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Q2 2016 REVIEW & OUTLOOK

The economy and markets so far this year are roughly conforming to the script we

penned in the first quarter, full year outlook. Just to refresh the memories, here

are the themes we laid out:

US economic weakness persists, moving toward recession

Interest rates continue to fall

The US dollar weakens further

Gold and other weak dollar investments outperform

Gold stocks outperform the metal

International stocks outperform the US

As a result, our global asset allocation models* performed well in the first quarter:

Q1 16

Aggressive 4.08%

Moderately Aggressive 4.75% Moderate 3.85%

Moderately Conservative

3.79%

Conservative 4.49% S&P 500 1.35%

World Stock 0.10%

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Aggregate Bond 3.06%

Global Aggregate Bond 5.90%

The quarter was a volatile one with a large drawdown in the stock market in the

first six weeks followed by a furious rally to end the quarter. Stocks did produce a

gain for the quarter but the ride was decidedly bumpy. Our global asset allocation

models offered a much smoother journey:

Beta SD

Aggressive 0.47 8.65%

Moderately Aggressive 0.37 7.01% Moderate 0.28 5.67%

Moderately Conservative

0.19 4.21%

Conservative 0.1 3.12% S&P 500 1 16.63%

Our portfolios changed slightly over the first part of the year. The duration of our

bond portfolios and our international stock overweight position were reduced in

early February. While we still believe International stocks offer greater value, US

stocks have maintained their momentum despite a host of issues that should have

brought them down. Momentum may finally be shifting to international in the

second quarter but it is a tenuous move so far.

We also sold our Yen hedged Japan ETF, reducing our Japan exposure. The move

up in the Yen was not something we anticipated, although in retrospect maybe we

should have. Our technical partner, MSA (http://www.olivermsa.com/), had been

warning about the potential for a move higher but we had trouble matching that

to a fundamental cause. It was still a very good run with that ETF, having first

bought it in the summer of 2012. The lesson to be taken from that episode is that

when the momentum shifts you need to act (and MSA’s specialty is momentum);

the market probably knows more than you do.

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Finally, we took profits on two other bond positions last month, TIPS and

investment grade corporate bonds. We still have positions in both but the size has

been reduced after big moves.

Here’s where the moderate portfolio stands now:

With the year a third done, we’re feeling pretty good about ourselves so naturally,

we’re looking over our shoulder wondering what is about to go wrong. Has

anything really changed? Do stock buyers know something that bond buyers don’t?

Can the commodity rally continue if the US economy continues to sputter? Are the

trends we rode in the first quarter about to reverse? Or accelerate?

In the yearly outlook piece we lamented the difficulty of timing this

investment/business cycle and despite our success in the first quarter that hasn’t

changed. The economic cycle has been elongated by government intervention,

monetary policy inducing risk taking in all the wrong places. We’ve been down that

path twice since the turn of the century and apparently the world’s central bankers

learned exactly nothing from the experience. And so this cycle runs on and on,

S&P 500, 9.00%

EAFE, 10.00%

Japan, 2.00%

US Small Cap, 2.00%

EAFE Small Cap, 4.00%

US REIT, 4.00%

Int'l RE, 4.00%

Gold, 5.00%IG Corporate Bond,

10.00%TIPS, 10.00%

7-10 Yr Treasuries, 20.00%

3-7 Yr Treasuries, 20.00%

Cash, 0.00%

Moderate Portfolio

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propped up on monetary methadone, a steady, monotonous drift down toward the

inevitable recession. Are we there yet?

