Updated Saturday, December 20, 2014 as of 3:08 PM ET

Gundlach Expecting Kaboom of Defaults

Now, after a global financial debacle, bank bailouts, the European debt crisis, a slowdown in China and a halting U.S. recovery, Gundlach is preparing for another bout of bad news -- his so-called third phase. While he doesn’t expect any countries to default in 2013, he points to Japan as an example of a government that may have to embark on more-aggressive asset buying that could lower the value of its currency.

Its economy contracted at an annualized rate of 3.5 percent in the third quarter. Japan’s trade deficit rose to a half-year record 3.22 trillion yen ($40.5 billion) in the six months ended on Sept. 30. And the central bank increased its asset purchase program on Oct. 30 to 66 trillion yen to overcome deflation.

European Events

“Japan is running out of policy tools,” he says.

Following actions by the European Central Bank that pumped $355.4 billion into the region starting in 2010, DoubleLine managers see several possible events that could hammer markets, from Finland exiting the euro zone to another near default of a Spanish bank.

“The only reason asset prices are up is because of all the liquidity in the system,” says Luz Padilla, manager of the $707 million DoubleLine Emerging Markets Fixed Income Fund. “Our concern is that it can turn very quickly.”

In the U.S., Gundlach sees a postelection, pre-fiscal cliff economy that’s growing anemically and only because of consumer loans, government stimulus and the Fed. He says inflation could jump by 2 percentage points if the Fed ramps up its purchases of government debt beyond what it has done so far.

Pressure Cooker

Led by Chairman Ben S. Bernanke, the Fed has purchased $2.3 trillion in securities in two rounds of quantitative easing since 2008. And it may extend its third round through 2013 and climb past a total of $1 trillion in purchases, according to economists interviewed by Bloomberg.

“You’re just going to build up pressure in the pressure cooker, and when it blows, the lid will blow sky-high, and that’s when you get to phase three,” Gundlach says.

His pessimism sets him apart from other prominent money managers, notably Larry Fink, chairman of BlackRock Inc. Fink says the U.S. banking system is in relatively good shape and the large supply of natural gas in the U.S. will create jobs. The economy grew at a stronger-than-forecast annual pace of 2 percent in the third quarter.

“In the long run, I’m very bullish on the United States,” Fink, 60, said at a BlackRock iShares conference in November.

Fiscal Cliff

Gundlach says he has no faith that President Barack Obama in his second term will reach an accord with Congress to make significant cuts in the $1.09 trillion deficit. He says the tax hikes proposed by Obama on the wealthy wouldn’t bring in enough revenue to have a significant impact and politicians probably won’t make major cuts in entitlement programs because the public overwhelmingly supports them.

Gundlach dismisses the chances of a grand compromise on the so-called fiscal cliff of automatic spending cuts and tax increases totaling $607 billion if an agreement isn’t reached by January. Rather, he expects politicians will find a way to push the deficit issues into 2013 and beyond.

“I don’t think Obama is likely to give on anything, and I doubt the Republicans are going to roll over because they failed to regain the White House,” Gundlach says.

In making his case to abolish the Fed, Gundlach cites an argument made by former Texas Representative Ron Paul in 2002. Paul said the U.S. Constitution grants Congress the authority to coin money and regulate the value of currency and that it doesn’t give Congress the right to delegate control over monetary policy to a central bank.

Emerging Markets

Richard Pildes, a constitutional law professor at the New York University School of Law, says that line of thinking has been widely discredited. “The constitutionality of Congress creating independent agencies like the Fed has been long settled,” he says.

Gundlach’s outlook isn’t uniformly bleak. He sees some opportunities in emerging-markets equities, particularly in China, where the Shanghai Stock Exchange Composite Index fell 3.5 percent in the first 10 months of 2012.

Chinese stocks make up the majority of international equity holdings in the DoubleLine Multi-Asset Growth Fund, says Jeffrey Sherman, a portfolio manager for the fund. It increased its exposure to international equities to 6.7 percent as of Oct. 31 from 4.9 percent a month earlier.

Beyond China, Gundlach says, the demographics in some emerging markets will support sustained growth. While developed nations will have fewer than three workers for every retiree by 2025, Brazil, India and Mexico will have almost six to seven workers, according to the U.S. Census Bureau.

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