The Goldilocks Era – Is it Really Coming to an End?

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Published by Taylor Financial Group

Easy monetary policies during the post-crisis period have propelled equity prices higher and driven bond yields lower. But as central banks reverse their quantitative easing (QE) and raise rates, this “Goldilocks era” will come to an end, according to Jeffrey Gundlach, the founder and chief investment officer of Los Angeles-based DoubleLine Capital, a wildly successful investment firm that manages $100 billion.

Though we don’t see looming threats of a recession or of significant inflation, there are some key areas to pay attention to, as Gundlach recently discussed during a webcast.  Mainly, Gundlach focused on global economic performance and the direction of interest rates.

Stock Market Performance and Central Bank Policies are Closely Linked – So What’s Next?  Gundlach noted that for the first time since the financial crisis, none of the developed economies are contracting.  And, in fact, more economies are accelerating than are expanding, including China, which has a GDP that has been growing at 6.8% to 7% for the last five years.  Gundlach also notes that Europe’s economy is doing as good or better than the U.S. based on almost all indicators, including manufacturing, retail sales, and GDP growth.  He credits this growth to stimulative monetary policies, stating that global Central Banks’ balance sheets (in aggregate) have consistently gone up since the financial crisis, with the exception of small bumps in the road in 2009 and 2013.  In Gundlach’s opinion, Central Banks’ balance sheet growth has created higher equity returns.

Interest Rates are Going Up!  By 2019, the positive relationship between expanding Central Bank balance sheets and low volatility and equity price gains will end.  Why? The Fed is reducing its balance sheet and the remaining central banks are expected to tighten up.  Will the bond market be able to post positive returns with the additional bonds and increasing interest rates?  Gundlach is not so sure.  And neither are we!

Recession and Inflation Risks

Though some analysts have tried to “explain it away,” the yield curve has, in fact, flattened, but it doesn’t necessarily signal a recession at this time.  Gundlach notes that the spread between yields on two and 10-year Treasury bonds has decreased significantly from 275 basis points just four years ago, to 52 basis points today.  Indeed, that is a considerable flattening – we can’t ignore the potential signs.  But it’s certainly not enough reason to panic as Gundlach doesn’t see signs of a recession.

On the other hand, should we be worried about inflation?  There is some risk.  But, again, nothing unnerving at this time.  The leading economic indicators (LEI) in the US are “downright strong” and near their best levels since 2010.  At these levels, it would take a year to get to a recessionary reading.  Gundlach discussed the historical performance of commodities relative to the S&P.  He said that stocks have “massively outperformed” commodities since the financial crisis.  The historical pattern indicates that commodities are very cheap as compared to stocks, such that it is “almost eerie.”  “Commodities have bottomed out and are at a level where they are a good buy,” says Gundlach. So, it may be a good time to buy commodities and is something we are considering for the portfolios.

Final Word

Gundlach also discussed how the Republican tax plan would affect interest rates.  Ultimately, he thinks cutting taxes is an unusual move for the current economic environment, since tax cutting typically takes place when the economy needs a boost, and that’s certainly not the case right now.  But, the tax cut will likely grow bond supply, boost economic growth, reduce revenue, and grow the deficit, all of which will not be “bond friendly.”

Gundlach’s concluding caution was that the markets have performed well with low volatility, so there is plenty of leverage in the system.  But highly leveraged strategies may suffer with higher rates.  Gundlach has previously predicted that the yield on the 10-year Treasury bond would be 6% by the next presidential election (in 2020).  On this point, he said, “Why not?  We could tack on 75 basis points per year for the next five years.”  If the 30-year yield goes up another 50 basis points, “then the bond bull market is over and the 6% yield is more likely.”  Gundlach said that bond investors should not be in an index fund with a duration of 6 (presumably referring to the AGG).  Nor should they be in corporate bond funds, which have attracted a lot of money because they have done well.  Investors should want lower duration bond funds, Gundlach said.

Ultimately, our thoughts are in line with Gundlach’s.  We are always on the watch and we will keep you posted on any developments or concerns.  We will also continue to keep you apprised of the Tax Act as it continues to play out.  To that end, please click here to read our recent tax update email, which has been updated with new changes as of today.

In the meantime, if you have any questions or would like to review your portfolio, give us a call today!

 

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