It’s been a week to remember for global financial markets, with equities and bonds the world over experiencing wild gyrations in value, and volatility spiking.

The precious metal sector has been caught up in the excitement, with gold pushing higher early in the week, reclaiming USD $1150oz for a time, only to ease back in the last 72 hours, as equity markets turned higher.

Silver has had a tougher time, caught up in the broad commodity carnage, and has fallen roughly 5% for the week in USD terms, though it is still above AUD $20oz.

Amazingly, this recent price action has pushed the Gold/Silver ratio to an incredible 77:1, though at one point earlier in the week it was nearly 80:1

As you can see from the chart below, relative to gold, silver is as cheap now as it was back when the GFC hit.

If history is any guide, there is a good chance this ratio will fall meaningfully in the years ahead, highlighting the huge potential for silver to outperform gold once the cyclical bear market in precious metals ends.

In Australian Dollars, gold prices actually reclaimed the $1600 level for a time earlier in the week, but have since eased back. Year to date, AUD Gold is up 8.5%, which is a solid if not spectacular return, especially when one considers where sentiment towards precious metals investments is today.

Just how decent the return on AUD Gold for 2015 so far has been is given even more context when one considers what has happened to risk assets over this period. Whilst the local market may follow Wall Street higher today, August, and indeed 2015 as a whole has been a year to forget for equity market bulls.

As you can see from the chart below, which plots the ASX200 over the last year, the last four months have been quite painful for equity bulls, with the market falling well over 10% in this period, with the majority of the pain concentrated in the last month alone.

Indeed the last week has seen some of the wildest intraday swings in developed world equity markets for some time, with what has happened to the ASX, the Dow and the S&P500 looking like the kind of volatility we’ve come to expect out of Shanghai alone.

Speaking of Shanghai, and China has been front and centre in the news again this week, not only for yet another interest rate cut to support their slowing economy, but also for selling US Treasury bonds, which they’ve done in order to shore up support for the Yuan.

The PBOC has sold over $100 billion of reserve assets in the last two weeks, according to an estimate from Societe Generale that appeared in an article on Bloomberg. That is a large number, though barely 1/15th of the estimated $1.48 Trillion in US Treasury debt that is controlled by China.

There is obviously significant interplay here between any reduction in US Treasury holdings by China, and the next move by the Federal Reserve. Any selling by China potentially adds upward pressure to bond yields.

This will further reduce what little scope the Fed has in terms of hiking interest rates, especially as we are already in an environment of low ‘official’ inflation, with commodity prices plunging, and financial markets on edge.

Between now and the end of this decade, we expect these forces, amongst others, to push the price of precious metals significantly higher, and we remain firm in our view that AUD Gold is highly unlikely to break below $1400oz

The Technical Picture

With John Feeney

The short-term outlook for Gold will largely depend on what happens with global equities. As you can see from the chart below, gold did have a good rally from the US$1,070 low and made it as high as $1,160 before rolling over. Short covering and some dollar weakness helped fuel this move, with not a great deal of flight to safety occurring. The rally needs to continue higher quickly in order to restore short-term confidence for USD gold.

RSI is suggestive of some potential short-term weakness for gold, but due to the action in broader markets I think this indicator can somewhat be ignored for now. Movements in the gold price could be volatile and if the chaos continues for conventional markets eventual flight to safety will support the gold price.

Australian gold Investors should look for short-term bounces in the AUD to add to positions as the currency continues to deteriorate in the wake of Chinese stock market gyrations and Australia’s economic growth outlook being cloudy at best.

A short-term bounce in the AUD to 0.73-0.74 US cents might provide the entry point that many some are waiting for, as there are a few oversold indicators on the AUD chart below.

By far the most important and interesting technical setup can be found in the S&P 500. On the long-term chart below, this rolling top formation has now indicated that there is a strong chance that this bull has run out of steam.

Stock valuations have been out of whack for sometime, and the selloff in commodities over the past year was a big indicator of lower than expected global growth on the horizon.

On the chart below the 50DMA, 100DMA, and 200DMA moving averages now look to be rolling over and there is no wonder we saw a massive sell off on large volume last week. This is a big enough signal that investors have woken up, and there is a good chance that equities worldwide could now trend downward.

A short-term bounce on the S&P 500 to back above 2000 will no doubt have mainstream media pulling out party hats, but investors should tread very carefully over the next few months.

Daily swings on indexes between 2-4% this is not a normal environment. The large volume exit last week could indeed signal the next bear market for US equities, and indeed equity markets worldwide.

Winning the War

The volatility we’ve seen in financial markets this week is but the latest skirmish in an ongoing battle that dates back to the beginning of the GFC, and indeed the multi decade credit binge that led to it.

The market crash that we saw back in 2007 and 2008 was a natural response to the investment world sobering up (temporarily at least) and realising that there is a limit to all asset bubbles and indeed to economic expansion themselves, especially when they rely on the perpetual expansion of credit. The flight from overvalued risk assets was hardly unexpected.

