The Rise of Private Assets Is Built on a Mountain of New Debt

Credit businesses have helped drive the private-equity industry’s expansion but things could get awkward when companies hit trouble

By Paul J. Davies

Assets under management in global private credit funds

In the world of private deal making, the biggest borrower in town is becoming one of the biggest lenders too. With so much money chasing buyout opportunities, big and risky deals seem the likely outcome.

A major change in financial markets in recent years is that private-equity firms have increasingly got into lending to buyouts, too—and often to their own deals. Their credit businesses are adding to the huge growth in specialist private debt funds and retail money that has taken place in loan markets since the crisis.

The flood of money into credit has driven down borrowing costs and cleared out traditional lender protections known as covenants on many loans.

Issuance of collateralized loan obligations

It is also starting to lift debt multiples on newer deals. Blackstone’s recent deal for a controlling stake in Thomson Reuters’s financial information arm includes debt worth about 7.5 times earnings before interest, tax, depreciation and amortization. That is approaching precrisis levels.

The growth of debt operations at firms like Blackstone, KKR and Apollo is an important part of their expansion. They can manage loans in private-credit funds, special vehicles known as collateralized loan obligations, or CLOs, and listed business development companies, or BDCs.

Private-credit funds run by major specialists like Alcentra or Hayfin, as well as the big private-equity firms, had nearly $650 billion in assets under management globally as of last June, three times more than in 2007, according to Preqin, the research firm. Retail loan funds manage about $100 billion. CLOs and BDCs add billions more.

Blackstone Chairman and CEO Stephen Schwarzman speaks in September 2017. Photo: Mark Lennihan/Associated Press

Investors like loans because they have floating interest rates—unlike bonds, which have fixed rates. That means loan investors don’t lose out when interest rates rise. But that can be bad for borrowers, who are hit by higher debt costs, especially if rates rise sharply.

Private equity’s growing involvement in private debt can make things awkward if a company gets into trouble and a firm’s credit and equity teams are on opposite sides of a workout.

Industry executives say their credit funds are never the lead lender to their own companies: That should allow their credit funds to take a back seat to the biggest lenders in any talks and avoid conflicts of interest. But their investors may still end up unhappy with the outcome.

Default rates on U.S. leveraged loans

Apollo will buy the debt of companies it owns if they get into trouble, but uses the same fund that holds the equity. That avoids internal conflicts, but can provoke fights with others. Its ultimately profitable restructuring of Realogy , the U.S. real-estate brokers, for example, involved legal battles with other lenders.

Other firms invest separately. Blackstone’s credit funds don’t lend to its deals, but its CLOs can buy the loans of its companies. Carlyle allows its credit funds to take about 10% of its portfolio companies’ debt, while KKR allows up to 30%. The firms say their credit funds aren’t forced to buy debt if they don’t like the terms, nor do they influence the pricing to make the debt more advantageous for their equity funds.

The big firms’ private credit businesses are clearly adding to the volume of money chasing deals. As the market heats up this approach means they risk losing on the credit and equity side after the next buyout bubble. 

Mexico’s Drug War Is No Closer to an End

By Jacob L. Shapiro


When Mexican President Enrique Pena Nieto came to office in 2012, he brought a list with him. It contained the names of 122 drug cartel leaders whom Pena Nieto wanted neutralized by the end of his time in office. The conclusion of Pena Nieto’s presidency is now fast approaching, with elections scheduled for July, and he is close to reaching his goal. After the arrest of Los Zetas leader Jose Maria Guizar Valencia in Mexico City this past weekend, just 14 cartel leaders are left from the original list. An 89 percent success rate sounds impressive, but it’s a Pyrrhic victory for the outgoing president of Mexico, where violence reached record highs in 2017.