Economic Situation

Economic Scorecard

Economic Growth & Investment Prior Consensus Actual Year Over Year %

Change Industrial Production -0.6% -0.1% -0.6% -1.76%

Manufacturing -0.1% 0.1% -0.3%

Capacity Utilization 75.3% 75.4% 74.8% -3.2%

Chicago Fed Nat'l Activity Index -0.38 -0.44

Existing Home Sales 5.070M 5.268M 5.330M 1.50%

Personal Income 0.1% 0.3% 0.4% 4.23%

GDP 1.4% 0.7% 0.5% 1.95

Leading Economic Indicators -0.1% 0.5% 0.2%

Non-Farm Productivity 2.1% -3.2% -2.2% 0.50%

Production

Empire State Mfg Survey 0.62 3.00 9.56

Philly Fed Survey 12.4 9.0 -1.6

ISM Non-Mfg Survey 53.4 54 54.5 -4.22%

ISM Manufacturing Index 51.8 51.5 50.8 -8.30%

Chicago PMI 53.6 53.4 50.4

Dallas Fed Mfg Index -13.6 -9.0 -13.9

Richmond Fed Mfg Index 22 12 14

Kansas City Fed Mfg Index -6 -4

Consumption & Distribution

Retail Sales 0.0% 0.1% -0.3% 1.31%

Less Autos 0.0% 0.4% 0.2% 1.80%

Less Autos & Gas 0.6% 0.3% 0.1% 3.90%

Wholesale Sales -0.2% -3.10%

Motor Vehicle Sales 17.5 17.6 16.6 -3.50%

Domestic Vehicle Sales 14.2M 14.1M

Consumer Spending 0.2% 0.2% 0.1% 3.48%

Inventories

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Business Inventories -0.1% -0.1% -0.1%

Inventory/Sales 1.41 2.92%

Wholesale Inventories -0.2% -0.2% -0.5% 0.60%

Inventory/Sales 1.36 3.82%

Orders

Factory Orders 1.2% -1.6% -1.7% -1.7%

Durable Goods -3.1% 1.6% 0.8% -2.5%

Ex-Transportation -1.3% 0.5% -0.2% -1.4%

Core Capital Goods -2.7% 0.0% -2.4%

Trade

Trade Balance $-45.9B $-46.2B $-47.1B 22.08%

Exports 1.0% -5.5%

Imports 1.3% -2.1%

Trade in Goods $-62.9B $-62.6B $-56.9B -19.36%

Exports -1.70% -5.80%

Imports -4.40% -9.72%

Inflation

CPI -0.2% 0.2% 0.1% 0.9%

less food & energy 0.3% 0.2% 0.1% 2.2%

PPI -0.2% 0.3% -0.1% -0.1%

less food & energy 0.0% 0.2% -0.1% 1.0%

GDP Price Index 0.9% 0.5% 0.7% 1.3%

Import Prices -0.4% 1.0% 0.2% -6.2%

Export Prices -0.5% 0.0% 0.0% -6.1%

Employment Cost Index 0.5% 0.6% 0.6% 1.9%

Unit Labor Costs 1.9% 4.7% 3.3% 2.1%

PCE Price Index -0.1% 0.1% 0.1% 0.8%

PCE Core 0.2% 0.1% 0.1% 1.6%

FHFA House Price Index 0.4% 0.4% 0.4% 5.6%

Case Shiller HPI 0.8% 0.7% 0.7% 5.4%

Farm Prices -0.7% 3.9% -6.4%

Employment

New Jobless Claims 248K 260K 257K -3.40%

Job Openings 5.604M 5.445M 6.12%

Labor Market Conditions Index -2.5 -2.1

Non Farm Payrolls 245K 210K 215K 70.63%

Private Payrolls 236K 200K 195K 116.67%

Unemployment Rate 4.9% 4.9% 5.0%

Participation Rate 62.9% 63.0%

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Avg Hourly Earnings -0.1% 0.2% 0.3% 2.3%

Avg Workweek 34.4Hrs 34.5Hrs 34.4Hrs -0.3%

Challenger Job Cuts Report 61599 48207 31.70%

ADP Employment 205K 203K 200K

Construction

Housing Market Index 58 59 58 3.6%

Housing Starts 1.194M 1.167M 1.089M 14.15%

Housing Permits 1.177M 1.200M 1.086M 4.62%

Construction Spending 1.0% 0.5% 0.3% 8.00%

New Home Sales 519K 522K 511K 5.40%

Other

Consumer Sentiment U of Mich. 89.7 90.4 89 -7.20%

NFIB Small Business Optimism 92.9 93.6 92.6 -2.93%

Consumer Confidence Conference Bd. 96.1 96.0 94.2

To answer the question at the end of the last paragraph, not yet. There’s a lot of

red in that economic data above but enough green to keep a plus sign in front of

the GDP number. We’ve previously described manufacturing as already in

recession and see no reason to change that characterization; if anything it appears

to be getting worse. Despite the recovery of the regional Fed manufacturing

surveys to positive territory, the goods side of the economy has so far refused to

justify those survey respondents’ optimism. Even automobile sales, one of the few

manufacturing bright spots, have disappointed. Sales peaked at an annual rate just

over 18.1 million in October of last year and are now down to a 16.5 million rate (-

3.5% yoy). The inventory to sales ratio for autos is running a not exactly lean 2.8 so

the latest durable goods report, not surprisingly, showed a 3% drop in the auto

orders.

