«The new subprime risk is in the emerging markets.»
Pressure on emerging markets is rising. For the past decade, a river of easy money rushed into developing countries. Now, that trend is reversing. Rising interest rates and trade wars are creating havoc. The Turkish lira and the Argentine peso have crashed. China’s stock market is stuck in a bear market. For Larry McDonald that’s only the beginning of a full-blown crisis. The renowned editor of the macro research platform Bear Traps Report knows what he’s talking about. As a former distressed bond trader at Lehman Brothers he experienced the emergence of the 2008/09 financial crisis at the center of the storm. Now, his biggest concerns revolve around the massive debt binge which took place in the emerging markets. He warns that mega cap tech stocks like Apple (AAPL 170.42 -0.22%), Amazon (AMZN 1607.95 -0.91%) and Google (GOOGL 1119.63 -0.85%) will be the most vulnerable when the crisis spreads to the financial markets of the developed world.
Mr. McDonald, as a former bond trader at Lehman Brothers you were one of the early voices warning of the subprime mortgage crisis. Where do you spot the most dangerous risks in the financial markets today?
The new subprime risk is in the emerging markets. There is a lot of concern about emerging markets debt, especially about the amount of Dollar denominated debt. For instance, the Chinese banking system is $44 trillion in size. That’s almost three times the US banking system and the Chinese economy is already weakening. So, you have a highly leveraged situation where you’re putting tariffs on. I don’t think the Trump administration is aware of how dangerous this is.
Why is this situation so dangerous?
It’s not just China. It’s Turkey, it’s Brazil, it’s all these countries which have issued so much debt. In total there is like $15 trillion of new emerging market debt since the financial crisis. There are trillions and trillions of Dollar and Euro denominated debt and now it’s starting to come into a massive default cycle. At the end of the day, the Federal Reserve and the European Central Bank are going to get the blame because they have been far too accommodative.
What could trigger this wave of defaults?
The Dollar plays a key part. It’s like a global wrecking ball: when the Dollar moves up and emerging markets currencies drop their interest costs are exponentially more difficult to pay off. In the case of Turkey, the currency is down around 40% against the Dollar this year. So, if you’re a Turkish company and the interest payment was 1 million Dollar per quarter you are looking now at a payment of 1.4 million Dollar per quarter.
How dangerous is this for the global financial system?
When we talk about financial conditions we’re talking about the tightness of credit and the speed of the tightening of credit. Right now, financial conditions globally are tightening at the fastest pace since 2015 when we had the Chinese currency devaluation. At the Bear Traps Report, we also measure currency volatility and credit default spreads on emerging market banks versus US banks. In this area, we’re looking for divergences. During a healthy «risk on» period, when everybody is taking risk, you typically don’t see divergences in credit quality globally. In contrast to that, in a market that’s about to turn «risk off» many times you see dramatic credit divergences ahead of it. Right now, the credit quality of European and Asian banks is weakening relative to US banks.
What does this mean for investors?
Today, everybody in the US is hiding out in FAANG stocks like Facebook (FB 162.5 -0.88%), Apple, Amazon, Netflix (NFLX 356.87 -0.61%), Google and Microsoft (MSFT 108.22 1.23%). That’s really concerning because there are more than six hundred ETFs which own these 6 stocks. The thinking is that the FAANGs are a safe investment because the US has decoupled from the rest of the world. But what’s happening is that the more money goes into passive investments the more these FAANG stocks get pumped up. For instance, think about the QQQ ETF which is based on the Nasdaq 100 (Nasdaq 100 7055.1793 0.47%) Index. If a billion Dollars goes into the QQQ ETF than close to 400 million Dollars goes into the FAANGs. That’s insane.
Ten years ago, we were lectured again and again that the emerging markets had decoupled from the US and that our money was save in emerging markets. That’s because in opposite to the developed markets like the United States, the so-called BRIC countries Brazil, Russia, India and China were growing at 8 or 9%. So, they were considered to be safe places to invest. The thinking was that their growth is so powerful that even if the US goes into recession the global economy is going to be OK. Literally every single TV program, magazine and newspaper was preaching this garbage.
But as a matter of fact, economic growth in the emerging markets was quite impressive over the last decade.
True, but US stocks did way better than emerging market equities over that time. It’s ironic that today, basically the exact same story is being pitched to investors again. But now, the US is the safe place and has decoupled from the rest of the world. So, there is safety in these FAANG stocks, the story goes. But that’s complete garbage. All these ETFs are a bit like shadow banks. They are like the CDOs on the eve of the financial crisis. There are so many people in them that there is not going to be enough liquidity when things turn bad. We saw this when Facebook dropped $122 billion in one day. That has never happened before.
How bad is it going to get?
