Gundlach Talks to Aston Part II
An Interview with DoubleLine’s Jeffrey Gundlach
(Part II of the recent interview between Aston CEO Stuart Bilton and Jeffrey Gundlach, Co-founder and CEO of DoubleLine Capital and portfolio manager of the ASTON/DoubleLine Core Plus Fixed Income Fund.)
Mr. Bilton: I have noticed that at DoubleLine you think a lot about demographics.
Mr. Gundlach: Much more than in prior years because demographics in the developed world are changing in a way that is unprecedented in modern human history. For example, the labor force in Italy over the next generation, absent very substantial changes in immigration policy, will fall by 35% to 40%. It is very difficult, if not impossible, to have positive economic growth with a drop of that size in the labor force. The same issue will have to be faced in Japan, Germany and, with a little delay, China. Improved mortality in the developed world combined with decreased fertility will lead to incredible demographic changes.
Some have drawn parallels to the 1970s and suggest stagflation will take hold in the United States. I think that is highly unlikely. The 1970s were driven in large measure by the baby boomers’ high demand for goods, services and credit. Demographically, it is crystal clear that this same group in the U.S., this bulge, is now heading into retirement with very low demand for credit and low demand for things, except medical care. They also have lot of wealth on paper, particularly in real estate. However, their savings are on average about $500,000 short of their likely retirement needs, which means their homes will have to be reverse-mortgaged or liquidated in order to help fund their retirements. There is a lot going on demographically which we have watched for the past 20 years. In the 1990s, when we talked about the year 2020, it seemed it was pretty hypothetical, but now it’s not very far away. These trends will start accelerating in about three years and will have a very large impact on the way in which markets and economies behave. Actually, we think that the demographic conversation could become the centerpiece of our investment strategy over the next few years. It’s similar to how we thought the credit bubble was what mattered starting in about 2005, and it turned out that three years later, the bursting of that bubble became everything.
A few weeks ago, a young man asked me to identify the best investment with a 40-year time horizon that could never be sold. I told him to buy Indian equities. They can be incredibly volatile and could drop 50% in any one year; but India has a really strong demographic story. India will have a few hundred million people entering the labor force in the next couple of decades. If the Indian government can implement even modest economic reforms, the country could become an engine of economic growth for decades. China, on the other hand, has zero people entering the labor force going forward after having about 300 million join the labor force in the last two decades. China grew at an incredible rate – a 23 fold increase in GDP in the last 20 years, but there’s no way, based on demographics or mathematics that can happen again. China cannot be the key engine of global economic growth going forward. In fact, China is the primary reason that global growth is slowing – a development that is certainly reflected in the Shanghai Index, which has been a horrible performer. The Shanghai is lower today than it was in 2009, while other stock markets around the world have hit new highs. I think it’s reflective of how the world is changing with China growing to a $10 trillion economy up from under $1 trillion a generation ago, but now slowing.
Mr. Bilton: Demographics also seem to be driving some of your thoughts about residential real estate.
Mr. Gundlach: Yes. For a long time we averaged about one and a half million housing starts a year; then starts dropped below 1 million during the Great Recession and have not really recovered much since. New homes and existing home sales are up a small amount but remain at levels formerly consistent with the depths of a recession. There is also strong economic resistance from the millennial generation towards buying houses – jobs are difficult to find and many of them are underemployed or unemployed with a lot of student debt. The bulls on homebuilding argue that there is a large amount of pent-up demand. The problem is that irrespective of the demand, it will be difficult to buy a home without a down payment. Also, many who bought homes six and eight years ago still have negative equity. So there’s no way that group is going to trade up and create new home demand. In addition, the millennial generation is the first to be building less wealth than the generations before. Beyond these financial realities, we have a change in preferences. Many investors who grew up in the 1970s and 1980s fail to appreciate how the world has changed. When the baby boomers turned 16, the first thing they wanted was a car, and in their 20s, they wanted a house. Today many twentysomethings don’t want a car, let alone a house. Whenever I meet with younger people, I raise this topic. It’s not uncommon – it’s actually the base case – to hear them say that they don’t really want to buy a house because the investment case is weak and they like the optionality of renting. The millennials remind me of my parent’s generation, who lived through a period when people lost literally everything. They were scarred by the Great Depression and consequently never borrowed any money.
I believe that same emotional scar towards real estate will forever concern the millennials and maybe even the generation just before. When you’ve observed people losing their homes and have seen 30% to 50% declines in real estate values, it is difficult to view housing as security rather than risk. Also, it is unlikely that government housing policy can be more supportive than it is already. In fact, I would not be surprised if sometime down the road, government policy turned into a headwind. One can foresee potential changes in mortgage interest deductibility, real estate tax deductibility and even the privatization of Fannie Mae or Freddie Mac.
