WRITER: Toufic Farah

A little earlier this year, the financial markets were a happy place again: corporate earnings were great, equity markets were rising slowly but steadily, commodities were running up nicely and the global economy was supposedly recovering after the 2008 financial crisis. What went wrong?

So what exactly happened in early August?

It was essentially a global re-pricing of risk across the financial system. Markets are now pricing in a significantly greater risk of a second recession or ‘double dip’ than they were before August.

1) The debt ceiling nonsense and the S&P downgrade triggered a paradigm shift in the market mindset whereby it appears to have lost faith or confidence in the capability or willingness of politicians and financial leaders on both sides of the Atlantic to effectively deal with the sovereign debt crises and global economic growth issues. Panic selling ensued; this opened the door for the shorts, sliding markets turned levered longs into forced sellers and the result was both de-leveraging and re-pricing across the global financial system.    

2) The second bout of quantitative easing (QE2) ended, which was effectively the life support system that was keeping the western markets and financial system afloat. As such, it’s not too surprising that not long after the end of QE2, we experience such a shock.

Looking back now, it appears that QE2 was actually a stimulus that created the illusion of economic growth and recovery, an illusion that has fallen apart since most of the equity market gains it gave us have evaporated!

What could happen now... in the short-term?

It appears that markets will endure further bouts of volatility, as uncertainty regarding the European debt crisis grows. You should expect swings and equity markets to trade lower than the first half of this year. March 2009 lows on the Dow were around 6,600, meaning they rallied over 90 per cent to the highs in April this year, of around 12,850. So for them to pull back 15-25 per cent from that point is not such a massive move given the current paradigm.

The possibility of further downgrades in ratings could mean more shocks to equity and bond markets. The U.S. credit downgrade has wider implications for the market as a whole because U.S.Treasuries represent the risk-free benchmark. And after the downgrade, USTs rallied implying that the market still perceives them as the risk free benchmark. Therefore, if USTs are the risk free benchmark and not rated AAA, then how can anything else be rated AAA? The spotlight will be thrown on all countries and corporations that are indeed AAA.

QE3, or whatever it may end up being called, was effectively announced by Big Ben [Ben Bernanke, chairman of the Federal Reserve] in August when he vowed to keep rates near 0 for 2 years and do whatever it would take to support the economy. Expect the world’s central bankers to get together at some point this year, as they did in 2008/9 and announce some form of global collaborative easing whereby they will all print, print, and print more money. Markets may well remain volatile until this point, but the VIX (Volatility of the S&P 500) should then come off and a commodity-led rally should follow.

*Scenario A: Consequently, the most likely outcome could be that everything priced in dollars will rally over the next 2 years, especially commodities and precious metals, with equities and bonds being held back somewhat by the looming threat of credit events, whether downgrades or defaults. I would also expect currency debasement, especially in USD, EUR, and GBP. This may well be a concealed debasement since their respective governments will be printing. So these currencies may also go downward in line, and therefore the loss of value cannot be perceived unless they are considered against something else, such as gold.

*Scenario B: The alternative scenario is that if a positive debt resolution comes out of Europe that’s well received by the market and supported by positive economic data from both sides of the Atlantic, QE3 could well stimulate a strong equity and bond market rally, possibly to new highs. In this case, metals and commodities may underperform bonds and equities.

What could happen... in the longer-term?

Quantitative easing is just a short term fix, and there are no long-term fixes for this problem - the August market plunge has shown this to be true. There is just too much debt in the system and there is nothing the politicians and financial leaders can do but print more money to keep us on life support until the time that structural changes can be made to the global financial system and we can be transitioned into some form of new global reserve currency... like hitting the reset button.

It seems to me that we are actually in a recession, if not a depression, and one that was interrupted by artificial stimuli, which has only served to worsen underlying economic fundamentals. Bernanke confirmed this when he told us all he would keep rates near 0 per cent for the next 2 years. The fact is, the powers that be have already decided that they will default. A country defaults by either restructuring its debt or devaluing its currency such that it repays its debt in money that  has considerably less purchasing power than that which it borrowed. Clearly, the pseudo-default inflation option has been selected at this time. Countries default all the time. For example, the U.S. defaulted in 1971 when it moved away from the Gold Standard because it borrowed currency that was pegged to gold, and then repaid its bond holders in a currency that wasn't.

