If you have not yet read Part I: The New Endangered Species: Liquidity and Reliable Income Streams, available free to all readers, please click here to read it first.

We began our reappraisal of scarcity, demand, opportunity cost, technology, and behavioral choice with an analysis of commodity demand in an era of declining income for labor and the decline of the ownership model of resource-intensive assets such as vehicles and homes.  This led to the thesis that reliable income and liquidity (the ability to sell assets quickly and safely for cash) will become scarce in the era ahead.

Let’s start by exploring the scarcity of reliable income streams in a recessionary, risk-averse, deleveraging environment.  In Part I, we noted the structural decline in earned income from labor, but thanks to the global financial repression of yield (that is, central banks lowering the interest rate to near zero), unearned income (i.e., interest income) has also plummeted.

The search for reliable unearned income has led investors and money managers to pile into dividend-paying stocks. This demand has pushed up valuations and price-to-earnings (P/E) ratios to levels where they are vulnerable to earnings disappointments and margin-compression; in other words, falling stock prices that drop P/E ratios.

Meanwhile, Web 2.0 stock market darlings such as Facebook, Groupon, and Zynga have been savagely revalued as the market recognizes that they lack reliable income streams.

Investors account for roughly one-third of all home sales in once-speculative real estate markets, another manifestation of the search for yield in a low-yield climate. But owning rental property is not risk-free, as I have discussed here earlier this year in some detail, and it carries the additional risks of being illiquid during a “credit event”-type crisis.  Since real estate isn't mobile like other forms of capital, the investor-owners are also at risk of becoming “tax donkeys” as local authorities raise taxes on the one class of investors who can’t easily move their capital elsewhere to escape ever-higher taxation burdens.

The potentially devastating dangers of illiquidity have driven global capital into the “safe haven” of highly liquid bonds, such as U.S. Treasury notes and Bank of Japan bonds.  So important is liquidity to professional money managers that they accept near-zero yields as the tradeoff for maximum liquidity and safety in size.  In other words, tens of billions of dollars can be moved around without distorting the market for these highly liquid financial instruments.

Others have accepted the promise of safety offered by municipal bonds, as the promise is based on the “guarantee” that irrevocable income streams will back up the bond payments.  But very little is guaranteed when crisis erupts.  Rules are changed, bankruptcy courts void claims, voters rebel, and so on.  The risk of local government promises being amended in the future may be much higher than is conventionally accepted right now.

Let’s review the risks created by central bank financial repression pushing yields to near 0% (or factoring in loss of purchasing power, negative real returns).  The policy’s explicit intention is to drive capital out of safe havens into risk-on assets such as stocks and to encourage new borrowing and speculation, with the goal being a reflation of asset valuations.

The net result of this policy is that investors are now exposed to potentially catastrophic levels of risk in terms of capital loss and declining income streams…