Druckenmiller Bullish On Copper, Gundlach Says Time To Play Defense
By Albert Lu
A dovish Federal Reserve and strong labor market make a recession in 2020 unlikely, according to two market experts.
“The odds are against a recession occurring before the end of 2020,” said DoubleLine Capital CEO Jeffrey Gundlach in an interview with CNBC.
“What’s happened is consumer confidence has really held up … Leading indicators are low right now.”
Stan Druckenmiller, the former chairman and president of Duquesne Capital, concurs. In a recent interview with Bloomberg’s Erik Schatzker, Druckenmiller explained,
“I think we’re close enough to the election, at least we can breathe for a few months. I don’t expect any dramatic policy that can overwhelm the favorable backdrop of monetary stimulus and a decent economy.”
Nevertheless, both men agree the economic environment is far from healthy for several reasons.
WEAK LEADERSHIP AT THE FED
When asked what grade he would give Fed Chairman Jerome Powell, Druckenmiller didn’t mince words.
“Not a good one.
“He’s a weaker version of Yellen, without the monetary framework.”
“[At least Ben Bernanke] had conviction and he controlled the room … I don’t see that here.
“Let’s not compare him to my true hero, Paul Volcker … It’s a shame we don’t have some of [his] courage today.”
When asked the same question, Gundlach was equally critical – assigning the chairman a C-minus grade.
“It’s difficult to give him a lot of credibility in the messaging because of the U-turn [that he took] … [I]nstead of raising rates successively in 2019, we’ve cut rates three times …”
ARTIFICIAL INTEREST RATES
At the core of the problem lie artificial interest rates — borrowing rates that, in Gundlach’s words, the market has not ratified. As evidence, he points to the repurchase agreement rate spike from last September.
“[The instability in the repo rate] suggests that the market doesn’t ratify the fed funds rate. The Fed has the fed funds rate at a level that isn’t really clearing the market, in a free market way, for overnight money. And what they’re doing is adding reserves to try to counteract that.”
“In the next recession, the amount of bonds that would be issued at the long end would be so horrifically high that I think interest rates, in a normal free market clearing mechanism, would rise, and rise fairly significantly,“ Gundlach said.
Higher interest rates strain marginal borrowers, those who swim naked when Buffett’s proverbial tide goes out.
As Druckenmiller put it,
“A lot of bad apples out there … are not being exposed because the interest costs are so low — by the way, one of them being the U.S. government.”
“A lot of these new professor geniuses think this is a free lunch.”
They are mistaken.
Gundlach believes that credit risk is a key concern.
According the Gundlach, the corporate bond market — which has grown from roughly $5 trillion, before the global financial crisis, to $11 trillion now — is misrated. Specifically, he claims that if one considers debt leverage ratios as the sole measure of quality, 39% of investment grade corporate debt should be rated junk today.
“If 39% of the corporate bond market were downgraded to junk, you would see some pretty horrific movement.”
“I think the time to be exiting the corporate bond market is presently.”
YIELD-STARVED FOREIGN BUYERS
The persistence of negative yielding assets in Japan and Europe has resulted in a flood of capital to U.S. markets. The capital surge has bolstered the U.S. dollar despite negative factors, such as the twin deficits (budget and trade) and easy monetary policy. The widely followed dollar index (DXY) has held up surprisingly in recent years, after hitting a peak in 2016.
The foreign practice of naked buying — unhedged purchases of dollar assets — is of particular concern, as Gundlach explained.
“Foreigners, you can understand, are buying U.S. bonds because their bonds are negative. If you’re an insurance company what are you going to do? You can’t buy bunds at -20 basis points. That’s just a sure money loser. So, what they’re doing is buying U.S. assets, and that’s helped the U.S. market.”
“The problem is if you buy the corporate bonds, as a European insurance company, [and] hedge the currency risk … guess what happens? You have a negative yield. You have a yield that’s even more negative than the German 10-year bund. So, you can’t hedge it.”
“European investors, insurance companies and the like, have been buying U.S. corporate bonds, and not hedging them. And that’s one of the reasons that the dollar has held up … There’s incremental dollar demand.”
However, the unhedged purchases introduce additional risk. If the corporate bond market falters, or if the dollar weakens, these foreign bondholders will register losses.
“My belief, based upon 35 years of experience in how investors behave when they start to experience losses, is they will then start to have waves of selling,” said Gundlach.
The situation, Gundlach feels, is akin to the overleverage of 2006.
CONCLUSION: TIME TO PLAY DEFENSE
Given the mounting risks, Gundlach believes bond investors should play defense.
“You’re picking up a tiny amount of money in excess yield — and yet the downside flush will be such that you will see tremendous losses accruing.”
Among his suggested alternatives are Treasury Inflation-Protected Securities (TIPS), which compensate investors when inflation rises.
Druckenmiller is embracing risk, albeit timidly. The billionaire reports he is long equities, commodities and commodity currencies. While he remains bullish on cloud growth stocks, he has added banks, financials and other holdings that fare well in a higher growth world.
Druckenmiller is particularly fond of copper, betting that the combination of fiscal stimulus, monetary easing and diminution of trade worries will result in a global economy that is stronger than current forecasts indicate. He also cites electric vehicles as a stronger driver.
“Copper has a little extra kicker relative to the other ones. We think EVs add .5% per year in demand and the supply outlook is challenged.”