Stay alert to signs that sea of cash is drying up

On the Money

Your Money

January 14, 2007|By Gail Marksjarvis | Gail Marksjarvis,Chicago Tribune

Whether your pockets are oozing with money or not, if you are an investor or homeowner you probably have been feasting on cash during the past few years.

The world has been flush with it.

Large flows of cash have been fueling a world economic boom, pushing stock markets globally to new heights, boosting the prices of everything from real estate to commodities, prompting record mergers and acquisitions and sending private equity firms on a buyout rampage.

But some refer to current conditions as "excessive liquidity" - or an unusual abundance of easy cash. And investors are watching for signs that the spigot might be turned down - perhaps cooling off stocks in the process.

Liquidity is like lubrication for the economy, says Wells Capital Management strategist James Paulsen. "Without proper lubrication, the economic engine grinds to a halt."

So when central banks, such as the Bank of England, raise rates as the institution did last week, and others in Europe and Asia consider similar moves to fight inflation, investors get jittery.

They are aware that the last few years have been a remarkable period that did not happen by accident.

In the early 2000s, after the technology stock bubble burst and terrorist attacks caused fear of a possible depression, the Federal Reserve took actions to juice the economy with cheap money.

The Fed lowered short-term rates below 2 percent, far below historic norms. And with emerging market currencies pegged to the dollar, countries throughout the world followed.

"The world is awash with U.S. dollars," said Paulsen. "Ultimately this prolonged period of excess liquidity will result in higher inflation [destroying the real purchasing power of cash] and a lower value of the U.S. dollar [damaging the international purchasing power of cash]."

So Paulsen is urging investors to watch for increasing signs of inflation and be ready to bolt from the types of investments that have benefited in the lush money environment. These would be cyclical companies, such as technology, that depend on a strong business spending, small-company stocks and emerging market shares.

He suggests investors keep an eye on economic reports that suggest inflation. For example, rising wages could force employers to raise their prices and spark inflation. The remedy would be to tighten the money spigot.

Still, Paulsen isn't urging investors to bolt now. "Prices of stocks, bonds and real estate will do well because there are too many dollars chasing returns."

Likewise, Standard & Poor's analyst Alec Young warned investors in a recent report not to jump too quickly away from stocks.

Some analysts have been particularly concerned recently about an investing strategy that has been popular in generating billions of dollars in easy money for investing.

It's called the "carry trade." With interest rates very low in countries such as Japan, investors have been able to borrow in Japan cheaply and make money by investing the money in countries with substantially higher interest rates.

But if Japan raises rates, as some investors fear will happen, the easy source of cash would dry up.

"Bears believe the potential removal of liquidity could result in a sharp rise in volatility, as investors shun stocks in favor of lower-risk asset classes like cash," said Young.

Still, he is not among the bears. He thinks Japan will raise rates only gradually - eroding the popularity of the yen carry trade, but not causing negative repercussions for global capital markets.

You can leave a message for Gail MarksJarvis at 312-222-4264.

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