Learning to live with market volatility

It is approximately a month since Japanese monetary policy makers destabilized their financial markets, and triggered instability everywhere else. Emerging-market currencies have been hammered, as have European and U.S. bond and equity markets. It has not helped that the debate has now turned to how the Fed will exit its strategy of buying $85 billion of Treasury and mortgage-backed securities every month, leading to the gradual realization that there is no plan, and worse, no exit.

This is very worrying, but has been obvious from the start. The surprise is that the investing crowd has been in denial of the facts, which we can only put down to the human desire to be blind to negative outcomes. Instead, investors everywhere have been happy to believe that Mr. Bernanke knows best.

While statistics such as brokers’ loans show that equity markets have become overbought, there is not a bubble mentality in equity and bond markets: By this I mean that the wider public is not scrambling to buy in the sure-fire belief that prices are going up. It is more a case of markets being mispriced on zero interest rates and investors being complacent.

Shifts in sentiment can be very sudden under these circumstances. A good example was the 1987 October crash, when markets were over-bought and investors were enjoying the ride, rather than going mad for equities. In that case equity markets lost between 30% and 50% in a matter of days, with New Zealand falling 60%. The reasons for the October crash are disputed, but it was the first time that global equity markets were linked together by financial institutions operating in multiple markets and investment diversification across a range of these markets had become the norm.

It was for this reason that all markets crashed together. Today, we have a similar set-up, but with far greater levels of inter-dependency between markets. No financial institution recommends an investment in one country, without comparing the alternatives in others. Nor will an investment manager contemplate an investment in, say, Spanish bonds without comparing them to Germany’s or perhaps Italy’s.

While this makes eminent sense in today’s investment world, it does mean that if one market weakens it is bound to affect others. When Japanese equities began their fall, not only did it undermine other markets, but hitherto bullish investors began to consider issues that hadn’t worried them before.

There is no knowing how far the increase in bond yields and the slide in equities will go. But with all the printed currency that has ended up in financial markets, the rush for the exit could be spectacular.

This leaves gold and silver in an interesting position. Short term instability in other markets usually has unpredictable effects. Holders of physical bullion should look through these and think about the end result of a bond and equity market crash. They should ask themselves, will it be more destabilizing for gold, or for paper currencies?

And here we must think about the central banks’ response. Their immediate problem is the consequences of losses on securities held in the banking system and being used as off-balance sheet collateral in the shadow banking system. Systemically-important banks particularly in Europe are still highly geared, and falling bond prices will likely wipe some of them out. There can only be one central bank response, and that is to accelerate the provision of liquidity to the banks to avert a crisis. Furthermore, central bankers firmly believe that healthy equity markets are necessary to bolster and maintain consumer confidence, so they will also wish to intervene for this reason.

When financial markets wake up to this inevitability they will seek safe havens; and the only ones that exist are in basic commodities and precious metals. While the ride in gold has been very uncomfortable for the last 21 months, gold bugs might reflect that it has taken less than one month in other markets to produce losses on a similar scale.

As to the future, I leave you with my favorite chart, which shows that the U.S. dollar is already experiencing monetary hyper-inflation, and that is before we consider the extra money supply needed to rescue the banks and to stop market falls become self-feeding.

 

And that is the real reason to have some gold and silver: Currencies are on the path to self-destruction.

About the Author
Alasdair Macleod

Alasdair Macleod is head of research for GoldMoney. He also runs FinanceAndEconomics.org, a website dedicated to sound money and demystifying finance and economics. He has a background as a stockbroker, banker and economist. He can be contacted at Alasdair.Macleod@GMYF.org and followed on Twitter @MacleodFinance.

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