Jeffrey Gundlach, founder of DoubleLine Capital and former CIO of Trust Company of the West, gave the keynote address at the Morningstar Investor Conference on June 23. He sat down with Wealth Manager Editor-in-Chief Kate McBride in Chicago that day to talk about his outlook.
When we spoke earlier, you mentioned the giant bond funds that are using derivatives instead of holding the underlying bond securities.
The mega funds use synthetic strategies–anyone with more than $200 billion. They can't really buy real bonds anymore–there aren't enough in the marketplace, and [the issue is] counterparty risk. The investor gets no payoff for the counterparty risk–so why take the risk for no payoff? Firms get the scale, and monstrous fee income and investors take the risk.
Nobody has been able to explain this to me in a way that makes me comfortable. In bonds there's a $600 trillion shadow market in a world that only has one-tenth of that in actual [underlying bond] assets. The total value of the bond mutual fund market is bigger than the total bond market; it's leveraged 10 to 1. The [counterparty] risk that showed up in September '08–Lehman–investors should get some payoff for that.
In September '08 if you had marked counterparty risk to market–what it would actually trade at–there would have been a run on the industry. No one will talk about it.
So was it that mark-to-market wasn't done?
It's possible mark-to-market was suspended on a special-case basis–too big to fail. And reference notes, derivatives that refer to real securities, create leverage beyond what is in the economy: there is close to a quadrillion dollars, that's $1,000 trillion in derivatives, floating around in the world. The total M3 money supply is [only] $13 trillion. You can't have debt go to 700% of GDP. It's not possible. The house falls down. We have to stop spending. Government policies have to change.
We have 22% unemployment, not 10%, if you count short-term discouraged workers and long-term discouraged workers. That becomes very low growth. There's deflationary pressure, because of the debt burden, that may make an inflationary outcome seem like a good idea.
Where do you stand on financial services reform?
The unintended consequences are much bigger than the intended consequences. The problem is it could harm banks–reduce credit and lending, counter-stimulate and weaken the economy. Banks stopped lending to businesses 30 years ago; lent to consumers instead, leading to consumption and (sometimes) non-payment. Student loans are a good idea; you have something better after that, someone who can earn more.
What's the rosiest part of your outlook?
It's still possible–through austerity–to ease back from the trends over a three- to four-year window. We've already had the inflation. Issuing debt over the last 30 years created inflation, and paying it back creates deflation. Pay back the debt, money becomes scarce, prices go down. We're seeing it, though gold, Toronto real estate, and vintage wine are up; oil and real estate are down. Socrates says you have to understand that you don't know everything.