Regardless of whether scenario A, B, or some combination of both unfold, I have a bleak outlook for 2013. I believe the events that transpired in the global markets during the month of August are very telling of what is to come in the longer run, in a similar way to how the Bear Stearns and BNP fund blow-ups in the summer of 2007 were indicative of what was to come in 2008 with Lehman and AIG. What was a liquidity and banking crisis in 2008/9 is now a sovereign debt crisis. We can have further Lehmans not just at the banking level, but also at the sovereign level. The market already has some corporate yields in Europe trading inside their respective sovereigns. Think about it, can everyone really be bailed out?

While things may get rosier in the short-term, we will approach the end of the coming bout of easing in 2013 with more debt and a potentially weaker economy. So expect more severe credit shocks, and serious equity and currency market volatility. This should put upward pressure on yields and rates, which will stress the system even further. This could also be combined with weak economic data, and if it is coming out of China, then the global economy and financial system could come to its knees.

Where should you be investing to preserve your wealth in the long run?

What the market showed us when it was stressed this time around is that almost everything went down with the exception of the Swiss Franc (CHF), the Japanese Yen (JPY), and of course gold. Grains and soft commodities remained relatively uncorrelated. So these are the areas that I would look at closely within 5-10 year horizon. Meaning: you should be looking at owning REAL ASSETS.

Note that while CHF and JPY rallied initially, there were some very important developments over the past weeks. Both the Bank of Japan and the Swiss central bank intervened in the market to weaken their currencies. While this may be an attempt to protect their exporters, what they are actually doing is propping up the U.S. dollar. The Swiss central bank has now soft-pegged the CHF to the EUR at 1.20. What all this means is that when push comes to shove, the JPY and CHF cannot be assured as safe havens because they will throw their lot in behind the USD and EUR. Because of this, I would eliminate those two from long-term picks.

Do's and Don'ts

1- Gold:

It cannot be printed or manipulated like currencies. This is the truth. Over a week in August, gold was up from 1,650 to a high of 1,815; that is almost 10 per cent in a week, and almost 20 per cent since July 14. For all of the naysayers and the dubious, this confirms that the market more than ever perceives gold as a safe haven. I would even go so far as to say that gold is actually trading as a currency right now and it is exactly where the herd will flock to when times get ever more trying.

If we do get positive news out of Europe and further positive economic data, gold should come off, but this should be viewed as a buying opportunity. Note that the CME Group hiked margin requirements on gold by 22 per cent in August, and I don't think that it will be the last time (it took 3 or 4 hikes on silver before its breakout was contained). Again, CME hikes should also be considered buying opportunities.

So you should consider buying physical gold (some of the forms in which I hold physical gold are - Sprott Physical Gold Trust, Hinde Capital, Goldmoney.com, Bullionvault.com). You should also look at gold miners like Barrick, Newmont, and include some of the Junior Minors (GDXJ) in your portfolio.

Now of course, the question I get asked the most these days is how high can gold go? Is it not reaching its peak at this point?
When should you start thinking about selling your gold?
a) Only when you have faith that governments and central bankers are acting responsibly!
b) If gold is some how linked to a new global reserve currency.
c) When the Dow-Gold ratio hits one to one (i.e. when gold and the dow are at the same nominal value).
d) When interest rates start to move up.

2- Silver:
I expect silver to outperform gold, once it breaks through 50 USD, it should get to 75 or 80 pretty quickly. I’d imagine this to happen over the course of the next 18 months. Again, you should look at owning the physical metal in addition to the mining stocks.

3- Agriculture:
This is the hottest asset class right now. The big stat to be aware of is that the global population will be 9 billion by 2050. So, nothing the Fed does can change the demographics realities. Ultimately, the improving and increasingly diverse diets of the global population will trump any quantitative easing and there’s only one direction for consumption to go. It’s a no-brainer.

4- Multinational Blue Chips with dividend yields greater than that of 10-year USTs:
If you want equities, consider giants like P&G, Coca-Cola and JnJ. You may want to build a position over time on weakness, as they faired better than most in the turmoil and have the kind of global positioning that’ll one day make them more credible than governments. They’ll especially perform well if we see (the not too unlikely) outflow of capital from bonds into the equity markets. But overall, I’m not bullish on equities at this time; there seem to be too many downside risks.