ago, the yield curve was flat. That upward curve betokens, by the market’s collective take, faster economic growth and more inflation.

To Gundlach, the expected inflation increase “is a real game changer.” In a recent CNBC appearance, he noted that inflation “has been subdued for 20 years.” And since Federal Reserve Chair Jerome Powell has stated that the central bank will hold down short rates for at least two more years, longer rates will continue to chase inflation higher, making the curve even steeper. Buoying that trend is Powell’s expressed willingness to allow inflation to run above the Fed’s 2% target without central bank intervention.

Right now, inflation appears to be staying tame. The Consumer Price Index (CPI) for the 12 months ending in January is 1.4%, and the Fed’s favorite inflation index, the Personal Consumption Expenditures index, is 1.3%.

But according to Gundlach, signs of incipient growing inflation are already here: He pointed out that “agricultural prices have been depressed for years, and now are rocketing higher.” Over the past 12 months ending in January, food prices rose 3.8%, the largest hike for any category in the CPI. Energy, lower for the 12-month period, had major jumps in the past two months, 5.1% and 7.3%, as oil prices began escalating again.

OK, in response to that, how high will rates go? Gundlach thinks that the 10-year T-note will move up to 2% by year-end. And if inflation exceeds the 10-year’s yield in the future (which it does now slightly), then he believes the bond will go above 2.5%.

Indeed, such yields are hardly radical. In 2007, the year before the financial crisis, when the economy was still booming, the 10-year had a 5% yield. On several occasions after the crisis, it was around 3%, most recently in July 2018. Gundlach concedes it’s possible that Powell could act to reduce yields on long-term bonds by buying more of them.

To DoubleLine, there are some compelling plays available to counter any inflation. Like leveraged loans (bank lending to highly indebted companies), which suffered badly during the early 2020 crunch. Overall, they returned an average 3.1% in 2020, versus 9.9% for investment-grade corporate bonds and 7.1% for junk bonds, Citigroup data indicate. As these instruments have floating rates, they are a good inflation hedge, DoubleLine stated in a commentary. And with the steepening curve, they yield close to 4.5%, not bad in a time of generally low rates.

The Economy

The size of the nation’s debt load, federal plus personal, corporate, etc., worries Gundlach. “We can’t pay it back,” he said in a conversation about the economy on Fox Business. The only way to do it, he said, is “debasing the liabilities through more inflation.”

Just as worrisome to him is the unsettled condition of US society. Looking at the divisive 2020 national election and its violent aftermath, he said “2024 will make 2020 look calm.” There could possibly be three parties vying for power then, he said.

The source of the current ferment, he said, is economic change centered on lost jobs and financial security for a chunk of the population, with the Trump presidency an outgrowth. Gundlach cites Karl Marx’s observation that when the means of production are transformed—industrialization in Marx’s time; technology, automation, and globalization in ours—the elite class will strive to protect its lofty position at the expense of the poorer classes.

The Biden presidency is an expression of that tendency, he said. “This is the last gasp of the elite,” he contended. “They’re getting the band back together. Even John Kerry’s back.”

To Gundlach, Biden canceling the Keystone XL pipeline is a prime example of how the elite sticks it to the average Joe: “If your job is gone, they’re saying, ‘Here’s an old couch and a Pabst Blue Ribbon. Now shut up.’” Estimates vary on how many jobs will be lost in the axing of the project, ranging from 1,000 to 11,000. More woes lie ahead for blue-collar workers, he warned: “When we have self-driving vehicles, that will put a lot of drivers out of work.”

To understand what’s happening, Gundlach often cites a 1997 book, The Fourth Turning, by William Strauss and Neil Howe, which presciently foresaw a new era of societal unrest and division, complete with demagogues—but hypothesized that eventually the populace arrives at a new communal pact. “We need a new system,” Gundlach said. Otherwise, “the people left behind get more desperate.”

Asset Allocation

Amid such scarifying times as ours, Gundlach recommends a variation of what’s called the “barbell strategy.” It’s a concept that was first voiced by statistician Nassim Nicholas Taleb and last year received Goldman Sachs’ endorsement: Namely, invest in extremes to let your portfolio better weather any turbulence, like pairing cyclical and defensive stocks.

Gundlach’s model portfolio, which he described in a DoubleLine webcast last month, seeks to protect against both inflation and deflation. For a time during the Great Recession and sporadically ever since, Wall Street and the Fed have had bouts of fear over deflation. At the moment, inflation appears much more likely. His asset allocation is to divide one’s holdings into four categories:

Long-term Treasurys. These guard against deflation. If the value of other assets shrinks, then the debt obligations of the richest and most powerful nation on earth will be, as they long have, the haven for investors. Thus, the government bond prices will lift.
Cash, also a deflation. As stocks, bonds, commodities, and other assets lose value, the amount of cash needed to buy them falls. So cash becomes more valuable.
Stocks, an inflation. Stocks didn’t fare well amid the double-digit inflation of the 1970s, yet those were extreme circumstances. Usually, corporate earnings keep pace with inflation, and stock prices are strongly connected to profits. For Gundlach, the best prospects are emerging market stocks, especially Asian names. In the US, he’d go for energy and financial services shares.
Bitcoin, gold, real estate. The last two are storied hedges in times of inflation. Bitcoin, certainly, is new on the scene. Gundlach suspects it now may be in a bubble that could burst: The virtual currency has more than quadrupled in price since August, and is now is at $48,992. Gundlach, though, suspects that Bitcoin, known as “digital gold,” would function well when the CPI heads north.

Today’s environment has an unreal aspect, in Gundlach’s eyes. “We’re not in Kansas anymore,” he said. Getting by in an Oz-like world, he believes, will not be easy.