When central banks start realizing they're not actually in control, it's time to get especially vigilant.
As currency volatility gyrates like a sine wave, central planners are becoming increasingly desperate. We've already seen the advent of negative interest rates in a number of nations.
Yet growing talk of possible capital controls is not only emerging, but gaining steam.
It's a disturbing trend that could blindside investors who stand unprepared.
Capital Controls and Their Prevalence
What are capital controls? According to Investopedia:
Any measure taken by a government, central bank or other regulatory body to limit the flow of foreign capital in and out of the domestic economy. This includes taxes, tariffs, outright legislation and volume restrictions, as well as market-based forces. Capital controls can affect many asset classes such as equities, bonds and foreign exchange trades.
Keep in mind that measures can also include restrictions on bank withdrawals, buying and selling of foreign currencies, and even taxes on bonds and equities.
Okay. So now that we all know what they are and how draconian they sound, you'd think they're pretty rare.
Not so.
Capital controls are actually pretty common. Right now, they're being used in Argentina, Venezuela, Ukraine, Iceland (it's been six years already), India, and China, to name a few. Even Russia recently instituted "soft capital controls," by instructing a number of state-owned exporters to sell their foreign currency reserves to help support the ruble.
But given the problems being faced by the European Union's southern members, some of those could well be next to take such drastic measures.
Confused Central Bank Policies Are Causing Wide Fallout
Greece may have made a deal with its reluctant lenders, but it's nothing more than an extension guaranteeing more negotiations within the next four months.
That's also spurred is massive capital flight out of this Mediterranean tourist haven. Greeks and Greek companies have headed for their banks' exit doors in droves. In January alone, 12.2 billion euros flowed out, leaving total cash holdings at 148 billion euros, the lowest since August 2005.
Moves like this conjure up thoughts of Cyprus, and for good reason.
Cyprus, an EU member, decided to introduce capital controls back in March 2013.
The island nation was in the throes of a bank run as the terms of a 10 billion euro bailout were being "negotiated." All of this stemmed from Cypriot banks holding too much public and private Greek debt. A massive write-down of Greek debt in 2011 wiped out a large portion of the value of those bonds.
As part of the country's attempt to deal with its financial system's meltdown, the central bank put capital controls in place nearly two years ago. And they're still in effect today. With Cypriot euros stuck in the country, this makes them arguably worth less than a Dutch euro, for example, which benefits from a lack of restrictions.
Central planners like to boast about a liberalized, global economy, but sadly the state of sovereign finances is such that capital controls are looking more likely, not less. In just the last few weeks, the Swiss National Bank's Governor Thomas Jordan has broached the topic.
A quick refresher is needed. He's the same guy who, two days before removing the Swiss franc's peg to the euro (causing currency volatility most traders cannot recall in their entire careers), had his vice chair Jean-Pierre Danthine affirm the currency cap would remain the cornerstone of SNB policy.
Bloomberg recently asked Jordan if Switzerland would resort to capital controls, to which he carefully replied, "It's not a measure that is at the forefront at the moment." (Emphasis mine.)
Shortly after which Zurcher Kantonalbank's (Switzerland's No. 4 bank) CEO Martin Scholl told a Zurich newspaper that implementing capital controls may be "dramatic," but was "certainly possible." Then on Feb. 20, the Danish Krone had its biggest intraday drop against the euro since 2001.
Why? While commenting on the central bank's currency peg to the euro, the head of Denmark's Economic Council remarked "If it takes restrictions on free capital movement for a period to defend the fixed exchange rate, I assess that the central bank would be willing to go that far."
Could the U.S. be next?
The Contagion Reaching Our Shores
Despite its own problems, the U.S. dollar has been exceedingly strong, with the U.S. Dollar Index rising a massive 19% in just the last eight months. It's not that the dollar is so great. It's just that all the others are worse.
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That's attracting a lot of capital to the United States, which clearly has contributed to buoying markets.