So housing bulls, hoping for mean reversion, are likely to be disappointed. I don’t think home prices will fall in the near term, though they could in time if the baby boomers choose to liquidate. The other reason housing has been a disappointment over the last 12 months is higher interest rates. Housing optimists argue that it does not matter if mortgage rates go from 3% to 4 ½%, because 4 ½% is still low. Unfortunately, it doesn’t matter if rates used to be double digits; it’s the delta that matters. Going from 3% to 4 ½% is a big increase, and that’s why mortgage activity collapsed starting in July of last year and subsequently existing and new home sales turned negative year-over-year. So many things will have to come together simultaneously to make homebuilding strong and it just seems unlikely.
Mr. Bilton: You have been negative on real growth going forward mainly because of demographics and housing. Is that correct?
Mr. Gundlach: Demographics more than housing because housing has become such a small part of the economy. In passing, I’d note that multi-family housing has been reasonably strong, which reinforces the concept that real estate preferences have changed. The big issue for economic growth is the labor force participation rate, which continues to decline. Stated simply, if the participation rate falls from 70% to 60%, then 10% of the population has gone from work to dependency; that means that the 60% still working now have to work about 15% more productively just to maintain economic activity. As labor force participation rates shrink, it becomes very difficult for baseline economic growth to do anything but fall. Unfortunately, this trend is going to continue, so real GDP growth for the next 15 years is probably going to be a full percentage point lower than it otherwise would have been. The beautiful thing about demographics is that it is not speculation; the labor force 15 years from now cannot be changed because it’s already baked in the cake.
Mr. Bilton: Ego clashes at investment firms are not uncommon. You have been operating for almost five years with some very strong-willed people working at DoubleLine, and with most of your senior portfolio managers for nearly two decades. Yet your investment team has remained remarkably stable. How has that been achieved?
Mr. Gundlach: People who have strong opinions and disagreements or different points of view are welcome. We just want to make sure that our judgments are based on clear analysis of data and we are not holding to a position because our ego is invested in a conclusion. The world is continuously changing, and our conclusions must adapt to that changing world. We try to make sure that we listen to ideas that are different from our own. We are skeptical, and we continuously challenge our baseline ideas. Also, our firm is owned by our investment and operations people. We are all owners in a significant way, so our interests are perfectly aligned. We do not have to answer to masters in some far off city or country. In addition, we have a culture of respect and inclusiveness. We just don’t have turnover; our teams have worked together for a very long time and have a lot of institutional memory. We understand our personalities and have learned how to work together over literally a couple of decades.
It also helps that our investment performance has been very good. I have noticed that ego clashes tend to happen at firms when they are having performance challenges. I do try to give credit to people when things are going well, but recognize that when things go wrong, I need to accept most of the blame. I am the CEO/CIO of the firm, and in the last resort I am responsible for what we do. I get asked this question a lot, and I do struggle with the answer. In reality, you are probably asking the wrong person and should ask other people in the firm. It does help to be on a winning team, although I tell everyone we don’t have a birthright to superior performance and there will be challenges sent our way. The fact that we haven’t had any in a long time should not be misconstrued to mean they cannot happen.
One of the things I have been successful at doing is keeping people grounded in reality. For example, in 2013 at one of our fund board meetings, I noted that DoubleLine had been in business for three years and we had perhaps experienced only four days of outflows during that whole period. However, I added that I would almost guarantee outflows before the year-end because of over-investment in fixed income by naïve investors in 2012. So when we actually had outflows, our team was psychologically prepared. We do try to avoid “rah, rah, rah” and instead pay attention to areas needing improvement. We will always have periods of good luck, but those will be balanced out by more-challenging periods. We’ve been around long enough, through enough turmoil and through enough changes in markets that we don’t get flustered by change. Sometimes I feel like a flight attendant on an airplane; when the turbulence comes, everybody looks at the flight attendant. If he or she is not overreacting, then it must be business as usual and everything is okay. In fact, when things are going well and a lot of people are jumping up and down, I try to put all of this good feeling into an escrow account. So when things are a little less wonderful, we can dip into the reserve and try to keep an even keel.
Mr. Bilton: You have said many times in the past that you’re never going to let DoubleLine get so large that you cannot run what I call CUSIP portfolios.
Mr. Gundlach: That is correct. One of the issues in fixed income has been the dominance of the industry by a few large asset management firms managing literally trillions of dollars. Some people refer to the “fixed income oligopoly.” The problem with size is that it becomes very difficult to perform at very large asset levels. Furthermore, being too large for the investible universe of true, CUSIP-numbered securities, the oligarchs have to resort to shadow financing schemes. Large portfolio exposures involve some kind of counterparty swap rather than cash bonds. Our firm is built on performance. We don’t run index funds. To perform means security selection has to be a contributor, which limits potential size. I also don’t like the idea of introducing layers of incremental risk through shadow financing and counterparty contracts.
