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Chris Whalen: "Gundlach Isn't Wrong, He's Just Early"

Chris Whalen, Chairman of Whalen Global Advisers and a very well-known financial analyst (he was one of the original forecasters of Lehman's inevitable demise) appeared on MacroVoices podcast this week to discuss the equity valuations, the path of the US dollar and DoubleLine Capital founder Jeff Gundlach’s declaration that the 35-year bull market in bonds is dead. Some of the key highlights:

"Erik: I want to start with the US dollar because, you know, we’ve had quite a few guests talking up a secular bullish argument on the dollar and, boy, it really all sounds very compelling, but look at the chart. The dollar bulls—the chart is telling us dollar bulls that we’re wrong. So how do you see this playing out? What do you think is driving the weakness that we’re seeing in the US dollar? And does it represent a secular change in direction, or is this just a natural pullback in an ongoing bull market?

 

Chris: Well, you know, it’s hard for analysts to get their hands around the dollar because the old relationships, particularly interest rates and trade balances, which used to give you a good idea of where a currency was going to go don’t seem to matter anymore. So the dollar was rising against major currencies after the financial crisis, and particularly over the last four or five years, in large part because people were fleeing whatever country they were in and going to the perceived safety of the United States. So Russian oligarchs, members of China’s communist party, they sent trillions of dollars to the United States over the past five years. Much of it went into American real estate. They also like Canada by the way, because both the US and Canada protect property rights, and they have a reasonable degree of confidentiality when it comes to investment flows. So if you’re a communist party cadre in China and you’ve stolen millions of dollars, you want a safe place to hide it.

 

 

And so this all, this capital flight contributed to the strength of the dollar, really, apart from the normal considerations of trade deficits and interest rates and everything else. Now it’s kind of reversing because there’s been this narrative on Wall Street, particularly in among the private investment community too. That said, well, you know, places like Brazil, Europe, even Asia, even Japan are all of a sudden attractive. And so you’ve started to see money flowing out again. Whether it’s going to be maintained or not I don’t know. Because, as I say, the old measures for whether a currency was going to appreciate or depreciate really have lost their validity since 2008."

Moving on from the greenback, Townsend and Whalen discuss the equity market, ballooning valuations and the role that the Federal Reserve’s interest-rate cuts have played in attracting a flood of capital stocks. Whalen said he agrees with other Macrovoices guests in believing that the equity market is overvalued, despite the many “rationales” for high valuations dreamt up by Wal Street analysts. In Whalen’s construction of the rally, corporations eagerly took advantage of low interest rates, borrowing excessively to buy back their stock and pad CEO paychecks. While market conditions will likely continue to support stock prices for the immediate future, according to Whalen, the Fed’s “social engineering” has already created the template for the next crisis as these companies struggle with these large debt burdens as interest rates rise to 3% and beyond. But for right now, at least, it appears stocks are safe. There’s so much capital that investors are bidding up “surreal” assets like bitcoin.  

“Erik: Let’s move on to the US equity market. We’ve had a lot of people on the program arguing that the market is way overvalued, this thing is overdone, it just has to crash here, the top has to be in. Yet it continues to march higher. And we’ve also heard the other opposite argument, which is that there’s so much new liquidity in the system in terms of the feds supporting the market, even if we’re supposedly talking about shrinking the balance sheet now it’s shrinking very slowly. Which way do you see this, or where do you think it’s going? What’s your outlook for short, medium, long-term in the equity markets?

 

Chris: Equity markets are clearly overvalued. They’re very much like what you see in the residential real estate market in the United States and also in commercial real estate. The Fed manipulated the credit markets, they took four trillion dollars’ worth of securities out of the market, and they’ve essentially forced all of us to invest in something else. And so you’ve had a situation where low interest rates have driven money into stocks.

 

You’ve also had companies buying back their stock because debt is so cheap. Look at IBM. They’ve a negative book value for the company now, because they’ve levered up so much and bought back so much stock. And so you have a scarcity of supply. And so I would not disagree at all with your other guests that the stocks are overvalued.

 

The Street keeps coming up with rationales why that’s not so, but I think it’s clear that it is. But on the other hand, do I expect the market to crash? No. Because, remember, the constraint here is supply. And there’s so much money looking to invest that it’s going into all of the possible asset classes and in some cases into surreal asset classes like bitcoin and all of these digital currencies.

 

It’s very much a function of the central banks. And I think that’s a problem, because when we “normalize” interest rates we’re going to see a lot of credit losses on the books of banks and bond investors because crappy companies are able to go out and borrow money like they were good companies. Thanks to Janet Yellen. There is a cost to the social engineering that the Federal Reserve Board engages in, and, you know, I think it’s going to—over time the history is not going to be kind to Yellen and her colleagues. Because they have created the next problem. We just haven’t gotten there yet. Rising interest rates could quickly expose the companies’ “short-term thinking” surrounding how we paid for buybacks.”

Companies, it appears, are eager to return capital to investors, but have so far hesitated in their business, which is one reason for slow GDP, Whalen said. Luckily, they might have another opportunity. Whalen believes 10-year rates are headed back to 2%, even as the Fed forces short-term rates higher.  

Erik: I want to go a little bit deeper on this subject of corporate buybacks, because I couldn’t possibly agree more with you. And I know you’ve done a lot of work on this and written quite a bit about it. That, you know, corporations basically looking at the cheap credit market saying, you know, forget about what’s good for our business. What’s good for the executives is to pump the stock price up. Let’s borrow a bunch of money, buy back our own shares; it may not make business sense, but it makes sense for my pocket if I’m the CEO. You know, you just have to go back to the old adage of what could go wrong here? It seems to me a lot could go wrong but what I can’t get my head around, Chris, is how does this actually end? Because it seems to me like if we do see interest rates start to back up, they’re going to back up slowly. There’s still going to be more opportunity.

