The "Reverse" Wealth Effect could be on the way

in #markets6 years ago (edited)

We all heard of the "wealth effect". This is a policy that was pursued by the governments and central banks for the last few decades. The idea is to keep interest rates low which push assets such as real estate or the stock market higher so that people feel "wealthier".

The idea behind this is that when people see their investment accounts growing, they are more apt to spend. This is enhanced when that situation is coupled with debt via using the home as an ATM.

Over the last decade, central banks put this policy on steroids by adding liquidity to the system with all the quantative easing. This helped to again push other assets higher giving many reason to believe we are seeing the "bubble of everything".

For those who are owning these assets, the ride up is a fun one. There is no doubt the policy was effective, at least in driving values up. The U.S. equities markets are at all-time highs. At the same time, real estate is nearing the 8th year of this bull run. Even after all the rate increase by the Fed, mortgage rates are still near all time lows.

parley.jpg

This appears to impacted the economy. The U.S. unemployment rate is near a 50 year low. The economy is growing at a satisfactory rate. Even inflation, something the Fed could not find for most of the last 10 years, is around their mandate of 2%.

All appears rosy.

Unfortunately, when it comes to markets, we know things do not stay the same for long. All bull runs come to an end. This is a natural part of the cycle when things get too heated. The scary thing is that when things pop, it can cause a lot of pain.

In this situation, effectively there is the reversing of the wealth effect. All the gains from the past 10 years can unwind quickly. We saw this in the 2008-2009 financial meltdown.

Many are watching the real estate market. This is such a large part of the economy that if it reverses, the tentacles reach almost every sector of society. The job situation is immediately affected meaning that personal income statements are put in jeopardy. This tends to be compounded by the fact that the average family is carrying more debt than they can reasonably afford. One hiccup and defaults start.

Real estate is a leverage asset in the vast majority of cases. This means that the ride up increases the wealth effect. With so little money on the line, all growth in value is profit. However, reverse this scenario and profits dry up quickly. If one is smart, this might not be a problem since the run up along with payments made could give one the margin of safety that is needed. As was stated, many like to use the home as an ATM which eliminates that safety net. This is where the wealth effect becomes the "buried under debt" effect.

The party is fun while the music is playing. When the music stops, however, that is when the pain can start.

Where will markets go next is the question on everyone's mind. Will the wealth effect continue or are we about to see a reversal?

Further reading on this subject along with the photo credit here.

Sort:  

Flagged for disagreement on rewards.

We also flagged all replies by bidbots under this post, as it is the only hook we have to express what we think about their upvoting this to these reward levels.

Omg those are all bidbots??

Thanks for that.

Macro economy I think

you sure?

Andrew Jackson said it best: "Should the bank, for the mere purpose of producing distress, press its debtors more heavily than some of them can bear, the consequences will recoil upon itself, and in the attempts to embarrass the country it will only bring loss and ruin upon the holders of its own stock. But if the President believed the bank possessed all the power which has been attributed to it, his determination would only be rendered the more inflexible. If, indeed, this corporation now holds in its hands the happiness and prosperity of the American people, it is high time to take the alarm. If the despotism be already upon us and our only safety is in the mercy of the despot, recent developments in relation to his designs and the means he employs show how necessary it is to shake it off. The struggle can never come with less distress to the people or under more favorable auspices than at the present moment." [September 18, 1833]
Oh, how history repeats itself. Gotta love Central Banks!

The US economy has been fluctuating since our colonial days under British rule. The US economy can be seen to rapidly expand every 54 years, more or less. Lewis and Clark expedition, Louisiana Purchase, Panama Canal, landing on the Moon were five of these expansive episodes. It does not matter who is president, nor which party is in power. You can see the graphs for yourself if you google it. The problem is after a huge expansion, it is always followed by a contraction. Hang on everybody because I think there is another contraction just about due.

howdy this fine Saturday finprep! very thought-provoking report, it seems that the reversal is certainly coming, it's just a matter of how long they can keep everything propped up!

@finprep
Thank you for writing such a thought provoking article. .The market has always moved up and down and it does not ever move in only one direction. The cycles have been repeating over the last 200 years of documented history. Some cycles have repeated every fourty years and some have repeated every decade and we all know the eight year equity cycle.These movements in the market are nothing but a reflection of the economy of that period.Any fundamental change in the economic condition will result in expansion of the economy.However we can generalize and say that a expansion in the economy is always followed by a contraction but we can never predict when will the contraction start.It is always post facto that we say that we are now into a contracting economy.

I haven't seen the sort of rampant speculation and things like condo conversions that you would expect from an overheated real estate market ready to collapse.

Money comes, money goes. This is the reality of life. You never know what tomorrow bring for you.

hahah philosopy in economy

There are a lot of way to earn money but from where we earn , it's depends on our investment of skill.