Gundlach, Klarman See Bull Market Undermined by U.S. Budget Gap
As signs of a sustained U.S. recovery increase, so do the ranks of big-name investors warning that economic growth will be undercut by the rising federal budget deficit.
Shrinking the gap between government revenues and spending will reduce the nation’s standard of living, slow the economy and crimp returns on stocks and bonds, according to DoubleLine Capital LP founder Jeffrey Gundlach, who managed the top-rated intermediate-term U.S. bond mutual fund for 15 years. Failing to fix the problem could trigger another financial crisis, said Robert Rodriguez, who ran the best-performing diversified U.S. stock fund for a quarter century.
“Unless we get government under control, we will see negative consequences in the form of higher inflation and higher interest rates,” Rodriguez, chief executive officer of Los Angeles-based First Pacific Advisors LLC, said in a telephone interview.
Prominent investors including Seth Klarman of Baupost Group LLC and David Einhorn of Greenlight Capital Inc. have sounded similar alarms. Concern that the expansion will be hurt by the deficit, as well as by political turmoil in the Mideast and North Africa and Europe’s debt crisis, could threaten the biggest bull market since 1955.
“All of a sudden you have this cascade of ominous headlines raining down and investors are trying to figure out what it means for the market,” Jack Ablin, who helps oversees $55 billion as chief investment strategist at Chicago-based Harris Private Bank, said in a telephone interview.
Standoff in Congress
Democrats and Republicans in Congress are divided on ways to reduce government spending in the current fiscal year, which started Oct. 1. The 2011 budget will climb to a record $1.5 trillion from $1.3 trillion in 2010, according to a Congressional Budget Office estimate released Jan. 26. A bipartisan group of senators led by Virginia Democrat Mark Warner and Georgia Republican Saxby Chambliss are working on a plan that would cut the projected deficit over 10 years.
U.S. net government debt will equal 74 percent of gross domestic product this year, compared with 42 percent in 2007, according to IHS Global Insight, a Lexington, Massachusetts- based consulting firm. Japan, at 120 percent, has the highest debt burden among developed countries, IHS data show.
“When you are addicted to living beyond your means and you fill the gap with debt, you reach a point where you are going to feel the pain,” Gundlach said in a telephone interview from Los Angeles.
Whittling down the debt will require higher taxes and lower spending, both of which will act as a brake on the economy’s growth, he said, and higher debt-service payments will create an additional burden.
Gundlach, 51, was fired by TCW Group Inc., a unit of Paris- based Societe General SA, in December 2009 after a dispute with the firm’s management. His TCW Total Return Bond Fund (TGLMX) had returned 7.6 percent annually in the previous 15 years, the most by any intermediate-term bond fund, according to data from Chicago-based Morningstar Inc.
At his new firm, the $5.3 billion DoubleLine Total Return Bond Fund has topped all rivals in the same category, returning 19 percent from inception in April 2010 through March 11, Morningstar data show.
Klarman, founder of Boston-based Baupost, is blunt in acknowledging the costs of cutting the deficit.
“Restoring fiscal sanity will be bad for the economy and financial markets,” he wrote in a Jan. 26 letter to clients. The alternative is worse, he said.
“Governments that run huge deficits, promise entitlements that will be next-to-impossible to deliver and depend on the beneficence of foreigners to stay afloat inevitably must collapse -- perhaps not imminently, but eventually as Greece and Ireland have recently discovered,” he wrote.
Greece and Ireland accepted bailouts after the cost of financing their debt became unsustainable.
Baupost managed $23 billion last year, putting it in a tie with Angelo Gordon & Co. as the 11th-largest hedge fund in the world, according to a ranking by Bloomberg Markets. The fund returned about 19 percent a year from 1983 through 2009, and almost 14 percent in 2010, data provided by Baupost show. Klarman declined to comment.
The Standard & Poor’s 500 Index, a benchmark for U.S. stocks, has gained 92 percent since hitting a 12-year low on March 9, 2009. Gross domestic product will grow 3.1 percent this year, its best performance since 2005, according to the average forecast of economists surveyed by Bloomberg.
The jobless rate unexpectedly fell to 8.9 percent in February, the lowest level in almost two years, and employers boosted payrolls amid growing confidence in the expansion, the Commerce Department said March 4.
“We think the economy is in a self-sustaining recovery right now,” Dean Maki, chief U.S. economist at New York-based Barclays Capital Inc., told Bloomberg Television after the employment report was released.
Mark Zandi, chief economist for Moody’s Analytics Inc. in West Chester, Pennsylvania, said a multiyear plan to cut the deficit can be carried out without derailing the recovery.
“Shrinking the deficit is likely to be a drag, but it doesn’t need to undermine growth,” he said in a telephone interview. Zandi recommended in a report last month that Congress postpone spending cuts until 2012, when he anticipates the U.S. economy will be stronger.
“If Washington comes out with a plan that begins to restore some semblance of sensibility to our fiscal situation, the markets would see that as a positive,” Brian Berghuis, manager of the $21.4 billion T. Rowe Price Mid-Cap Growth Fund, said in telephone interview.
Such a deal could boost the dollar and stocks while cutting commodity prices and expectations for inflation, Berghuis said. His Baltimore-based fund beat 89 percent of rivals over the past five years, data compiled by Bloomberg show.
Rodriguez, the CEO of First Pacific Advisors, isn’t optimistic about the immediate future. He said stock market returns will “underachieve” for the next several years and the economy’s growth will be sluggish as consumers struggle to recover from the financial crisis.
“There is a possibility we are already seeing the high- water mark in employment growth,” Rodriguez said.
Rodriguez told clients in 2009 that if the U.S. government didn’t get its finances in order, the nation would face a crisis in three to seven years that could rival the financial meltdown of 2008.
Music May Stop
“I haven’t changed my opinion,” Rodriguez said. He believes the next crisis could be triggered by investors balking at buying U.S. debt, which in turn could cause the dollar to plummet and interest rates to soar.
“You never know when the music is going to stop,” Rodriguez said.
Rodriguez, 62, ran the $1.4 billion FPA Capital Fund from 1984 through 2009, when he left on a one-year sabbatical. In addition to CEO, he’s an adviser to the funds at First Pacific, which manages $16 billion. In the 25 years ended Dec. 31, 2009, FPA Capital gained 15 percent a year, better than all diversified U.S. stock mutual funds, Morningstar data show.
Rodriguez isn’t alone in warning that the next crisis could involve government debt.
“The global economy is in a period between two crises,” Greenlight’s Einhorn said in a December interview with Charlie Rose. Einhorn’s New York-based firm manages $6.8 billion and profited from betting against Lehman Brothers Holdings Inc.
The debt problems that caused the 2008 crisis have shifted from the private to the public sector without being addressed, Einhorn told Rose. The combination of “a very large budget deficit and a monetary policy that is extremely easy” could eventually bring the economy “to a tough spot,” Einhorn said.
The Federal Reserve has kept its benchmark lending rate at between zero and 0.25 percent since December 2008. Einhorn declined to be interviewed.
Rodriguez says there are glimmers of hope on the fiscal front. States such as Wisconsin, New Jersey and Ohio, he said, are trimming their deficits with spending cuts, potentially providing a road map for politicians in Washington.
“I don’t say it is impossible to change course, but the time frame is growing short,” he said.
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