A shaky week in the markets has investors worrying about risk. And according to one noted strategist, there are three big ones out there right now.
Larry McDonald, senior director at Newedge, says the market needs to watch the Fed and what’s going on in Europe. He should know: He’s the man who called the financial crisis two years before it happened.
Risk 1: Russia sanctions hurting Europe
McDonald says credit default swaps (CDSs) give an indication on how the market views Russia’s risk. And right now, it’s not improving. CDSs are essentially insurance bets on a borrower’s credit status.
“People are starting to price in some measure of default,” McDonald said. He believes sanctions on Russia due to its conflict with Ukraine are also hurting the rest of Europe.
“If you think about the sanctions, there are economic impacts to the greater European economy,” McDonaldsaid. “The European economy is not growing at 4 - 5 percent. It’s growing at probably a little bit more than 1 percent, maybe a little less. Therefore in the old days you could do these sanctionsand it wouldn’t affect the greater economy, but an economy that’s growing that weakly, that’s the problem…. That’s one of the reasons why the market’s going lower.”
Risk 2: The Fed could lose control of the yield curve
McDonald believes people have been too trusting of the Federal Reserve Bank. “Until this week, the Fed has had really good control over the yield curve and yields have been going lower,” he said. “But what people are worried about is [Fed chair] Yellen is a labor market economist… and she’s focused on labor costs. Those labor costs have spiked more in expectations. Therefore it moves up… the possible date for the Fed to take action and that means it’s the end of the punch bowl.”
Risk 3: Portugal could be a sign of credit spread contagion
Like Russia, credit default swap spreads for Portugal have been widening. They are now at their highest level since February, notes McDonald. “CDS is being bid up in terms of default,” he said. “The problem with Europe–still it hasn’t been fixed – is the relationship between these banks in terms of the risk GDP. These banks are enormous relative to countries’ GDPs in Europe. That’s a big problem that Portugal has.”
This could lead to a similar situation to Greece’s crisis two years ago, warns McDonald. “When you have this credit weakness in one country it leaks over to the other,” he said. “So far, Spain’s moved a little bit wider, Italy has moved a little bit wider too but not much. So far, the contagion is relatively contained, but it’s starting to spread.”
For those looking to play these risks, such as with the CBOE Volatility Index (the VIX), McDonald has a recommendation: “Buy dips in volatility for the next 30 days.”
To see the interview with McDonald on risks to the market, watch the above video.