How To Fix This ‘Vicious’ Market Cycle

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 ETF.com about what he calls the “vicious circle” that continues through global markets today and how it can be stopped.

ETF.com: 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%.

ETF.com: 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.

ETF.com: How disruptive is this to the Fed's plans? This seems to have an overbearing impact on the U.S. markets that the Fed can't really do anything about.

McDonald: The Fed is filled with academics that have never taken professional risk. It totally misjudged the dollar's impact on China, and all these emerging markets, and all the debt. If you've got $10 trillion of dollar-denominated debt and the dollar surges by 30%, now you have $13 trillion. It's crazy. And when the dollar was up by 30% over the last 18 months, what does that do to China? It screws them.

The credit markets vetoed the Fed policy. They literally took control of the wheel. And that's what's going to happen again. The Fed is losing control of the wheel as we speak. That's why [Fed Chair Janet] Yellen was embarrassed this past week. Look at her testimony relative to market conditions. She was talking up China and talking down China risk and global economic risk.

But the CFO of Maersk, which is the largest shipping company in the world, came out and said that this is the worst condition since '08. They're down about 14% in shipping rates. Look at the traffic decline at the Panama Canal.

Stuff doesn't match up. Yellen is like the pilot saying, "OK, ladies and gentlemen, fasten your seatbelts. We're coming into some turbulence. Everything's OK." I get why she's doing it; she doesn't want to scare the markets, she's trying to calm the markets. I get it. But it almost gets back to General Jessup in “A Few Good Men”: It's like, you can't handle the truth. And that's the point. She clearly thinks we can't handle the truth.

ETF.com: Let's look at U.S. markets. A lot of the economic data we've seen lately really doesn't match up with some of the market sentiment.

McDonald: Well, let's look at just the last 48 hours, from Friday [Feb. 12] to today [Feb. 16]. We had strong consumer data in retail sales Friday that’s showing you that lower oil prices are finally starting to impact the economy positively. The bond market sold off viciously. We went from a 1.52% yield on 10-year Treasury on Thursday morning to 1.80% on Friday. That shouldn't happen. That's like a third-world-type move in terms of the yield.

But then, today, the Empire State Manufacturing Survey came out with its seventh-consecutive month below zero. That's only happened twice in the last 20 years, and both times in recessions.

So you have this dynamic where the consumer is relatively OK, but anything that's tied to oil or most commodities—copper, iron ore—is not OK.

And so, it's this wacky dynamic that's playing itself out in the market where certain companies are OK and the consumer in some respects is OK, but the corporations that do business in the global economy are suffering.

ETF.com: You've painted a fairly bleak picture. Did you intend to?

McDonald: I see a bleak picture the next few months. The dollar has to come lower. The dollar is the most vicious wrecking ball, and if the Fed doesn’t get it down by having more accommodative policy, then we're just going to continue down this lower commodity price path, and we’ll see more defaults, more pressure on China. It's just a vicious circle. The one way they can get us out of this is by getting that dollar lower.

ETF.com: The Fed would have to reverse its monetary policy for that.

McDonald: That's the problem. It's a bad situation for the Fed governors because if they reverse course, then they keep building up these debt excesses. It's this really ugly circle. We don't get out of it until you have a lot of defaults and repricing of risk.

ETF.com: What’s a U.S. investor to do?

McDonald: Take a stab at high yield, because high yield has priced a lot of this in. Right now, [the spread is] around 900 basis points, well above the 20-year average in spread. Default rates are 5-6%. You want to start buying high yield.

ETF.com: Would you be buying high yield ETFs, like the iShares iBoxx $ High Yield Corporate Bond (HYG | B-68) and the SPDR Barclays High Yield Bond (JNK | B-68)?

McDonald: Yes. In the meantime, if equities rally, say 10%, the high-yield fund's going to go up 5%, and you're going to get a 6-7% coupon while you wait.

The other thing is gold (SPDR Gold (GLD | A-100). We were very bullish on gold last year. This isn't a new call. But our call in the fourth quarter was that if the Fed softened its position, gold would be the big winner, and it has been. There's $7 trillion in negative interest rate bonds in the world supporting gold. I think you buy the dips in the gold, because gold's probably going to go back to $1,400-$1,500 if the Fed is forced to accommodate.

Contact Drew Voros at [email protected].