To be fair, Mexico’s spike in violence – the result of a countrywide turf war between a fractured and competitive assortment of drug-trafficking organizations – is not Pena Nieto’s fault, nor was there much he could have done about it when he came into office. Like Mexico itself, Pena Nieto came face to face with forces beyond his control. His policies represented his best efforts to fight them.

Insatiable Demand 

The story of the rise of Mexico’s drug-trafficking organizations, or DTOs, begins not with Pena Nieto’s list but in the 1980s, when the U.S. government became alarmed with the amount of cocaine entering the U.S. from Colombia via South Florida. The U.S. stepped up its interdiction efforts, forcing Colombian cartels to find alternatives to their Caribbean routes. Mexico became the most important of the new routes.

By the late 1990s, between 75 and 85 percent of cocaine consumed in the United States came through Mexico. This was a boon for Mexican organized crime syndicates. Even the most conservative analysis by U.S. officials in 1995 estimated that the cocaine trade generated more annual income ($10 billion) in Mexico than Mexico’s most valuable export, oil ($7.4 billion). Mexican government estimates were much higher.

Mexico’s poverty magnified the impact of this sudden influx of capital. World Bank data on poverty unfortunately doesn’t go back as far as 1995, but in 2016, 50 percent of Mexicans lived below the national poverty line – and there’s no reason to think that number was much lower 21 years ago. If anything, it was probably higher.

It was the combination of Mexico’s poverty and proximity to the U.S. – both a result of the country’s geography – that led to the impossible challenge Pena Nieto faced when he came to office. Mexico, despite being a wealthy country in absolute terms (it was 16th in global gross domestic product in 1990 and is 15th today), is a country of vast and desolate border regions where poverty has run rampant for generations because of a lack of economic opportunities. For better or worse, much of Mexico’s 2,000-mile (3,200-kilometer) border with the U.S. runs through that territory – and U.S. demand for cocaine was so intense and so lucrative in the 1980s and 1990s that it created incredible economic opportunities in these far-flung places that have always been outside the writ of Mexican authorities.

A Disturbing Trend

Even if they didn’t have lists like Pena Nieto’s, successive Mexican administrations sought to attack this problem head-on. Ernesto Zedillo (1994-2000), Vicente Fox (2000-06) and Felipe Calderon (2006-12) all deployed the Mexican military in various attempts to rein in the newly rich and powerful DTOs. But the military was not immune to the seduction of wealth. Corruption was already rampant throughout the system, and at the same time that Mexican presidents were asking the military to deepen its role in the fight against the DTOs, Mexican prosecutors were arresting Mexican generals for being complicit in DTO activities. The Los Zetas group was formed in the late 1990s by former Mexican special operations soldiers who had taken over protection and enforcement duties for the then-powerful Gulf cartel.

Even so, successive Mexican governments were undeterred. They had little choice – cooperating with the DTOs would have meant their further entrenchment, and the fight couldn’t be ignored, however hopeless it seemed. Calderon famously began his term promising a war on organized crime, and he was a man of his word. Pena Nieto came in with his list, and he has been slowly crossing names off it. These efforts have not been ineffectual. In 2000, there were four main cartels: the Sinaloa, Juarez, Tijuana and Gulf cartels. By 2013, under the weight of government pressure, the cartels had splintered to such an extent that it was impossible to analyze them by focusing on just the major players. By the Drug Enforcement Administration’s count, there are nine major DTOs and 45 smaller organized crime groups in Mexico today.

Unfortunately for Mexico, the byproduct of the government’s efforts has not been a reduction in violence. On the contrary, violence has increased, in large measure because of the fracture and proliferation of smaller cartels as hostile to one another (if not more so) as they are to Mexican authorities or the local populations. On the one hand, this means that the power of individual cartels has been curbed. On the other hand, cartels continue to wield significant power in the areas they control and have diversified the sources of their income far beyond the drug – cocaine – that got them rich. One of the most violent areas in Mexico today is Tierra Caliente, a desert-like region encompassing parts of Michoacan, Guerrero and Mexico state, where fentanyl, methamphetamine and opiates have become the predominant moneymakers.

