Larry McDonald: «We Will Witness a Historic Migration of Capital» (2024)

Deutsche Version

Over decades, the global financial markets have enjoyed a period of low and stable inflation, accompanied by steadily declining interest rates. This fertile environment fueled a spectacular bull market in equities, particularly favoring growth stocks in the tech sector.

In his new book, «How to Listen When Markets Speak: Risks, Myths, and Investment Opportunities in a Radically Reshaped Economy», best-selling author Larry McDonald argues that the era of low inflation and declining interest rates is over – with significant implications for investors around the globe. (Here's an excerpt.)

«The danger of these long cycles is that the belief lives on for much longer than markets allow,» says the creator of «The Bear Traps Report» and former senior trader at Lehman Brothers. «Many investors are therefore unprepared for this new environment,» he adds.

In this in-depth interview with The Market NZZ, which has been lightly edited, Mr. McDonald explains why he believes the macroeconomic environment is about to change fundamentally and which sectors and companies will be the big winners.

Your new book is entitled «How to Listen When Markets Speak». What are the markets telling us right now?

It looks like the central banks are no longer too worried about inflation. This comes at a time when the signs are pointing to a second wave of inflation. I therefore believe we’re about to witness a historic multi trillion-dollar migration of capital, one that ushers in a new class of winners and losers.

What does this mean for investors?

Anyone invested in the markets will be affected by these tectonic shifts. Since the end of the Cold War, the world has experienced an almost uninterrupted period of declining inflation. Most people have become so accustomed to this environment that a significant proportion of global wealth has been, and still is, concentrated in financial assets such as growth stocks and bonds.

However, such investments have paid off well in the past.

That’s true. But from an investing standpoint, the danger of these long cycles is that the belief lives on for much longer than markets allow. Many investors are therefore unprepared for this new environment and are still convinced that tech behemoths such as Apple, Microsoft, Amazon or Nvidia will continue to outperform the market over the next ten years. But here’s the problem: As we transition to a new era of persistent inflation, similar to the stagflation period of the late 1960s to the early 1980s, we can expect a significant rotation away from growth stocks and towards hard assets and value stocks.

Why do you think we’re about to observe a similar shift today?

The main drivers of the great boom that shaped the financial markets in the past period were globalization and the integration of labor and savings from Asia into the global economy. An increasingly borderless financial system emerged, to which technological innovations from Silicon Valley made an important contribution. These structural forces have driven inflation ever lower since its peak in the late 1970s. But this era is now over.

How come?

One of the main reasons has to do with geopolitics. As we’re already witnessing, conflicts around the globe are on the rise. After the United States have largely dominated global politics for many years, a multipolar world order is emerging, which will be accompanied by a devaluation of the dollar and sovereign debt crises. This, coupled with trade wars and the re-shoring of industrial production, creates a recipe for sticky inflation. Against that backdrop, I also fear that we will soon be faced with a catastrophic shortage of natural resources.

What leads you to this assumption?

The roots of the problem lie in the fact that booms and bubbles lead to excesses. For example, the final phase of the last major commodities boom was characterized by exuberant capital investment in the years between 2009 and 2014. From oil, gas and uranium to industrial metals such as iron ore and copper, gigantic sums of money were poured into new projects, leading to a total collapse of commodity prices. This brutal bear market fundamentally changed the mentality of the industry. If you’re the CFO of a commodities producer and see one CEO after another being fired, you soon adopt a very conservative attitude to investments.

So what are the consequences today?

This unrestrained behavior, which resulted in numerous bankruptcies and asset sales during the crisis, as well as stricter regulations, killed investment in the traditional energy sector, including oil, natural gas, and coal. According to my calculations, investments in fossil fuels and metals were cut by $2.4 trillion between 2014 and 2020. In recent years, Western countries have also waged a political campaign against fossil fuels. As a result, supply has declined across the board, while the global population has increased by 800 million people since 2014. So today, we might need $3 trillion in additional capital expenditure just to play catch-­up.

What is the best way to prepare for this new environment?

You want to be in hard asset type companies, companies that do well in an elevated inflation regime. Copper and aluminum producers such as Freeport McMoRan and Alcoa will benefit from the lack of capital investment, as the electricity infrastructure needs to be modernized and expanded. Big names like BHP, Rio Tinto and Vale should also be part of your portfolio. It’s expected that 40% of the growth in demand for copper will be based on green technologies such as electric vehicles, wind turbines and solar systems. And there’s been such an aversion to mining that the amount of copper mines scheduled to come online over the next decade is probably less than half of what it was ten or fifteen years ago. I think Barrick Gold could even change its name to Barrick Copper and Gold because copper will play such an important role for their business.

