Markets Prepare for Downside Risk

The markets experienced lots of turbulence this week following Fed Chairman Bernanke's plan for more easing. However, that alone was not the major worry among investors. It's the growing concern that rescue initiatives are exhausted, leaving everyone forced to make key decisions that avoid risk.

As IMF Chief Lagarde accurately puts it, "[there are] downside risks on the horizon, they are piling up." Everyone knows this, but it seems that investors are the only ones making the necessary bold moves, sending shocks throughout the financial system. As more rhetoric fills the airwaves from political officials, the more investors and common folk lose trust in the system. At this point, it's actually good. These officials have got us into more economic trouble, and perhaps it's best they continue to talk and not act. Let the markets do the work.

For sure, we always expect more of the same to come out of these talks - things like QE3 or more bailouts. Bernanke's long awaited speech and FOMC decision did not live up to the hype. The markets expected a grand program of more quantitative easing (heavy purchases of treasury debt to encourage more lending and spending). Instead, Bernanke did not come to the rescue, and proposed a lighter adjustment to the Fed's gradual withdraw of monetary stimulus. There will be more purchases than planned, but still less as the months go on. The Fed is exhausted, and Bernanke is pressuring Congress to take  responsibility for the fiscal problems in the US.

These grand expectations caused investors to scramble for liquidity. As Gold prices rose in anticipation of QE3, it declined following the announcement of Bernanke's 'operation twist' as investors sold gold positions for cash to cover losses in risky assets like stocks. These margin calls require more cash on hand to cover greater risk. There is also an opportunity cost for holding gold (storage), so during cash-strapped times, it makes sense to just sell this liability and seek hard cash coupled with income generating assets like treasury bonds. The dollar was also heavily bought for added security as Europe faces heightened risk of a Greek default. Italy's downgrade added more fuel to the fire. Here's a breakdown of the market's reaction:

• Gold dropped 5.7% on Friday, down 9.6% for the week to 1,638/ounce
• Silver down 18% on Friday (was highly overbought before 'operation twist' announcement..also industrial use of silver is more of a hassle to hold).
• Dow down 6.4% this week, but up 37 points on Friday to 1,0771 (cash from gold/silver sell-off put back to cover equity positions).
• Euro down 6% this month, ended week at 1.35

The markets show the flow of dollars in response to the economic politics of the world. It's the strongest indicator that we have. 

Europe is still examining ways to lend Greece more money. 15 billion euros ($20 billion) has already been allocated to Greece until 2013. The request for more euro's comes at a cost -- the country must enact tougher austerity measures. The problem with this is that austerity will cause a slowdown as more financial pain is placed on the people of Greece, and crucial services that have the potential to revive the economy are receiving cuts. Transit workers recently staged a massive strike in protest of cuts, grinding the system to a halt. Greece will need an investment plan coupled with incentives making full use of its resources. 

China is not coming to the rescue of Europe, especially Greece. It knows that the bailouts and political dithering are clouding the structural reforms so desperately needed. China is in seek of return on investment if it does provide some assistance; Europe is not in the right position to provide a return. A free check will not come from China; the IMF, G20, and European Stability Fund handle the unsustainable flow of aid. 

China is busy handling its own problems - withdrawing stimulus which caused domestic problems such as a construction boom, 6%+ inflation, 7% growth targets (lowered from the 8-9% trend), and local debt issues which call for tighter lending standards going forward. 

The world can no longer depend on China, bailouts, stimulus, etc to solve its problems. The markets need to be accepted as a sustainable alternative. The Australian dollar has been on a decline recently as weak economic data out of Asia spread fears about trade volume between China and Australia due to lack of demand for natural resources. Leaders need to fess up and provide sufficient returns for capital injection.