This is indicative of a disturbing trend. In a vacuum, the breakup of large DTOs into smaller ones could be considered a success, as it might be easier to take out smaller, less powerful DTOs than to go up against one large one. Defeating the cartels was never going to happen bloodlessly. But it does not look like the cartels are being defeated. In southern Mexico, a group known as the Jalisco New Generation cartel has become much more powerful and aggressive in the past year. This is particularly disturbing because this area is not in the vast, desert border area with the United States – but is relatively close to the main seat of power itself in Mexico City. Geopolitical studies of Mexico often blithely point out that because northern Mexico is defined by mountains and deserts, the country’s geography lends itself to cartel activity. But cartel activity is not limited to these lawless and historically hard-to-control regions of Mexico. It is endemic to the entire country, and the weakening of individual cartels – or the assassination of the leaders – has not stemmed the tide.
The Same Problems, Only Worse

This has grave implications for the next Mexican government. Pena Nieto’s successor will face the same predicament as previous Mexican presidents and will have the same array of ineffective solutions. But the incoming president will differ from Pena Nieto in that he or she will come to power with indicators like homicides, extortion and kidnappings at or near all-time highs, and with the drug trade continuing to flourish on the strength of U.S. demand. The incoming president will also come to power as internal migration within Mexico is increasing, the result of Mexicans seeking to escape the collateral damage of the cartel wars, and as more refugees from Central America, beset with its own political and social problems, attempt to make their way across Mexico to the United States.

There are no up-to-date statistics on Mexican emigration figures – 2015 is as far back as the data goes. But if violence in Mexico is increasing as much as anecdotal and statistical evidence suggest, it is not unreasonable to expect that there will also be an increase in the number of Mexican nationals looking to escape violence at home. Despite the political climate in the United States and despite U.S. efforts to harden its border, the U.S. remains the destination of choice for Mexicans seeking safety and new opportunities. Since 2005, Mexico has been able to respond to U.S. pressure on immigration by pointing out that more Mexicans are returning home than going to the United States each year. If that were to change, it would have serious ramifications for U.S.-Mexico relations, already strained because of NAFTA negotiations and the Trump administration’s stance on immigration.

In the 1960s, when the Vietnam War was going badly, U.S. officials took to emphasizing “body counts” and “kill ratios.” They did this to give the appearance that the war was going well, when in actuality, the Viet Cong had lost none of its will to fight and was prepared to expend many more fighters in battle than the U.S. could ever imagine sacrificing of its own. Pena Nieto’s list and the touting of every major arrest of a cartel kingpin suffer from a similar problem. Cartel leaders are being killed, but the drug trade that makes them rich is still making them rich. Mexico’s GDP growth figures slightly exceeded expectations, but poverty is still rampant. Mexico is still so far from God – and so close to the United States.

sábado, febrero 24, 2018



China’s Modernization Ambitions

Yao Yang

BEIJING – Last October, as he opened the 19th National Congress of the Communist Party of China, President Xi Jinping vowed that the country would have a “fully modern” economy by 2035, and would reach high-income status by 2049 – the 100th anniversary of the founding of the People’s Republic. One hopes that he is more successful than China’s first premier, Zhou Enlai, who in 1964 promised “four modernizations” by the end of the twentieth century.

Zhou’s plan focused on reforming four key sectors: agriculture, industry, defense, and science and technology. He did not set a specific income goal, but it is safe to say that he probably expected China to do better than it did: by World Bank standards, China at the turn of the century was a lower-middle-income country.

This time around, reaching China’s income goals might actually be the easy part. China’s real per capita GDP currently amounts to about 25% that of the United States. To join the high-income club, embodied by the OECD, China will have to raise that figure to at least 45% (depending on how real income is measured) – a level achieved, so far, by 36-40 economies.

