Gundlach: For 2024, Expect Lower Rates, Higher Volatility and a Recession

“Am I rough enough?”

Recession indicators are rough, Gundlach said. There is a 75% chance of a recession in 2024 and he cited several metrics to support his forecast.

The yield curve has been inverted for the longest period since the late 1970s – 79 weeks – based on the 2-10-year slope. That “increases the odds of a recession on a mathematical basis,” Gundlach said, and is long enough that we should see a recession soon. It has also been de-inverting (becoming less steeply inverted) long enough that it shows a high probability of a recession in 2024.

The leading economic indicators (LEIs) have been low for more than a year, and typically there would have been a recession already. But LEIs depend on manufacturing, and the economy has been supported by services, he said.

The Fed’s monetary stimulus has diminished the LEI’s predictive value, as well as forecasts that are based on the slowing of the money supply (using M2). That is because much of the excess liquidity from monetary easing has remained on banks’ balance sheets and not in consumers’ hands on Main Street.

Historically, when the unemployment “backup” (the rate of increases in unemployment) goes above 0.5, there is a recession, and this threshold should be reached soon. Once layoffs begin, according to Gundlach, the sentiment propagates among companies and gives them “cover” to reduce headcount. On the day he spoke, BlackRock announced a 3% reduction in its workforce.

Typically, unemployment rises starting about six months before a recession, and based on the unemployment data since 1949 we are positioned for a recession.

Unemployment is also about to cross its 12-month moving average, which is a recessionary signal.

One indicator that has not signaled a recession is that unemployment has not crossed its 36-month moving average, but that should happen in the first half of 2024, he said.

Employment is shrinking in cyclical sectors, which is another precursor to a recession.

“The labor market is the last one to go,” Gundlach said, “and it is weakening.”

The Philly Fed coincident index, which measures whether states have shrinking economies, is at 30 out of 50, and that has never happened without a recession.

“Ain’t I tough enough?”

The toughest problem facing the economy is budget deficits. Gundlach covered this issue in his December webinar, but he focused on a “strange” phenomenon that has happened since.

From 1970 to 2015, when recessions occurred, deficits went up and vice versa. But since 2015, that pattern has not happened. The deficit is higher, but unemployment is lower. This is a problem, Gundlach said, because rates are high, and it is more difficult to borrow.

That is causing major stress for our economy, particularly if there is a recession. A recession would force greater fiscal stimulus that would have to be financed through borrowing. Interest expenses are already 15% of tax revenues, and Gundlach posited that this could be why the Fed pivoted (it did not raise rates at its last meeting).

The Fed may have realized rates were unaffordable for the government. The Fed will not allow high real interest rates, he said.

The Congressional Budget Office (CBO) is projecting that in 5 years interest expenses will be 20% of tax revenues, and that assumes there is no recession and a smaller deficit than there is now.

But this 20% could happen in 2025, Gundlach said.

Interest on the debt is $1 trillion. As a percentage of GDP, it is going “vertical,” according to Gundlach.

“When there is a recession, which is likely this year, there will be an exploding problem with this debt,” Gundlach said. “It will prompt extraordinary measures, like quantitative easing (QE).”

“This is not our grandchildren’s or our children’s problem,” he said. “It is our problem. We are going to go broke a lot sooner than that.”

Based on historical data, if there is a recession, the deficit will increase by about 5%, according to Gundlach. But that percentage has been greater for recent recessions, like COVID (2020) and the global financial crisis. The deficit could go to $3 to $3.5 trillion, or $4 to $5 trillion using data from those more recent recessions.

“We are going to have a lot of angst and inflationary policy when there is a recession,” he said.

The yield on the 10-year Treasury could go to 3.3% if the economy weakens. It was 4.01% on the day he spoke.

“Am I rich enough?”

The S&P 500 is rich enough, according to Gundlach. This is a lousy trade location to own stocks. The S&P 500 closed at 4,757 on the day he spoke.

Gundlach favors equal weighing over capitalization weighting (which is tantamount to favoring small-cap stocks), value instead of growth stocks, avoiding the Magnificent Seven, and non-U.S. over U.S. stocks.

The S&P is very rich compared to the emerging markets, and the U.S. will underperform in the next recession.

“I'm not too blind to see”

Gundlach is not too blind to see where the value is.

“It will be an active management environment,” he said.

That is because inflation will be low, he said, and the economy will weaken.

The Fed follows the 2-year Treasury yield in setting the Fed funds rate, and the 2-year is signaling that the Fed will cut rates by 1% or more in 2024. That is more than in the “dot plots,” which show where each Fed member expects rates to be.

Commodities will not go up initially in 2024, he said, but will along with emerging markets if the dollar weakens.

“Super core” inflation, which excludes housing, is at 3.5%, and Gundlach expects that the Fed is encouraged by that reading. The Fed’s focus has shifted to six-month annualized measures of inflation, he said. Core PCE is 1.9% on this basis, which is below the Fed’s target. Core CPI is 2.9%.

“It is no wonder the Fed is more relaxed about the need to raise interest rates,” Gundlach said.

Inflation is driven by the lag in the incorporation of shelter prices into CPI measures. Shelter is about a third of the CPI, and it is at 6.7%. But the Case-Shiller housing index is increasing at 4%. That means the CPI will come down, Gundlach said. That forecast is reinforced by owners’ equivalent rent as measured by Zillow.

The monthly mortgage payment on median-priced homes has risen since early 2021, which will dampen housing prices and turnover, which is deflationary. Multi-family homes under construction are at historically high levels, which will increase housing supply and depress rents.

Near the end of his presentation, Gundlach presented some ominous data for commercial real estate (CRE) delinquencies.

CRE delinquencies are rising, he said.

But those troubles are confined to certain categories – offices and to some extent retail. Other sectors, like lodging and multi-family, are not as threatened.

There is widespread fear that the work-from-home movement will cause a “slow-moving train wreck” in the office space market. But Gundlach said that this emphasizes why active management is called for in the year ahead.

Robert Huebscher is a vice chairman of VettaFi and the founder of Advisor Perspectives

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