 

Where we saw, you know, oh bottom, bottom, bottom prices on money, let’s buy more stock, well now it’s going to be a little bit more expensive. It’s going to lead to let’s do some more stock buybacks before it’s too late. When does this eventually end, and what could happen?

 

Chris: One scenario I’ve been pondering is, you know, companies are not very good at predicting the movements of financial markets. They’re very short-term in their thinking. And if interest rates were to rise significantly—let’s say we got the ten year bond up to three-and- a-half, four percent, which is a lot given where we are—companies might have to start rotating out of the debt that they incurred to buy back their stock and start issuing stock.

 

In other words, they have those shares, they’re sitting in Treasury on the books of the company. They can reissue that stock and raise money. But they may be forced to do that at a price that’s lower than the price they paid to buy the stock back, in which case they’ll take a loss. So, I think there are a number of scenarios that could unfold when you look at the balance sheet of corporate America and the huge amount of debt that they’ve taken on. But the one saving grace is that deflation is still a dominant tendency in the market today. So, while the Fed can push short-term rates up (by brute force in this case), the ten-year bond is still dropping. You know, mortgage rates have been falling for the last two months. And I think that the secular demand for paper—that hunger on the part of investors for what we call duration, which is another way of talking about the bond market—is quite profound.

And I’ve been telling people I think the ten-year treasury will go back to two percent, which is another half point in yield. That’s a lot. So, in the near term I don’t think that medium to long-term interest rates are going to go higher. The markets are very keen. Look at the last treasury auction. It went extremely well. They want the paper.

But the real issue to me is why aren’t these companies investing in their businesses instead of buying back their stock? You know, people always—in the economics profession they’re always talking about how can we get companies to invest? How can we increase productivity? Which is their big thing obviously, because at the end of the day growth is a function of population growth and how productive your workers are. How much is that increasing? And productivity hasn’t been increasing in over a decade. It’s flat.

 

So that’s why you’re not seeing GDP growth much more than about one-and- a-half, two percent annually. That’s not good, because when you look at all the debt these countries have, public sector debt, they need to grow faster (laughter). You know, the low interest rate environment since 2008 was meant to help debtors. It was an explicit transfer from savers to debtors. And, instead, all of these countries continued to go out and incur more debt. So, you know, we have a fundamental problem in our society with governments that can’t live within their means. They can’t say no to the voters because the politicians will get voted out of office.

 

And private sector investors and companies have to live in this same environment. And that’s, you know, that’s a difficult thing going forward. I don’t know how we’re going to preserve value for our families and our future if governments are borrowing from everyone every day with no intention of repaying. There’s not even a discussion of repaying.
When I was a kid a billion dollars was a lot of money. Now nobody cares. They just kind of say, oh well, it’s okay. But I think that’s really the issue. I’m not worried about a short-term crisis for companies that have, you know, levered up to buy back their stock. But if rates pop you could see quite a scramble from corporate America to try and rebalance their capital structure back to something that makes more sense.”

When Treasury yields fell to all-time lows last July following the UK's vote to leave the EU, many analysts said the 35-year bull market in Treasury yields had finally reached its zenith, and that interest rates would only move higher from there. Doubleline Capital’s Jeff Gundlach was among the big names calling for a shift in the secular trend, though Gundlach later said the bull market would be over once the 10-year Treasury yield reaches 3%.

“Erik: Let’s come back to treasury yields, because, obviously, a little over a year ago Jeff Gundlach made this big profound announcement that the 35-year bond bull market was over and that’s it. The top is in on price, the bottom is in on yield, it’s all the other direction from here. We’ve heard quite a few views in the opposite direction. Lacy Hunt on this program made a very compelling argument that if you just look at the over-indebtedness of the world and of governments, it’s impossible to get to what we think of as historically normal rates. Now, you just said a minute ago you definitely see a move back toward two percent. Does that mean that you think that Gundlach is right and this is just a correction towards two percent? Or do you think that the jury’s still out on whether or not the 35-year bond bull market is over or not, or how do you see this in the longer term?

 

Chris: Well I think Gundlach is right, but he’s way early. You know, in order for you to have a selloff in the bond market and really see interest rates move higher, especially medium and longer-term rates, that money has to have somewhere to go. There isn’t an obvious outlet or venue for the funds that are currently invested in US treasuries, US corporates, US high-yield debt. Where else is it going to go in the world? We’ve created so many pieces of paper with pictures of presidents on them that they all want a home and they all want a positive return. And you’re right. The indebtedness of the world, especially the public indebtedness of countries, I think is the real driver behind central bank action. The reason is the dropping interest rates has ceased to be an effective way to get economies moving.

 

You know, back in the 70s and the 80s you dropped interest rates a point or two and the economy would increase, quickly. Now there’s nothing. In fact there’s an argument that says that deficit spending is actually bad for growth. It’s almost like the old crowding-out argument from economics which had been dismissed long ago.

 

So I think that the secular tendency of markets has not yet changed. You know, the hedge funds would love to go and make some money on a rising interest rate trade, and many of them have tried over the last couple of years, and they’ve all gotten annihilated. So I think people have to realize that the weight of debt, and also the posture of all the major central banks, is such that low interest rates are going to be with us for a while. And until you see a change in demand so that treasury auctions are not as successful and yields in fact have to rise to attract investors, I really don’t see that changing.”

You can listen to the full interview below: