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Investing

Jeff Gundlach on the Next Economic Collapse

Jeff Gundlach, CEO of DoubleLine Capital predicted the election of Donald Trump and the 2007 housing crash. He is now providing insights into the next economic collapse.

Headshot of Jeff Gundlach

In 2011, he was featured as “The King of Bonds” in Barron’s, and named one of “5 Mutual Fund All-Stars” by Fortune Magazine. In 2012, he was named one of the “50 Most Influential” by Bloomberg Markets magazine. In 2013, he was named “Money Manager of the Year” by Institutional Investor.

When Jeff Gundlach speaks, people listen. Unlike most investment managers, he doesn’t hold back and is willing to tell it like he sees it. Listening to Gundlach is like getting a bucket of cold harsh reality poured on your head.

He was recently interviewed by a Swiss newspaper on what the next recession might look like. Gundlach warns investors to prepare because it will lead to big changes in the market. He argues investors need to reduce risk and own their house free and clear. (in fact, he says anyone with a mortgage should not own stocks.) While there might still be market gains over the near term, when the downturn does come people will be “overwhelmed by problems” with their investments. In particular, he sees big problems with the US corporate bond market.

“This time the liquidity is going to be very challenging in the corporate bond market. The corporate bond market in the United States is rated higher than it deserves to be. Kind of like securitized mortgages were rated way too high before the global financial crisis. Corporate credit is the thing that should be watched for big trouble in the next recession. Morgan Stanley Research put out an analysis about a year ago. By only looking at leverage ratios, over 30% of the investment grade corporate bond market should be rated below investment grade. So with the corporate bond market being vastly bigger than it’s ever been, we’ll see a lot of that overrating exposed, and prices will probably decline a lot once the economy rolls over. Furthermore, central bank policies have forced investors into asset classes that they usually would be a little bit more hesitant to allocate to.”

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Gundlach also sees major problems with the US stock market, arguing it will be the worst performing equity market in the world. Why? Partly because it is currently the strongest.

“The late 1980s saw Japan as invincible with the Nikkei tremendously outperforming every other market to the point where there was incredible overvaluation of Japanese real estate when the recession came in the early 1990s. The Japanese Market was the worst performer. It never made it back to that level. In the advent of the Euro, there was a lot of enthusiasm about the economic prospect of the Euro area, and the stock market in Europe was incredibly strong in 1999, outperforming every other market. When the recession began, it was the worst performing market and never made it back again, broadly speaking. This time US stocks are crushing every other area. It’s due to some fundamentals like the better economy, but also due to tax cuts and share buybacks. In the next recession, corporate bonds will collapse, and buybacks will stop. The dollar has already topped. It may begin falling in earnest during the next downturn and US equities will lose the most. They will probably not make it back to the peak for quite a while. When the US market drops, it will drop a lot.”

The next recession will see deficit spending balloon. The US is already running $trillion+ deficits and this is supposed to be the best economy ever. The next recession could put upward pressure on interest rates, as demand for funding rises. Of course, the Fed will do everything in its power to combat this, but possibly not until after a crisis emerges. The firefighters don’t show up until the house is ablaze.

“Powell said he’s going to use large scale asset purchases to fight the next recession. That’s what he said at his last press conference. He could introduce negative interest rates, but I think Powell understands that the US cannot introduce negative interest rates without the entire global financial system collapsing. Because where’s all that capital going to go? Which markets are big enough? Negative rates are the worst thing that could happen in the US. You can see what negative rates have done to the banking system of Japan and Europe. All you’ve got to do is look at the relative performance of bank stocks. The underperformance of European banks is correlated to the yield of the 10-year German Bund. I don’t know if the politicians understand that negative rates are fatal. It’s fatal to Deutsche Bank and insurance companies in Switzerland.”

So what happens post recession when US public debt levels skyrocket due to massive deficit spending? Suddenly, the problem everyone has ignored could smack the US right in the face, and the US government will look for solutions.

You could create inflation through universal basic income. That would debase everything. Or you could default on Social Security benefits and welfare benefits. These are the options. We’ll do some combination, maybe raise the eligibility age from 65 to 75. I don’t know what’s going to happen, but what we have now is unsustainable. The debt is unsustainable. Interest rates are unsustainable. The wealth inequality gets worse every minute. It’s already beyond the point of sustainability, and when the next downturn comes, there will be a lot of anger and unrest. …the misery is going to be apparent for a considerable fraction of the population. It’s going to be pretty intense, and the response will be money printing. When Ben Bernanke said, we’ll never have deflation because we have the printing press and when he used the word helicopter money, people thought it was some euphemism, some joke. People thought that that could never happen. Now we have candidates running on it. Kamala Harris has a version of it, Cory Booker has a version of it. And for Andrew Yang it’s the centerpiece of his campaign.”