China could join these countries’ ranks by 2049 if its economy grows by at least 1.7 percentage points more than the US economy every year, starting now. Assuming that the US economy maintains its long-term growth rate of 2%, China would have to grow by 3.7% annually.

That’s a lot lower than China’s current 6.5% rate. Even if China’s GDP growth decelerated steadily to 2% by 2049, the average rate would amount to at least 4%.

But modernization is about more than income. It is a comprehensive process that would ultimately transform China into a society with the kinds of benefits – opportunities, personal comforts, and public services – found in today’s advanced democracies. Completing this process will not be easy.

For starters, China will have to clean up its environment – something that ordinary Chinese now view not as a luxury, but as an imperative. The government has taken some positive steps: the air quality around Beijing, for example, has improved considerably this winter, thanks to efforts to shut down polluting factories and replace coal with natural gas for household heating.

But this change has come at a high cost, including rising natural gas prices. The cost of improving air quality in all Chinese cities, let alone cleaning up all the polluted rivers, lakes, and soil in the country, will be massive.

A second challenge China faces in pursuing modernization is to narrow the rural-urban divide. Notwithstanding the narrowing income gap, rural residents still face inferior access to education, infrastructure, and public services.

Continued urbanization will help, but even the most optimistic forecast estimates that more than 300 million people will still living in the countryside in 2035. No country can be considered modern, regardless of how shiny and dynamic its cities are, if its rural areas are left behind.

Compounding the modernization challenges China faces, its working-age population is beginning to decline, and could fall by more than 10% by 2040, according to the World Bank. While automation may protect China from severe labor shortages, population aging will increase the economic burden of social security.

Despite the introduction of individual accounts 20 years ago, China’s pension system effectively still functions on a pay-as-you-go basis. When China’s “baby boom” generation – born between 1962 and 1976 – begin to retire, the system’s deficits will mount. In fact, some rapidly aging and slow-growing provinces already depend on central government subsidies. China desperately needs a more unified and comprehensive system to balance social security coverage across the country.

Of course, China’s rising national income will help the country confront the challenges it faces. But wealth, while necessary, is not sufficient. For one thing, the rule of law must be strengthened considerably, and not just to rein in official corruption. There needs to be a cultural shift, with citizens learning how to function in a society governed by reliable rules and legal structures, not geographical or familial ties.

The good news is that Xi recognizes the importance of the rule of law. In the report he delivered to the National Congress, he mentioned the phrase more than 20 times, emphasizing “the overall goal of comprehensively advancing law-based governance” in order to “build a country of socialist rule of law.” Nonetheless, transforming traditional ways of living in China will require more than hortatory rhetoric.

One key obstacle lies in the Chinese political system. It is widely believed that democracy is indispensable for a dynamic civil society. Yet the Chinese authorities are determined not to introduce electoral democracy in any way, shape, or form. Recent political developments in advanced democracies – in particular, the rise of right-wing populist movements and leaders, including US President Donald Trump – have reinforced their resolve.

To the extent that it raises living standards, the “China Model” fulfills some requirements of political legitimacy. But, once those living standards reach a certain level, the Chinese people will almost certainly demand more personal freedom and political accountability. The most fundamental challenge facing China’s leaders, then, is to find a governance model that fulfills these demands while continuing to exclude electoral democracy.

Yao Yang is Professor and Dean at the National School of Development and Director of the China Center for Economic Research, Peking University.

Why You Should Cut Cable—and What You’ll Miss

YouTube TV is now the top internet-TV contender—but how does it stack up to your cable bundle?

By David Pierce

A couple of weekends ago, my life became a cable-cutter infomercial.

On the morning of Super Bowl Sunday, my remote stopped connecting to my Comcast CMCSA +0.56% cable box. After an hour spent mostly waiting for Comcast customer service to “send signals” to my box, I finally had help—in the form of a Tuesday morning appointment. With kickoff coming a bit sooner, I fired up my Roku and opened YouTube TV, the live-TV service from Alphabet Inc.’s GOOGL +1.42% video giant.

Other than a brief hiccup when my Roku rebooted itself, all things Super Bowl streamed flawlessly for the next eight hours.

People who watched the Super Bowl on Hulu and Sony Corp.’s PlayStation Vue, two of YouTube TV’s competitors, encountered a compelling endorsement for cable, though. Both services suffered outages during the game, including one during the thrilling final moments.

Super Bowl snafus aside, streaming live TV from the internet works far more reliably now than it used to. Between the five big names in the space—the other two are AT&T Inc.’s DirecTV Now and Dish Network LLC’s Sling TV—you can get everything from a $20-a-month bare-bones replacement to a $75 option that almost resembles your cable lineup.

My current pick In the shifting landscape is YouTube TV. It recently released apps for Roku and Apple TV devices, and on Wednesday added TBS, CNN and more to the service. (The others have recently added new channels, too.) It’s raising its price to $40 a month on March 13 to accommodate for the new lineup—but that’s still a far cry from the $100 or more that people on average pay for cable, according to the media analysis firm Leichtman Research Group.

So far, the best thing about ditching satellite or cable is a sweet release from the constant, throbbing pain of dealing with your cable company: annoying set-top boxes, inscrutable bills, limited mobility. But in some ways, especially channel count and that vague-but-important sense that it’ll always work when you need it, cable still feels like the safer bet.

Here are the four biggest benefits of internet TV:


Signing up for internet TV is like joining Instagram: Download the app, get a username and password, off you go. The apps work on your phone and your iPad, in your web browser and (usually) on the box you already use to get Netflix in your living room. You’ll use a different remote to watch TV now, but in many cases your viewing experience won’t change much.

Portability is key to internet TV: Shown, Sling TV streams a basketball game to a smartphone live and full-screen. Photo: Emily Prapuolenis/The Wall Street Journal

Not all services are equally portable, however. PlayStation Vue doesn’t let you stream some channels when you’re away from your home Wi-Fi. Similarly, if you want to stream to a TV via a device such as a Roku or Apple TV, Hulu’s service only works in your own home, though this limit doesn’t apply to mobile devices.


You probably watched only a fraction of the 487 scripted shows that aired in 2017, not to mention the decades of content also readily available. Every time you open their app, Hulu and YouTube find you new stuff—if you watch football they’ll recommend more football. But YouTube TV also guessed that my “Parks and Recreation” affinity might transfer to “Party Down.” Which it did.

At a minimum, every streaming TV service lets you save and quickly find your favorite shows and channels. They tend to split content into categories—Kids, News, Sports, etc.—but the best recommendations are the ones just for me: They know I prefer Colbert to Fallon, ESPN to FS1, and the Warriors to the Cavs.


I like seeing these services finding ways to blend live, on-demand and recorded content. I’ve made heavy use of PlayStation Vue’s Recently Watched menu, which combines live and on-demand content.

Hulu makes recommendations based on what you’ve been watching, from sports to sitcoms. Photo: Emily Prapuolenis/The Wall Street Journal

These services tend to be far more modern in design than your average, blocky white-on-blue cable interface. They use large images and bold text to help you surf. Lots of services let you watch shows while searching for other content. And these apps all work well on the phone’s smaller screen.

PlayStation Vue and DirecTV Now still use those clunky, side-scrolling programming guides, which are especially hard to parse on mobile. They also don’t offer much else to help you find stuff to watch. DirecTV is expected to launch a redesign son.


Here’s a tip: When you first sign up for an internet TV service, go in and immediately pick your favorite handful of shows, so the system starts automatically recording all new episodes.

You can even record shows you won’t find on demand.

YouTube TV lets you record as much as you want, and keep it all for nine months. PlayStation Vue keeps unlimited recordings for 28 days. Hulu and Sling store just 50 hours of video—Sling even charges you $5 a month for the privilege. DirecTV Now doesn’t offer recording yet, though it says the feature is coming.

DirecTV Now’s on-screen programming guide is a little old-school, but a redesign is in the works. Photo: Emily Prapuolenis/The Wall Street Journal        

If you could combine the best parts of each service—Sling’s price flexibility, Hulu’s on-demand content, YouTube TV’s interface and recording powers, PlayStation Vue’s device compatibility, DirecTV Now’s channel selection—your internet-TV Voltron would be nearly perfect. Over time, they’re all likely to copy each other. Still, for now you have a bunch of solid options and no truly great one.

Among them, though, YouTube TV feels the most ready. It combines live and recorded TV with the massive YouTube library, so I could watch an episode of “The Good Place” then dive into bloopers and late-night interviews with the stars. Now that it’s available on the Roku I use every day, YouTube TV has become my go-to internet TV service.

Yet it doesn’t work on Amazon’s popular Fire TV devices. (Come on, Amazon and Google, can’t we all just get along?) Its updated 60-ish channel lineup still doesn’t include HGTV or Comedy Central.

YouTube TV feels the most mobile-native; simple menus and large images point you to fresh recommendations or your own recorded shows. Photo: Emily Prapuolenis/The Wall Street Journal

Even as programming gaps continue to shrink, no service can replace all of cable. Nearly every one of the 100 most popular channels exists somewhere, but no service has them all. And by the time you get close, that $20 Sling plan you thought you were signing up for turns into more like $50 or $60 before you even get to HBO or Showtime.

Cable and the other traditional pay-TV providers may be more expensive and frustrating, but at least they offer everything. And Comcast, Verizon and the rest are watching their new competition. Soon, you’ll likely get many of the features of internet TV with your existing subscription, once they feel the pressure to compete.

Where does all that leave you? Maybe still paying your cable bill for a while, if it isn’t too high.

If it is, call your cable company and threaten to leave. Reps can often find a way to reduce your monthly fees.

But if you’re willing to miss out on a few shows, and suffer through the occasional outage, you can already get a TV experience that’s much more fun and modern—and mobile—than cable, and usually saves money, too. We’re heading toward the future of TV. It’s just buffering a little on the way.

QE and Its Apologists

My friend Tom Bentley sends me political rants every day and then attaches an article from someone. Today’s is from Brian Wesbury, a brilliant economist who packs a thoughtful free-market punch. I mention Tom because I want to also pass on you the note he sent me this morning, introducing Brian. Here’s an excerpt (and Tom’s full note appears below, as a preface to Brian’s piece):

As we continue to suffer under the blizzard of bullshit about everything put out by both sides, and hugely amplified by the media, it’s nice to find a feel-good piece that takes us back to the basics. Much of what Brian writes in the first part are things you have heard from me before. Markets are inherently cyclical and inherently volatile, but they do self-correct before inflicting massive damage.

Now you put government in the mix, it zigs when it should have zagged, and all hell breaks loose. Think of it as an airplane in a storm – it bounces around, people grab their air-sickness bags, then the plane lands and all is fine. Now let’s assume the hand of God intervenes and grabs a wing of the plane in an effort to stop the shaking – the wing will break off, and the plane will start it’s death spiral. Think of mark-to-market accounting rules that Brian describes below as the built-in clasp on the wing, then the regulators refused to let go when the banks hit turbulence.

Seriously good economic news has gotten to be something of an outside-the-box commodity, but that’s what Tom and Brian have for us today.

I find myself in a literally freezing Sonoma Valley. Thank goodness the weather app gave me a heads-up, as most of the attendees at this gathering came expecting “California weather.” I am listening to a few of the people who will also be at my conference make private presentations. Powerful. Has me excited.

