ALHAMBRA INVESTMENT PARTNERS

The economic statistics continue to point to growth in the US economy. Last week's employment report showed solid, if not spectacular, job growth with gains in manufacturing, construction, professional and business services, leisure and hospitality and health care. In other words, it showed gains in an ever widening range of industries. Jobless claims are still trending lower, down again last week to 367k. Auto sales announced last week are running at a 14 million annual rate, well above the sub 10 million rate seen at the depths of the recession. Construction spending rose again in December and is now up 4.3% year over year. Factory orders jumped in December and the ISM surveys, manufacturing and non-manufacturing, show growth continuing at a moderate pace. Personal income rose in December while spending stayed flat as the savings rate rose a bit.

If one merely looks at the incoming aggregate data, it seems obvious the US economy is improving. It isn't a surprise to us at Alhambra. We've argued for the last six months that the US economy would not fall back into recession even as some very smart people have said the opposite. Maybe we've just been lucky so far and the pessimists will be proven right in coming months, but for now, the US economy is performing pretty much as we expected. And absent an exogenous shock, such as a disorderly breakup of the Eurozone, I think the "recovery" will continue.

This "recovery" though is not the one we seek (apologies to George Lucas) . It is a manufactured, cyclical recovery and cannot be sustained in the long term. From a cyclical standpoint, the US economy has reached a point where two large sectors – housing and autos – are turning higher out of necessity. Household formation is rising again and while house prices are still falling, apartment rents are rising and vacancies are falling. With few new housing units built since the bust, construction is now inevitably recovering. The average age of the auto fleet is at a multi-decade high and replacement is more economic than continued maintenance for many individuals. While lending is not as free as it was during the housing boom, credit is available. Non-revolving credit, primarily auto loans, is rising at about 5% year over year. Even outstanding revolving credit, primarily credit cards, has stopped contracting.

The recovery is also being driven by malinvestment, a result of loose monetary policy. The global monetary expansion of the last few years – and especially the last year – was massive and was bound to have an effect eventually. The Fed's repeated rounds of quantitative easing haven't had much effect up to now except on financial and commodity markets but lending appears to be picking up as financial institutions are forced to find profits outside of trading thanks to the new Dodd-Frank rules. As noted above consumer lending is rising and commercial and industrial loans are also up 10% year over year. Meanwhile, the Chinese are lowering reserve requirements for their banks and consumer lending in emerging markets such as Brazil is still expanding. The one exception in the world is Europe where lending is contracting.

Unfortunately, we don't know where interest rates would be today in a market free of central bank interference. With ZIRP (zero interest rate policy) seemingly ineffective in reviving the housing market, it is tempting to assume it is having no effect but I think the Fed's low rate policy is having an impact. Austrian economics tells us that rates held below the free market rate will distort the investment decision process, create malinvestment and destroy capital. The current boom in shale oil and tar sands as well as the disputed Keystone pipeline would seem to fit the bill perfectly. $100 oil prices, a product primarily of expansive monetary policy and a weak dollar, have produced a false boom in what should be non economic oil production. For now, oil can be profitably extracted from shale and tar sands and that has produced a boom in western Canada and North Dakota, among other areas. The oil producers are rushing in and investing billions in production that is only profitable at current prices. If and when we get better fiscal policy that hopefully leads to better monetary policy, the dollar will rise, oil prices will fall and the capital invested in these areas will be wasted. Just as it was the last time this happened in the late 70s, early 80s. If Keystone is built and oil falls to less than about $50, it will end up being a large empty pipe. He might have made it for the wrong reasons, but President Obama's rejection of Keystone may end up being the best investment decision he's made since taking office.

I should stress that this may be an example of malinvestment. There is no way to know whether this is malinvestment or investment that produces a long term return since we don't know the true price of oil in a world free of monetary distortion. It may be that some areas opened to production from fracking will remain profitable even at lower oil prices but it seems unlikely that all will. The natural gas market may offer a glimpse of the future and a warning as increased production from fracking has produced a glut of gas and falling prices. Chesapeake Energy, a leader in natural gas production from fracking, is cutting production because prices have fallen to "economically unattractive levels". The oil market is more global than the natural gas market so more US production may not affect prices as quickly but eventually oil prices will fall.

(By the way, to those who claim this is an example of new technology being put to good use, I would point out that the first horozontal well was drilled in North Dakota in 1987 and fracking was developed in the late 90s. It isn't new at all and it is only being applied now because oil prices are high.)

True recovery based on fundamental changes in monetary and fiscal policy has not arrived yet and probably won't for some time. That makes investing a particularly difficult task at present. We cannot know how long a recovery based on cyclical factors and monetary distortions will last. The housing boom lasted for years before the malinvestment was revealed. While I suspect this expansion may have a more limited life, there is frankly no way to know. In addition, we still have the potential for that exogenous shock I mentioned above. I still see no way for Europe to keep all its members in the Euro and the consequences of a break up are impossible to predict.

Meanwhile, as investors, we must invest with one eye on this current cyclical expansion and one eye on the future and its eventual decline. We cannot invest long term with confidence until we see better fiscal and monetary policy, something that seems far off at present. If we are right and the effects of the Fed's monetary expansion are starting to hit the markets, the result could be more spectacular than anyone currently expects. Considering the magnitude of the change in the monetary base and the difficulty of removing the excess reserves from the banking system, an inflationary boom is not out of the question. Those who expect the Fed to keep their promise of low rates until 2014 would be wise to review the Fed's economic forecasting track record.

Because of the difficulty of divining the magnitude and/or duration of the current expansion, we continue to invest cautiously. As Doug Terry reports in his tactical update, we slightly reduced our risk positions last week, selling into the recent strength. If and when we finally get better policy that includes reduced government spending, tax reform, monetary reform and more intelligent regulation, we will start to think longer term. Until then, we will have to navigate a recovery that may not be the one we're looking for but is the one we've found.