After a crucial week for global financial markets with all the big tech giants reporting quarterly earnings and The Fed hiking its key interest rate further from 1.75 to 2.5%, the world's investors are asking - what comes next?
Larry McDonald thinks Fed Chairman Jerome Powell will soon be forced into another pivot because the financial system is under severe stress. «Our 21 Lehman systemic risk indicators globally are the highest since the financial crisis, a lot of these risk metrics blew through Covid levels,» says the macro strategist and former senior trader at Lehman Brothers.
The editor of the «Bear Traps Report», a research service which is based on a network with over 700 financial advisors and family offices in more than 23 different countries, sees particular risks in emerging markets credit and the European banking sector.
In this in-depth interview, which has been edited and condensed for clarity, he shares his outlook on the stock market in the second half of the year, explains what risks to watch out for, and tells where opportunities for prudent investments.
«With a raging greenback, you add lighter fluid on to the credit risk fire in emerging markets»: Larry McDonald.
Mr. McDonald, stocks have seen an impressive rally over the past few weeks. How do you assess the overall market situation?
Many of our institutional clients are nervous because the Nasdaq 100 is now unchanged after close to two years, and has been under the 100-day moving average since January 13th. We haven’t seen this pattern for quite some time. It’s the longest such stretch since the Lehman crisis in 2008/09.
And how do you interpret this pattern?
The issue of demographics has been out there for years, but it hasn’t really mattered because the Fed always had the market’s back. But now, the risk of inflation hanging around at an elevated rate for several years is rising every day. In this regard, it’s important to be aware that the baby boomers in the US have about $56 trillion of wealth, ten times what the millennials have. Today, the average age of a baby boomer is 67, and the oldest ones are 80. So if you’re a baby boomer and just lived through the Global Financial Crisis and then Covid and you’re seeing the Fed dealing with this elevated inflation, the probability that you’re selling the rallies in the stock market is extremely high.
That means the baby boomers use such rallies to cash out?
Exactly. There is a lot of money in big names like Apple, and the supply of Apple stock at a price level of about $150 is very large. The stock is having a very difficult time getting through all this supply. Same thing with Tesla. And keep in mind: Apple and Tesla are around 9% of the S&P 500. There is a huge amount of overhead supply in these dominant tech stocks, and that’s going to put tremendous pressure on the big index.
What does this imply for investors?
Over the last five years, basically all you had to do was to buy the index. But now, we’re in a new area where the outperformance of certain sectors is going to be spectacular. In 1980, the energy and materials sectors together were close to 28% of the S&P 500. Today, it’s less than 7%. There is always one favorite sector. As you know, in 2007, at the peak of the credit boom, financials were 24% of the S&P 500. They were the Bob Marley sector. It was «One Love», everybody was in financial stocks. Obviously, in 2000 it was tech. But this time, so much wealth has gone into tech stocks that they had to redefine the communications and consumer discretionary sectors to include tech stocks: Amazon and Tesla are about 45% of the consumer discretionary sector. In the communications sector, Google and Facebook make up close to 50%. And finally, Apple, Microsoft and Nvidia make up about 52% of the information technology sector. At the end of the day, they have shoehorned tech into nearly every corner of the S&P 500’s valuation. These three sectors represent close to 50% of the S&P 500´s market cap.
What will happen next?
Here’s the sizzler: We’ve come through a period where inflation has hung out at high levels for about twelve months. If inflation goes away quickly, it’s not such a big deal in terms of the loss of purchasing power. But the problem is that financial instability is going to force the Fed out of its proposed policy path. There is so much risk showing up in things like credit default swaps on European banks or emerging market bonds. Our 21 Lehman systemic risk indicators globally are the highest since the financial crisis, a lot of these risk metrics blew through Covid levels which is really bad. That means the Fed is not going to be able to complete the job on inflation which gets you to inflation sticking around at something like 3 to 6%. And that means you need a whole new portfolio.
Does that mean this counter trend is just a classic bear market rally?
I don’t want to sound too bearish here, maybe there will be one more leg down. But then we could very well see a big rally toward the end of the year because it’s highly likely that the credit risk is going to force the Fed out of its path. If they march on, they’re creating another Lehman situation. That’s the big story at the end of the year. But if inflation stays at an elevated level, that’s going to be a big problem for next year. It forces the Fed to come back and fight inflation again, and the supply overhang is going to kill the big indexes because of the baby boomers cashing out. Hence, my outlook for the next couple of years is around 3000 for the S&P 500 before it’s all set and done.
At the current level, this would mean a further setback of around 25%.
