Lawrence McDonald, publisher of the investment research publication The Bear Traps Report, blames the Federal Reserve for the global slowdown and expects a softer US Dollar. He bets on emerging markets, commodities and the Chinese EV market.
The countdown is on: Next week, the Federal Reserve will lower interest rates for the first time since December 2008. In the eyes of Larry McDonald, it’s past time for the Fed to ease monetary policy since tight financial conditions are the main cause for growing fears of a global recession.
«It’s not that Fed chairman Jerome Powell is behind the curve. It’s more like the Fed crashed the global economy», says the renowned publisher of The Bear Traps Report, a weekly investment research publication focusing on global political and systemic risk with actionable trade ideas.
To avoid a worldwide recession, the Fed has to move quickly and weaken the Dollar, argues the former vice-president of distressed debt trading at Lehman Brothers. With the depreciation of the US currency, he expects a capital flight out of the United States.
Against this backdrop, he spots danger in big tech stocks like Amazon and Facebook. In contrast, he sees opportunities in emerging markets, in commodities and in the Chinese market for electric vehicles.
Mr. McDonald, Wall Street is excited about the first interest rate cut in more than a decade. What’s your take on global financial markets?
The Federal Reserve backed away and saved the day for now. But the world is dramatically out of balance: There are a massive $65 trillion of GDP outside of the United States and $19 trillion of GDP inside. Yet, foreign nations rely heavily on US Dollars for all types of international trade. As a result, the Fed cannot conduct monetary policy in a traditional sense. It’s basically the world’s central bank and therefore its policy actions have far too much impact on the rest of the planet. That’s why economists who are myopically focused on US economic fortunes keep embarrassing themselves.
What does this mean for monetary policy in the United States?
The Fed tried to tighten interest rates and to shrink the balance sheet at the same time. In response, they blew up the global economy for the second time since 2015. Everybody blames the trade war for the economic slowdown. But if you look at the real numbers, trade is just a part of it. It’s the Dollar moving higher that crushed the global economy. Just look at the German economic data for instance.
Why is the Fed to blame for Germany’s trouble?
The Fed has laid a beating on the global economy with eight rate hikes and more than $650 billion balance sheet reduction; all since 2016. That’s an enormous amount of tightening compared to the rest of the world. It’s draining Dollars from the global system and really hurts Germany’s trading partners. In consequence, Germany is facing a recession and the US hasn’t even started trade negotiations with Europe.
Until last summer everything looked fine. The Fed was normalizing its monetary policy and it seemed like the stock market is playing along. What went wrong?
It’s like a multiplier: Even though the Fed hiked rates eight times since the US elections you can make the argument that they really hiked fifteen times because of the reduction of the balance sheet and the impact on financial conditions tightening. So essentially, they have tightened much more than they have led us to believe.
Now, Fed Chairman Jerome Powell is determined to ease monetary policy. Is the Fed behind the curve?
At the beginning of the year, financial conditions have tightened so much that it took at least 1 or 2 percentage points off of global GDP growth. So it’s not that Powell is behind the curve. It’s almost like the Fed crashed the global economy. Remember, in October, Powell said that «we will stay in our lanes» and that he didn’t care about the global economy. Now, it’s very clear that the Fed has to reverse at least two of those fifteen rate hikes until September.
How will this impact the outlook for the global economy?
The Dollar is like a global wrecking ball: There is about $15 to $16 trillion of US Dollar denominated debt in the world. Everybody has borrowed in Dollars. So in recent years - while the Fed was trying to hike rates and simultaneously reduce its balance sheet - trillions of Dollars were sucked back to the United States. The big loser was the emerging market’s economic engine. Now, there is almost no growth anymore in the world.
China recently posted its lowest quarterly growth in almost a decade. What’s going on there?
Before the trade spat even started, China was deleveraging and in a really bad place. At the end of May, we saw the collapse of the Inner Mongolian regional bank, Baoshang. At the same time, the Chinese economy is weakening at a fast pace. That’s having a massive impact on exporting countries like Germany or Japan. In Japan, machine orders were down 40% in June. That’s worse than during the financial crisis.
What’s going to happen next?
The global economy is headed for a recession. The only way out is if the Fed pulls out the fire hose and weakens the Dollar. If they are successful, the global economy is going to stabilize and will have a good run. But if the Dollar stays up where it is then the world goes into a deep recession.
Other important central banks like the ECB and the Bank of Japan are signalling a fresh stimulus as well. Is it even possible for the Fed to weaken the Dollar under these circumstances?
Think about this: Mario Draghi is now heading for retirement. But everything he tried to accomplish during his tenure has been wiped out by the Fed: Italy is basically in recession and the same is true for Germany - and that after the ECB expanded its balance sheet by €3.5 trillion. It’s so absurd. Why is the ECB executing monetary policy when, at the end of the day, the Fed is really Europe’s central bank?
What’s more, negative interest rates - designed as a short-term jolt - have become a permanent policy tool in Europe and Japan. What do you make out of negative interest rates as a former senior distressed debt trader at Lehman Brothers?