Technology has bitten me and I am having to do this intro on my iPad keyboard, typing with one finger. First-world problem. Thinking back 25 years, my choices then would have forced me to be at my office, wielding a pen and yellow pad, and then I’d fax the thing off on my big old clunky fax machine. (Or, if I was on the road, I’d have to pay a king’s ransom to fax.) So I like where we’re going with these technologies. In 10-15 years what we’re doing today will seem so last-century – we forget how fast things are changing, and for the better. It’s no wonder that businesses that “get it” are seeing earnings grow. Those that don’t get it get left behind – creative destruction.

Sidebar: There is going to be more creative destruction in the next decade or two than in all of last century. We are going to have to be able to absorb new ideas and technologies and keep on moving and growing. And do it all over again the next year or even the next month.

It will be the most exhilarating time in history for entrepreneurs and businesses that get it. And difficult for all of us, because central banks and governments will present us with “issues” that will require of us even more creativity – but that’s what free markets and nimble managers are good at.

Lots of moving parts, which will require you to work more and to focus better. Most of us will need an extensive network and trusted sources to help us keep up.

Have a great week. We will talk about inflation and central banks this weekend. I hope to add to your understanding of how it all fits together.

Your trying to put all the puzzle pieces in place analyst,

John Mauldin, Editor

Tom Bentley’s introduction:

Brian at his best

As we continue to suffer under the blizzard of bullshit about everything put out by both sides, and hugely amplified by the media, it’s nice to find a feel-good piece that takes us back to the basics. Much of what Brian writes in the first part are things you have heard from me before. Markets are inherently cyclical and inherently volatile, but they do self-correct before inflicting massive damage. Now you put government in the mix, it zigs when it should have zagged, and all hell breaks loose. Think of it as an airplane in a storm – it bounces around, people grab their air-sickness bags, then the plane lands and all is fine. Now let’s assume the hand of God intervenes and grabs a wing of the plane in an effort to stop the shaking – the wing will break off, and the plane will start it’s death spiral. Think of mark-to-market accounting rules that Brian describes below as the built-in clasp on the wing, then the regulators refused to let go when the banks hit turbulence.

During the Obama years, government loved to take credit for putting out a fire that government had started, but truth lies elsewhere. It’s now becoming apparent that our private sector is as strong as it ever was, and still able to kick ass everywhere if we just let it. American business has the secret sauce, and no other country has been able to challenge us at the leading edge (they do kick our ass in the old stuff, like steel and cars). Absorb this: "Corporate earnings are rising rapidly, too, and the S&P 500 is now trading at roughly 17.5 times 2018 expected earnings. This is not a bubble, not even close. Earnings are up because technology is booming in a more politically-friendly environment for capitalism. And while it is hard to see productivity rising in the overall macro data, it is clear that profits and margins are up because productivity is rising rapidly in the private sector.” That last point is important, and will make my friend John smile. Three sectors have been a drag on productivity – housing, education, and medical care – and they have been masking all the gains elsewhere. Even then, medical productivity is way up if we judge by longer, healthier lives, but we have no way to capture the value of that in national aggregates. Keep in mind, part of the reason profits are booming is that the overseas share has been increasing, which explains why profits and stock prices have been able to grow much faster than GDP.

Amidst all that success, the failure lobby is still hard at work: "The sad thing about the story that QE saved the economy is that it undermines faith in free markets.” I explained a few days ago that monetary economics is one step away from voodoo, and the world would be much further ahead if the gold standard were still the norm. But that genie is never going back in her bottle, so we have to live with the modern-day version of children running with scissors (shoutout to Patsy for that one), which is Big Government types and the sycophants they appoint to the Federal Reserve getting seduced by their newfound powers. “Give a mouse a cookie, he’s gonna want a glass of milk…."

