Interview

«We’re at the Beginning of a Commodity Super Cycle»

Larry McDonald, founder of the investment research service The Bear Traps Report, is betting on a global synchronized boom in the economy. He predicts rising inflation and a strong bull market in the commodity sector, particularly in energy stocks.

Christoph Gisiger
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Investors look back on a number of turbulent years. With Brexit, the trade wars and, most recently, the global pandemic cyclical stocks had a hard time. On the opposite side, large tech names such as Apple, Microsoft and Amazon dominated the stock market.

«The last ten years were all about austerity and Tea Parties. Now, we’re going to have no trade war, no Brexit, no Covid and a far more global fiscal receptivity framework,» says Larry McDonald. «This is going to be a massive commodity boom. We’re at the beginning of a commodity super cycle,» adds the internationally renowned investment strategist.

As Mr. McDonald points out, signs of a revival of the global economy are already evident in the shipping industry, where freight rates for containers are skyrocketing. A similar trend is going to be emerging in the energy sector, where serious capacity shortages could boost fossil fuel prices as early as next summer.

In this in-depth interview with The Market/NZZ, the former senior distressed debt trader at Lehman Brothers reveals which investment strategies are most promising for the coming commodity upturn, which individual stocks he favors, and which leading indicators investors should pay particular attention to in the coming months.

Mr. McDonald, after a strong surge in the first half of November, stocks have lost momentum. What’s going to happen next?

«We are going to have a real energy crisis by probably August next year where the oil price shots up to something like $100 per barrel.»

«We are going to have a real energy crisis by probably August next year where the oil price shots up to something like $100 per barrel.»

Near term, we are going to have some problems: In the US, the contested election risk is still there, and it’s going to get ugly. Also, we’re not going to get enough fiscal stimulus for now, and that’s another big problem: Every day a new Covid-19 relief bill doesn’t come in, it increases the credit risk in the commercial real estate space where rising Covid cases are showing up.

How serious is this situation?

There is a huge problem in commercial real estate. Many big cities need to soften the blow from the pandemic. All these mayors and governors are taking measures to close down parts of the economy to try to slow the spread. But they’re not doing the math. Just last week, New York City announced that they’re going to lay off close to ten thousand people that work in the subway system, planning a 40% reduction across all subway lines. This whole de-organization is going to create massive defaults in commercial real estate.

How will this affect the financial markets?

There are some real weaknesses that are percolating. Take Vornado, a realty trust that’s heavily concentrated in New York City. Despite the large rally in high yield credit since March, Vornado's CDS spread is just below its March peak. You see it also with some CMBS tranches where the predictive default rate is spiking in the fastest pace since the financial crisis.

How big is the risk that the stress in the commercial mortgage space spills over into other areas of the financial system?

There is going to be a spectacular default cycle over the next year, but it’s going to be highly concentrated in sectors that have exposure to these cities. Also, the Fed is taking measures to try to contain the risk. Unlike in 2007-08, today the banking system is strong, and they don’t want this risk to contaminate the banking system. So it should get a little bit ugly first, but the Fed will be able to contain it. In terms of the CMBS market, they already can buy tranches of Triple-A rated securities. So all they have to do is to buy sub-investment-grade CMBS tranches. And of course, they’re already making mistakes. For instance, they’re buying bonds backed by the New York subway system. They get like a 1.9% coupon, but those bonds should be yielding around 10% right now.

So what is your investment outlook for the coming year?

Over the past few years, we had Brexit, trade wars and now Covid. But most importantly, the Fed was extremely hawkish: In 2017-18, Congress did a trillion-dollar tax cut, and the Fed literally lit it on fire because they hiked interest rates five or six times in one year. Actually, when you add the shrinking of the Fed’s balance sheet, it was more like eight or nine hikes. So the Fed obliterated the tax cuts. Now, they have admitted that that was wrong. They won’t say that President Trump was right, but when you listen to all the Fed speeches, they’re basically saying: «We shouldn't have done that.» Going forward, they are going to have a much more accommodative posture. They won’t hike rates until they see the whites of inflation’s eyes.

And what can be expected with regard to Washington? Are Republicans going to take a hard line on the budget once again, as they did during the Tea Party years of Barack Obama's presidency?