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Market Indicators

The energy industry has gotten the blame for much of what ails the economy and

manufacturing in particular and there is certainly an element of truth to that, but

the economy hasn’t just slipped on the oil patch. Consider that of the 10 sectors

tracked by Factset, earnings will decline for 7 of them in the first quarter, the fourth

consecutive quarter of year over year earnings decline overall. Revenue will be

down for 5 of those sectors as well. The shale industry touched a lot of other sectors

including transportation (particularly the rails), steel and of course, finance but

does it seem likely that it is solely responsible for the economic slowdown? If it is,

one might consider what that says about the quality of this fragile, Fed induced

recovery.

Bond traders certainly aren’t buying the growth story. The 10 year Treasury note

started the year trading at 2.25% and now sits at a less optimistic 1.93% after

visiting 1.6% in mid-February. And most of the back up in rates since February

would seem to be more about inflation expectations than growth. Looking at the

TIPS market, inflation expectations moved up about 25 basis points as rates rose

into April.

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Currency markets have also refused to acknowledge the stock market’s bullish call.

The dollar index is down roughly 6% so far this year, not a death defying plunge

exactly, but not the direction one would expect from an economy that is

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supposedly going to do well enough to get corporate earnings growing again by the

second half of the year.

The yield curve has stopped flattening, at least for now. It hasn’t steepened

appreciably either though so nothing to get too excited about just yet. It is, more

than anything, an indication the market just isn’t buying the Fed’s rate hiking

schedule.

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Credit spreads have also improved markedly since hitting almost 9% in early

February, right about the time the stock market bottomed by the way. Spreads are

still elevated at 6.3% but things may not be quite as dire as stocks thought at the

worst levels. Or maybe yield starved seniors just couldn’t pass up a sale. We hope

they noticed those “as-is” tags because some of that merchandise is damaged

beyond repair.

Gold, a shiny metal more useful to the conspiracy theory sector than the industrial

one these days, is the big winner so far this year. That isn’t, in case you were unsure,

good news. An “investment” in the barbarous relic doesn’t produce much of

anything except peace of mind but for thousands of years it has been the most

remarkable currency man never printed. Rising demand for it is not a vote of

confidence in the powers that be - or probably more accurately in this case, the

powers that might be.

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Indeed the big winners so far are all what we described at the beginning of the year

as weak dollar investments. It isn’t just gold that has gotten off the mat. Everyone

knows oil has rallied big too but who’s talking about copper up 17% from its lows

or silver up 25% and starting to outperform gold? How about timber stocks up 23%,

gold stocks up nearly 87% from their lows or oil service stocks up 45%? For now,

the fundamentals of the global economy would not seem to support a sustained

move higher in commodity prices, but markets often diverge from fundamentals.

Markets are leading indicators after all. Is this trend durable? Is this the beginning

of a long term trend? Good questions but ones that are impossible to answer right

now.

Ultimately the lynchpin, the key to tactical investing, is the fate of the US economy.

As noted earlier the evolution of this economic cycle has been excruciatingly slow

but the direction has been clear and steady for several years. We first noticed a

marked slowdown way back in 2012 and while there have been some minor

countertrend moves since then, growth has steadily eroded - despite enthusiastic

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cheerleading from Wall Street and the Federal Reserve. And the slowing has

continued, as we expected and predicted, into 2016.

The first estimate of Q1 GDP growth is just 0.5%, a year over year growth rate of

1.95%, down from 2.88% in Q1 2015. We expected this year to be slower but how

much is unknowable. Is 1.95% as bad as it gets? There seems to be an expectation

that growth will just reaccelerate in Q2 like it has the last two years. Maybe, maybe

not but there’s no evidence of it yet. Could we enter recession this year?

Absolutely. Could we just slow more and avoid recession? Absolutely. There’s no

law that says once you fall to some low rate of growth, recession is inevitable.

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If the US slows further but avoids recession, the dollar will remain under pressure

and the trends that started in the first part of the year at least have a chance to

persist. The fall of the dollar has already relieved the angst about global dollar

debts. The rise in commodity prices has in turn relieved the pressure on the US junk

bond market. We think that might be premature since oil still hasn’t reached a price

where most shale companies can break even but if the commodity/oil rally

continues we might have just missed a wonderful opportunity in high yield bonds.