Gundlach is not talking about a garden variety recession. This situation – massive debts, slowing growth, rising wealth inequality – has been building for decades and the world is approaching a point at which seismic shifts will occur.

This situation has taken since 1945 to develop. And it really got going with US-President Ronald Reagan. So I started in this business when the scheme was starting. And we used to think that 8% interest rates were set to last forever, and it was unthinkable that the Fed would buy bonds, inconceivable! And now it’s normal. And free money used to be unthinkable. What people got themselves fooled by was feeling somehow that there’s real stability to societal institutions because they’ve experienced it most of their life. Some still think they’re experiencing it. But they’re not.”

So what does normal look like?

In 1970, there were no credit cards. In 1970, there were no car loans. People saved money and bought things. That was normal. The debt-to-GDP ratio was stable. Economic growth was real. It really happened. In 2018, the dollar growth of nominal GDP was less than the dollar growth of the national debt. That means that there is no growth. We’re having an illusion of growth. It means that we’re issuing IOUs and spending it, and it shows up in the calculations as growth. But spending is not growth.

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Investing

Money Is Debt, Gold Is Money

“In numerous years following the [civil] war, the Federal
Government ran a heavy surplus. [But] it could not pay off its
debt, retire its securities, because to do so meant there would be
no bonds to back the national bank notes. To pay off the debt was to destroy the money supply.”

— John Kenneth Galbraith

In the investing world, you can take a 3 month view, a 3 year view or a 30 year view. One person looking at one asset class might have a different forecast depending on the time horizon he is considering. In this article, I will look at gold through a 30 year lens.

I believe that structural forces will support gold and other hard assets over the long term. While current forces may be bearish for gold in the immediate term as investors panic and liquidate everything, there are a number of underlying currents that demand a strategic allocation to the metal. While the sophisticated gold investor is already familiar with these concepts, I think it is important to re-introduce them to a broader audience who may have zero allocation to gold, other precious metals and hard assets.

The Origins of Money

Throughout history, money has always held an important position as a means to facilitate transactions, thus creating massive efficiencies within an economy. Sometimes money was issued by governments. Other times a common means of transacting arose organically within a population.

Many historians suggest that fractional reserve banking and private money creation started when gold owners stored bullion within the vaults of goldsmiths for safe keeping. As proof of deposit, goldsmiths issued paper receipts that could be redeemed in exchange for gold. Seeing an easier way to transact, when buying goods and services gold owners would simply hand over gold receipts as forms of payment instead of redeeming for gold and delivering the metal.

Eventually, enough people were doing this that some enterprising goldsmiths, who noticed that the gold in their vaults was rarely reclaimed, started lending (with interest) new paper receipts that weren’t tied to a specific gold deposit. After making these loans, more paper existed than gold in the vaults, resulting in an early example of expanding money supply and credit growth. Of course, any goldsmith that manufactured receipts far in excess of gold reserves risked a run on deposits and existing receipt holders may have experienced a loss of exchange value.

Money Creation Today

In the US today, many believe that the Federal Reserve is the primary source of money supply growth. Many also believe that the Fed creates money and simply pumps it into the economy somehow. This assumes the Fed has some sort of authority over how money is spent, but this is untrue. Monetary policy is the handmaiden of fiscal policy, but both are quite distinct.

Through open market operations, the Fed adds to the money supply by purchasing assets such as US Treasuries and mortgages. Effectively, each dollar injected this way is the mirror image of someone’s liability, giving rise to the concept that money is debt.

Think about it this way, the massive fiscal response to the 2008/2009 recession and sluggish recovery has added trillions to the Federal debt. Much of this debt was indirectly financed by the Federal reserve (although they’d never admit it) via open market operations. So instead of simply printing and spending its own money, the US government has granted an independent entity (the Federal Reserve) the right to print and lend to the government and its citizens. Some might see this as ‘checks and balances’ while others might argue that it grants unnecessary power and profit to the banking cabal that controls the Federal Reserve. In the end, the US government has added $trillions to its debt.

I digress…

The truth is that while the Federal Reserve can add to the money supply the biggest driver of money growth is the private sector. And this is where it gets especially important for the gold investor.

The monetary system does not stand still – it operates on a treadmill of debt. The majority of money in the economy is created when private banks make loans. One might think that these loans are based on deposits, but the reality is that – much like the goldsmiths of days past – in a fractional reserve system far more loans are made than deposits on hand.

Modern Money Mechanics, a publication by the Federal Reserve Bank of Chicago in 1968, states the following:

” For example, if reserves of 20 percent were required, deposits could expand only until they were five times as large as reserves…Under current regulations, the reserve requirement against most transaction accounts is 10 percent…Of course, they [the banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created…The deposit expansion factor for a given amount of new reserves is thus the reciprocal of the required reserve percentage (1/.10 = 10).”

