The Reverse Wealth Effect

In our current global economic environment, the number of moving parts for the individual investor to track and attempt to analyze is often overwhelming. Without a systematic approach to the global asset markets, it is virtually impossible to discern the relative importance of an almost infinite number of inputs. While it is a tall order, we’ll attempt to highlight the some of the key moving parts of the economic engine in terms of the possible long-term impact on your portfolio and purchasing power.

Monetary Policy, Structured Finance, and Net Worth

According to the Wall Street Journal, the net worth of individuals soared 82% from 1992 through 2000, and increased 39% from 2000 through 2008. How did this happen? Was it the “productivity miracle” fueled by technology? Since we all know productivity did not increase by 82% from 1992 through 2000, and again by 39% from 2000 through 2008, there had to be some other important factors.

A prime candidate to explain the previously unheard of rapid increases in John Q. Public’s net worth is access to credit. By slicing and dicing debt into marketable and tradable (at least in theory) securities, Wall Street’s promise of reducing risk to lenders helped John Q. borrow his way to prosperity. During the last 15 years, John and his neighbors, the Jones family, borrowed money and bought consumer goods, stocks, bonds, and real estate. Sales increased and asset prices went up. John and the Jones family were happy because they felt better off when they looked at their brokerage statements and ever-increasing home equity. Feeling good from the “wealth effect” of their new found net worth, John, the Jones family, and the banks all thought even more credit was a good idea. It all worked well as long as asset prices continued to go up. It does not work so well when they don’t. With stocks not doing much since March of 2000 and real estate prices dropping like a lead balloon, it may be time to coin the term “reverse wealth effect.” Today, rather than feeling wealthy, the American public is saddled with debt loads which are heavier than ever. Since homes became ATM machines during the boom, John and the Jones family also have record low equity in their once piggybank homes.

Asset Prices, the Fed, and Prices at the Pump

How does our government, which is also bursting at the seams with debt, attempt to stop the continuing erosion of the wealth effect? Right or wrong, they do everything in their power to attempt to stop asset prices (homes, stocks, etc.) from falling. As odd as it sounds, the policy makers “solution” to the problems caused by excessive debt and credit is to encourage more borrowing and more spending by lowering interest rates, sending checks to us in the mail, and moving ever closer to ownership in both our property and financial markets. When the Fed puts taxpayers’ money behind Bear Sterns and the Congress moves towards more and more loan guarantees, the American public is really being forced into indirect ownership of these assets.

As the policy makers push more and more money into the economy to boost asset prices, the law of unintended consequences is raining on the bailout and money printing parade. Unfortunately for debt burdened citizen, the new money being pumped into the financial system is primarily flowing into commodities, not residential real estate or stocks.

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Why did Friday’s bad employment report help push oil prices even higher?

A sagging economy also contributes to the deterioration of the wealth effect. The commodity markets feel policy makers’ response to the weak employment report will be to contemplate more fiscal stimuli while having an increased aversion to raising interest rates. After the technology bubble popped, easy monetary policies were able to maintain consumers’ feeling of wealth by fueling the residential real estate boom. The easy money experiment may be nearing its end as the current recipients of the newly created money (commodities) are now contributing to the reverse wealth effect.

Are there fundamental forces behind oil’s recent move?

Yes. In many of the world’s major oil fields it is becoming increasingly difficult and more expensive to get oil out of the ground. Much of the world’s low hanging fruit has already been snatched from the oil patch. According to the Wall Street Journal, OPEC’s spare capacity is “unusually thin – around 2 million barrels a day in a market of 86 million barrels a day – and much of that consists of a grade of heavy, sour oil that’s less attractive to the market because it yields fewer high-value products such as gasoline.” Additional supply issues facing the U.S. include more OPEC oil being sold to China, and declining U.S. imports from Mexico and Venezuela.

Are there speculative forces behind oil’s recent move?

Yes, but there are speculative forces in every asset market. There are plenty of speculators trading on every major stock exchange in the world. There is no question the investment demand for oil and all commodities has rapidly increased as prices have climbed. There are a couple of issues that make me question the significance of the role of speculation in the oil markets. First, one speculation argument says diversified commodity index-based investments are artificially driving up the price of oil. If this were such an important factor, would not all commodities in these indexes have also benefited from the increased demand? If so, would not all the commodities in these indexes have seen price spikes? Well, they have not. Second, these index investors never take physical delivery of the commodities. Instead the indexes keep rolling over contracts. If speculation was pushing prices significantly higher than what the fundamental market demands, wouldn’t stockpiles of oil be building up? They are not. In fact, oil stockpiles in the U.S. are well below the five-year average.