President Obama was really unfortunate to deal with these people. At the start of his first term, he was running a $1.2 trillion deficit, and then they came up with the sequester. This was a forced mechanism that brought the deficit down to $500 billion over three years. Soon after that, the Fed started the taper, scaling back its monetary stimulus. So you had the sequester, the taper and thereafter you had Brexit and the trade war. You had all these growth inhibiting developments back to back, and they created a massive deflationary disaster. That is a bond buyers dream! When you buy bonds in a gridlock government situation, you do really well.

Will President-elect Joe Biden have to deal with a similar situation?

First of all, we have an active Covid-cycle. So Congress can’t go down that same fiscally conservative route now. In January and February, we’re going to have to spend at least $500 billion, maybe even a trillion. Also, it’s a different world. For Republicans, it’s very difficult to go from Trump’s expansive fiscal policy to austerity just because they don’t like Biden. In 2013, when Obama was coming into his second term, the political environment was totally different. At that time, it was a lot easier to sell yourself as a member of the Tea Party if you were a Republican. But make no mistake: This has nothing to do with Trump.

Why?

Trump was just lucky to be at the right place at the right time. This is a populist revolution in America, and it has a major impact on the financial markets because you’re seeing a big fiscal push. Against this backdrop, Trump just brought in tons of Democrats and independents into the Republican Party. Since 2016, the GOP has expanded by 12 million votes. And, he’s spending money. So it’s very difficult to go back to austerity from this kind of spending because you’re going to shrink the party. If Republicans want to take Congress seats in 2022, they are going to have to be more like Trump.

What does this mean for the stock market?

We’ve already pounded the table on this in March and April: The dollar should collapse, and we foresee a global synchronized economic boom once the pandemic is over. The multiplier effect of the stronger Yuan has an incredible impact on the global economy. We now have the vaccines, and a Biden administration that is globally friendly. As a result, we’re going to have a massive global synchronized growth trade. Just look at Microsoft’s stock price: It's basically flat since June, whereas Caterpillar is up almost 40%. Tech stocks are in deep trouble, because everybody who was hiding in those FANG names, now wants to be in Caterpillar, Exxon Mobil, and all these industrials.

Cyclical sectors such as industrials and energy have seen impressive gains in recent weeks. How much upside potential is still in these stocks?

We have a risk of whether the vaccines are safe. So there is a little bit more testing that needs to be done, and maybe it’s going to be slowed down somewhat. But with these vaccines, which are 95% effective, a fair amount of testing and a weaker dollar, we will get a booming global economy that will feed demand for commodities and eventually result in true inflation. The good news about the vaccines are a home run for the inflation trade. Right now, we’re only at the end of the second inning, and our team just scored 15 runs in one inning. So yes, we already had one reflation/reopen trade in the middle of June. But look at where Exxon is trading today: In June, the stock was at $55, today it’s at $39. Same thing with Chevron.

What would be the consequences of a return of inflation?

Bonds are dead. The traditional 60/40 portfolio is going to be in a transformation to something like 50/30, and 20 into commodities. On planet earth, there are $110 trillion of bonds yielding less than 1.75%, and there is no protection. That means investors are going to be forced into commodities to protect their portfolio against inflation. The last ten years were all about austerity and Tea Parties. Now, we’re going to have no trade war, no Brexit, no Covid and a far more global fiscal receptivity framework. This is going to be a massive commodity boom. We’re at the beginning of a commodity super cycle.

What should investors pay attention to?

An important leading indicator in this cycle in comparison to the previous ones is that bonds in the energy sector have been dramatically outperforming the equities so far. This is a really big buy signal for energy equities which now are playing catch up. The energy sector went through hell in 2016 with the global slowdown, it went through hell in 2018 with the strong dollar, and it went through hell in 2020 with Covid. Now, what credit metrics in the energy space are telling you is a screaming buy. Many stocks will be up 100% over the next year.

What strategy do you recommend against this background?

We like commodities in general, also on the agricultural side where some of our favorites are Mosaic, a fertilizer manufacturer, and Teck Resources, Canada’s largest diversified resources company. You can also buy an ETF, for example the XOP. Another ETF is the FCG which is more on the natural gas side. We also like Royal Dutch Shell, Chevron and Exxon. Basically, any company that has exposure to oil.

What’s the specific bull case for energy stocks?

