The world is at a crossroads

We are at a juncture for the world economy, for many reasons. To start, we are dealing with a severe tightening of financial conditions. It’s not just interest rate tightening, we are also in the process of a liquidity tightening, and together, these two processes are likely to provoke economic damage. Even Stanley Druckenmiller, usually a hawk, has turned dovish in an op-ed for the Wall Street Journal.

Additionally, the conditions in the global economy have deteriorated significantly due to the uncertainties of the trade war and the increase in the dollar value. The USD strengthening has resulted in a selloff in emerging markets currencies and stocks.

That means that a rate hike, coupled with the ongoing quantitative tightening, will likely result in resuming the selloff in EM currencies and stocks. If this materializes, there is no way the US won’t feel its shockwaves sooner or later.

The bursting of the liquidity bubble would produce a debt crisis around the globe coupled with a slowdown in global growth. The escalation of the trade tensions could very well materialize in further tariffs and aggressions that would depress the Global economy even further. It may seem like an unlikely catastrophic scenario, but the truth is that every piece of the puzzle has been coming together.

A rate hike at this juncture could very well set the gas tank on fire, and, in my opinion, the need to raise interest rates now seems off-tempo. Inflation seems under control in the most important economies.

The market is already screaming trouble

The Heisenberg Report highlighted Goldman Sachs research, where the low liquidity level seems to be the main cause for periodic volatility spikes.

Additionally, the S&P 500 is down -4.85% in 1 year. However, the difference across the industries is revealing. The most cyclical industries are heavily down, while the most stable ones are doing fine. The stock market is anticipating a recession at a time the US economy seems to be doing fine. Basically, the remaining liquidity is playing it safe.

S&P industry performance 1 year

(Click on image to enlarge)

(Source: Fidelity Investments)

Looking at all the pieces, I would say that maybe it is time for a pause in the normalization policy.

Conclusions

If the Fed follows through with the rate hike, USD long positions should do well during the beginning of 2019. On the other hand, stocks will keep suffering around the globe. The cocktail will be ready when the real economy is damaged, and signs of it start emerging in the statistics. Then, the Fed will have to come back to some monetary easing, or risk damaging the economy even further. That scenario would mean that we are already in a recession, without even acknowledging it.

Since that scenario is very dangerous, I would rather have a no hike meeting that relieves the current market tension and provides some room to breathe. In that case, the worst outcome would be a credit expansion that ends in a recession a couple of years down the road. I prefer that scenario because it would give us two years to normalize the monetary policy and allow us to face a recession with monetary dry powder.