The Pew Research Center last week released a report showing that from 2009 to 2011 the top 7% of American households (based on net worth) realized a 28% gain in wealth while the bottom 93% saw a 4% decline. In a statement of the blatantly obvious, Pew said the difference was a result of the wealthy being more likely to own stocks and bonds. Those assets, owned primarily by that top 7%, recovered while poorer households continued to see their main asset – their home – decline in value. The bottom 93% may be in the black now with house prices rising, but the gap probably hasn’t closed much since the last I checked, wealthy people own real estate too.

Another report released last week by Central Bank Publications and highlighted by Bloomberg, found that 23% of central banks around the world reported that they are either now buying or plan to buy equities (stocks). The central banks in Japan, Israel, Switzerland and Czechoslovakia the Czech Republic have already boosted their holdings to over 10% of reserves. This shows rather starkly the direct connection between the inequality reported by Pew and central bank policies. Ben Bernanke has said publicly that his goal with QE is to affect economic growth through the “portfolio balance” channel. Lower interest rates force investors to buy stocks and corporate bonds driving up their prices and producing a wealth effect. Bernanke believes that investors who feel wealthier will spend more producing higher economic growth. Other central banks are apparently just taking this to its logical extreme. Why bother buying government bonds to force people to buy stocks when they can just buy the stocks directly?

My first thought when I saw the central bank report was that if central banks are buying stocks, I should feel pretty comfortable about our recent selling. I remember when central banks were falling all over themselves to sell gold at $300 which pretty much marked the low. I also remember the plethora of articles in 2011 about how renewed central bank buying at prices 6 times that amount meant that gold prices were unlikely to fall. The near perfect symmetry of selling the low and buying the high in gold puts central banks in a market indicator category all by themselves. So, if you are still adding to your stock allocations up here in the stratosphere, consider yourself warned by the mother of all contrarian indicators.

Of more importance is the effect of these central bank interventions on the elusive economic growth they are intended to foster. Unfortunately for Bernanke and his more aggressive cohorts, the wealth effect doesn’t seem to be trickling down as their elegant economic models predict. The US GDP report Friday came up short again showing growth of 2.5% versus the expected 3%. While on the surface that seems better than the 4th quarter rate of 0.4%, the details were actually worse in many ways. Inventories alone added 1.03% to the total so real final sales were only 1.5% which was actually down from the 4th quarter rate of 1.9%. Other than inventories the other area of “growth” came from Personal Consumption Expenditures which were primarily funded from a decrease in the savings rate from 4.7% to 2.6%. Real non residential fixed investment rose by 2.1% but that was way down from a 13.2% increase in the 4th quarter and all the components either declined or rose at a slower rate. Even residential investment slowed to 12.6% rise from 17.6% in Q4. Overall, the GDP report confirmed our view that the real economy performed very poorly in the 1st quarter and in many respects got worse.

One of the big drags on GDP growth in the quarter was government spending at all levels. Government consumption reduced GDP by 0.8% in the quarter. That was seized on by political partisans as evidence that the sequester is having a negative impact but the drag was actually less than it was in Q4 2012 before the sequester even started. I would also add that while government spending may show up as “growth” in the short term, the current composition of government spending, concentrated as it is in income supports, does little to expand the future growth potential of the economy. Calling for increased government spending just for the sake of propping up GDP statistics is the equivalent of eating our seed corn and cannot be sustained in the long term, Reinhart and Rogoff Excel errors notwithstanding.

So, is there a connection between the inequality reported in the Pew report, central bank policies and the weak economic growth we are experiencing? I think so and have written on the topic before (see here). The seeds of our current economic predicament were sown long ago when we shifted from the stability of the Bretton Woods monetary system to the chaos of the floating exchange rate system we’ve been saddled with since. Bretton Woods was far from perfect but it did create a stable value for money for several decades and while the Krugmans of the world concentrate on things such as high tax rates to explain that golden era, the key ingredient was stable money.

It is the serial inflations and occasional deflations of the Fed during the post Bretton Woods era that produced the inequality, crony capitalism and distorted growth we see today. The wealthy, as we see from the Pew report, are better able to cope with the volatility associated with floating exchange rates and interventionist monetary policy. The inflation of the Fed since the end of Bretton Woods is also the source of the banks outsized position in our current economy. Being the first recipients of new Fed created money the big banks have a first mover advantage in the economy unavailable to other industries. As they grew larger and more important to the status quo their political influence increased and allowed them to grow even larger.

The large companies who are their primary customers have also gained advantages over their smaller rivals. Together the banks and large companies act in ways to protect their status. Dodd Frank will not have much effect on JP Morgan but the small local bank will find it prohibitively expensive to comply with the new regulations. Obamacare won’t have much effect on Google, but an up and coming company trying to compete with them will run into a wall at 50 employees. For the large companies that dominate our economy the preservation of their owners’ and managers’ wealth, income and perks has become more important than the creation of new wealth. They have no incentive to promote or support economic policies that would benefit a future competitor. It is easier to strangle the competition in the crib through political influence than compete in an open and free market.

Over the decades since Bretton Woods, Fed policy – and Treasury policy since the US Dollar is in their purview – has systematically reduced the dynamism of the US economy. Easy money policies make it more profitable – at least in the short term – to buy existing assets with cheap financing than to build new plant and equipment. QE may be good for financial markets – and therefore the wealthy – but it isn’t good for investment on which is built future productivity gains and growth. We have now reached a point where our leaders are more interested in protecting the large incumbent firms and the jobs that remain rather than implementing policies that would encourage new competition and create new jobs. The current obsession with redistributing the wealth created by previous generations is a consequence of the times but it does nothing to correct the problem. We cannot solve a problem rooted in our monetary system through changes in fiscal policy. Taxing the rich might feel good but it is a blunt tool that ultimately hits the wrong target.

One final thought on the current economy. The Fed has succeeded in their primary goal of raising asset prices but in doing so they are distorting market prices. When those prices are eventually revealed as false, it won’t be the wealthy who feel the pain. It will be those who get suckered into buying an asset at an inflated price and get caught holding the bag when it falls back to reality. To quote from my own previous essay:

Consider the fate of a relatively poor individual who was coerced by the siren song of rising real estate prices (and a “helpful” mortgage broker) to fudge their personal data on a loan application (liar loan) and purchase a house in 2006. That person today is not only poorer but also likely now has a foreclosure on their credit report. Inequality has risen as a result.

 

Markets are being distorted in unprecedented ways right now. Central banks are directly and indirectly supporting stock and bond prices. Given their track record that should make every investor wary. You might also consider that government agencies aren’t exactly known for being price sensitive in their purchasing habits. If the world’s central banks are buying stocks and bonds, it probably isn’t a sign that they are cheap. In fact, I’d say the odds are heavy in favor of them overpaying. Remember the $500 hammer?

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“Wealth preservation and accumulation through thoughtful investing.”

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.