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The coming depression blog | May 29, 2017

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The Two Questions that Matter Most

Two questions stand out amid the complexity of the current economic and market environment, according to Jeffrey Gundlach, both of which relate to critical elements of fiscal and monetary policy and should guide portfolio construction for investors.

Gundlach, who is the founder and chief investment officer of DoubleLine funds, spoke to investors in a conference call last Tuesday. The title of his talk was the “The Decline and Fall of the Roman Empire.” The US economy, he said, is on a path that bears alarming similarities to the one that befell the Romans in the fifth century.

Gundlach’s two questions were when the Fed will increase interest rates and what effect the end of fiscal stimulus measures will have on the economy. I’ll return to why he said those questions are critical to investor’s decisions, but first let’s look at Gundlach’s parallels between the US today and the Romans a millennium-and-a-half ago.

Republicrats and perpetual dictators

The Roman Empire was founded in 44 BC, when Julius Caesar was appointed as a “perpetual dictator.” Gundlach said that reminded him of what is currently going on in Washington, DC.

The US is not governed by a perpetual dictator per se, he said, but instead by a dual-party system he dubbed the “Republicrats.” The two parties squabble over who will be the president, and the result is policies that are “awfully unchangeable,” he said.

Those policies – specifically ones that have expanded the fiscal deficit – need to change in the next few years, he said, in order for investors to thrive in the investment markets. Republicrat-led deficit spending measures have driven each household’s share of the national debt from $20,000 to $84,000 since 2000, while median-household income growth has barely increased.

An important contributor to the fall of the Roman Empire was the lack of a middle class, thanks in large part to a lack of infrastructure spending and taxation policies that created a destitute underclass, according to Gundlach. He said taxes levied by the Romans were used to fund their military and to wage wars in order to defend their territory, which was almost as large as the continental US.

Similarly, the US has an “outsized” military budget of nearly $700 billion, Gundlach said. In a distant second place is China’s spending of $199 billion. We spent 5% of our GDP on the military last year, about twice the percentage spent by China, the UK or France.

“It’s really a problem when you are running this massive military machine,” he said. “It is one of the things that undoubtedly caused the very slow but inexorable decline of the Roman Empire.”

A huge underclass of the “seemingly permanently unemployed” was one cause of the decline of the Roman Empire, Gundlach said. He said that similar conditions plague the US today. The employment-to-population ratio has decreased from 65% to 59% since 2008 – despite what Gundlach called a “kitchen sink” of stimulus measures. He said that he doesn’t expect that ratio to improve, at least not under the budget that Obama has just proposed.

Don’t be misled by the modest improvement in the unemployment rate, Gundlach cautioned. It is only because the “denominator is shrinking” – the size of the workforce is contracting. Finding employment is particularly challenging for younger Americans; the labor participation rate for 16- to 19-year olds has gone from 60% to 30% since the financial crisis.

Another indicator of the growing size of the underclass, according to Gundlach, has been the increase in the number of Americans on food stamps – now approximately 46 million of our 313 million people.

Gundlach noted some trends in the unionization of the workforce, although on this point he did not draw any parallels to the Roman Empire. Within the private sector, he said, most industries are becoming less unionized – for example, wholesale and retail trade and even manufacturing. But federal, state and local government workers are now “massively unionized,” he said.

“No wonder we are in a situation where it’s difficult to get the fat out of the government, when there is all this kind of unionization happening,” he said. “It has led to an outsized comparison of private- versus public-sector earning power.” In 2000, he noted, federal civilian workers made $76,000 annually, versus $46,000 in the private sector, including benefits. As stunning as that difference was then, the gap has widened; federal workers now make $120,000, versus $60,000 in the private sector.

“Something about this clearly is responsible for part of the massive deficit problem that we continue to deal with – and will continue to deal with, certainly throughout the course of this year and next year,” he said.

Two key questions

The Roman Empire declined slowly over a period of several hundred years, Gundlach said. Advances in technology and information flow suggest that the US might have much less time to address its debt problems, he said, adding that the answers to the two key questions described above should guide investor decisions in the short term.

On the question of what will happen when government stimulus ends, one insight comes from the data for real personal disposable income in the US, Gundlach said. The official data shows that income rose dramatically until 2008, then fell steeply during the recession before rebounding over the last couple of years. But, according to Gundlach, a more telling story emerges from the data after it is adjusted by eliminating transfer payments, such as extended unemployment benefits and food stamps. It shows that the recent rebound is a mirage – income is at the same level as in 2005 – and growth has been entirely stimulus-induced.

“When the stimulus ends you are going to see negative movement in economic growth,” Gundlach said.

The second question is when the Fed will increase interest rates. The Fed’s most recent announcement was that the Fed funds rate will be maintained at near-zero levels until late 2014. Its previous policy announcement was to keep rates at that level only until mid-2013.

But under Bernanke the Fed has adopted more a transparent communication policy, and the Fed’s meeting minutes showed that 11 of the 17 Fed Governors favored raising interest rates sooner than late 2014 – possible as early as this year.

“While the message from the Fed is rates will be low for another three years or so,” he said “a lot of the voters in the survey don’t even believe their own chairman. We need to be open-minded about where interest rates are going, but certainly in the short term it seems extraordinarily unlikely to me that short-term interest rates are about to be raised.”

Market forecasts

Gundlach’s uncertainty with respect to the Fed’s direction on interest rates was reflected in his forecast for the fixed-income markets, where he expects rates to remain largely unchanged, at least in the near term.

Overall, he said that Treasury yields are “carving out a bottom,” but that is a process that may take “years” to complete.

The two-year note, he said, doesn’t seem to be able to hold its near-zero rates. Five-year yields have been “more muted” in their upward movements this year. Ten-year bonds have been “bottoming out,” he said, as have 30-year bonds, which are unlikely to go below 2.5%. But he warned against any significant changes in allocations. “I’ve been at this game a long time,” he said. “Usually when interest rate bottoms are put in, they are put in and there is a quick reversal out of them.”

The stock market, he said, is “very over-bought” with declining volume and the beginning of some very significant insider selling. “The market is vulnerable to a significant setback,” he said, but not one that would constitute a bear market in equities or “risk assets.” He said recent better-than-expected data on the economy were numbing investors into complacency, and “sowing the seeds for disappointment” for equity investors.

“This is a bad time to be deploying money in risk assets,” he said. “If you have a dollar-cost-averaging program, you certainly should turn it off for the time being.”

In response to a question Gundlach is often asked, he said inflation should not be an imminent concern. “We shouldn’t expect anything of great significance in the very near term.” The TIPS market confirms his prediction; it has been forecasting inflation of 2% to 2.25% for the past five years, he said.

Gundlach affirmed his earlier advice for investors to hold entirely dollar-denominated positions. He said that trouble in Europe will lead to a dollar rally, and that emerging markets will be vulnerable. A crisis in Europe, he said, would lead to a “repatriation of money back into Europe by European investors,” which would, in turn, trigger divesting of emerging-market positions.

Even dollar-based investors should heed a warning from the Roman Empire, though. In that era, the edges of coins were flat, and the Romans cleverly found that they could file small amounts of gold or silver from the sides of coins, in what was perhaps the earliest form of currency debasement.

The Romans solved their problem by adding small ridges to the edges of coins, a practice that continues today. Now investors should fear the modern-day form of debasement, Gundlach said. Our money may now trade as electronic computer blips, but its value still ultimately depends on the ability of our government to address its fiscal problems.

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