Jeff Gundlach Interview

Jeffrey Gundlach is the billionaire founder and CEO of DoubleLine, a Los Angeles based investment boutique mainly specializing in bonds, ranks among America’s highest-profile investors. His bold calls and correct prediction of the 2007 housing crash have earned him a solid reputation. A recent interview is most interesting in that he clearly, if intuitively, understands the instability inherent in the Fed’s attempts to control the economy by hindsight.

The next shock is that we’re having to put in a big overreaction to the inflation problem which we created from our initial reaction of excess stimulus. My guess is that we will end up creating momentum that’s more deflationary than a lot of people believe is even possible.

Of course he is very probably correct. A deflationary economic collapse is very likely to follow the inflationary phase. So long as the Fed is willing to make massive interventions in the economy without understanding the dynamics of control, we are utterly screwed. There comes to mind a well-known class of control systems known as bang-bang control.

Caveat Emptor

Bond guru Jeff Gundlach observed that the stock market has become a market for high-risk CDO residuals.

I must admit that I had not thought about this but he is exactly correct. CDOs (Collateralized Debt Obligations) were at ground zero in the last financial crisis. A CDO is constructed from a collection of assets, for example mortgages, and is divided into slices (“tranches”) which receive income in a priority sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. So for example, if $100 comes in, then slice 1 may be entitled to the first $25, slice 2 the next $25 and so on. But if only $10 comes in, slice 1 gets it all and nobody else gets any money. The last or lowest priority slice is called the residual, which receives whatever is left over after the other slices with fixed entitlements have been satisfied.

Gundlach’s point is that companies which have bought back shares with debt now have a capital structure essentially identical to that of a CDO, where the debt obligations have first claim on the company’s income and the equity investors must be satisfied with the crumbs. They are in the same position as the owner of the residual tranche of a CDO. So long as earnings are high and interest rates are low, all is well and there will be yachts and jets. But when the tide goes out, there will be naked swimmers as the ugly side of leverage becomes visible. Read Jeff’s piece and be very very scared.

Tick, Tick, Tick

Jeff Gundlach, who has been warning that the U.S. Federal Reserve should not tighten monetary policy in December, gave his “most bearish yet” presentation. According to zero hedge, he cited a number of asset classes that are signaling deteriorating conditions. The commodities market has been facing monstrous declines with copper prices, as an example, down 37 percent since July 2014 while “the breadth of the equity market may be the worst ever.” Gundlach characterized commodities as the “widow maker” of the markets.

Overall, Gundlach said it is “unthinkable” to raise rates with junk bonds and leveraged loans struggling so much. Slides are here, well worth reviewing.