«We’re seeing a sugar high in the markets, but there’s a good chance that we are going to get a big leg down in the next couple of months and test the lows of March.»

«We’re seeing a sugar high in the markets, but there’s a good chance that we are going to get a big leg down in the next couple of months and test the lows of March.»

«Underneath the Surface Trouble Is Brewing Once Again»

Larry McDonald, publisher of the investment research service The Bear Traps Report, warns that this crisis is far from over. He spots growing tensions in the credit markets and thinks that large public borrowers like Italy and New York State are in need of massive bailouts.

Christoph Gisiger
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Stocks have staged an impressive comeback. Since the lows of March, the S&P 500 has gained almost 30%. Despite that, Larry McDonald would not be surprised if new turmoil soon arose.

«In March 2008 for instance, after the failure of Bear Stearns, the Fed acted aggressively and we had a big relief rally. But then came Lehman,» says the renowned investment strategist.

Mr. McDonald knows what he’s talking about. As a former vice-president of distressed debt trading at Lehman Brothers he witnessed the meltdown of the global financial system first hand. Today, he runs the The Bear Traps Report, an independent investment research service for institutional investors.

In this in-depth interview with The Market/NZZ, Mr. McDonald warns of rising defaults in the credit markets and points out that large public borrowers such as Italy and New York State are going to need bailouts of historic proportions. However, he spots opportunities in the metals and mining sector.

Mr. McDonald, despite a grim economic picture, investors are getting confident that the worst of the pandemic is behind us. What’s your take on the financial markets?

Equity markets have priced in a lot of love from the Federal Reserve. The Fed has done a lot to ease financial conditions, and the amount of liquidity is amazing. Since late February, they’ve done more in terms of balance sheet expansion than nearly two years of action in 2008 to 2010. They’ve clearly pumped up asset prices. Moreover, we have cities re-opening across the United States and some good news on Covid-19 treatments. So the bar is very high in terms of expectations, but underneath the surface trouble is brewing once again.

Why do you think so?

Everyone knows the Fed has expanded their balance sheet by nearly $3 trillion in recent months, but few realize the colossal distortions that are forming in markets. On February 20th, our 21 Lehman systemic risk indicators to gauge the health of financial markets were at the highest levels in years. And then, the market obviously rolled over. Now, our indicators are rising again because there are rising defaults in the leveraged loan space, and there is a lot of credit weakness lurking underneath. Additionally, stock buybacks are shrinking. Over the last decade, we’ve done around $5 trillion of repurchases. But that’s no longer going to be viable. Buybacks are going to go from $600 to $800 billion a year to something like $300 billion. So we’re seeing a sugar high in the markets, but there’s a good chance that we are going to get a big leg down in the next couple of months and test the lows of March.

What could wreak new havoc on the financial markets?

Credit spreads have tightened a lot, especially in the «buy what the Fed is buying» trades, such as investment grade and some fallen angels. But here’s the problem: Whenever we had these situations in the past, there was always another shoe to drop. In March 2008 for instance, after the failure of Bear Stearns, the Fed acted aggressively and we had a big relief rally. But then came Lehman. When you have this type of economic dislocation like today, you are going to have a major default cycle even though the Fed has provided lots of liquidity.

As a former senior distressed debt trader at Lehman Brothers you had a front-row seat at the financial crisis. How do today’s events compare to 2008?

In this recent panic, it got a little worse. During the Lehman crisis, you could still go to a Broadway show or to a ball game. But this is such an incredible economic hit across the board. The banks’ credit default swaps have been much tighter than in 2008, but in Europe there are so many of these zombie banks out there. There’s a whole bunch of institutions that have such massive losses on their loan books that the central banks have to take some of these assets off their balance sheet. But the question is at what price. You can’t move things off at par when they are 50 cents on the dollar.

What kind of loans are you referring to?

One of the big issues are EETCs, enhanced equipment trust certificates. Some of these loans are backed by airplanes and banks finance these things. The way airlines are going to come back is going to be like the restaurants: Let’s say you have a fleet of 4000 planes. So you bring back 1000 planes for the first month, then 2000, and finally you will get to 4000, probably in a year and a half or two years. This is why Boeing is in trouble because that pushes Boeing’s entire sales-production cycle out multiple years. But the worst part is that there are loans on all these planes. That means you are going to have a whole bunch of planes sitting in the desert for many months and even years with loaned capital against it. So interest has to be paid. It’s like a big apartment building with no tenants. This is setting up for a real problem.

In February and March, we witnessed market turmoil of historic proportions. Yet, there has not been a «Lehman Moment» so far. Who could become the Lehman Brothers of 2020?

