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As fresh economic data is reported from developed and emerging economies, the probability of a meaningful global slowdown or recession has increased.

Today's statement by the Fed also confirms the fact that the U.S. economy has slowed down. Several countries in Europe are already in a recession. Furthermore, emerging economies are also slowing down very meaningfully and will have a profound impact on global GDP growth.

From an investor's perspective, the key concern would be the reaction of asset markets to the slowdown. This article discusses the probable near-term trend for equities and commodities.

Over the last decade, there has been a strong relation between the dollar and other asset classes. Generally, a weak dollar is a sign of expanding global liquidity and has resulted in a rise in asset classes such as equities and commodities. On the other hand, a strong dollar is a sign of contracting global liquidity resulting in the correction in risky asset classes.

In this article, I use the relation between the dollar and asset classes to determine the near-term market trend. Furthermore, I have used the U.S. adjusted monetary base, the dollar index, and the velocity of M2 money stock to arrive at a conclusion on the probable direction of the markets.

The chart below shows the U.S. adjusted monetary base plotted with the trade-weighted dollar index. The adjusted monetary base data has been taken post-2008 since the monetary base has surged after the crisis.

Click to enlarge images.

Adjusted Monetary Base and Dollar Index

From the chart, one can draw a relation between the adjusted monetary base and the dollar. A surge in the monetary base in the beginning of 2011 was associated with a weakening dollar. Very recently, as the monetary base has started to decline, the dollar is getting stronger.

The only exception to this relation was witnessed in 2008 after the Lehman collapse. A complete credit freeze lead to a strong dollar, and the impact of a significant increase in the monetary base was felt later.

Looking at the current scenario, I am of the opinion that the dollar will strengthen further in the near term. With the Fed announcing no new stimulus measures, the probability of a stronger dollar has increased.

Therefore, liquidity tightening (indicated by a declining monetary base) will lead to a correction in risky asset classes. In other words, equities and commodities will witness bearish sentiment over the next two to three months. The Treasury yields also point to risk aversion and movement of money to relatively safer asset classes. Therefore, investors need to avoid fresh exposure to equities and commodities as markets gradually react negatively to no action from the Fed.

Having said this, I do believe that another major stimulus will be announced sometime in the fourth quarter of 2012. Besides the economic factors, one of the most important reasons for the Fed to continue expanding its monetary base (to provide liquidity) would be the collapse in money velocity.

Velocity of Money Stock (M2V)

The velocity of M2 money stock (M2V) is at its lowest from the time the data is available from the Fed. With money velocity at all-time lows, the Fed would look to boost liquidity in the system (which is currently tightening) by expanding the monetary base. Therefore, we are headed for QE3 in the next three to six months.

Investment Strategy

As mentioned before, investors need to avoid fresh exposure to equities and commodities and wait for a correction, which will make valuations attractive. It is difficult to talk about the extent of correction in asset markets. However, a 10%-15% correction can lead to another stimulus and further quantitative easing.

If asset markets do correct by 10%-15%, I would look to consider exposure to equities by investing in the SPDR S&P 500 Trust ETF (NYSEARCA:SPY). Precious metals would be buys on every correction, and a strong dollar is a good time to accumulate gold and silver. In my opinion, gold might see new highs after another round of stimulus later in the year.

Besides physical gold and silver, investors can consider exposure through the gold and silver ETFs. SPDR Gold Trust ETF (NYSEARCA:GLD) and iShares Silver Trust (NYSEARCA:SLV) would be good investments for the long term.

Investors also need to focus on emerging markets to diversify their equity portfolio and generate relatively superior returns over the long term. A slowdown in emerging market GDP growth has lead to a correction in emerging market equities. A strong dollar and a slowdown in the developed world will impact equities, and further correction in these markets can be used as an opportunity for fresh long-term exposure.

In particular, I would be interested in investing in Chinese and Indian equities. The iShares FTSE/Xinhua China 25 Index (NYSEARCA:FXI) and iShares S&P India Nifty 50 Index Fund (NASDAQ:INDY) ETF can be used when considering exposure to large companies in these two emerging markets.

Conclusion

The positive impact of another round of stimulus measures on the economy is debatable. Going by the outcome of the previous stimulus packages, I don't see a great turnaround happening for the real economy due to another stimulus. However, I do remain positive about all risky asset classes for the long term. Excess liquidity will continue to flow into equities and commodities and will benefit long-term investors. Traders need to be cautious as markets could exhibit a high degree of volatility in the next few months.

Source: No Stimulus And Tightening Global Liquidity Point To Correction In Equities, Commodities