With stock markets near record highs, everything is going swimmingly – at least on the surface. Dig a little deeper, though, and it’s apparent that markets are behaving very differently to how they have in previous decades.
For one, the ‘exceptional’ US stock market is getting trounced by the likes of Europe. Also, during the March/April stock correction, US bonds – a normal safe haven in share market dips – fell. So too did another typical safe haven, the US dollar. Meanwhile, gold and bitcoin have continued to soar.
For two Wall Street legends, Paul Tudor Jones and Jeffrey Gundlach, these events signal a regime change and investors need to adjust their portfolios accordingly. What’s remarkable from two recent interviews that they did on Bloomberg is how much their views overlap, despite their different backgrounds and skillsets.
The US is caught in a debt trap
Tudor Jones, the hedge fund billionaire, made his name by shorting stocks into Black Monday in 1987 and the Japanese market in 1990.
He says the US is now caught in a debt trap – a vicious circle of higher borrowing costs and larger deficits sending the stock of debt on an uncontrolled upward spiral.
Tudor Jones says one way to address the problem is to reduce the budget deficit by increasing taxes and cutting spending, but America doesn’t want to do that. And it’s easy to see why given the economic pain it would involve.
Tudor Jones says that to stabilize the current US debt to GDP ratio of 124%, the government would have to balance its budget and cut back on about US$900 billion in spending. He broke down a scenario for how this could happen:
- If short-term rates were cut under a new Federal Reserve Governor, it could reduce 10 year rates by 100 basis points, equating to around US$175 billion in saved interest costs. That leaves a gap of US$725 billion.
- Assume the rest will come from a 50/50 split of tax hikes and spending cuts. If you do a 6% blanket cut across all government spending programs, that would save US$360 billion.
- The other half of the money could come from raising the top income rate from 37% to 49%, introducing a 1% wealth tax annually, and raising the capital gains rate to 40% from the current maximum of 20%.
Understandably, Tudor Jones believes America won’t go down this road. Instead, it will opt for a less painful route, by attempting to inflate its way out of the problem.
This involves getting interest rates below the rate of inflation, otherwise known as negative real rates or financial repression. Higher inflation means the current stock of debt would be worth less in future. Do this for long enough and the debt to GDP ratio would decline to more manageable levels.
It’s been done plenty of times before. The US did it in the 1950s when real rates were negative for much of the decade. And Japan is trying to do it now by being reluctant to raise rates even though inflation there is spiking higher.
Tudor Jones believes this is what Trump will attempt too. And his playbook is obvious. Trump has repeatedly called for rates to come down by up to 100 basis points and threatened Federal Reserve Chair Jerome Powell if he doesn’t follow through.
Tudor Jones thinks Trump will appoint an “uber dovish” Fed Reserve Chair when Powell’s term ends in mid-May next year. That Chair will do Trump’s bidding and drop rates swiftly towards 3% from the current range of 4.25-4.50%. That should be enough to turbocharge both the US economy and inflation. The ultimate objective will be to run inflation hot, so it remains above interest rates for a long period of time, thereby reducing the country’s debt burden.
The 2 easy trades
Given this scenario, Tudor Jones suggests there are two easy trades over the next 12-18 months. First is that short term rates will be dramatically lower, leading to steepening in the yield curve (with long-term rates being a lot higher than short-term rates). The second is that lower rates will lead to further falls in the US dollar.
Constructing a long-term portfolio for the new regime
Tudor Jones is sceptical that financial repression will work this time. That’s because at some point, and he doesn’t know whether that will be in 1, 2 or 10 years, the bond market will break, resulting in much higher bond yields.
Due to this, he says building a long-term portfolio is difficult. He would own shares given the inflation he sees ahead, although higher bond yields will eventually hit stock price-to-earnings multiples.
He especially likes gold, commodities, and bitcoin (1-2% of a portfolio) for inflation protection.
QE is coming
Jeffrey Gundlach is one of the world’s best-known bond managers and though he sees markets through a different lens from Tudor Jones, their views are quite similar. Like Tudor Jones, Gundlach sees the US debt situation as unsustainable and that a bond market revolt is nearing.
Gundlach is remarkably bearish on the near-term outlook for bonds given that he’s a bond manager. He says recent market action is signalling that long-term Treasury bonds are no longer a “legitimate flight to quality asset.”
He says bond vigilantes will send long-term bond yields towards 6% at some point soon. At those rates, government debt will become unsustainable and that will lead to a policy pivot. Gundlach expects quantitative easing will be introduced to get long-term bond yields down.