We haven’t identified a real corporate short yet. But the big one in this cycle is Italy. Italy has shut its economy down for too long, and they have too much debt. Tax revenues are going to be severely impacted, and Italy’s GDP is going to drop massively. The country is insolvent, and the Italian banks are insolvent, too.

Still, central banks are moving heaven and earth to try to avoid another financial crisis.

What central banks are doing is just fueling populism. In America, many people of the middle-class are unemployed, some are getting checks and some aren’t. But then, you have stocks racing back towards their all-time highs after multiple years of buybacks and companies propping up their stocks. It’s similar in Europe where central banks fueled inequality. In Italy, people were already going down this road of populism with Matteo Salvini. So if Europe doesn't issue Euro bonds, then Italy is going to leave. But if they issue Eurobonds, the Dutch are going to leave. There’s not a lot of wiggle room.

What about financial hotspots in the US?

There are massive defaults in CMBS, corporate mortgage backed securities. And then, the big ones are New York City and New York state. They’re both insolvent, which means the federal government has to bail them out. We think New York City, New York State and Illinois need about a $500 billion bailout.

What does this mean for investors?

Sell the sugar high. Since 2015, the only investment thesis which has consistently worked while providing the best risk-adjusted returns is buying capitulation panics like in September 2015, February 2016, December 2018, and March 2020, and then selling or lightening into strength.

Even in an environment like today, where central banks are moving full steam ahead with their massive stimulus programs?

We think equity markets have priced in a lot, and the real economy has lagged. In February, when the Fed was still expanding its balance sheet at a very aggressive pace, every single analyst on the Street told you: «Don’t fight the Fed.» Over and over again, we were lectured to not bet against the central banks. And, sure enough we got hit with Covid-19. So if you invested with this mantra, you have been destroyed. Now, here we are again: The Fed is extremely accommodative, and they’re using a tool box that is probably ten times more creative than the 2008 tool box. So we’re back again to «don’t fight the Fed». The problem is that this type of thinking gets too many people offsides, and it creates really poor risk reward in the market.

Then again, stocks have staged a strong comeback since the lows of March. April was the best month for the Dow since 1987.

Today, the S&P 500 is trading at 21 or 22 times this year's earnings, and 24 times last year's earnings. Now, same crowd that was telling us «don’t fight the Fed» in February, is pushing two new theses. Number one is the «look through». This is just classic: After the S&P 500 has gone from 2200 to 2900, analysts are coming out with reports saying that you can look through two years of bad earnings: We have a 30% hit to earnings, but in two years from now, we will be back at $170 earnings a share for the S&P 500 and work our way to $200. According to this logic, stocks are «cheap». The theory is that the Fed is going to do so much stimulus that you can look through a 30% hit to earnings.

And what’s the second thesis?

Number two is the Fed model which compares the stock market’s earnings yield to the yield on long-term government bonds. The theory there is that even if you cut the earnings for the S&P 500 by 30%, you still got a superior yield of 150 to 160 basis points compared to less than 120 on 30-year Treasuries. Therefore, stocks are cheap. This all looks great on the chalkboard, but when the next shoes start to drop, it’s going to get ugly. In a crisis, there’s never just one shoe, there’s always three or four. The last time it was Bear, Lehman, AIG, Wachovia, Fannie and Freddie. Yet, the same fools that were telling us that stocks are cheap in February because of the Fed model are back at it again. But in March, you didn’t hear a thing from them, not a peep. They were hiding under their desks.

Where do you spot investment opportunities against this backdrop?

It's very rare that you walk into a set up with a risk-reward profile as attractive as in the materials sector. We believe this is the trade of a lifetime: Investors are focused on deflation risk, but the side effects of all that fiscal and monetary spending globally are underappreciated. Everybody knows the Covid-19 tragedy poses a significant deflation risk. But in our view, the «unexpected» we must be positioned for is trillions in fiscal stimulus oozing into the economy after this virus has been snuffed out. Also keep in mind that many mines shut down. So you are going to have an increase in demand for commodities with less supply. That means there is a very high probability of a big move in commodities late this year. That’s why we’re long the XME Metals & Mining ETF and the XLE Energy Select Sector ETF.

What makes you so sure this bet will pay off?

It’s a fascinating setup because the supply destruction is unprecedented. If you are a company in the copper, steel or iron ore space, and you’ve gone through the 2016 debacle, you’re a survivor because that was the worst commodities sell-off in decades. So all these companies have massively deleveraged. Now, they are a little expensive, because their stocks have been up 20 to 30% in the last few weeks, but there will be temporary pullbacks, and then you buy the dips.

Then again, demand for commodities seems to be quite weak. The IMF is predicting the worst economic downturn since the Great Depression.

