The “wealth effect” isn’t working but investors can still benefit

Central bankers can create additional liquidity, but they have little control over where or how that money gets put to use. What they would like is for banks to increase lending such that the new money is channeled into the real economy. However, banks are still in the process of recapitalizing their balance sheets, which means they are unwilling to make new loans and extend credit.

Therefore, unable to push their new money into the real economy, the Fed and other central banks are doing their best to direct the flow of liquidity into financial assets. That’s because they believe in something called the “wealth effect”.

The idea is that as the price of assets such as houses and stock portfolios rise, consumers feel wealthier, and will therefore consume more than would have otherwise been the case. If the phenomenon continues, consumers might even be willing to spend beyond their means, taking advantage of cheap credit, and because consumption accounts for such a large portion of western economies GDP, all this excess spending creates growth.

The problem however, is that the “wealth effect” card has already been played. In the run up to the bursting of the credit bubble in 2008 consumers took on unprecedented amounts of debt, and they are now in the long process of deleveraging (paying back debt).

Central banks than, are losing the battle of restoring GDP growth because they are still fighting the last war, but investors can still profit from their efforts.

As Brian Pretti, Editor of ContraryInvestor.com, noted recently, “Almost as a process of default, that leaves the global financial and commodity markets as a potential repository for historic global central banker largesse… Although we are certainly not there yet with equities (we are there with bonds), the danger is that this current round of truly extraordinary excess central banker liquidity creates further asset bubbles, very much as happened with the late 1990’s tech stock bubble and the clear bubble in mortgage lending in the middle of the last decade”.

The chart below shows various assets that are rising, including the S&P 500, the Nikkei, the Dow Jones Transportation Index, Brent crude, Emerging market equities, and Palladium.

A 6 month chart of various assets that are rising (Click on the chart for a larger version)

A 6 month chart of various assets that are rising (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

Sooner or later there is a good chance that equity and commodity prices will reach bubble territory, but in the mean time, these markets look set to be the beneficiaries of ultra-loose monetary policy.

The end of the trend

Typically it is bonds that top out first, followed by stocks and then commodities, so investors should keep a close eye on the bond market for signs that this trend is coming to an end.

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