How To Fix This ‘Vicious’ Market Cycle

February 19, 2016

Lawrence McDonald is currently managing director, head of U.S. strategy, Macro Group at Societe Generale, based in New York City. At the height of the 2008 financial crisis, McDonald wrote a book on the fall of Lehman Brothers, "A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers." In the book, McDonald details his experience working as vice president at Lehman Brothers in New York and provided a behind-the-scenes look on why one of the most prominent investment banks failed. McDonald is a popular speaker and appears regularly on CNBC and Bloomberg TV, among other media appearances. He talked with about what he calls the “vicious circle” that continues through global markets today and how it can be stopped. What is your biggest concern with the global economy right now?

Larry McDonald: Central bankers have dislocated the relationship between bond sales and interest rates and credit quality. In the old days, if you sold a bond, it would be based on the company's credit profile. And that's the way it's worked for hundreds of years. Today there's $10 trillion of new debt in the world that's dollar-denominated. And a lot of that debt is tied to China and commodities and materials.

The way the business cycle is supposed to work is if commodity prices go down, you should stop production. But because the Fed kept rates so low for so long and so much debt has been issued, these companies are actually increasing production of commodities and of oil to pay the coupons of all the debt. And the debt has given them a lot of wiggle room. If the Fed hadn't done so much QE, we wouldn't have anywhere near as much copper in the world. We wouldn't have anywhere near as much oil.

The most dangerous thing in the global economy is China's weakness and all of this debt tied to commodities, which is a vicious circle that is feeding on itself. Lower commodity prices are creating more stress and more bankruptcies in the commodities space. China is doing a lot of business with emerging markets, and all these commodity-producing countries—like Australia, Brazil and South Africa—are weakening as well.

So the problem is this massive amount of debt that's tied to commodities and China. And China's currency is overvalued. Last year, the Brazilian real devalued by 50%. And the South African rand devalued by 30%. Many of these emerging markets have seen 20-40% devaluations. And the Chinese yuan only devalued by 6.5-7%. How do you see this cycle ending?

McDonald: Instead of taking a big bite of the apple and devaluing its currency the way other emerging markets have done, China is taking only small bites. It took a bite of the apple in September. The S&P 500 lost 13%, and it said, "OK, we're sorry. We're going to do this on a much more controlled basis." Then the market rallied back, and it took another bite of the apple last month. So the market sold off again.

It’s going to run out of cash because its cash-burn is about $100 billion a month and there are large currency outflows. Eventually it’s going to just devalue at a 5% or 10% clip. That'll create a bottom in the market, which will probably happen sometime midyear. That will be a buying opportunity. But it's not going to play out until China is done devaluing. It’s playing cat-and-mouse.

Find your next ETF