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A little over a year ago when the world was discussing the realms of currency wars and central banks purposely imposing policy in order to devalue their exchange rates with trading partners, it was the policy makers that argued that their approach was directed domestically, and a weaker currency was simply an indirect consequence. As long as the policy intent was not, for example to weaken their currency, or to better the country’s respective terms of trade by cheapening their exports, it was deemed acceptable.

Today, however, we are seeing the other side of that coin as western central bankers once again look out for their respective countries best interest, and in an uncoordinated approach adjust their monetary policy and stimulus. And it’s the worlds emerging economies, who were the engine of growth for the global economy as it climbed back from the worst recession since the Great Depression, that are feeling the pain.

It was only by coincidence, not by design, that central bankers around the world coordinated policy in order to spur economic growth. It prompted fears of currency wars or a “race to the bottom” in terms of devaluing their exchange rate. I think it’s clear now that did not yet happen. But if the tremors we are witnessing in currency markets over the last few days have illustrated anything, it’s that nothing destabilizes risk assets like the boisterous equity markets of 2013, more than uncertainty and instability in foreign exchange markets. And that’s exactly what’s to come as the world’s central banks once again operate in this unilateral non-structured fashion.

Over the course of the last week we saw action from central banks all over the world in attempts to stabilize their financial sectors. As the markets perceive the United States and the US Federal Reserve to be tightening their policy by altering their stimulus and decreasing their bond purchases by a successive $10 billion per month, the emerging market economies have no choice but to follow suit. It’s simply a stronger dollar attracting capital and foreign investment back towards the US, and other advanced economies. In the last week, countries like Turkey have had to raise their key policy interest rate from 7.75 percent to 12 percent in an emergency meeting. Although not as drastic, South Africa and India raised their rates also. And this doesn’t discredit that the home grown problems some of these countries already face may be the root cause of their suffering; moreover, a strengthening US dollar only acts to exacerbate their problems.

It’s almost paradoxical though how emerging economies through the efforts of the G20 were relied upon to fuel a recovery for the industrialized nations of the world. Many countries saw their exchange rates significantly strengthen against the US dollar, with Brazil being the textbook example as the Real appreciated by as much as 48 percent. No questions this strangled their export sector, especially given they represent resource based open economies which thrive on strong international markets. But now, a rift if being created as no consideration is yet to be given from the western world. A dollar tug of war is creating a global imbalance. And what’s surprising is that with a strengthening dollar, we are seeing the rebirth of the safe haven characteristics of gold.

Only in periods of extreme turmoil do we see gold and the US dollar trade higher in tandem. And that’s not to suggest that we have entered a period of extreme turmoil, but it certainly shows the potential for gold. To some extent it’s argued the industrialised nations can immune themselves from an emerging market crisis; nonetheless, periods of economic uncertainty have always been favourable for gold. That’s when insurance is needed more than ever. Alternatively, a weak US dollar also bodes well for the yellow metal. I don’t want to attempt to forecast a crisis, but this tug of war, juggling act, or whatever we want to call it is what will see gold bottom in 2014.

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According to the Bank for International Settlements, the total of public and private debt in the G20 Nations is 30 percent higher than it was before the Great Recession of 2008 and 2009. And when you think of a crisis as a period for deleveraging, or starting to reign in and payback debt, that hasn’t been the case across the world’s 20 largest and emerging market economies, and policies like ultralow interest rates and quantitative easing have only acted to encourage and exacerbate the issue.

The concern stems from the stimulus driven policies of the world’s central banks that have allowed consumers to go out and make big ticket purchases at relatively low financing costs. Buying that new car or managing mortgage payments were made significantly more achievable because of how longer term interest rates were and are being suppressed. But as the Fed enters this period of altering their form of stimulus which they provide to the market by shifting away from an exhausted bond purchase program towards enhanced forward guidance on record low policy rates, the market still conceals a lot of uncertainty that becomes difficult to price in.

We like to believe in the efficiency of markets and that the price of an asset reflects all the current available information to any level of investor. And that encompasses the fact that expectations of future events are priced into the market as well. Hence the episode back in May of 2013 when Chairman Bernanke hinted at the idea of paring back bond purchases, the effect on financial markets was significant because easy money policies from the Fed provided fuel for risky assets. But now that the markets have seemed to have digested the idea of a taper from the US Federal Reserve and the realization that Quantitative Easing (QE) can come to an end, some analysts suggest that this is then realized in the price of financial assets.

But the uncertainty still remains, and unfortunately I think it’s more prevalent than ever. Beyond the fact the G20 Nations are more levered than they were before the crisis, the biggest risk to 2014 is that the market has mispriced the effect of tapering QE. As we know, the monetary efforts employed by the US Fed were experimental policies that have previously never been experienced. It’s very difficult to price something into the markets that we have never seen before.

