Comstock Partners, Inc.January 03, 2018
THE FREE LUNCH
But Don't Be Fooled Because The Check is Coming Courtesy Of The Central Banks
So, here we are. Stock indexes are through the roof and making new highs almost every day. Realized volatility is collapsing through the floor, and has never been lower for such a protracted period. The era of (normal) five, ten, or twenty percent corrections seem like a distant memory of another time and place. Interest rates remain near historical lows, with seemingly benign duration risk in the bond market. Inflation has all but been pronounced as “dead as a doornail”.
It was not through brilliance in the management of our major corporations that account for the (irrational) exuberance that the markets seem to be embracing. Though they certainly did their part with stock buybacks that helped inflate prices and knock compensation options “into the money”, thereby coincidentally increasing their own personal incomes. No, it was something even greater and more damaging that is responsible for the gross inflation of financial assets. It was nothing less than the massive balance sheet growth of the central banks of the United States, Europe, China, and Japan that is responsible for what we have termed “The Free Lunch”. The “Free Lunch”, in this context, implies there have been little to no negative ramifications to what we and some others have described as “insane” policies on the part of the major central banks.
So let’s get this straight. The “all knowing” central bankers blew out their balance sheets to unprecedented levels. They bought not only government and mortgage debt, but in Europe the ECB even bought bushel baskets of corporate debt. In Japan the BOJ upped the ante by buying enough equity ETFs to become a top 10% shareholder in most companies in the Nikkei Index. They supplanted the market mechanism of pricing interest rates to the point that short term rates were zero in the U.S., and negative in Europe and Japan (which continues). They forced savers to become investors and speculators; thereby driving asset prices ever higher. Given that capital is the life blood of capitalism; its mispricing can result in nothing but mal-investment. This is true across the entire spectrum; from governments, to corporations, to individuals. And oddly, during and possibly as a result of this “mad experiment”, the world has seen the emergence of possibly the most strange of all assets, crypto currencies.
So all of this happened; (disparate) wealth created out of thin air, inflation seems decimated, stocks up, bonds up, real estate up, art up, and the amount of government, corporate and personal debt in the stratosphere. CNBC guest bears have been as rare as sightings of Bigfoot, all because central bankers were so “brilliant”. If they can just unwind their balance sheets with little or no disruption, they will have truly gifted to the world this rarest of phenomena…”The Free Lunch”.
The problem for us is that we were taught that there’s no such thing as a “Free Lunch”… because someone ALWAYS has to pay. Sarcasm aside, what the Fed and its central bank European, Chinese, and Japanese counterparts have done is nothing less than caused what we believe will prove to be the greatest asset bubble of the modern era. As stated above, by not allowing the free market to price capital, they have allowed years of mal-investment, which will negatively affect growth long into the future. Furthermore, going forward, the impending new federal tax legislation along with growth of entitlements will likely cause the debt and deficit to further skyrocket. And excessive debt lowers economic growth in the long run as debt service consumes capital that could be used constructively. We don’t, for one second, believe the projections of the administration, or anyone else, that growth is set to “take off”. In the past we’ve discussed how, just on demographics alone, the odds are greatly stacked against returning to growth rates of the past. To our way of thinking, short term blips aside, the economy will revert to the anemic growth of the past eight, or so, years. The markets will ultimately return to more traditional patterns of volatility as interest rates and risk become more correctly priced.
When that happens, it will be “look out below” for stocks, bonds, and financial assets in general. The creators of the “Central Bank Bubble” and their cheerleaders in the media may think they’ve given the world a “Free Lunch”. But we continue to believe the “check” is coming, and when it does, it will be a very, very expensive one.