That might be the quickest distress cycle in history but funny things happen when

interest rates are zero or negative.

The fall in the dollar this year has so far been orderly, a reflection of our growth

rate and that of the rest of the world passing each other, a tectonic shift that has

produced only mild tremors. Europe’s first estimate of Q1 GDP growth actually

exceeded our own quarter to quarter. It isn’t much but is all the explanation we

need to justify the move of the dollar. The dollar index is really mostly about the

Euro which has a weighting over 50% in the index.

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But it isn’t just the Euro moving up against the dollar. This move is pretty broad

based as the rest of the world recovers from its near death by lack of dollars.

Canada, for instance, did not have an official recession but you’d be hard pressed

to prove that by looking at markets. The Canadian dollar fell in lock step with

commodities, down 35% from mid-2011 to the end of 2015 when the recovery

began. The TSX dropped over 20% and more in US dollar terms. It was, by any

definition, a bear market. Now, with commodity prices recovering, the Canadian

dollar is up 17% since mid-January against the US version. And the TSX is up 40%

from its lows.

There is the potential for a bit of a positive feedback loop as a rising currency

attracts capital inflows which positively affect growth. Capital moves more freely

and rapidly today than it ever has in history and with the complete lack of interest

rates, anything producing a positive return immediately attracts attention. Was the

move up in the C$ and the Toronto exchange in anticipation of renewed Canadian

growth? Hard to say for sure but the market move itself makes it more likely.

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Major Indicators

We use four main indicators to tactically manage asset allocation. Two of them –

the shape of the yield curve and credit spreads - are intended to give us advance

warning of US recession. Right now, neither is definitive. Credit spreads did widen

a lot but have recently narrowed. And much of the time it is the direction that

matters not the magnitude. The yield curve is sitting in the middle of its historic

range, nowhere near the flat or inverted structure we generally see right before

recession. Of course, in a world where central banks are suppressing short term

rates the yield curve may not be able to invert prior to recession so that indicator

has to be taken with a grain of salt.

And so with the yield curve maybe not working as it has in the past and credit

spreads at warning levels but improving we are left to ponder the other indicators,

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valuation and momentum. The first, valuation, offers little solace to the US based

investor with the S&P 500 expensive by all reliable measures. Ok, not year 2000,

dot.com mania expensive, but expensive relative to most of the rest of history;

upside potential is necessarily limited. But outside the US the story is quite a bit

different. Emerging markets in particular are trading at cheap valuations no matter

how you measure them. Developed markets are a little less appealing but still a lot

cheaper than the US.

Momentum though, at least when it comes to developed markets, continues to

favor the US. We have seen EAFE outperform the S&P 500 over the last month but

that isn’t much to hang your hat on if you want to get aggressive about

international markets. Emerging markets have been outperforming the US for all

of this year and the trend appears intact. So, a bit mixed, but momentum is pointing

to international markets over US.

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Momentum also continues to point to bonds and gold over stocks within the US,

bolstering our slowdown thesis. That shift started quite a while ago and so the

trend is pretty well established. And changing long term trends is difficult over a

short time frame so we expect those trends to continue.

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While we might see another short round of dollar strength, we believe the tide has

turned, that momentum now favors non-US markets and economies. With risk

appetites returning we may be able to raise our risk allocation sometime soon from

the below normal level we’ve been at for the last two years.

Economic Environment

Part of our process is to assess the economic environment using this four box

matrix:

Rising dollar, rising growth Rising dollar, falling growth Falling dollar, rising growth Falling dollar, falling growth

We’ve been in that rising dollar, falling growth box for two years now and it has

had us on high alert. Why? Quite simply, some of the worst market outcomes have

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occurred when those conditions existed, the most prominent and recent being late

2008. The top of the dot com bubble, the Asian crisis and almost every other

emerging market crisis in recent history would be other examples. We act very

conservatively when those conditions are present. So certainly, exiting that box

allows us to breathe a little easier. We would much prefer the rising dollar, rising

growth box but we can live with either of the falling dollar boxes because in those

scenarios we have plenty of investment options. In a rising dollar, falling growth

scenario about the only thing that has worked consistently is Treasuries.

So where does all this leave us? What do we expect for the near term and the rest

of the year?

