John Butler's Blog

Some readers might be familiar with the use of the “butterfly causing a storm” analogy, the point of which is to demonstrate the concept that, the more complex a given system, the more difficult it becomes to identify the ultimate causes of changes in the system. In this respect, the “Butterflies of Complex Systems Theory” can be compared to the “Black Swans” of author Nassim Nicholas Taleb, which represent the unforecastable uncertainties inherent in financial markets.

Champagne is popping in Brussels, Strasbourg and other EU-bureaucracy cities this weekend, a major decision by euro-area governments to address the prolonged euro-area sovereign funding crises with a dramatic expansion in cross-border financial support, including both fiscal transfers and guarantees.

Do we feel fine? With each passing month, the dollar moves closer to becoming what one might call a ‘normal’ currency, in that it is gradually losing the pre-eminent reserve currency status it has enjoyed since the 1920s. In certain months, including that just passed, the end approaches rather more swiftly. While we have always regarded the demise of the fiat dollar as both necessary and inevitable, it is important to understand that, using history as a guide, what lies ahead is highly likely to be some combination of unpredictable, disorderly and even dangerous. But rather than stand as deer in the headlights, investors need to take action to prepare. Most important, they need to diversify away from not only dollar assets, but from fiat currencies and financial assets generally.

As the world reflects on the earthquake and tsunami tragedy still unfolding in Japan, investors are seeking to understand the economic and financial market implications. There are some general observations that one can make at this point, the most important of which is to recognize that, in much the same way that the Japanese authorities are responding to the disaster with monetary stimulus, other major governments around the world continue to implement stimulus of their own in a futile and counterproductive effort to restore high rates of economic growth following the global credit crisis of 2008.

THE DURATION PARADOX: It is commonly held that, by setting only short-term interest-rates, central banks leave bond yields for the free market to determine. While mostly true under normal conditions, there are situations in which this is clearly not the case, for example, when the central bank becomes a large buyer of longer-dated bonds.

DEFENSIVE NOTES ON THE MARGIN: Investors sharing our view that financial assets in general are fundamentally overvalued in real, purchasing-power terms naturally seek to preserve wealth in alternative assets, including commodities. However, while commodities may indeed be more fairly valued, that does not mean that they can decouple entirely from developments in financial markets. Should equity markets suffer a major correction, commodity prices are also likely to fall, in particular those for industrial commodities.

Ever since the global financial crisis struck in 2008, there has been a lively debate between those who have been expecting a prolonged deflation and those who have been predicting a rapid transition to inflation. In certain respects, both sides of this debate have been correct in their arguments, if not entirely consistent. Recent data indicate, however, that the terms of debate are now shifting decisively in favor of those anticipating inflation. Within a period of months, financial markets will begin to adjust accordingly, indicating that an important inflation “tipping point” has been reached. Once this occurs, there is a risk that economic behavior changes in ways that can damage economies. Investors need to prepare accordingly.

We don’t normally discuss our views on the stock market except in relative terms vis-a-vis bonds or commodities, but in this edition we take a direct look and conclude that the stock market is now not only fundamentally overvalued but at risk of a major correction. In all probability, should that occur, commodity prices are likely to correct in tandem, yet also outperform on the downside. Why?

We have read much in the financial press of late regarding Japan’s poor demographics, chronic government budget deficits and declining household savings rate. Several of these analyses conclude that these factors are negative for the yen.

2011 is thus not only the Year of the Hare, following the 12-year zodiac cycle, but also the year of yin metal, following the Wu Xing. As yin is associated with the feminine and the moon, the most prominent yin metal is silver. 2011 is thus not only the Year of the Hare but the year of silver. It should therefore be no surprise to find Chinese jewellers currently offering a range of commemorative silver pendants of hares or of the Chinese language symbol for hare, as shown on the right.