The direction of an economy’s stock market has long been considered a good barometer of the health of that economy.

Over the past several quarters stock markets throughout the world have been rising rapidly while the economies of the developed world have been stagnating and the growth in the economies of the developing world have been decelerating rapidly.

Another very good market barometer of economic activity is the price of commodities. The relationship between global industrial production and virtually any broad index of commodity prices has been highly positively correlated over long periods of time.

It still is: commodity prices have been falling for almost a year and the growth in global industrial production has been subsiding.

Therein lies the contradiction between the soaring prices of stock markets and the dismal performance of the underlying global economies.
productioncommodityGrowth of Global Industrial Production and Commodity Prices 1998-2013

This financial enigma can be understood by examining the behavior of major central bank policies.

The biggest central banks in the world have been expanding their balance sheets at an unprecedented pace since the 2008 financial crisis. A glance at the second chart reveals that this unprecedented growth in central bank assets is occurring throughout the developed world (the US, UK, Japan, and EU).
bankassetsGrowth of central bank assets in past seven years

For example the US Federal Reserve has increased its assets fourfold over the past 5 years, from $830 billion to $3,200 billion. The Fed’s asset purchases expand the US banking system’s reserve base.

Given the present 10 to 1 reserve ratio, these increased reserves could multiply money creation enormously. The fact is money creation hasn’t proceeded at this extravagant pace because business loan demand has not expanded rapidly. This however could quickly change once the economic outlook improves.

The intention of central banks is admirable and understandable: they need to stimulate aggregate demand in their respective dormant economies. Their Herculean efforts reflect their frustration with only middling results following years of money and asset creation.

TA6 no borderTheir frustration results from the negative nature of fiscal policy in each of their economies. Present fiscal policy in all of these economies is creating a contractionary impact on each economy’s growth. In the US the Congressional Budget Office has estimated that the fiscal drag implied from this year’s fiscal budget would reduce GDP growth by 1.5% to 3%.

Fiscal austerity imposed by European leaders upon most of the EU members has dragged all European countries into their second round of recession in less than 4 years. As a result, macro policy is working in opposite directions because austerity oriented fiscal policy is offsetting all, or more than all of the positive effects from expansionary monetary policy.

This negative fiscal counter weight has become a serious dilemma for monetary policy makers and it has led them into creating too much monetary creation.

The inevitable consequence of too much money creation is a rising price level. However, while economic growth is subdued because of tightening fiscal policies, inadequate domestic demand, and suppressed business expectations for future economic activity, money creation’s effect on the general price level for goods and services is negligible.

Instead, most of the central banks’ monetary creation has poured into financial assets rather than real income producing assets. Because the central banks purchased massive quantities of longer-term government bonds in the past several years, bond yields have tumbled down to unattractive levels.

Central banks had already lowered money market rates down to minimal levels draining investment away from money market funds. Consequently, investors quickly altered their traditional diversified approach to investment and allocated proportionally more funds to higher risk equities, and real estate assets. Cheap surplus funds pushed asset prices substantially higher than they would have been especially relative to the feeble growth of their economies.

Moreover, in this increasingly interconnected world money created by central banks in the advanced economies is easily distributed throughout the world. The money created by advanced economy central banks is flowing to emerging markets, thus boosting stock indexes and real estate asset prices everywhere. Cheap and abundant liquidity is creating asset booms in many parts of the world.

Often we acknowledge the role of animal spirits in asset price appreciation, but this time incremental price performance is attributable to surplus liquidity.  Many economies in Asia have recently experienced surging real estate prices in recent years forcing local governments to impose strict regulations limiting local housing demand.

Of course present owners of financial assets think these policies are wonderful and hope that the party continues. But these aggressive monetary conditions have not helped the workers and unemployed who have no assets. Thus the rich get richer and the poor poorer. Aggressive monetary policy in the present global circumstances is widening the wealth inequality gap everywhere.

However, when liquidity creation stops and the central banks begin raising policy rates and shrinking their balance sheets, the global asset accretion party will end. All interest rates will rise, liquidity will contract, and the surplus liquidity-driven equity markets will become quite vulnerable.

Then no one will be happy.

This article originally appeared in the CAMRI Global Perspectives: Monthly Research Digest series, published by the Centre for Asset Management Research and Investments at NUS Business School.