The McKinsey Global Institute published a challenging paper back in November of last year stating the effects of ultra-low interest rates and a stimulus policy on financial markets is inconclusive. That could suggest the withdrawal of stimulus might not impact asset prices, but this paper has been refuted quite logically by many leading thinkers as it assumes that stimulus level rates had no effect on the real economy. It essentially ignores the fact that businesses were able to finance new projects and lock in record low borrowing rates (which they have), or make those investments in an easy-money environment. The markets are forward looking (and given strong annual returns, economic growth numbers are beginning to echo that), but the uncertainty questions whether the natural players in the market can pick up the slack created by the US Fed’s diminished presence.

Whether this market can sustain its momentum once the US Fed no longer plays an as active role in the longer term debt markets is the unknown for 2014. Its without doubt the Fed will remain in its accommodative stance with their forward guidance and projections while maintaining a rock bottom Fed Funds Rate, but the question will be with regards to how the economy will fare one to two years down the road.

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The biggest question for 2014 is not whether the US stock market will be able to perform a repeat of the exuberant gains achieved in 2013. It does, however, relate to whether stocks will be able to repeat their exuberant gains. Ultimately though, that depends on the sentiment of investors and the perception of where capital should flow in the coming months and year ahead. A key contributor to that will be the pace at which the Fed tapers backs their bond purchases versus what the markets expectations will be, which at this point is to see the Fed’s Quantitative Easing (QE) wound down by the end of 2014. Moreover, tapering is associated with the expectation of continued modest improvements in the labour market and broader economy. But the more important investment question for the year ahead looks beyond the recent action in the markets and surrounds the debate of economic growth, the prospects for the US and global economy, and particularly the premises of a return to normalcy versus secular stagnation.

Another way of asking that question, what is it about the general economic growth environment that influencing financial markets?

The most striking fact of 2013 is that companies who make up the S&P 500 will payout or return the greatest amount of funds to investors since 2006. This was done in the form of dividends or stock buybacks, and some final totals sum up to over 500 billion dollars. The even bigger number though is that “Blue Chip” firms, comprising the Dow 30 paid out their highest levels since the late 1990’s. What this could say about the American and global economy is twofold.

On the one hand, American corporations are still finding their share prices relatively cheap. They would opt to repurchase their shares in what has been a rallying market, and seize the opportunity to issue debt at record low interest rates. Obviously, if they are seizing the opportunity to buy back shares at current prices, their outlook is for their share prices to trade higher, if not see some level of stability, but the other major factor of buying back stock means the number of outstanding shares in a company is falling and with the same growth potential share value increases.

That being said, there is also a flipside to firms returning cash to shareholders, and that is that the present value of investment opportunities is less than what shareholders might be able to earn elsewhere. Or simply put, investment in research and development for American companies is becoming exhausted. In this view, there are few and far between opportunities for American business. Instead of employing that extra worker or investing in new equipment, cash is being returned to shareholders. This is something that fits with the hypothesis (hyped by Larry Summers) of secular stagnation, but at the same time, US capital expenditure contradicts this as its highest level in 2013 in November.

Going into the beginning of this year, I think it’s evident that money will continue to flow into equities. It’s trading off the dynamics of central banker’s interference in the economy. And as markets climb a wall of worry, investors will be looking to hedge and limit their downside risk. A hedge, by definition, is an asset that is negatively correlated, or uncorrelated with another asset. Over the last year, the S&P500 gained approximately 30 percent and gold lost that amount. Gold is, and always has been a hedge for risk assets, but as the markets trade higher into 2014 gold will continue to catch bids as investor’s hedge their exposure to equities, and it’s my opinion a bottom will be in place following the first half of this year.

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It’s hard to avoid the topic of the beleaguered Canadian dollar given the swift move down we have seen against its US counterpart over the last six weeks. Just six weeks ago the Loonie was much stronger, roughly trading around 97.50 Cents US before the Bank of Canada abandoned what many referred to as their hawkish bias on their second most recent policy announcement. And by removing that reoccurring implication that the next move in interest rates was going to be higher and just simply waiting for the economy to pick up some steam, economist and investors took the withdrawal of that hawkish tone as an indication that next move in interest rates could just as likely be to the downside.