The recovery in asset markets that we have seen since early 2009 has also been quite natural, as trillions in QE and over 600 interest rate cuts have pushed investors into risk assets, even though economic growth remains weak, debt levels are higher than they were pre GFC, and company earnings have been goosed up by financial engineering.

And so we come to Q3 2015, a time where market historians will note a handful of important forces are at play.

• The worlds second largest economy, and most important contributor to global growth over the past 15, and especially last 5 years, China, is experiencing significant growing pains.

• At the same time, the central bank of the largest economy in the world, the United States Federal Reserve, threatens (and that really does seem to be the appropriate word) to increase interest rates for the first time almost a decade.

• Meanwhile, commodity prices, despite the extraordinary growth in emerging market economies in the past 15 years, have plunged, with the Bloomberg Commodity index of 22 raw materials this week closing at it’s lowest level since August 1999, with major implications for expected capital investment in the sector.

• Finally, despite the greatest credit binge in history, and the mathematical impossibility that developed market sovereigns will be able to honour their debts in dollars, euros, yen or pound sterling, sovereign borrowing costs are at their lowest level in 5000 years, dating all the way back to the Babylonian Empire.

That is the field of battle that we are all on, and once one recognises it, increases in volatility, and the wild swings in risk assets we’ve seen the past 5 days can hardly be seen as a surprise.

But what should investors do? How do they win this war that is raging between the real economy and financial markets, and ensure they can protect, and hopefully grow their own wealth in the period ahead.

In an article dealing with the tragic death of Adelaide Football Club coach Phil Walsh earlier this year, journalist Mark Robinson reported on a conversation Walsh had with an SAS leader during Walsh’s time at the West Coast Eagles.

According to Walsh, the SAS leader commented that only three things determine a battle, which were

• Field Position

• Fire Power

• Morale of the Troops

The article went on to comment that the morale of the troops was really the only thing that was in the control of the SAS leader, and indeed a football coach, so he saw great merit in spending a lot of time focusing on that factor.

I was re-reading that article overnight and thought those comments were highly relevant to investors today, and how they should be thinking about their portfolios.

For ultimately, there are three factors that will play a big role in determining returns in the coming years, which are;

• Global economic conditions

• Global monetary settings

• Valuations, and the price investors are paying to own financial assets

And if we draw a line between the SAS leaders comments and financial markets, we can see that global economic conditions and global monetary settings are much like the field position and the firepower.

They are outside of our control!

We can have a view that the global economy will improve in the coming years, or that it won’t, but we don’t really know, and whilst we all play our own little role in it, none of us is big enough to drive the good ship GDP in any particular direction.

Similarly, we can take a view on where interest rates and monetary policy will head, but again we can’t really know. Perhaps it will tighten, but then again, perhaps we will remain in a world of ZIRP and real NIRP, with QE on top for years to come.

And perhaps those monetary settings will continue to exert their somewhat benign influence on the real economy, through eased borrowing costs and minimal official inflation, whilst continuing to support asset prices.

But it is also possible that in the coming years, as in every other occasion in history where such desperate monetary policy measures have been undertaken, unintended and largely negative consequences of QE and ZIRP will rear their ugly head.

Richard Fisher’s warning that "Inflation is a sinister beast that, if uncaged, devours savings, erodes consumer’s purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency”, is something all investors should be aware of, even if the threat is not on the immediate horizon.

Again, when it comes to where monetary settings will head, and what their impact will be on the economy, none of us can be truly sure.

Instead, much like a SAS leader or a footy coach can only fully be in control of the morale of their troops, the only thing we as investors can control is the price we are willing to pay for the assets we buy.

Are we comfortable buying developed market sovereign debt at negative real yields, when they’ve been in a bull market for over 30 years?

Are we comfortable buying Australian property when it too has been in a bull market for the better part of three decades, with prices at all time highs, and rental yields at all time lows

Are we comfortable buying international shares, which if we use Shiller CAPE as a guide, are already trading at 25 times earnings, fully 50% above the long term average and at a historical entry point that suggest a high risk of significant losses in the decade ahead?

How investors approach this battlefield in the years ahead is a personal decision, but I for one will not concentrate too much of my own, or my families money in financial markets today.

The valuation that I would need to pay, which is the only thing I can truly control, is simply not attractive enough, and warrants a more cautious approach.

And whilst none of us can know with 100% certainty what will happen in the economy in the years ahead, and what the impact of the extraordinary monetary largesse we see being deployed around the world will be, we will not ignore economics, or history, to paraphrase Ray Dalio.

As such, we will continue to own physical gold and silver.

Until Next Week

Disclaimer

This publication is for education purposes only and should not be considered either general of personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, past performance is not necessarily indicative of future performance. Any prices, quotes or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.