And what about the energy sector?

Energy stocks such as Chevron, Shell or ExxonMobil are also a good starting point. Just think, for example, of the additional demand for energy created by the rapid expansion of data centers for artificial intelligence and the mining of cryptocurrencies. If you believe the growth forecasts of chip providers such as Nvidia, natural gas producers such as Chesapeake Energy and Antero Resources are particularly attractively valued.

In this respect, do you also spot opportunities in the uranium sector?

We’re seeing some interesting movements here. At the beginning of a bull market, investors usually go into the «mother ship» first, i.e. they bet on an industry leader such as Cameco in the uranium sector. If the bull market then gains momentum, capital migrates to smaller, riskier companies with correspondingly higher upside potential. It is therefore notable that NexGen Energy has clearly outperformed Cameco recently. The company is smaller, but has impressive uranium reserves in Canada, where the regulatory process for new projects will hopefully now be accelerated. In the oil sector, service companies such as Schlumberger and Transocean will benefit from such capital moves, although in the case of Transocean it’s important to be aware of the risks associated with its pretty leveraged balance sheet.

What role do geopolitical risks play against this backdrop?

In the nuclear space for instance, western nations face a significant vulnerability: Russia controls nearly half of the world’s uranium enrichment capacity. But solving such a problem is like turning around an aircraft carrier in the middle of the ocean. There has been a severe brain drain in the nuclear industry. It’s similar in other segments of the commodity sector, which is why these extreme cycles occur time and again. In other words, anyone who holds commodity stocks for the next twenty years is likely to be disappointed. But for the next five to eight years, all the ingredients are in place for a spectacular outperformance versus the market.

What are the implications in terms of investment strategies?

As mentioned, low inflation and steadily falling interest rates have led to an overdose of financial assets: so-called long duration assets such as growth stocks and long-term bonds, where the expected cash flow is far in the future. This excess reached its peak in early 2022, when the weighting of technology stocks in the S&P 500 rose to a whopping 43%. From today’s perspective, I believe this was the turning point at which a sea change in the markets began.

In other words, stocks related to hard assets will be given more weight again when it comes to portfolio composition?

Yes, at the beginning of the 1980s, the end of the last inflationary phase, commodity and value stocks had dominated the US stock market for more than ten years. Most of the S&P 500 was in companies from the real economy: in 1981, energy stocks made up over 27% of the index, industrials 12% and materials 10%; so almost 50% in total. At the low point of 2021, these three sectors accounted for just 12% of the S&P. At the end of this new bull market, they will probably not account for as high a share as in the last bull market. But 30% of the S&P is certainly in the cards. Put differently, names such as Chevron, ExxonMobil, BHP and Rio Tinto will be among the top 10 most valuable companies in the world, whereas today it’s predominantly tech companies.

What would this imply for the allocation in an average portfolio?

This is where another important topic of the book comes into play: the dark side of passive investing. Nvidia, for instance, accounted for around 1% of the S&P 500 a year and a half ago; today it is almost 5% due to the AI mania. In other words, the index and thus the retirement funds of many Americans are exposed to considerable risk, especially from a geopolitical perspective. As we know, Nvidia’s chips are produced in Taiwan. So what happens to the stock if tensions with China escalate? I’m not even talking about an invasion of Taiwan. Even a naval blockade would put the shares under severe pressure – and that’s not the only problem.

What do you mean by that?

The movement towards passive investments began with the best of intentions. Since then, however, tens of trillions have been poured into passive investment vehicles without considering how this can distort valuations and market behavior. Just look at what happens when a company is added to the S&P 500. Super Micro Computer, for example, another «hot» AI stock, advanced around 300% from the announcement to the index inclusion. In the case of Uber it was an 80% move and for LuluLemon it was 40 to 60%. This was mainly based on technical market reasons, without any significant change to the companies’ fundamentals.

Why is this so problematic?

The problem is that people are paying less and less attention because stocks are simply being bought mechanically. Passive strategies now control at least 50% of all fund assets in the US, compared with around 25% ten years ago. This means that fewer and fewer investors are taking the time to carefully analyze individual companies and ask critical questions. Instead, large asset managers such as BlackRock, Vanguard, and State Street are in the big seat at the table, using criteria such as ESG guidelines to decide on the inclusion of companies in their funds and thus on the capital flows. As a result, most portfolios are dominated by tech stocks and are not prepared for an environment of stubbornly high inflation, which will lead to nasty surprises.