But rest assured, a move lower in interest rates is not in the cards from the Bank of Canada in the months ahead, and the despite the toll its taking on the dollar, we won’t see the bank change step. In fact, this most recent downturn in our currency is one of the most natural trade boosters we could receive. But there is no question that the Canadian economy is struggling to achieve the economic growth forecasts that many had been optimistically hoping for earlier in the year. However, it is still nowhere near sluggish enough for the central bank to re-enter (or arguably remain in) a sustained period of emergency level record low interest rates. And quite simply, it is the inability for the Bank of Canada to raise interest rates due to the inherent weakness in the economy, and that is the main factor driving the Loonie lower.

There are also two fundamental reasons though we are seeing weakness in our currency. The first has to do with the lack of inflation. Most recent data highlights the price level advanced by an annualized rate of a mere seven tenth of a percent in October. And the lack of inflation in the economy has two very simple implications. One is that low inflation levels are associated with more muted periods of economic growth. The second and relating to the lower levels of economic expansion is that the economy struggles to create jobs. But when you have the Canadian economy still averaging over 13,000 jobs created a month, it’s not yet a worry. For any serious credibility given to a downward move in interest rates, job growth would seriously have to dissipate.

The second reason we are seeing the dollar trade lower is to do with a deteriorating balance of trade. Particularly, the weakening demand we are seeing in the resource sector is equating to a waning demand to purchase those commodities. And as that sector of the economy has proven to be so pro cyclical with GDP growth, it can be expected that when the resource sector picks up again, and it will, we will see a renewed demand that is very supportive of the Canadian currency.

While examining the fundamental factors impacting the Canadian dollar these last few months, if these volatile financial markets over the last few years have illustrated anything, fundamentals, albeit important, can very much be trumped by the sentiment of investors. And the fact that Canada was the least dirty shirt among the worlds developed economies was what elevated our Canadian dollar above parity. In fact, beyond the fundamentals, the Canadian dollar almost carried an elite status because of the relative strength of our financial institutions following the worst recession since the Great Depression. In the moment though, the story is very much about the regained strength of the US dollar. Pair that with a central bank abandoning their hawkish views and we will see the premium in our currency dissipate.

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“Continuing assessment of the efficacy and costs of asset purchases might lead the Committee to decide at some point to change the mix of its policy tools while maintaining a high degree of accommodation.”

-Minutes of Federal Open Mark Committee October 29-30, 2013

The above text is the most important aspect of the most recent Federal Open Market Committee (FOMC) meeting that took place between October 29 and 30. The text is in no way novel as the sustainability of this economic stimulus program has always been of concern, and thus examining its long term benefits and consequences continues to be the focus of Federal Reserve officials. However, moving past analyzing the efficacy or cost of the program, it is the end of the above quote that is most telling. And that is that the misconception by the financial media of tapering Quantitative Easing meaning that the Fed is attempting to make their policy less accommodative. In fact to the contrary, it is not that their goal is to be less accommodative, but change the medium in which it is delivered.

In most recent months the newest term to be thrown around in the tool basket of Fed policy approaches is forward guidance. Essentially, it is a central bank utilizing their ability to vocally influence markets by casting their projections on economic activity or policy interest rates. The most recent projections have the Fed maintaining their emergency low federal funds rate at a quarter of a percent or 25 basis points until the beginning of 2016. Similar to quantitative easing, where the fed acted as a backstop for the threat of illiquidity in financial markets, and acted to supress long term interest rates (something not typically within the conventional capability of central bankers), which gave investors’ confidence not only in the present, but also into the future. Forward guidance gives a similar message, and that is that policy will continue to be highly accommodative; we are just witnessing it in a different form.

The problem that we are learning with a program like quantitative easing is that it has seemed to run its course. Where the anticipation was that the fed would inject massive amounts of liquidity into the financial system, and in turn banks and other financial institutions would go out and lend and spur investment fell short. What predominantly occurred was these financial institutions sitting on massive amounts of capital earned a minimal interest rate parking funds with the Fed and without ever incurring any real risk. James Bullard, President of the St. Louis Fed and who is arguably one of the most creative thinkers with the US central bank even took to discuss the idea of a negative policy rate this week to create an incentive to lend those funds. And it’s because the mere idea of printing money is no longer sufficient as the policy becomes ineffective without the printed money changing hands.

And this is simply why the Feds taper, as has been argued in past newsletters, is inevitable. It’s not to be confused with the aspect of an improving economy as we are yet to witness that. It is the fact that this trick has gotten stale, and the Fed’s looking for another manner in which to accommodate. When Ben Bernanke began what was originally referred to as QEIII, every analyst warned of the central bank running out of policy bullets as the effects not on the stock markets, but the economy seem to be wearing off. What we very well could be witnessing is the actuality that QE has run its course. No question it served its purpose, and with a dysfunctional federal government we can hope for some form of support from the US central bank, but at the moment, the fed looks to be out of ammo.