There was a lot of talk about a Green New Deal. We never got it, but every investor in the energy space had been listening to the Democratic party primaries debates about the Green New Deal for almost twelve months. So they are terrified when it comes to capital investment in the US commodity space. This Green New Deal is a wonderful thing, and I support it. But people forget to do the mathematics behind it. It wasn’t thought through. This is something that takes twenty years, but they want to do it over two years. As a result, the Green New Deal scared everybody in the energy space to death. Now, they start to realize that we’re just not getting rid of the energy sector and fossil fuels for quite some time.

What does this mean for the oil price?

We are going to have an energy crisis. With the US energy sector, it’s like turning around an aircraft carrier: If you talk to anybody in the Permian basin, where we have lots of contacts, they’ll tell you that with the amount of supply relative to demand, we are going to be three or four million barrels short a day by the summer. Look what's happening with big shipping companies like Maersk. In some ways, shipping is like energy where they took so many big ships in a drydock because of Covid. When you have a snap back in demand, you can’t just switch the supply of these ships back on, so the price of shipping containers is exploding. The same thing goes for energy: If you have a snap back in demand, there isn’t enough production out of the US and the rest of the world. That’s why we are going to have a real crisis by probably August next year where the price shoots up to something like $100 per barrel.

And how do you see the prospects for metals?

In this market segment, we like commodity producing countries. Chile and Brazil are in a great position, and Mexico too. On the copper side, we like the XME ETF, and people who want to speculate can take a look at Freeport-McMoRan. But with commodities, it’s best to be in a wide basket. In the first part of this commodity cycle, which was from March to June, gold and silver outperformed, and energy was left behind. Then, we had a strong rally in copper, and the later part of the cycle is going to be oil, natural gas as well as agricultural goods.

The price of gold has weakened by around 10% since the record-high in August. Does that open up new opportunities for investors?

We’re long some gold, but gold is in a really nasty spot right now. It’s not a sweet spot, it’s a dark spot. Usually, gold does well in the early stage of a commodity cycle, which we just went through. Keep in mind: Gold likes negative real yields. Recently, nominal yields have gone up, but so far inflation expectations haven’t followed enough. Today, real yields on ten-year treasuries are at around minus 80 basis points. In August, that number was minus 110. That means you had 30 basis points of increase in real yields. So the market is starting to price in a global cyclical revival, but bonds don’t trust it yet. Here’s what will happen sometime next year: Yields will stop going up because the Fed will contain them, and inflation expectations will keep rising - and that’s when gold and silver are going to explode higher.

Where else do you spot opportunities?

There is a colossal migration in the works. Both the GOP and the Democrats have been warming up to Japan in an attempt to move away from China which is a negative focal point in the US populist movement. Republicans and Democrats in the United States have sold out the hearth land of America. A whole group of people was disenfranchised. Five years ago, these people didn’t really know why they were suffering. They knew their taxes were going up, their cost of education was going up, and housing costs were going up because of the Fed. So the American Dream, the ability of the average American to succeed, had been impaired by globalization. As we look forward, that isn’t going away. It’s going to impact the US-China relationship, and it will force us right into Japan's arms. Obviously, Warren Buffett sees something as well, as you can tell from his large investments in Japan.

Why exactly is Japan becoming more important for America?

Japan has a large manufacturing base; they have supply chains. In the past, we put way too many of our eggs into the China basket. There won’t be any new tariffs, but there are going to be some disincentives in terms of US-China trade relations. At the same time, there are going to be more incentives on reshoring, and on trade with countries like Japan. What's more, Japan benefits from global synchronized growth. Reflation will help Japan dramatically. They have an aging population, so they can’t grow organically. They need the world to grow.

Are there any risks investors should pay special attention to in this regard?

We’re seeing a spike in defaults in China. But so far, it’s contained in the onshore companies, and it hasn’t broken out. In some ways, it’s the same thing as with the credit risk in the US commercial real estate space: You have a spike in defaults that hasn’t broken out. A great leading indicator for China over the last ten years has been CDS spreads on Standard Chartered. For now, they’re tight, so credit risk isn’t leaking out of China yet. These are the two main risks, but other than that, all of our Lehman systemic risk indicators have come down. For example, one great leading indicator for global equities is that the yield on CCC-rated bonds tightens fast relative to BB-rated bonds. That’s a sign that good things are happening with cyclicals.

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. 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. 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.