Markets feel like 1999
Gundlach isn’t enamoured by the outlook for stocks, either. He says the US market is more overvalued now than it was before the sell-off in April because earnings estimates have since come down.
He says the stock market feels a lot like 1999 or even 2006-2007. He implies that the bubbles back then were obvious in advance though they took a long time to play out. This time could be similar, he says.
Gundlach believes that AI stock boom is overdone. He likens it to the advent of electricity in 1900. It was met with great enthusiasm and stocks were bid up. But electricity stocks started underperforming non-electricity stocks in 1911, and they’ve been underperforming ever since. And that’s despite electricity being an amazing invention that has since transformed the world.
Private assets are the new CDO market
The other aspect that worries Gundlach is the private asset market. He sees massive over-investment in this space and likens it to the notorious CDO (collateralized debt obligations) market which below up in 2007-2008.
Gundlach says private assets share two characteristics with CDOs: illiquidity and complexity. And he believes the recent investment moves by Harvard University are a warning sign for the sector.
Recall that Harvard’s $53 billion endowment has tapped the bond market twice for money. And it’s announced that it intends to sell some of its private equity interests at a discount.
Gundlach says it’s staggering that Harvard doesn’t have enough money to pay for its operating expenses and it shows the pressure that those heavily invested in private assets are under.
He says public credit has started to outperform private credit and that’s a sign of things to come. And Gundlach expects more cases of forced selling by big holders of private assets such as Harvard.
What would Gundlach own?
Given Gundlach’s bearishness, where is he putting money then? For his funds, he’s mainly sticking to investment-grade credit. He’s also introducing foreign currencies for the first time given his pessimism on the prospects for the US dollar.
Personally, Gundlach has been a long-term holder of gold, which he describes as “the flight-to-quality asset”, replaced bonds.
As for the long-term, he thinks India is a great bet. He says India has a similar demographic profile to what China had 35 years ago. And like China then, it has many problems, including with its legal system and corruption, though these issues are fixable.
My two cents
There are some large gaps in Gundlach’s India thesis. For instance, India has never been a manufacturing powerhouse like China was back then. Interestingly, India skipped the normal stage of growing from a manufacturing dominant economy to a service-based one.
Also, his analogy is odd given that though China’s stock market has performed miserably over the past 35 years, despite the huge leap in economic growth.
Put simply, I don’t think India is anything like China was then. That said, like Gundlach, I am still reasonably bullish on the long-term outlook for India with its favourable demographics and the quality of its listed companies.
As for the other views of both Gundlach and Tudor Jones, their take on the US being caught in a debt trap seems compelling and the potential for a bond market ruction makes sense, as does the possibility of QE. The market implications of this also appear logical - lower US short-term rates, higher inflation, and a lower US dollar.
The problem, as they acknowledge, is one of timing – it could happen this year, or in 5-10 years.
For long-term investors, Tudor Jones and Gundlach's opinions are valuable to help identify potential market risks as well as to ensure that your portfolios can withstand whatever is thrown at them in future.
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In my article this week, I look at whether young Australians will be better off than their parents via a new report that digs into they key drivers behind the generational wealth divide.
James Gruber
Also in this week's edition...
Three weeks ago, ANU Emeritus Professor Ron Bird outlined why he thought that the tax concessions for superannuation totalling $50 billion were a waste of taxpayer money. This week, Tony Dillon, takes issue with the $50 billion figure from Treasury, suggesting it's grossly exaggerated.
Not sure about you but I enjoy reading the annual lists of Australia's richest people. It turns out that so too does Tony Kaye at Vanguard, though he reckons that many of the wealthy could have done better in recent years by employing simpler investment strategies.
Would a corporate tax cut boost productivity in Australia? Zac Gross says while overseas evidence in favour of business tax cuts is compelling, it's less clear cut here.
For me, it does seem that V-shaped market recoveries have become more common versus 20 years ago. Is it real or imaginary? Peter Weidner and his team at Man AHL - a GSFM affiliate - run the numbers and give us an answer.
Many asset classes this year aren't behaving as they've done in recent decades. That's especially the case for bonds, where traditional safe havens have proven anything but, and 'riskier' elements of the market have displayed resilience. Peter Kent says asset allocations need to adjust to this new paradigm and portfolio diversification has never been such a virtue.
As the July school holiday break nears, UniSuper has some investment classics to put onto your reading list. The books offer lessons in investment strategy, financial disasters, mergers and acquisitions, and risk management.
Lastly, in this week's whitepaper, Fidelity is rethinking its equity positioning in a de-globalising world.
Curated by James Gruber and Leisa Bell
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