Could oil have significant corrections even if it eventually moves higher?

Yes. Commodities in general have historically experienced some wild swings even in the context of a long-term bull market.

Are home prices showing any real signs of stabilizing?

No. This is not good news for the consumer, economy, and banks. According to the Wall Street Journal, more than $200 billion of complex mortgage securities called collateralized debt obligations (CDOs) have hit “events of default,” which give some of their investors the right to force the vehicles to liquidate their holdings of mortgage-backed securities or swaps tied to them. The percentages of both subprime and prime mortgages that are seriously delinquent are at record highs. Delinquency rates and losses are also rising on construction loans, some commercial loans, and other forms of consumer debt, such as credit cards. This means access to mortgage credit will not significantly improve anytime soon. More foreclosures are coming which will only add more inventory to an already flooded market.

Is there any good news on the credit front?

Some. Banks have thus far been able to raise capital from individual investors, pension funds, and foreigners, who have helped them make some headway in terms of repairing their balance sheets. While far from normal, the conditions in the credit markets in general are better than they were in March. If I were running a financial institution, I would swallow my pride and quickly admit my mistakes and continue to raise capital as fast as possible. Why? Because at some point, the odds are good when the financial institutions go looking for new capital, the response from the markets will be less than cooperative. Those who attempt to raise capital late in the cycle, may find there is no more capital available. If and when this happens, the credit crisis will move to a second stage in terms of severity. The renewed weakness in financial stocks (see chart below), will make raising additional capital more difficult since recent equity investments have not been profitable.

How does the value of the U.S. dollar come into play?

When policy makers increase the supply of dollars (monetary inflation) in the financial system, the dollar becomes worth less in terms of purchasing power. It takes more dollars to buy the same amount of gas (price inflation is the result of monetary inflation). The dollar is being devalued via loose monetary and fiscal policy.

Can’t the policy makers defend the dollar?

Yes, but the best way to defend the dollar is to raise interest rates, which will in turn put more pressure on the U.S. housing market, consumer, and economy. As both the Fed and Treasury officials tried to do last week, releasing statements which express concern about the dollar and inflation are another way policy makers attempt to stem the dollar’s slide. Unfortunately, the Fed and Treasury officials may be losing credibility with the financial markets based on the lack of sustained reaction to their strong dollar talk last week.

Technical Analysis and Asset Class Outlook

As shown in the table below, investments which provide some protection against price inflation continue to dominate the CCM Asset Class Rankings, a proprietary technical model which attempts to rank the relative attractiveness of investment opportunities. Physical commodities continue to give commodity stocks a run for the money. Timber, which is somewhat its own animal, has also shown some recent encouraging activity. Keep in mind, if timber prices are not attractive, the owners can continue to let the trees grow while waiting for more attractive prices. Broadly diversified and un-hedged global stock investments are less attractive than more selective hedged approaches which contain fewer positions and have exposure to fewer economic sectors. Precious metals remain attractive, but need to show some more strength in order to improve their outlook. U.S. bonds, not surprisingly, are less attractive than foreign bonds which can provide some protection against the ever-weakening U.S. dollar.

The Big Picture and Your Portfolio

U.S. policy makers’ fight to sustain the wealth effect coupled with the debt burdens of the federal government (budget deficits, Medicare, Social Security), strongly favor fiscal and monetary policies which will continue to increase (inflate) the number of U.S. dollars floating around the globe. Monetary inflation leads to price inflation. In an attempt to outrun the purchasing power drag of price inflation, investors are turning increasingly towards commodities and non-U.S. dollar denominated assets (foreign stocks and bonds). As a result, a traditional portfolio of U.S. stocks and U.S. bonds may offer disappointing real returns (after “price at the pump” inflation). In terms of recent history, 1970 through 1981 offers the best, all be it not perfect, comparison to what the future may hold for investment returns. A review of volatile stock, bond, and commodity prices from 1970 through 1981 is enough to get your heart racing. Our challenge as investors will be to build portfolios with acceptable levels of volatility that have exposure to inflation hedging assets.