If inflation stays at a range of 3 to 6% for a long time, the loss of purchasing power will be significant. There has already been enormous wealth destruction. The Nasdaq has lost around $8 trillion in market cap, and the Barclays Aggregate Bond Index has lost about $10 or $11 trillion, and that’s just counting investment grade sovereigns and corporates. Adding leveraged loans, high yield debt, private equity, unicorns, cryptos and real estate, you’re talking about a $30 trillion wealth wipeout. Put differently, the 50% of upper income households in the United States have taken a huge loss, and the other 50% have been hit by inflation. It’s a double whammy, and it’s going to force investors out of tech stocks. In our last interview, we talked about the rotation from growth into value, but it’s really commodities, emerging markets and hard assets. These kinds of assets are still dramatically underowned.
In recent weeks, however, commodities have also suffered a sharp correction, especially energy stocks. Does this open up opportunities to increase positions?
Yes, at this level the energy names are a gift. Number one, they are underweighted in the S&P 500. Number two, what’s happening right now is what I call the «hot money flush» - and that’s one of the greatest opportunities in investing. We were talking about the bull case for energy stocks in the fall of 2020 when the amount of pessimism was off the charts. Since then, a new bull market started and a whole bunch of tourists were coming in. Next, you typically have some type of event that shocks those tourists and flushes them out.
So this violent correction in commodity prices is such an event?
If you go back fifty or sixty years, we’ve never seen that kind of move in copper, interest rates and oil as we’ve seen in the last forty days without a deep recession. These are the great indicators when it comes to the economy, and they’re down 25 to 35%. That’s extremely deflationary short-term which has scared all these tourists out. However, the beautiful thing is that we’re only in the second or third inning of a big materials, energy, hard asset bull market. So this is a gift, because as I said earlier: If inflation sticks around at something like 3% to 6% over the next few years, all the pension funds and real money accounts are going to be forced to re-allocate their portfolios to hard assets.
Precious metals and mining stocks have also suffered a severe downturn. How do you assess the prospects here?
The risk reward of the miners here is terrific. You have 10 to 15% down risk, and I think potentially 100% up. Right now, the Fed is pumping a false narrative and pushing up the front end of the yield curve. At 2,9% six months treasuries are yielding as much as, or more than ten-year treasuries, and that’s taking away a lot of money from gold.
What makes you confident about the sector?
Every time when the Fed is selling a false narrative, gold does poorly. In 2015 and 2016, they were promising eight rate hikes for those two years, but then they were only hiking twice. Gold and the miners did very poorly there for some time. But they do extremely well when the Fed overpromises and underdelivers. That’s exactly what’s happening now.
Since March, the Fed has raised the fed funds rate from 0% to 1.75% at a near-record pace. This Wednesday, another 0.75 percentage point move is in the cards. What will this rate hike cycle look like after that?
The Fed is promising 15 rate hikes in total, and $1 trillion of quantitative tightening. They will have to cut that in half because the systemic risk indicators are so dangerous. They must be seeing the same thing I’m seeing, but they can’t admit it yet. They have to publicly show that they are fighting inflation. Meanwhile, we’re actually in a recession, or at the brink of one. After the next Fed hike, the 10-year/3-month Treasury yield curve is going to be inverted. The Fed will start to cut rates next year and the real yield on bonds is going to get extremely negative, and that’s when the miners will do very well.
Which names do you think have the most potential?
I like names like Hecla Mining, one of the largest silver producers. At $3.80 the stock is a screaming buy. Your downside is $3.50, and the upside is massive. Fundamentally, there’s immense demand for silver for electric vehicles and solar panels over the next decade. Hecla’s market cap is around $2 billion, and they have an extremely unlevered balance sheet with only $500 million of debt. The Street’s estimate for next year’s EBITDA is $300. Right now, silver is at $18.50, in the last cycle it peaked at $50 in 2011. It’s pretty likely that silver will see $40 to $50 in this commodity super cycle. That means Hecla is probably going to earn up to $750 million in EBITDA sometime in the next four years. On that basis, the stock is trading at less than 3x potential forward EBITDA. That’s extremely cheap.
Yet, at the moment, it seems that virtually no one wants anything to do with gold and silver stocks.
It’s always the case at this point of the cycle. Pan American Silver, another large silver miner, traded at $6 when the Fed started the hiking cycle in 2015. Once they ended hiking, the stock was up more than 200%. That’s why you want to buy silver and gold miners now, because the important thing about this hiking cycle is the global systemic risk. The Fed has been exporting inflation all around the world into countries that can least afford it.
What do you mean by that?
The strong dollar a global wrecking ball. There are $70 trillion of GDP outside of the United States, but only $23 trillion in the US. The Fed pretends to care about inequality and all the related issues. I’m sure they do in some respect, but they are exporting inflation to places like Chile, Columbia, Panama, Sri Lanka and the other countries where we see protests in the streets. Societies are being destroyed, families crushed because they’re trying to buy essential commodities like oil, gas, food, coffee, corn which are traded in US dollars. When the Fed is promising all these rate hikes, they make the dollar stronger and commodities more expensive. It’s a colossal tax on emerging market countries. If you’re in an emerging market country, you’re getting annihilated. Your standard of living is being destroyed because the Fed is trying to fight inflation in the United States. It’s heartbreaking.
