Gundlach Is Right About Junk Bonds And Stocks
Pacific Park Financial Inc. | Jan 16, 2019 11:05PM ET
Stock enthusiasts think the worst is behind us. Of course, they appear to be ignoring the fact that bear market rallies are quite common, and that the current upswing may just fit the bill.
The average bear rally in history is approximately 11%. We stand at roughly 11.5% off of the correction lows right now. What’s more, there’s a fair amount of technical resistance in and around the S&P 500 range between 2625 and 2650.
Credit key players in the Federal Reserve for the recent upturn. Indeed, the timeline for the correction that began three and a half months ago is worthy of review.
Back in October, when the Dow had hit an all-time record, Fed Chairman Powell stated that the rate range was a “long way from neutral.” Stock sellers overwhelmed buyers through the start of the fourth quarter.
By November, however, Powell had changed his tune. He went form claiming that the range for the Fed Funds rate was a long way from neutral to a place that was “just below the neutral range.”
A completely different outlook in a matter of weeks? Seriously?
Granted, the stock market does not care if Powell bowed to pressure from the Trump White House; the S&P 500 does not care if the head of the Fed listened to a financial celebrity like Jim Cramer. Nevertheless, Powell backtracked and stocks gained ground in November.
Then things became very interesting in December. Whereas risk asset investors had come to believe that the Fed might be “one and done” on rate hikes, Powell described a likelihood of two more occurrences in 2019.
More important? Buyers had hoped to hear a little something about an eventual end to balance sheet reduction known as quantitative tightening (QT). No dice. Powell praised the $50 billion per month in QT. A December bloodbath across risk assets ensued.
Fed heads shifted yet again in early January. Chairman Powell said that the central bank would be “patient” with respect to any additional rate hikes. Vice Chairman Clarida invoked the word “patient” as well. Meanwhile, former chairwoman Janet Yellen said that she does not expect any more rate hikes in this cycle.
Translation? The Fed will do whatever it takes to support stocks. (Of course, that does not mean that the Fed will always be successful.)
Before breaking out the champagne, however, consider that the Fed has yet to suggest that it will slow its quantitative tightening. And if the Bank of Japan had stayed the tightening course — if the European Central Bank had truly ended its quantitative easing (QE) — the recent excitement for equities might have been more modest.
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It is going to be a significant challenge to identify net easing versus net tightening across the world’s central banks. When risk assets fall apart, monetary policy makers appear ready to step in. And yet, if the Fed and others do not back away from endless accommodation, they won’t have the tools to help when economic contraction inevitably occurs.
We are already witnessing slowdowns across Europe and Asia. For instance, industrial orders for export dropped sharply in Germany. Similarly, German GDP contracted 0.2% in its most recent reading.
What about England? Is the constant confusion over Brexit helping or hurting the U.K. economy?
Perhaps the biggest elephant in the room is China. In a traditional sense, one might not use the term “recession.” Yet the GDP trend in China is most certainly not its friend.
From my vantage point, global central banks will be more of a headwind than a tailwind for stocks in 2019. Economic slowing around the world will serve as a headwind as well.
Still, the biggest trouble spot may be in corporate debt land. There has been a 64% increase to $9 trillion in debt since the financial crisis. Credit quality is now weakening. Marginal increases in the cost of borrowing from higher rates are making it more difficult for companies to manage their debt loads. And it is hardly far-fetched to anticipate a monumental chunk of the investment-grade universe losing its BBB standing and becoming high-yield (a.k.a. junk).
DoubleLine’s enigmatic founder, Jeffrey Gundlach, believes investors ought to be wary of stocks and high yield bonds in the first half of 2019. He said, “Use the strength we’ve seen in junk bonds as a gift and get out of them… to survive the zigzag of 2019.”
Balance sheet risk is real. In truth, default concerns and potential bankruptcy may even occur in higher-rated investment grade debtors. PG&E (PCG) comes to mind.
Bottom line? A resurgent stock bull throughout 2019 is unlikely. For one thing, there are limitations on how much stimulus and how much “non-tightening” that central banks will commit to in the near-term. Secondly, the global economy is slowing. And third, corporate debt is likely to drag on both earnings as well as stock prices.
If you missed an opportunity to lighten your allocation to risk assets like stock and high yield bonds when the S&P 500 was peaking near 2930-2940, you might want to tactically lower some risk during the current rally. Or as Gundlach implied, you might be wise to look away from the mouth of a gift horse.
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