The recent carnage gripping global equity markets will likely remain a primary point of focus for investors this week. Last week saw some of the steepest declines in stocks in years, including the largest recorded point drop in the Dow Jones Industrial Average. The mayhem in equities also coincided with the largest-ever daily gain in market volatility as measured by the CBOE’s VIX.
Investors will be heading into this week wondering if the worst is over, and a cautious tone is to be expected following recent market activity. Whether the recent sell-off represents a bottom and buying opportunity or a glimmer of more selling to come, one thing seems to be certain: The era of easy gains and non-existent volatility is over.
Rising bond yields have been a major story for Wall Street in recent weeks, with the benchmark ten year note yield approaching 3%. The bigger picture, however, is more alarming. Bond yields are rising, and rising rapidly, due to increasing inflation expectations. Although recent economic data shows inflation still running below the Fed’s desired 2% target on a year-over-year basis, it is not far off. In fact, the worry now is that with full employment and strong GDP data, inflationary pressures could easily exceed desired targets and become problematic.
The economy may already be overheating, and the Fed may be forced to act more aggressively as it looks to normalize monetary policy. Such a scenario presents several problems. Excessive inflation increases the costs of everyday goods and services, as it erodes purchasing power. Not only that, but higher inflation and a weaker dollar also eat away at real returns. On the other hand, if the central banks raises rates higher and/or faster to combat inflationary pressures; stocks could be in for a rough ride. Higher rates make bonds more attractive, and investors could elect to shift capital away from the aging and arguably overvalued bull market in stocks into fixed income which carries less risk.
The current headwinds being faced by equity markets could be very bullish for gold and other hard assets. The gold market could see substantial inflows as investors seek its perceived safety and look to diversify away from stocks and risk assets. The notion of rising inflation could also fuel sizable allocations into the metal, as it may potentially provide a meaningful hedge against a weaker currency and declines in purchasing power.
The perfect storm of rising inflation, higher rates, a return of stock market volatility and the current geopolitical backdrop could send gold not only back to all-time highs near $2000 per ounce, but could also drive a rally that goes far above and beyond making $3000, $5000 or even $10,000 per ounce not only feasible but a distinct possibility.
Years and years of ultra-low rates and quantitative easing have backed central banks into a corner. As asset values come back down to earth, and as central banks look to shrink balance sheets and normalize monetary policies, market volatility may increase while equity market returns decline. As central banks now battle rising inflation, any large missteps could not only exacerbate such issues but could also send risk assets into a major tailspin.