Comments

[The RealExpert]

Chris, it is easy to explain the situation now that it has occurred. But where were you 2 or 3 years ago? I would venture to guess you were riding the wave of thought on our "great economy," similar to all of the other "pros." If you are going to hold yourself out as a CIO, you need to predict what is going to happen instead of reporting what has happened. As far as I can tell from this article, you are way behind the curve. If you would like some real insight let me know. I'm here to help.

[Lisa]

Excellent overview.

Here's an alternative way of looking at the situation:

Unlike the 70s, there's no wage-price spiral now. Inflation is being fuelled by growing global demand due to the opening of the Soviet Union and E Europe and the economies of China and India. That's boosting demand for commodities, particularly oil. But wages are being held down because those countries are also supplying a ton of low-cost labor. As a result, it's hard to imagine that there will be an inflationary spiral as there was in the 70s.

Rather, we're suffering from a repricing of commodities due to a step shift in demand. That means that countries like the U.S. are facing a decrease in relative wealth, because their "cost of living" just went up due to external factors. Nothing to do with printing money. U.S. consumers now have less to spend on other things, because the price of gas and food just went up. Combine that with a negative wealth effect from declining house prices as the article suggests, and there's a big hit to consumer demand. A weak U.S economy will lead to loose monetary policy, and that will leave the dollar weak. Weakness in the U.S will spread to Europe and China; it's only a matter of time.

How best to invest in that environment? The only thing I can think of that's a cert is agricultural commodities. But as the comment above points out, that's somewhat backward looking.

[Rabbito]

Why is their no wage-price spiral now???

I have 2 theories

1. Today's consumers easy access to credit cards. With that access consumers put the higher balances on their cards instead of asking for higher pay at their jobs. What happens when their balances get too high? Bankrupcy.

2. Too much competition for jobs. In the world economy. If Americans ask for more $$ their jobs will be shipped over seas.

Anyone else have any theories as to why wages won't keep pace with inflation like what happended in the 70's

[Rabbito]

who deleted my post?

[icandoitdon]

chris:

"If speculation was pushing prices significantly higher than what the fundamental market demands, wouldn’t stockpiles of oil be building up?"

you conclude that speculation cannot be causing the increase in oil prices, because oil inventories would build if speculation pushed the price of oil beyond the natural equilibrium price. this might be true in the long run but it is not true in the short run. oil has a very inelastic demand curve, i.e. short term demand is not price-sensitive

gasoline is a good example we can all relate to. it is only after doubling of price in the last couple of years that consumers are starting respond to the price by cutting back on consumption. cigarettes are another example. demand for cigarettes is notoriously insensitive to price and for decades has been the classic example of an inelastic demand curve taught in economics classes in universities through the world.

in two years if the price of oil remains at current levels i will throw in the towel and agree that speculation has not influced the price of oil. but it's far too early to draw that conclusion...i believe that financial speculation is a significant driver of the doubling we've seen over the last year.

"there are speculative forces in every asset market."

this is true, with a big BUT

BUT nothing comparable to today's market.

speculative activity is every market far greater today than in the past,made easier by futures exchanges that didn't exist 30 years ago, and by the emergence of trading entities that either didn't exist or didn't stray from their traditional domains of stocks and bonds. today hedge funds, mutual funds, soverign funds, pension funds and my grandmother can trade virtually any kind of futures for which a market exists. the cost of trading, in terms of exchange costs, margin and opportunity costs (i.e. cost of short term money) are lower than they've ever been. trading volume has exploded...and speculators far outnumber those who trade these futures for the purpose of hedging their production or consumption activities.

there is good reason to speculate in oil today. we have a wreck of a financial system, a declining currency, a runaway national debt, wars we can't win....and people are afraid of a crash. seems like an intelligent bet for turbulent times, but for those who haven't laid the bet long before now they're a little late to the party...

i would bet my mother in law that speculation accounts for at least 1/3 of the cost of a barrel of oil today. matter of fact you can have her even if i lose the bet.

[Jerbear]

Is it possible that Saudi arabia, Iran, Russia, Venezuela and others could manipulate the oil commodities market to such an extent that they can control the price of oil and tank the US economy??

There are intelligent people out there suggesting such a thing. The Hunt Brothers tried to corner silver but they had to buy the silver. The Saudis and other already have the oil.