As discussed earlier, it looks like inflation is flaring up again. What does this mean for the Federal Reserve’s monetary policy and therefore for interest rates?

Fed Chair Powell is under severe pressure for two reasons: First, US politics and the upcoming election are pushing him to a more dovish stance. Second, the financial system still faces vulnerabilities. Last year’s interest rate shock sent bank stocks tumbling, with Bank of America and Citigroup suffering drawbacks of up to 50% from the highs. For the regional banks, the situation is even worse, not only because of the commercial real estate crisis, but also because of problems with other mortgages and loans.

How dangerous is this situation?

If the Fed keeps interest rates higher for longer to combat inflation, there is a substantial risk that two or three super regionals will collapse. This is probably the reason why the Fed made this mysterious pivot towards the end of last year and suddenly started talking about cutting interest rates. Maybe they saw a ghost, a potential Lehman type problem in the banking system.

The crucial question therefore remains whether the Fed will manage a soft landing. What do you think?

We hear all these apologists for the Fed, claiming we are going back to 2% inflation. The problem is, it doesn’t work that way. You can’t run such enormous budget deficits and inject all this liquidity into the market to bail out the banks, as they did from March to June 2023, and not have massive inflation repercussions. Furthermore, ongoing supply chain disruptions and the recent surge in energy prices make the situation worse. That’s why I still believe that the US economy will ultimately fall into recession. The downturn will probably be triggered by inflation and some kind of financial accident, causing a 1980s-type recession.

How can you protect your portfolio against such a scenario?

At the end of a hiking cycle and the beginning of possible rate cuts, that’s where gold and other precious metals start to move. Keep in mind what happened after previous rate hike cycles: In June 2000, the Fed completed its last rate hike for that cycle; gold appreciated 47% in the next four years. In June 2006, the Fed raised rates for the last time in that cycle, and gold was 50% higher by 2008. In December 2018, the Fed finished off that rate-hiking cycle; gold was 47% higher by the third quarter of 2020. In all three instances the central bank pushed up front-end rates and eventually broke something.

The price of gold is already at a record high. What do you think of gold and silver mining stocks?

Names like Barrick Gold, Newmont, Hecla Mining, Sibanye-Stillwater and Impala Platinum are excellent places to park your money. This is a particularly good time to invest in silver. The gold/silver price ratio is at almost 90, having fallen to around 60 in the last bull markets, and it has been as low as in the 20s. At this point, several factors strengthen the case for precious metals and mining stocks: looming economic challenges, the Fed’s ballooning balance sheet, and the already strained fiscal situation of the US government, which could deteriorate significantly in a recessionary environment.

What would that mean for the dollar as the reference currency for commodities and as the world’s reserve currency?

Look, Putin’s war against Ukraine is a terrible crime. However, if a country’s assets are confiscated just like that, as in the case of the sanctions against Russia, this changes the mentality of other countries. It prompts them to invest more in other assets such as gold or bitcoin. El Salvador already holds bitcoin and other countries are almost certainly doing it too, although we will probably only find out after a while. Under Obama, as well as under Trump and Biden, the US government has repeatedly misused sanctions as a weapon and this is starting to hurt the dollar more and more. I am not suggesting that the dollar will lose its status as the global reserve currency. But its current share of 60-65% may well fall to 50% in the coming years.

What would that mean for the rest of the world?

If a shock in the economy or in the credit markets forces the Fed to ease its policy and the dollar weakens as a result, this will also help emerging markets to outperform. ETFs on countries such as Brazil or on emerging markets in general therefore have considerable upside. With our clients, we’re also discussing the VanEck J. P. Morgan EM Local Currency Bond ETF. This fund pays a 6% dividend yield and its portfolio is loaded with emerging market bonds in local currencies. However, it’s similar to commodities: due to these extreme cycles, it’s important to be aware that these are not investments you can buy and then forget for the next twenty years.

What is the most important thing to take away from this conversation?

The percentage of global assets currently invested in US stocks is at an unsustainably high level. Everybody is just hiding out in the US. But this imbalance will unwind itself in the coming years. The great global migration of capital from growth stocks to value stocks, real assets and emerging markets has only just begun.