QE and Its Apologists

By Brian S. Wesbury, Chief Economist; Robert Stein, CFA, Dep. Chief Economist; and Strider Elass, Economist, First Trust Advisors LP

On March 9, 2018, the bull market in U.S. stocks will celebrate its ninth anniversary. And, what we find most amazing is how few people truly understand it. To this day, in spite of massive increases in corporate earnings, many still think the market is one big “sugar high” – a bubble built on a sea of Quantitative Easing and government spending.

While passing mention is given to earnings (because they are impossible to ignore), conventional wisdom has clung to the mistaken story that QE, TARP, and government spending saved the economy from the abyss back in 2008-09.

A review of the facts shows the narrative that “Wall Street” – meaning capitalism and free markets – failed and government came to the rescue is simply not true.

Wall Street was not the driving force behind subprime mortgages. In his fabulous book, Hidden in Plain Sight, Peter Wallison showed that by 2008 Fannie Mae, Freddie Mac and other government programs had sponsored 76% of all subprime debt – not “Wall Street.” Everyone was playing with rattlesnakes and government was telling them it was OK to do so. But, when the snakes started biting, government blamed the private sector, capitalism and free markets.

At the same time, Wall Street did not cause the market and economy to collapse; it was overly strict mark-to-market accounting. Yes, leverage in the financial system was high, but mark-to-market accounting forced banks to write down many performing assets to illiquid market prices that had zero relationship to true value. Mark-to-market destroyed capital.

QE started in September 2008, TARP in October 2008, but the market didn’t bottom until March 9, 2009, five months later. On that day in March, former U.S. Representative Barney Frank, of all people, promised to hold a hearing with the accounting board and SEC to force a change to the ill-advised accounting rule. The rule was changed and the stock market reversed course, with a return to economic growth not far behind.

Yes, the Fed did QE and, yes, the stock market went up while bond yields fell, but correlation is not causation. Stock markets fell after QE started, and rose after QE ended. Bond yields often rose during QE, fell when the Fed wasn’t buying, and have increased since the Fed tapered and ended QE.

A preponderance of QE ended up as “excess reserves” in the banking system, which means it never turned into real money growth. That’s why inflation never took off. Long-term bond yields fell, but this wasn’t because the Fed was buying. Bond yields fell because the Fed promised to hold short-term rates down for a very long time. And as long-term rates are just a series of short-term rates, long term rates were pushed lower as well.

We know this is a very short explanation of what happened, but we bring it up because there are many who are now trying to use the stock market “correction” to revisit the wrongly-held narrative that the economy is one big QE-driven bubble. Or, they use the correction to cover their past support of QE and TARP. If the unwinding of QE actually hurts, then they can argue that QE helped in the first place.

So, they argue that rising bond yields are due to the Fed now selling bonds. But the Fed began its QE-unwind strategy months ago, and sticking to its plans hasn’t changed a thing.

The key inflection point for bond yields wasn’t when the Fed announced the unwinding of QE; it was Election Day 2016, when the 10-year yield ended the day at 1.9% while assuming the status quo, which meant more years of Plow Horse growth ahead. Since then, we’ve seen a series of policy changes, including tax cuts and deregulation, which have raised expectations for economic growth and inflation. As a result, yields have moved up.

Corporate earnings are rising rapidly, too, and the S&P 500 is now trading at roughly 17.5 times 2018 expected earnings. This is not a bubble, not even close. Earnings are up because technology is booming in a more politically-friendly environment for capitalism. And while it is hard to see productivity rising in the overall macro data, it is clear that profits and margins are up because productivity is rising rapidly in the private sector.

The sad thing about the story that QE saved the economy is that it undermines faith in free markets. Those who argue that unwinding QE is hurting the economy are, in unwitting fashion, supporting the view that capitalism is fragile, prone to bubbles and mistakes, and in need of government’s guiding hand. This argument is now being made by both those who believe in big government and those who supposedly believe in free markets. No wonder investors are confused and fearful.

The good news is that QE did not lift the economy. Markets, technology and innovation did. And this realization is the key to understanding why unwinding QE is not a threat to the bull market.