They further illustrate this with the following diagram, showing the initial deposit and the cumulative expansion via additional loans.

Fractional Reserve Banking

Fig. 1: Cumulative expansion in deposits on the basis of 10,000 of new reserves and reserve requirements of 10 percent, from: FED, 1968. Modern Money Mechanics – A Workbook on Bank Reserves and Deposit Expansion. Federal Reserve Bank of Chicago, Revised Edition, February 1994, p. 11

In essence, the banking system has the legal power to create money out of thin air

The Debt-Money Conundrum

Here’s the kicker: whether the money is created by the Fed or by the private banks, the money must be paid back with interest. Because only the principal amount is loaned, only the principal amount exists in circulation. In aggregate, enough money doesn’t exist throughout the economy to pay both principal and interest on all debts.

Bernard Lietaer, who helped design the Euro and has written several books on monetary reform, explains the interest problem like this:

“When a bank provides you with a $100,000 mortgage, it creates
only the principal, which you spend and which then circulates
in the economy. The bank expects you to pay back $200,000
over the next 20 years, but it doesn’t create the second $100,000
– the interest. Instead, the bank sends you out into the tough
world to battle against everybody else to bring back the second
$100,000.”

The debt-money conundrum results in two conditions:

1. Systemic Competition. Like rats in a cage, society is provided too few resources. In this case, the money required to repay debts plus interest is short. This means that if one person or company is able to repay their debts another is not. This raises the level of competition within society. Arguably this has been a positive economic characteristic since the industrial revolution, however one must wonder what the world would be like if debt-fueled competition didn’t exist. Competition goes far beyond the healthy – many wars and crimes can be traced to the competition for the resources required to indirectly repay debts through economic growth. Right or wrong, money loaned into existence has created systemic competition. On an individual level, many refer to this as the ‘rat race’. On a macro level some refer to this as the New World Order.

Lietaer continues:

“The problem is that all money except coins now comes from banker created loans, so the only way to get the interest owed on old loans is to take out new loans, continually inflating the money supply; either that, or some borrowers have to default. Lietaer concluded: [G]reed and competition are not a result of immutable human temperament . . . . [G]reed and fear of scarcity are in fact being continuously created and amplified as a direct result of the kind of money we are using. . . . [W]e can produce more than enough food to feed everybody, and there is definitely enough work for everybody in the world, but there is clearly not enough money to pay for it all. The scarcity is in our national currencies. In fact, the job of central banks is to create and maintain that currency scarcity.

The direct consequence is that we have to fight with each other in order to survive.”

2. The Ultimate Ponzi. If money was lent into existence on a single occasion only, the first condition would lead to a deflationary outcome and shrinking total credit. Lenders would take haircuts and, knowing this in advance, potentially would have never lent the money in the first place. Or lenders would have priced the defaults into interest rates and covenants, paradoxically making it even harder for all loans to be repaid with interest. The banking system simply would no longer exist in its current state.

In reality, new money supply begets new money supply. To reduce the number of defaults caused by the competition for money, the banking system must continually lend more money into existence. As new money is introduced it helps money flow to past borrowers enabling them to repay their debts. To adequately offset the number of bankruptcies in the system, money must continually be created. This is precisely why modern industrial economies have a implicit ‘normal’ inflation rate of 1-3%. In good times and bad, money supply simply must expand for the system to survive. Normally that money is created by banks; however, sometimes the lender of last resort (i.e. Federal Reserve) – as the only lender that can continually accept losses – steps in to offset private loan destruction in periods of extreme financial distress, such as the 2008/2009 crisis.

The Growth Imperative

When inflation must be maintained at 1-3% for the system to stay solvent, many other areas of society are significantly affected. Companies must continuously raise prices, salaries must continuously increase, economies must continuously grow, populations must continuously increase, food supply must continuously rise, and so on.

Over the long run, continuous monetary expansion leads to the destruction of the value of the dollar relative to stable assets. While continuous monetary expansion can provide a tailwind to many businesses with pricing power, I think most investors are already set up to benefit from this through the equity portion of their portfolios. Where I think many investors are deficient is in a strategic allocation to gold.

Gold is Money

Many investors have a 3 month or 3 year view on gold, but few have a 30 year view. While I agree that intermediate forces could send the gold price down, I believe that structural monetary expansion means that all long-term investors should have some strategic weight to the yellow metal, which can serve as stable money while fiat currencies around it are devalued.

While equities (and other assets) can benefit from these same structural forces, gold has different risk-return characteristics and can help to diversify a portfolio. I am not saying that investors should dump half their portfolio into gold bars. What I am saying is that, as a stable currency, gold can help mitigate the effects of never-ending monetary expansion, and most investors are significantly underweight.

Gold can provide factor exposure not obtained through traditional asset classes and may be a valuable tool in the preservation of long-term wealth in a world in which money is debt and gold is money.