Markets continued to trade last week as if the risks facing the global economy have been or soon will be resolved. Stocks moved higher with the S&P 500 up another 2% last week while European and emerging market stocks performed relatively better. Chinese stocks moved higher in anticipation of further monetary easing and a soft economic landing. Commodities continued the rally that started at the beginning of the year, with the notable exception of oil, natural gas and gold. Treasury bonds fell and the yield curve steepened as European worries eased and confidence in the US recovery strengthened. Markets are moving pretty much as one would expect if the problems of last year were truly being resolved. So why can’t I shake the feeling that it isn’t supposed to be this easy and that some bogeyman is about to jump out of the market closet and scare the bejeezus out of a bunch of complacent investors?

China’s economy has indeed slowed and it does seem likely that more monetary easing is in the pipeline but it isn’t an instant tonic. The Chinese tend to move incrementally – look at how they tightened policy – and monetary policy tends to work with a bit of a lag anyway. China has plenty of scope for growth over the coming years because their economy is still relatively inefficient but volatility in a developing economy is the rule, not the exception. The housing market is obviously correcting and their banks are sitting on a pile of bad loans. Export growth is slowing for a variety of reasons and shifting to internal demand will not happen overnight. China may avoid a hard landing this year but I doubt we’ll know the verdict anytime soon. In the meantime, the Baltic Dry Index is falling hard and that real world indicator probably says more about the health of the Chinese economy than the official statistics.

Europe appears to have avoided the worst case scenario for now but investors should not get too complacent. The cure may turn out to be worse than the disease. The ECB’s monetary machinations are exacerbating the very imbalances that produced the crisis in the first place. Deposits are fleeing the periphery to the stronger core leaving local banks to fund their assets through the ECB. As capital flees the periphery, money supply is collapsing and economic activity will likely follow in the coming months. Meanwhile the inflow of capital to the core probably explains the relative optimism about the German economy. The divide between the haves and have nots in Europe would appear to be widening rather than shrinking. How long this can go on is frankly anyone’s guess but it is not a stable situation. Can the capital inflow to the core create enough activity to offset the recession in the periphery? Count me as skeptical.

Back here in the US, our economic recovery continues apace and investors seem to be gaining confidence that it is the real thing this time. John Chapman has a very thorough round up of last week’s economic data (Welcome To The Plod Along Economy), so I won’t rehash all the numbers here. We remained positive – and right – about the US economy over the summer and fall when so many others were falling all over themselves predicting a new recession, and we’re still fairly optimistic. However, the recent monetary easing around the world – and the prospect for more here in the US – gives us pause. Recoveries engineered through monetary manipulation contain the seeds of their own destruction. I think we already have an inflation problem in the US and rising commodity prices will not make it any better. Earnings reports this quarter (click here to see next week’s earnings calendar, a preview of Apple earnings, some interesting charts, as well as some commentary from Joe Gomez) haven’t exactly been gangbusters and the prospect of shrinking margins may put a kibosh on the nascent hiring recovery.

There are reasons to think the US economy could accelerate this year but I wonder if the market hasn’t already incorporated a lot the potential positives. Construction is picking up and the homebuilding stocks have been on a tear but most of the new construction is in multi-family dwellings where most of the homebuilders have little exposure. Bank lending has been rising and financials have led the market since the beginning of the year, but as Goldman’s earnings showed pretty emphatically, the trading business – which provided a majority of industry profits over the last decade – is shrinking and shows no sign of turning around. Manufacturing, particularly the auto industry, also looks poised to continue growing this year but that depends at least to some degree on how the emerging market and European economies perform.

I think it is also important to remember that what we are currently experiencing is a cyclical recovery and not a secular shift to higher growth. We have reached the point where cyclical forces are overwhelming the underlying lousy economic policy. Household formation has picked up and people have to live somewhere so construction is picking up because it has to. The age of the existing automobile fleet is older than its been in several decades and at some point it becomes more economically logical to buy new rather than keep maintaining the old clunker in the driveway. Banks are lending again because they can’t maintain their profit margins – and management bonus levels – collecting 0.25% on excess reserves parked at the Fed but loan demand is still weak.

In addition to the uncertainty surrounding current economic performance, we have a contentious Republican primary contest that leaves future policy completely up in the air. The policy prescriptions of a Gingrich administration, a Romney administration or a second Obama term with a Republican controlled Congress (which seem like a pretty good bet by the way) would be vastly different. The US cyclical recovery may continue despite whatever transpires in China or Europe but better performance long term will require major policy changes. How those changes are effected will have a large impact on future economic performance and investors will have all year to ponder the outcome of the election. Polls may be leading indicators this year.

Last year was a year when investors had plenty of opportunities to make big mistakes and based on the results of the hedge funds, even the so called smart money didn’t miss them. Getting too bullish right now is probably our first opportunity to make a big mistake this year. Ignore the call of the bulls and stay skeptical.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com

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