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Comstock Partners, Inc.
March 01, 2018

We have been discussing for years how the growth of the Fed’s balance sheet from $800bn to $4.5tn from 2009 to thru 2014, and near zero interest rates (ZIRP) have caused all forms of mal-investment that in the final analysis will bring down the “house of cards” that is the stock and bond markets.  But it gets even more interesting, in terms of the central bank “insanity”.  That the ECB, BOJ, and the BOE upped the ante even more by instituting negative interest rate policies (NIRP)  will prove to be even more detrimental, in the long run, than ZIRP.  (We did not include the PBOC (Peoples Bank of China) in this, the reason being that China is not a fully opened economy, given the fact that currency cannot flow freely across its borders.  But they take a second seat to no one when it comes to over-leverage and debt.  The downside of that story will surely come in the future as well.)

While the balance sheet of the Fed has gone basically sideways for the past 3 years, the ECB, BOJ, and BOE were adding just under $5tn collectively, to theirs.  And given the fact that foreign exchange markets are very liquid and well developed, it should be of no surprise that much of that non-US central bank stimulus found its way here to further inflate U.S. stock and bond prices.  Now the Fed is reducing its balance sheet, albeit quite slowly.  If all goes according to plan, however, the combined balance sheets of the big four will still increase by about $235bn this year, according to data from J.P. Morgan and the banks themselves.  It is not until 2019 that the net of the balance sheets result in a reduction.  But there is no doubt about that after ten years of central bank balance sheet expansion, the reversal of the process is a ”giant elephant” in the room for stocks and bonds.

The “second elephant” in the room is the tremendously large and growing Non- Financial Debt to GDP ratios that exist in the developed world.  We, and others of a similar persuasion, have said for years that excessive debt slows growth as increasing resources are consumed by debt service.  According to a report in October 2017 by David A. Rosenberg, at Gluskin Sheff +Associates Inc., these ratios now stand at 250% for the U.S., 372% for Japan, 257% for China, 180% for Germany, and 240% for the G20 as a whole.  All but Germany are up substantially over the past ten years.  Does anyone think these numbers are coming down?   Does anyone think that the Trump tax cut and infrastructure plan, assuming it gets through, will result in lower deficits and less borrowing?  We believe a substantial extended growth in GDP, even once the effect of the tax cut and repatriation are factored in, is a pipe dream.

The "third elephant" in the room is the state of employment, labor force demographics, productivity, entitlements, and how they all relate.  The growth rate in GDP can be viewed as the change in hours worked multiplied by the change in output per hour.  With the economy at or near full employment, it is hard to see how there can be a large increase in hours worked.  In addition, the Trump Administration immigration policies have the potential to cause a reverse migration of the workers, particularly Central American, that have been here.  While there are arguments as to the wisdom of those policies on both sides, we see a reverse migration as being highly wage inflationary as individuals in the social safety net will need financial incentives to enter the work force and take those vacated jobs.  That leaves output per hour, i.e. productivity, to do the heavy lifting.  Productivity growth has been anemic, (under 1%per year).  In the absence of some unforeseen leap in technological innovation there is nothing on the horizon that portends a resurgence of productivity.  In fact, it’s just the opposite.

None other than the “Old Maestro” himself, Alan Greenspan has been sounding the alarm on growth of entitlements as it relates to both debt and productivity.  His thesis, which we subscribe to, is that entitlement dependency discourages savings, which is the lifeblood of investment.  And it is investment in plant, equipment, and human capital that increases productivity.  And of course, given this as a backdrop, what are some of our leading politicians doing?  According to a Wall St Journal editorial of 2/28/18 titled “A New GOP Entitlement”, a new family leave benefit is being proposed and would be financed by a present day raid on the Social Security Trust Fund.  As the editorial points out, “every entitlement since the Revolutionary War Pensions has skidded down the slope of inexorable expansion”.  

So these are just three of the “elephants in the room”, that we believe will provide significant headwinds to economic growth.  They are very detrimental in the long term, and are a large part of the reason we have been so negative on the stock market, and remain so.

 P.T. Barnum’s elephants once thrilled and amused tens of thousands of people around the world every year.  Millions of investors around the world will have quite the opposite reaction when the aforementioned "elephants" bring down the stock and bond markets!

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