1. US economic growth continues to fall. We would not expect to see obvious

recession signs before the second half of the year if then. We may well be

headed for a stagnation, a la Japan, that persists but doesn’t turn into a deep

recession.

2. Nominal interest rates could continue to fall but rising inflation expectations

may mean that TIPS are the better option. We may well see a rise in nominal

growth expectations coupled with a fall in real growth expectations.

3. The dollar may see a short term rally from oversold conditions but the trend

is down. Keep your eye on real interest rates for clues about a reversal.

4. If the dollar does rally short term, gold will correct at the same time but long

term momentum for gold has broken out to the upside. For those with an

aggressive urge, silver is likely to outperform gold from here on.

5. Gold stocks and other commodity type stocks continue to outperform but

again, a short term correction should not be a surprise.

6. International stock outperformance spreads from EM to developed markets.

EM will likely correct at some point, again likely with any dollar rally.

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CEO Comment

When Japan entered its long period of stagnation back in the early 90s, I don’t think

anyone believed that it would last as long as it has. I also don’t think most people

thought the world’s second largest economy could stagnate for a couple of decades

and that the rest of the world would just move on. But that’s exactly what

happened. And it may be happening again, as the US stagnates and the rest of the

world moves on or at least tries to.

The US will always be important to the rest of the world but is a high rate of US

growth absolutely necessary for the rest of the world to grow? Maybe not. It may

be that we Americans believe ourselves to be more important to the global

economy than we really are. If the US falls into a deep recession then of course, all

bets are off. But if we just plod along, growing very slowly, the rest of the world

may just find other ways to grow and wean themselves off their dependence on

the US.

That is, of course, the US secular stagnation theory in a nutshell. I don’t think we

are doomed to that fate but avoiding it will require a fairly big change in economic

policies, something I don’t see on the immediate horizon. That doesn’t mean there

won’t be some changes with a President Clinton or President Trump – which seems

the most likely outcome right now – but the changes seem unlikely to be for the

better.

With Mrs. Clinton, we really don’t know who we’d get. Would it be the Hillary that

wrote healthcare reform back in the early 90s? Or would it be Bill Clinton’s third

term? I’d vote for the latter but I’m afraid we’ll get the former which probably isn’t

a lot different than what we have now. Clinton is the conservative choice in that

sense.

As for Trump, I’m not sure what to expect but if he follows through on some of his

campaign rhetoric, particularly with regard to trade, a new depression isn’t out of

the realm of possibility. Fortunately, I don’t think Congress – no matter who

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controls it – is ready to drive off an economic cliff with the Donald so he’ll be held

in check. I’d say the best bet is that policy doesn’t change all that much no matter

who gets elected. And that means what we have now is what we’re going to get.

Not very inspiring I must say.

It is, however, an environment we believe we can navigate profitably. Jeff Snider’s

work on international capital markets, financial flows and the Eurodollar market is

particularly useful. Capital flows can shift rapidly, affecting money and currency

markets first, an early warning system for stocks, bonds and commodities.

It is a strange world we live in, central banks conducting monetary experiments in

real economies, with results often contrary to what theory expects. When

announcements from the Bank of Japan or the ECB have consequences far from

Tokyo or Frankfurt, often in rapid fashion, an informed global perspective is not a

luxury but a necessity for the modern investor. I believe we are well equipped to

face the challenges the rest of the year will surely bring and extend our success of

the first quarter.

Joseph Y. Calhoun III

CEO of Alhambra Investment Partners, LLC

“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:

786-249-3773

Jyc3@alhambrapartners.com

For information about our risk based Global Asset Allocation models or any of our other tactical

models, please contact Joe Calhoun at jyc3@alhambrapartners.com or 305-233-3772. You can

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also book an appointment using our contact form. Some of our tactical models, including the

Global Asset Allocation models mentioned above, are also included in our subscription service

available through Seeking Alpha.

*These are model results. Individual client portfolio performance can and does diverge – positively and negatively -

from the model results for a variety of reasons. We try to make our models as representative of the real world as

possible but it is still a model. Our client portfolios are custom and their make-up can be quite a bit different than

the model for reasons specific to that client. We believe there are problems with presenting past return data in any

format, not least that it could just represent luck. It doesn’t tell you much about what future returns might be and

certainly isn’t any kind of guarantee. What we try to show with our models is that our methods, our process works.

We can’t tell you for sure that our methods will continue to work in the future but we obviously believe they will.