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Wealth Effect 2.0 Is Here

Wealth Effect 2.0 Is Here
(Alexander Kharchenko/Dreamstime)

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Thursday, 11 January 2018 05:53 PM Current | Bio | Archive

Perception is reality. Or, rather, close to it. That’s how we’re wired as human beings. Our notion of the truth and what we think is the truth can get rather blurred.

When people feel or become wealthier, they do things like increase their consumption. Or they shift their consumption to higher goods, such as substituting chicken for filet mignon.

When people feel that they’re worse off, however, they cut back on spending. If enough people suddenly feel richer or poorer, then something tremendous happens. That perception ends up shaping reality.

Note that people don’t need to actually become richer or poorer. It can only take that feeling to occur, not that fact.

Whether it’s driven in fact or perception, this propensity to make shifts in consumption is known as the wealth effect.

Historically, it’s largely been driven by huge, top-down factors. The biggest factor is rising asset prices, whether stocks, bonds, housing, you name it. An on-paper rise in someone’s financial assets can get the wealth effect going. When you’re excited to get your monthly financial statements in the mail, you’re seeing the wealth effect at work. Ditto when you avoid opening your statements because you know the market had a bad month.

In recent years, rising asset prices have been inarguably affected by the Federal Reserve’s ultra-low interest rate policy. Yet the Fed has now embarked on a course of rising interest rates. I don’t see that policy shifting as we rotate from the steady and cautious Janet Yellen to the steady and cautious Jerome Powell. We’ll need a bigger move in the economy to get a bigger move from the Fed.

We might get more interest rate hikes later in the year if it appears inflation is picking up. That could occur thanks to today’s low unemployment rate, which should make wage growth more competitive. But should we end up in a recession instead, the Fed may cut interest rates and scale back or eliminate its current plan to start gradually reducing its balance sheet.

With the Fed out of the game, at least for the moment, there are two powerful trends that could create new wealth effects. Only instead of being the result of top-heavy, trickle-down factors, they’ll be bottom-up ones from the creation of new wealth rather than the rising price of existing assets.

The first factor is tax reform. Although no deaths have been attributed to it yet, the despair that some have over other people getting to keep more of the money they earned has been palpable. Yet when people get to keep more of their money, they can pay down debt, increase their consumption, or increase their investments. No matter what people do when they have more of their own money, all roads lead to someone who is financially better off in real terms.

The second factor is more off-the-radar. But I think it’ll prove to be the most powerful one of all. It’s regulatory reform. In his first year in office, President Trump has proven to be The Great Deregulator. Amidst a campaign promise to cut 2 regulations for every new one, the results of his first year have instead ended up with cutting a whopping 22 regulations for every new one.

Deregulation is critical because it has huge, unseen effects. We don’t see the big, multi-billion dollar businesses that weren’t built because of existing regulations that prevented it from coming into business in the first place. And it favors large, established businesses over financially smaller competitors.

The less regulations in the way, the easier it is for new businesses to start and thrive. It will force larger players to compete. Consumers will be king, not companies favored by regulatory rules. One of the challenges of growing the economy in the post-Financial Crisis era of 2007-2009 has been the below-average growth of new businesses. I see that changing thanks to this new deregulatory trend.

New businesses create new wealth in new hands. They don’t simply reward shareholders in existing big businesses, unless those firms find ways to defeat the new competition by offering customers better products and services. Smaller businesses will find that they can better compete with large ones on better footing.

What does all this mean for investors?

For starters, it means in the world of publicly-traded companies, that smaller firms will likely start to outperform larger ones. They’re more nimble, and with can thrive more easily with fewer regulatory shackles. And while larger companies can benefit from regulations—even if that “benefit” is simply that they can afford the costs while smaller competitors can’t— that’s no longer a guarantee. It may take more time for a larger firm to respond than a smaller one.

Meanwhile, passive index investors are also starting to question how their passive investments are made. After all, when Apple (AAPL) makes up the largest company in the S&P 500 by market cap, it’s also weighed more heavily than the bottom 250 stocks in the index combined. There’s more to the investment universe than mega-caps, and smaller companies can grow faster than larger ones.

Regulatory reform means less resting on laurels and more growth. Apple could double in the next eight years. But truly smaller companies could grow at multiples of that. Consider ditching a market-weighted S&P 500 Index for one that’s equal-weight. The Guggenheim S&P 500 Equal Weight ETF (RSP) has outperformed the index by 2 percent in the past 2 years. It could do better in the next few years thanks to deregulation.

The final impact of tax and regulatory reform is simply that it gives corporations a huge incentive to make big merger and acquisition deals, expand operations, return cash to shareholders, or increase pay to employees. That should prove well for nearly all companies big and small over the next year. But the impact will likely be better with smaller firms.

This new shift in the wealth effect is underway. It’s more bottom-up rather than top-down. That means bigger companies trading at lofty valuations may still grow, but they’ll have less upside. Look at smaller companies. Over time, they should best benefit from the trends underway and deliver the best returns.

Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.

© 2019 Newsmax Finance. All rights reserved.

   
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AndrewPacker
This new shift in the wealth effect is underway. It’s more bottom-up rather than top-down. That means bigger companies trading at lofty valuations may still grow, but they’ll have less upside.
wealth, effect, investors, fed
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2018-53-11
Thursday, 11 January 2018 05:53 PM
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