How dangerous could this situation become?
With a raging greenback, you add lighter fluid on to the credit risk fire in emerging markets. Emerging- and frontier market countries currently owe the IMF over $100bn. The strong dollar is vaporizing this capital as we speak. Based on our conversations with clients, we believe that at least five finance ministers globally have called the Fed in the last two weeks. There is so much credit risk in emerging markets, it’s like 1998 levels. In many countries, the credit spreads are through Covid levels, with places like El Salvador, Ghana, Egypt, Tunisia and Pakistan appearing particularly vulnerable. If the Fed is trying to complete their agenda, they’re risking the greatest emerging market credit crisis in thirty years.
The situation is also tense in Europe. In the market for credit default swaps, prices for hedging against the default of European banks have skyrocketed in recent weeks, particularly in the case of Credit Suisse.
The problem is the much bigger loan book of European banks as a percentage of their market cap. Now, the strong dollar is creating tremendous amounts of stress in the European financial sector, and they’re dealing with the Russian crisis as well. This creates a massive tightening of financial conditions. Hence, the credit default swaps on European banks are near or through Covid levels, and a bank like Credit Suisse is just another victim here.
Why are investors particularly nervous in the case of Credit Suisse?
They were already wounded going into this crisis because they were burned by the Archegos and Greensill scandals and never really recapitalized enough. We hear that Credit Suisse is going to be forced into a merger with UBS which is reminiscent of the onset of the Global Financial Crisis when they forced Bear Stearns into a merger with JPMorgan. Every crisis has its hallmark moments, and the probability of the regulators forcing a merger between UBS and Credit Suisse is high. So again: The Fed’s promise of 16 rate hikes including 1 trillion of quantitative tightening is insanity. The problem is that the academics on the Fed’s Board have never been in a risk seat in their lives. They are nice people, and they’re very highly educated. They’re smart, but they just never sat on Goldman Sachs’ trading desk. They never traded bonds, leveraged loans or emerging market debt, but they’re sitting on $9 trillion of assets. This is pure madness.
We have already talked about commodities. Where else do you spot opportunities in this explosive environment?
The big thing is that the credit risk is going to veto the Fed’s policy path. Hence, you’re going to get a weaker dollar and elevated inflation sticking around. In this environment, a commodity producing country like Brazil is going to do extremely well. I’m excited about Brazilian equities. There is some election risk, but net-net, it’s a commodity producing country with much cheaper stocks, and you have the dollar at a secular high.
Any other investment ideas worth considering?
The supply chain woes prompt a renewed push to bring manufacturing back from overseas. It’s a big deal, and everybody knows about TSMC and the China-Taiwan risk in the semiconductor sector. Ramping up reshoring is very inflationary, but a lot of companies can’t roll the dice on globalization. They have to have a backup plan, and Intel is going to be one of the main beneficiaries. If there is an escalation in Asia around China and Taiwan, Nvidia and all the other chip design companies that don’t have a manufacturing base and use TSMC as a foundry are in deep trouble.
In the tech sector, speculative stocks have plummeted. Are there any names that look attractive now?
As a long-term tech play, we like Joby Aviation. It’s an aerospace company, developing an electric vertical takeoff and landing aircraft. Over the next decade, your package deliveries are going to Joby, especially in the countryside, across the farming community or other wide spaces. Joby is going to dominate this business because their first mover advantage on the technology is spectacular. I also like the ownership. Baupost Group, Seth Klarman’s Hedge Fund, is one of the original investors and still owns close to 2 million shares. Toyota and Intel together own 20% of the company. Obviously, the risk is that you’re dealing with a company like Tesla ten years ago. They have no revenues, but the technology leadership and the management team look highly promising. The market cap is about $3 billion, and that could very well be a $30 billion in ten years.
In our last conversation at the end of December, you also identified upside potential in cannabis stocks. Does that still apply?
So far, that was our worst pick of the year. But it’s no question that the GOP and the Democrats are going to come together on the SAFE Banking Act. Even if the Republicans take the House and Senate, they have moved dramatically more to the center on this subject. As I said, it’s not about getting high, but getting well. Everybody looks at these cannabis companies as if they are just marijuana gummy producers. I get that, that’s the near-term cash flow. But the number of drugs that will come out of the Cannabis molecule is going to be tremendous.
What would this mean from an investment perspective?
Over the next twenty years, you have spectacular growth potential. And if we get some kind of legalization on the federal level, that means these companies can have a banking charter and ETFs can own their stocks. If just one third of one percent of BlackRock’s passive assets go into the cannabis sector, we’re talking about these stocks being up 200 or 300%. It’s still a good story, but it’s taking longer to play out. We’re in a bear market, and in a bear market you want to have a part of your portfolio in things like Joby Aviation, Cannabis stocks and other speculative names that have been destroyed.