Today, you have $13 trillion of negative yielding bonds. That’s absolutely sickening. It’s a colossal failure of common sense all over again. Negative rates obviously are helping to put Deutsche Bank out of business. Also, they are forcing capital into really bad places. The central banks are literally sowing the seeds of the next crisis.
More than a decade ago, the fall of Lehman brought the financial system to the brink of a melt-down. Where do you see the greatest risks today?
It’s like in the movie Terminator II with this villain who turns into liquid-metal: When you watch liquid roll down a hill and it runs into some obstacle; it just moves around it. The same is the case with risk. The regulators have regulated the big banks and taken down the risk in one spot. But, like this silver man in the movie, the risk has just oozed into other places.
Where did it ooze to?
A perfect example is private equity: Around $2 trillion have flown into this sector. You have Softbank, venture capital firms and all types of debt funded instruments in private equity. Just look at these loan portfolios. For instance, you had this dramatic situation at Natixis' troubled H2O fund in London. There literally are dozens of H2Os out there. All across the corporate space, you have these kinds of black holes. That’s where the money has flowed to.
What does this mean for investors? Where would you advise extra caution?
The high yield market, because negative interest rates are dramatically altering investor behavior. The bid to European and US high yield bonds has been very strong. Therefore, the spreads are not widening even though the credit quality has dramatically worsened. The slightest weakening of the US economy will cause a massive spike in defaults because so many bad loans have been made. There is a lot of bad paper out there and you are going to have $1 trillion that’s going to be lost.
Where else do you see trouble brewing?
Clearly sections within China; local government entities for example where we see rapid defaults. And then in Europe. Greece is on a better road, but Italy is primed for some type of default. Italy has almost $3 trillion in debt and the GDP growth rate has been negative. They are going to have a massive stand-off with the ECB sometime in the next five to seven months.
And what about the banks? Could Deutsche Bank become the next Lehman Brothers?
No, this is a totally different situation. They have been bleeding out the bad news one quarter at the time for ten years. If anything, European banks are a buy here because they are extremely cheap relative to American banks. You still have the risk of defaults in Italy. But European bank equities have priced in a lot of bad news.
What’s your view on the two big Swiss banks, UBS and Credit Suisse?
I don’t have a strong opinion. But the way banks like Société Générale, Credit Suisse or UBS are trading, it looks like they’re back heading toward their all-time lows. So you might have one more leg down with a period where they have to raise capital to strengthen the balance sheet. But then, there is going to be a screaming buy opportunity in the European banking sector sometime over the next year and a half.
Meanwhile, the S&P 500 is trading near record highs. What’s your take on US stocks?
The strong Dollar and stock buybacks have been funding the stock market in the United States. Investors are betting on passive investments and chasing the FAANG stocks. Since 2010, their weight in the S&P 500 has gone from around 3 to 15%. You have a lot of money hiding out in the FAANGs and that money is at risk.
You have this situation where the Trump administration is going to come at them as well as the House and the Senate. The Democrats have seen President Trump taking so many populist votes away from them. Now, they are going to turn even more populist and turn against these big tech companies through aggressive taxing the topline. Every single Presidential debate is going to have a really nasty FAANG component to it.
Yet, Washington is also known for all talk and no action. Why should it be different this time?
At the end of the day, investors sell first and ask questions later. When the Department of Justice starts poking around, you could see the stocks of Amazon, Facebook and Google drop 50% over the next three or four years. Remember, in 1998 Microsoft was the big FAANG stock. In the end, Microsoft won the battle against antitrust charges. But it took them twelve to fourteen years to fully recover. For investors, this was a dead period.
Where do you spot opportunities for investors in this environment?
As mentioned, the Fed’s only choice is to soften the Dollar. As they unwind their policy normalization experiment, the Greenback is in big trouble. There are too many Dollars in the United States and that money is going to flee from a weaker exchange rate. That’s going to give a strong bid to commodities, to emerging markets and to other parts of the world.
Which countries will be the big winners?
Brazil and Mexico, for example. You can buy emerging markets equities for 12x to 13x earnings whereas US stocks are trading at 17x to 18x. Also, South Korea has been destroyed because of the trade stand-off and is very cheap. We love South Korea at this valuation level.
And what about commodities?
We started getting long gold last fall. Gold is going to make a run at $2000 per ounce sometime in the next eighteen months. But the best place is silver because the gold to silver ratio is extremely high: Silver is the cheapest to gold in maybe twenty years. That’s why you don’t want to be long just gold. You want to be long gold, silver and other commodities.
Where else are attractive places to invest?
Mathematically, China is energy wise unsustainable. They are consuming more coal than the United States, the UK and Europe combined. Therefore, China needs more nuclear power and that’s where you get the uranium plays; companies like Cameco. Another play is electric vehicles because carbon emissions are so high in China. Against this backdrop, we see 300 to 500% growth in the Lithium and electric vehicle space. So we’re bullish on the lithium ETF LIT and love BYD, the world's biggest electric car maker with Charlie Munger and Warren Buffett as shareholders.