There's little doubt that, while everyone else is tripping over each other to cut rates and weaken their currencies, the anticipation of a U.S. rate hike has contributed to the dollar's strength.
Which has caused yet another dilemma for the Fed, a fact made clear by Chair Janet Yellen's waffling over when rates will actually rise.
It's a fine line to walk. The Fed has created the expectation of higher rates before long. Meanwhile, a strong USD causes American exports to become more expensive, and spurs deflation as imports become more costly. And deflation is the Fed's sworn enemy.
What's more, the strong dollar heightens risks for emerging market players, both sovereign and corporate. That's because many have issued debt in U.S. dollars, in many cases because they're unable to borrow abroad in their domestic currency; a phenomenon known in economics as "original sin."
Problem is, when the debt's underlying currency gains in value, sometimes dramatically and rapidly like the dollar in recent months, even paying the interest on those loans can become unaffordable. Scores of Eastern European homeowners who took on Swiss franc mortgages to benefit from low interest rates are facing that music now.
If the U.S. dollar weakens, this problem could heal itself. If not, huge amounts of U.S. dollar-denominated international debt could threaten the global financial system.
Would the Fed resort to capital controls of its own? It's not sounding quite so far-fetched right now.
If restrictions on the flow of capital come to the United States, you can expect it to be as pleasant as it is for the Argentines, Venezuelans and Ukrainians to deal with: black markets to exchange cash at drastically higher than official rates, shortages of staples, and major price inflation. Maybe even empty ATMs.
Prepare Now and Profit
So what can you do about it?
According to the 2015 Legg Mason Global Investor Survey, affluent Americans have allocated 41% to equities, 22% to cash, 16% to fixed income, and 21% to other sectors including investment real estate, non-traditionals (including private equity, hedge funds, currencies and commodities), and gold/precious metals.
There is of course no one-size fits all solution, especially in investing. But with the protection afforded by hard assets like real estate and precious metals, I think it wise for the average investor to consider increasing those allocations.
Within resources, precious metals and agricultural commodities look the most undervalued right now. And within precious metals, I believe gold equities are among the best value in the entire market, which have been rising despite the strong dollar - a bullish sign.
In particular, a simple and instantly diversified way to play this is through the Sprott Gold Miners ETF (NYSE: SGDM). SGDM is performance-related, rather than market-cap-weighted. It tracks the Sprott Zacks Gold Miners Index, which is rules-based and rebalanced quarterly.
The Gold Miners Index seeks to identify about 25 gold stocks with the highest historical beta to the gold price. The weighting also depends on quarterly revenue growth year over year and balance sheet quality (long-term debt to equity).
Essentially, the rules-based method looks to identify quality rather than size and then allocates on that basis every three months.
In tracking the Sprott Zacks Gold Miners Index, SGDM seeks out the healthiest companies in the sector and adds them to the ETF's holdings.
As a result, current holdings show a high concentration in three names: Randgold Resources Ltd. (Nasdaq ADR: GOLD) at 17%, Franco-Nevada Corp. (NYSE: FNV) at 16%, and Goldcorp Inc. (USA) (NYSE: GG) at 14%. What's also interesting is that besides Franco Nevada, the two other largest royalty/streamer companies, Royal Gold Inc. (USA) (Nasdaq: RGLD) at 4% and Silver Wheaton Corp. (USA) (NYSE: SLW) at 4%, make it into the top 10 holdings.
In addition to its focus on quality, there are a couple of other big reasons for investors to love the Sprott Gold Miners ETF.
SGDM also comes with the standard fare that makes ETFs attractive: a low management fee of 0.57%, diversified holdings within sector and passive management.
With $216 million in assets and 270,000 shares trading daily, SGDM has built a significant following and momentum, and should outperform its peers given its superior construction.
Remember, capital controls may seem like a far off flaky idea for others to deal with. But the fact is it's a lot more common that most of us realize, and it's even being contemplated by central planners in the some of the world's most developed nations.
While its effects can be seriously detrimental, there are ways to protect your financial well-being.