We’re going to get massive infrastructures bills, both in the United States and in Europe. Covid-19 destroyed so many service-sector jobs. When we come back to restaurants, the number of waiters and waitresses is going to be cut in half because you are going to have half the tables for years. Since the pandemic has destroyed the service sector, you are going to have hundreds of thousands of people who need to get a job, and they go to migrate into infrastructure jobs. The US is the perfect example. We have such horrific infrastructure. More than 47,000 bridges are in crucial need of repairs. So you are going to have this tremendous demand for commodities.

Are you long commodity producing countries, too?

Yes, we’re long equities in Chile and Brazil. They are screaming buys.

How important is inflation for this bet to pay off?

We are going to have inflation in about six to nine months. There are massive deflationary forces at work now, but supply chain efficiencies have been destroyed because of Covid-19. In the US, we had to send private citizens to China to buy masks because we don’t produce enough. The US doesn’t produce anything anymore. So even though it costs more, there is going to be a massive incentive to bring production back, and this ruins the whole supply chain efficiency. But we don’t even need inflation for commodities to outperform. The consensus is so skewed to further deflation that even the slightest change in expectations will lead to meaningful outperformance from commodity-sensitive risk assets relative to the S&P 500.

What role does the dollar have in your commodity play?

We are highly focused on the US dollar. The Fed has rolled out the big guns to prevent a disorderly dollar move higher. Of course, there is only so much they can control with every central bank around the world in easing mode. With that said, the Fed has done a lot of key work in dislodging the dollar funding markets. Part of the squeeze for dollars at the onset of the crisis had not only to do with emerging markets and dollar-denominated debt, but Asian financial players who fund and hedge their US risk books with dollars. These things are balance sheets intensive, so as dollar funding disappeared from global markets, many big players in the FX swap market were left desperate for dollars and no way of getting them. However, going forward, the Fed has tamed the FX swap market which should ease the dollar pressures.

Nevertheless, the DXY dollar index is up 3% since the beginning of the year.

We think the dollar is the next policy tool for the Fed. They don’t want the dollar wrecking ball undoing many of the successes other programs have had in easing financial conditions. But the rest of the world is in so much pain, that the dollar has not weakened. And, the problem with Covid-19 is that it’s exponentially more damaging for emerging markets because they don’t have the fiscal and monetary engine the US has. So there is tremendous pressure behind the scenes for the Fed and the Treasury to get the dollar lower to save the global economy. In other words: Why would you use $15 trillion of fiscal and monetary stimulus in the US, Europe and Japan combined, and then have emerging markets defaults blow it all up? The only way out is to weaken the dollar. If the dollar strengthens from here, you are going to have a colossal default cycle.

So what will the Fed do next?

The Fed will communicate to the market that just because things are getting better, it doesn't mean that they will take their foot off the pedal. In fact, what the Fed is really going to be saying is: «Don't worry about tightening for a long, long while». The point is: I expect a big forward guidance change to be accompanied by some sort of yield curve control implementation, as Fed Governor Lael Brainard argued for in a speech in February. And that’s very good for silver. The trade of the year will be silver. Every time the Fed used forward guidance aggressively, silver exploded.

Lawrence McDonald

Lawrence McDonald is the founder and editor of The Bear Traps Report, an independent macro research platform focusing on global political and systemic risk with actionable trade ideas, based in New York. As a former vice-president of distress debt and convertible securities trading at Lehman Brothers, he wrote a book on the fall of the investment bank, titled «A Colossal Failure of Common Sense». Published in 2009, the book hit the New York Times Best Seller's list upon release and is now translated into 12 different languages. Prior to working at Lehman, he was the co-founder of Convertbond.com, a website that provided convertible securities information and was acquired by Morgan Stanley in 1999. From 2011 to 2016, he was Managing Director and Head of US Macro Strategy at Société Générale. Mr. McDonald grew up in the Cape Cod region. He attended The University of Massachusetts Dartmouth and received a degree in Economics in 1989.
Lawrence McDonald is the founder and editor of The Bear Traps Report, an independent macro research platform focusing on global political and systemic risk with actionable trade ideas, based in New York. As a former vice-president of distress debt and convertible securities trading at Lehman Brothers, he wrote a book on the fall of the investment bank, titled «A Colossal Failure of Common Sense». Published in 2009, the book hit the New York Times Best Seller's list upon release and is now translated into 12 different languages. Prior to working at Lehman, he was the co-founder of Convertbond.com, a website that provided convertible securities information and was acquired by Morgan Stanley in 1999. From 2011 to 2016, he was Managing Director and Head of US Macro Strategy at Société Générale. Mr. McDonald grew up in the Cape Cod region. He attended The University of Massachusetts Dartmouth and received a degree in Economics in 1989.