US stocks continued their recently more volatile ways this week giving up almost all the gains of last week. In fact, the S&P 500 is now basically flat for the last four months, making no headway since late November despite a series of nominal new highs along the way. As the Fed has backed away from buying assets – assets on the Fed’s balance sheet are now actually, finally falling – stocks and other assets have become more volatile. That is primarily a function of shrinking dollar liquidity globally but also a function of a more volatile economic environment as well. Momentum is shifting, in the global economy and markets, away from the US to international economies and markets. It isn’t a smooth transition and the new uncertainty regarding US monetary policy just adds to the volatility.

The US economy has been slowing pretty obviously in the first quarter of the year. The slowdown is, so far, confined to the industrial/manufacturing part of the economy and while there is some comfort in the fact that we are mostly a service based economy, first quarter growth is looking quite weak. The economic stats last week were a bit more mixed with a few more good reports mixed in with what has become a disturbing trend of weak and getting weaker manufacturing data points. The string of weak surveys from the regional Federal Reserve Banks continued with the Richmond and Kansas City districts reporting contraction. Confirming the survey data was a much weaker than expected durable goods report. Declines were spread across the spectrum of industries and the capital spending portion was particularly weak. The year over year change in new orders is now down to just 0.6%, essentially showing no growth year over year.

A bit better were the housing reports. Existing home sales were up from the previous month very slightly but still less than consensus expectations. New home sales beat expectations, coming in at a 539k annual rate but frankly the details were a bit hard to take seriously with the biggest gains coming in the Northeast where the worst winter weather has been concentrated. We’ll see if the gain survives revisions but I wouldn’t count on it.

The best reports of the week were the PMI flash reports showing some improvement in manufacturing and services. It is interesting though that these surveys are big outliers compared to the hard data. I don’t put a lot of stock in any of the surveys in any case as they are, at best, coincident indicators and provide little guidance about the future. For a better view of the overall economy, the Chicago National Activity Index encompasses a wide variety of indicators. Unfortunately, that report showed exactly what I would expect, below trend growth at -0.11. The three month average is now negative and confirming of the slowdown I’ve been reporting.

The weakness in the US and relatively better data overseas is starting to affect markets as investors begin to accept the durability of the trend. The US dollar, which had been on a tear, has fallen back the last few weeks as growth expectations start to equalize between the US and the rest of the world. That should provide some relief – if it lasts – for all those effectively short dollars outside the US and ease fears of some kind of emerging market blowup (although it may be too late for Brazil which is sinking rapidly under the weight of economic contraction and political crisis). The pullback in the dollar has also produced some stability in oil prices although the supply/demand picture would seem to point to still lower prices. But if oil prices can stabilize here, it might mean we’ve seen the worst of the shale oil sector problems. Credit spreads, which had widened with the shale defaults, narrowed very slightly last week and are off the highs seen earlier in the year.

As for other asset classes, momentum is shifting right along with the economic growth expectations and the dollar. Foreign stock markets have outperformed this year by a pretty wide margin, although emerging markets continue to struggle mainly due to problems in Latin America. Asian emerging markets, which I wrote positively about a few weeks ago, have performed better along with the developed Asian markets such as Japan. Even Europe, which has seen some improvement in its economic data, has outperformed the US. And with the dollar now easing, currencies are starting to add to returns (just as everyone has piled into currency hedged ETFs by the way). That is also true of Japan where the unhedged ETF (EWJ) is now outperforming the hedged version (DXJ) over the last 3 months. Meanwhile, commodities also seem to be forming a bottom as the dollar forms a top. If that turns out to be a durable trend, even Latin America, Canada and Australia might start to join the parade of markets outperforming the US.

While economic momentum is shifting, it is too early yet to say that the US economy faces anything other than a slowdown. Neither the yield curve nor credit spreads – the two most reliable forecasters of recession – are at levels associated with past recessions although they are generally moving in the wrong direction. Will the US economy, as it did last year, get back on the 2% growth track the rest of the year? I’d be a lot more comfortable with such a prediction were the US dollar to stabilize at this or a slightly lower level. That would likely allow oil prices – and other commodities – to stabilize and give the US shale industry time to adjust – as best they can – to lower prices for their product. The biggest threat to the expansion is further downward pressure on oil prices and the consequent fallout in the energy patch. I think most people underestimate the extent to which this expansion has been powered by the shale boom and therefore underestimate the impact of its potential bust.

One thing won’t change even if the US economy manages to get past another weak first quarter. Stock prices in the US are expensive by historical standards – and earnings estimates are falling fast; future returns are likely to disappoint long term investors. While international markets are not as a whole particularly cheap either – with some notable exceptions such as Japan – they are a lot cheaper than the US and offer more upside potential. If the US economic expansion can be extended by more stable exchange rates, investors are likely to find greater rewards in international markets. And while every talking head I hear on CNBC touts the potential of Europe, I still believe Asian markets offer greater value and more upside despite – or maybe because of – the obvious slowing of China.

US bonds on the other hand still offer more value than anything that can be found in Europe. The stretch for yield on the continent is reaching absurd levels. It isn’t just sovereign bonds trading at negative yields; European junk bonds trade at tighter spreads than their US counterparts. And I wouldn’t touch US junk with barge pole at this point in the business cycle. The only attraction to foreign bonds at this point is the potential for currency gains which I hope turn out to be modest. If the US dollar’s rise turns into a rout, the odds of a second half rebound in the US economy that the Fed fervently expects and desires would likely get a bit longer. A falling dollar would revive US inflation at a moment we can least afford it and probably wouldn’t be enough to reignite the shale boom. A weakening economy, rising inflation and a more aggressive Fed does not sound like a recipe for a continued US bull market.

The most favored trades of the last year – long US dollar, long US stocks and short long term US Treasuries – are still pretty crowded trades. I suspect that all of them are reversing or about to with major implications for investors. The dollar and US stocks are peaking while momentum in bonds continues to favor duration over credit risk. If the US economy continues to struggle, speculators short the long end of the Treasury curve will eventually have to cover their bets as US rates converge with Europe. Momentum – in markets and economies – and capital flows are shifting and value is found largely outside the US. With the dollar up it’s a great time to take an international trip. Don’t forget to pack your portfolio.

Click here to sign up for our free weekly e-newsletter.

“Wealth preservation and accumulation through thoughtful investing.”

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 or   786-249-3773. You can also book an appointment using our contact form.