We are going to see this across all the FAANG stocks. It’s going to get really ugly and it’s probably going to happen in the next six to nine months. It’s going to be close to a 20% drawdown for the entire US stock market. But the FAANGs, these crowded stocks, are going to drop 30 to 40%.
The last big stock market crash in the US happened ten years ago. What goes through your mind when you think back at the failure of Lehman brothers?
People blame Wall Street for the financial crisis of 2008. That’s fine. But the largest misconception has to do with the central banks. The Lehman management never ever would have taken that much risk if the Federal Reserve was aggressively raising rates. Central bankers have put us in such a bad place and now they have done the same thing again. If you look around the world, overall there is around $45 trillion of new debt that wasn’t on the planet ten years ago.
What exactly happened at Lehman in the time leading up to the financial crisis?
I remember being on the trading floor in 2006 and 2007 and they were telling us: «take more risks, take more risks.» So, I was asking one of the senior guys: «Why are they telling us to take more risks?» He said: «The Fed had kept interest rates super low for almost three years and then raised rates very slowly». This was the reason why the Lehman managers were going around and giving us orders to take more risk. They were doing it because the Fed had laid out this very transparent policy path. But here’s the key: There is a beast in the market and in capitalism in general. So, the Fed gave the capitalist beast far too much visibility on monetary policy. In other words, when monetary policy is so visible it creates more risk taking. And that’s happening again today. The central banks have created a dynamic where if things are starting to soften they are trying to contain the risk. But each time they do that they’re building up more risk.
Why didn’t the Lehman managers understand these risks?
You could see the iceberg ahead. I was part of a group of revolutionaries within Lehman. We were trying to stop the madness. But one by one we were all silenced. At Lehman, you did your job and you kept your head down or you lost both. Also, the top managers on the 31th floor at Lehman’s headquarters in Midtown Manhattan were totally disconnected from the world. They had a private elevator which means that we never saw Dick Fuld and the management team. Up on that floor, they were focused on philanthropy and they had a beautiful, $200 million art collection. They were just consumed with other things. What’s more, the management team surrounded themselves with people that weren’t even in finance.
How did the fall of Lehman Brothers change Wall Street?
There were so many bad apples on Wall Street at that time, but Lehman gets a crazy amount of the blame. Other banks were even more screwed up. For instance, Merrill Lynch was a total disaster. So, the most important change is that the major banks are much less leveraged today. Also, there are more people working at hedge funds, mutual funds and other asset management firms than there are people working at banks. This means there has been a transfer of talent from the banks over to money management firms.
Where do you spot the biggest risks in the global financial system in case of another crisis?
A lot of banks are exposed globally to this emerging market debt. Deutsche Bank (DBK 7.722 4.63%) could go down, but they had like ten years to prepare for this. So, it’s probably going to be banks in Australia and Canada which could get into trouble. But it’s not going to be one big Lehman situation. It’s going to be much more of a spread-out global situation.
Over the last hundred years inside financial markets, we’ve found in each crisis there’s a metamorphosis, a transformation into another serpent, a far different beast. In the 1970’s it was runaway commodity prices, a real energy crisis. In the 1980’s, it was Savings and Loans. The 1990’s brought us sovereign credit defaults and the dot-com blow up. By 2008, a full-blown subprime mortgage crisis was upon us. At that time, the small banks were fine, but the big banks got into trouble. So, each financial crisis is followed by a metamorphosis into another beast and the next crisis is going to look much more like the one in 1998. It’s not going to look like anything like 2008.
What could this mean for a global financial hub like Switzerland?
Right now, the most leveraged organization on earth might be the Swiss National Bank. They own all these FAANG stocks and it’s really concerning because the people of Switzerland are going to lose a lot of money when this crowded trade blows up. Just look at how much of that central bank’s money is in equities. It’s obscene. They don’t understand. In the last five years, $2 trillion has gone into passive asset management. A lot of that money has to go into the FAANGs. So, the Swiss National Bank has made a lot of money because of this passive revolution. They probably think they’re really smart. But they’re just benefiting from this move here in the United States where so much money has gone into passive strategies. Now, the Swiss National Bank is sitting on all these profits and they are going to look like complete imbeciles when the FAANGs are going to blow up.
So, what should investors do?
This may sound insane, but emerging market equities are the cheapest to US equities ever. So even though in the emerging markets there is this credit crisis brewing, over the next six months you want be moving into emerging markets equities because the big drop is going to be in the developed markets where stocks haven’t fallen yet. For instance, Chinese stocks are down 20% whereas US stocks are basically at their all-time highs.
Then again, executing this strategy takes a lot of courage.
What’s going to happen is that China is going to launch another $500 to $600 billion stimulus program and that will give us a rally. Also, I think the Fed will back away a little bit and probably take a December rate hike of the table. Add to that China’s stimulus and you could have a very nice rally in emerging markets stocks.