DoubleLine will never be a $500 billion asset manager. I doubt that we will ever be a $200 billion asset manager. Frankly, our goal was to get to where we are today – to be a $50 billion-$60 billion asset manager. If we go to $70 billion or $80 billion, okay, but I’m not spending a lot of time obsessing over a plan to get to $200 billion because I really don’t want to get there. We have 125 employees; we only had 50 a couple of years ago. A lot of that increase is for infrastructure, but we’ve also started some new products. Given the importance of our culture of outperformance, I want the firm to be manageable, so that I know what is going on. I want to know every employee because we must not lose the culture. If we lose the culture, we lose what makes this firm work so well.
Mr. Bilton: Jeffrey, you have been a collector of modern art for a long time. Do you think there’s a bubble in the modern art market?
Mr. Gundlach: Oh, no. The modern art market is not as strong as people think. What gets reported from the auctions are a handful of sales, maybe a couple of dozen a year, that really are at astronomical price levels. Those transactions for pieces at the highest tier of the market reflect the amazing amount of wealth polarity that exists globally and the amount of wealth that has been concentrated in a few hands, particularly in China and Russia. For example, Monet’s “Water Lilies,” a beautiful painting that’s as blue-chip as it gets, recently sold for $54 million at Sotheby’s. However, when you drop down a couple of price points, there is not a lot of movement in the art market. For example, prices for paintings by Alfred Sisley, a second-tier French Impressionist, haven’t changed in years. The art market is very diverse. Analogous tiered price behavior occurs in other asset classes. Consider the market for real estate. Median home prices are down and the upper-middle-class home price is going nowhere, but a 10,000-square-foot penthouse in Manhattan is up massively. Again, these differentials reflect the wealth polarization brought about by globalization and the hollowing out of the U.S. and European middle classes. The art market is just a piece of this trend. The interesting thing about the art market is the area of the market that has the highest liquidity is the very high end. It sounds counterintuitive because there are very few buyers, but there is in fact always a buyer. The person who bought the Monet could probably sell it next week for the same price. If you buy an Alfred Sisley and try to sell it next month, you will probably take a 30% hit.
Mr. Bilton: Jordan Ellenberg, professor of mathematics at the University of Wisconsin, just wrote a book, “How Not to Be Wrong: the Power of Mathematical Thinking.” How do you think your mathematics training has helped you in investments?
Mr. Gundlach: There is no opinion involved in mathematics, and I think that helps with our investment approach. There is so much noise in the investment world, so many opinions. At DoubleLine, we try to focus on the data and tune out the noise. We don’t need reinforcement from the opinions of other firms, because we believe our positions are provable. I get a lot of solicitations from economic consulting firms asking us to subscribe to their services. We have no interest in that because all that does is cloud our thinking. We spoke about housing earlier. Recently one service contacted me to tell me we are totally wrong about housing; that they are the world’s experts and we should subscribe to their service. I found it remarkable that they thought we would care. It reminds me of an artist named Donald Judd. He was an art critic, a painter and a sculptor. Over time, Judd increasingly disliked the herd mentality of the art world and felt that talking to other artists made it difficult for him to follow his own vision. He did not deny that talking to others could help him think more broadly and expand his artistic direction, but he felt whatever benefit came from that was more than offset with the loss of his own perspective. So he left New York City and ended up working and living in Marfa, Texas, which is as far away artistically as you can get from New York. What he liked in Marfa was the absence of outside influence: he was completely alone in setting his own artistic direction.
While we’re open to new ideas and certainly question ourselves about why we are right or wrong, the danger always exists that we get could sucked into the consensus. My biggest mistakes as an investor typically occur when I find myself caught in the vortex of consensus thinking. It doesn’t mean that the consensus is always wrong. Contrarianism is not an evergreen strategy. However, I often find that we are most profitable when we enter a strategy with very little company. Mathematics helps in that regard because when you study math, opinions regarding the outcome are irrelevant. 2+2 is always going to be 4 in base 10. Years ago we developed a way of thinking about the high-yield bond market when we compared it to the 30-year Treasury bond. Most observers thought the idea made no sense, but we believed that the two instruments had the same risk when it came to drawdowns and volatility and therefore could be reviewed in the same context. Mathematics training forces us to think objectively.
Mr. Bilton: I would like to keep asking questions, but I think our time is up. Thank you, Jeffrey.
Mr. Gundlach: Thank you, and remember we reached the three-year anniversary of our ASTON/DoubleLine partnership on July 18th.
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The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change. It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. Investing involves risks and possible loss of principal. Aston Asset Management does not accept any liability for losses either direct or consequential caused by the use of this information.