A little earlier this year, the financial markets were a happy place again: corporate earnings were strong, equity markets were rising slowly but steadily, commodities were running up nicely and the global economy was supposedly recovering from the 2008 crisis. So what exactly happened in early August? It was essentially a global re-pricing of risk across the financial system, and markets are now pricing in a far greater chance of a second recession, or 'double dip', than they were before.
Two things drove it. The debt-ceiling nonsense and the S&P downgrade triggered a paradigm shift in the market mindset: it appears to have lost faith in the willingness of politicians and financial leaders on both sides of the Atlantic to deal with the sovereign debt crises and growth issues. Panic selling ensued, which opened the door for the shorts, turned levered longs into forced sellers and produced both de-leveraging and re-pricing across the system. At the same time the second bout of quantitative easing ended, removing the life support that had been keeping Western markets afloat. Looking back, QE2 was a stimulus that created the illusion of recovery, an illusion that has fallen apart now that most of the equity gains it gave us have evaporated.
In the short term, expect further bouts of volatility as uncertainty over the European debt crisis grows. The March 2009 lows on the Dow were around 6,600, meaning it rallied over 90 per cent to the April highs of around 12,850; a pull-back of 15 to 25 per cent from that point is not such a massive move given the current paradigm. The U.S. credit downgrade carries wider implications because Treasuries are the risk-free benchmark. After the downgrade, Treasuries rallied, implying the market still treats them as that benchmark. But if they are the risk-free benchmark and no longer rated AAA, then how can anything else be? The spotlight will fall on every country and corporation that is.
QE3, or whatever it ends up being called, was effectively announced by Ben Bernanke in August when he vowed to keep rates near zero for two years. Expect the world's central bankers to gather at some point and announce some form of collaborative easing whereby they all print, and print more. The most likely outcome is that everything priced in dollars rallies over the next two years, especially commodities and precious metals, with equities and bonds held back by the looming threat of downgrades or defaults. I would also expect currency debasement, especially in the dollar, euro and sterling; a concealed debasement, since the loss of value cannot be perceived unless measured against something else, such as gold. The alternative scenario is that a positive debt resolution out of Europe, well received and backed by good economic data, lets QE3 stimulate a strong equity and bond rally to new highs, in which case metals and commodities underperform.
In the longer term, quantitative easing is just a short-term fix, and there are no long-term fixes for this problem. There is simply too much debt in the system, and there is nothing the politicians can do but print money to keep us on life support until structural changes can be made and we transition to some form of new global reserve currency, like hitting the reset button. It seems to me we are actually in a recession, if not a depression, one interrupted by artificial stimuli that have only worsened the underlying fundamentals. The powers that be have already decided they will default: a country defaults either by restructuring its debt or by devaluing its currency so it repays in money worth far less than it borrowed. Clearly the pseudo-default inflation option has been chosen. The U.S. did much the same in 1971 when it abandoned the Gold Standard, repaying bondholders in a currency no longer pegged to gold.
Regardless of which scenario unfolds, I have a bleak outlook for 2013. The events of August are as telling of what is to come as the Bear Stearns and BNP fund blow-ups of summer 2007 were of 2008. What was a liquidity and banking crisis is now a sovereign debt crisis, and we can have further Lehmans not just at the banking level but at the sovereign level too. Can everyone really be bailed out? We will reach the end of the coming bout of easing with more debt and a potentially weaker economy, so expect more severe credit shocks and serious currency volatility; if that is combined with weak data out of China, the global system could come to its knees.
Where, then, should you be investing to preserve wealth? When the market was stressed this time, almost everything went down with the exception of the Swiss franc, the Japanese yen and gold, while grains and soft commodities stayed relatively uncorrelated. Note, though, that both the Bank of Japan and the Swiss central bank have since intervened to weaken their currencies; the Swiss have soft-pegged the franc to the euro at 1.20. When push comes to shove, the yen and franc cannot be assured as safe havens because they will throw their lot in behind the dollar and euro, so I would eliminate both from long-term picks.
That leaves real assets. Gold cannot be printed or manipulated like currencies; over one week in August it rose from 1,650 to 1,815, almost 10 per cent in a week and nearly 20 per cent since 14 July. It is trading as a currency now, and is exactly where the herd will flock when times get harder. Any pull-back on positive European news should be viewed as a buying opportunity, as should the CME's margin hikes. Consider physical gold alongside miners such as Barrick and Newmont and some juniors. I expect silver to outperform once it breaks 50 dollars, reaching 75 or 80 fairly quickly over the next eighteen months. Agriculture is the hottest class of all: the global population will be nine billion by 2050, and nothing the Fed does can change that demographic reality. Finally, if you want equities, consider multinational blue chips yielding more than ten-year Treasuries, giants like P&G, Coca-Cola and Johnson & Johnson, built up over time on weakness, though overall I am not bullish on equities given the downside risks.