I don't know enought about commodities markets to know. How about one of you experts telling me.

[Eagle-Chief]

Chris -

good article, however, your point about the price of oil increasing because of "....it is becoming increasingly difficult and more expensive to get oil out of the ground. Much of the world’s low hanging fruit has already been snatched from the oil patch."
C'mon, Chris. Think about it. If we believe this, we're all being taken for a bunch of suckers. Other factors such as government policies (not allowing for drilling in many parts of the USA, especially offshore) affect the price of oil. Turmoil in the mideast may also adversely affect the price of oil, and the falling dollar is a huge factor. But your argument above, no Chris, I don't fall for this one.

Take at the one year crude oil spot price here:
www.wtrg.com/daily/cls...
Oil went from about $65/barrel one year ago to $138/barrel today.

C'mon Chris. Think again. We're being taken for suckers.

[johngonole]

Eagle Chief - the low hanging fruit has been picked in many areas of the world. The north sea is declining. Russia is declining. Many countries that used to produce oil no longer can. Many believe the world has reached peal oil production and production will decline slowly at first and then drop exponentially. Of course prices will slow the decline of reserves.

Icandoitdon - Agree speculation is way up. The printing of money forces people to speculate to preserve their purchasing power.

I believe that we are seeing stagflation. The global economy is holding labor prices in check in terms of real income adjusted for inflation. Meanwhile the government and the federal reserve are printing money to force interest rates lower. This is causing the inflation in just about everything but housing which is pretty much tapped out. Too many houses. In sum I believe the politicians and the bankers abuse the monetary system and its power to line their pockets. Low interest rates are caused by the expansion of the money supply. The expansion of the money supply is essentially the same as saying the expansion of obligations or debt (since it is debt that backs our paper money). The politicians gain a smoother economy in the short term and money to fund their social spending schemes and ear marks. The bankers take their cut of an ever enlarging pie of debt making them rich. Think about it we as citizens give the banks our purchasing power. They lend it out like 30 time over all the while taking a cut of it in term of interest. Depositers in essence bear the risk and are compensated nothing. If we don't deposit the dollars are still wiped out by the expansion of the money supply and th ensuing inflation. Alternatively we can invest in stocks, bonds, etc... Again however the same bankers/finacial firms take their cut. They bear no risk because the government is ready to use the power of taxation to bail them out.

This is ultimately the problem with Fascism and Socialism. Unfortunately the monetary policy failures continue to breed more and more people who are willing to entrust more power to the same persons holding them down.

The grip of power that the government and the Federal Reserve have over the purchasing power of the people (as well as being a monopoly) is so vast and lock tight it is scary. Spend your money or we'll spend it for you. Then we'll tax your assets. We'll tax your income. Perhaps this is the price we pay for living in the type of society we have but clearly their were times when we didn't have all this regulation and things worked out pretty much the same or better. They have the power to bankrupt everyone at will. The only checks on this system are pitch forks and shot guns. This could very well happen if they drive our economic system into the ground. Our economic realities are less and less dependent on free market allocation of resources and more and more on how the government decides to allocate resources. The public needs to be more mindful of this and DEMAND and end to corruption, a balanced budget, and less tinkering with the economy.

[bbzz24]

great article! the theory of capitalism is based on the creation of capital and stockpiles of money do not constitute capital. so are the current u.s./u.k. run more or less like the already defunct soviet socialist republics? yes. and there can't be any inflation-wage spiral as the lack of production resources in the above countries leaves the emolyees powerless before the threat of outsourcing even in healthcare. gloomy future indeed.

[rigel]

Jerbear, while they arguably could do it, there's very little incentive for them to do so. Sovereign wealth largely funded the booms in the US. If they tried to manipulate oil prices to tank the US economy, those investments would be lost. In fact, as the recent bust happened, foreign dollars stepped in (arguably too early). If you were manipulating a downfall, you might be more careful about picking the bottom.

China has a lot of US treasuries and manufactures a lot of US goods. It's certainly not in their best interest to help orchestrate a US downfall.

[Jerbear]

Thanks rigel,
With all the political rhetoric we forget how depended we are on one another.

[icandoitdon]

johngonole...

"Spend your money or we'll spend it for you."

very perceptive comment and absolutely true. the bastards punish savers and reward debtors. it's been that way for 40 years and it's getting worse.