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General Outlook
Fueled by massive financial liquidity and government spending, global equity markets continued their cyclical rebound from March's bear market lows, posting positive returns for the third consecutive quarter and a substantial recovery for the year. As can be seen in the table below, emerging markets led the world for both the quarter and the year, a speculative trend also witnessed within the U.S., where "low-quality" stocks dominated. Although leadership by the smallest market capitalization and lowest stock price shares diminished substantially during the fourth quarter, most of the year was characterized by a renewed risk appetite, as excess liquidity banished fear in favor of greed.
Although the 30% climb by U.S. and European stocks during 2009 eased the pain of the bear market, equities on both continents still reside about 30% below their 2007 peaks, a level that would normally take about four years to recover. Even worse, the first ten years of the new millennium, as popularly celebrated, have generated negative equity returns in both geographies, hardly the reward expected for taking risk. Fortunately for Columbus Circle Investors, one part of the market is making a major comeback.
Don't Look Now
After a seven year losing streak following the technology bubble burst a decade ago, it seemed that value had permanently vanquished growth. But last year growth soundly trounced value, marking a three year recovery for the previously depressed style. Over that period, large cap growth has compounded at about 700 basis points better than value, enough to give growth the advantage over the last five years. Although value's lead over the last decade seems insurmountable given the starting point, growth could continue to lead in the near term.
Since annual rebalancing forces the growth indexes to reinvest in winners while exiting losers, continued outperformance requires sustained trends in which the "rich get richer". Should the economic recovery prove sub par, as currently forecast by economists, economic growth could prove insufficient to lift value stock earnings. As value companies exhaust their ability to cut costs, their earnings would stagnate, allowing growth shares to shine as their exposure to favorable secular trends drives revenues and earnings higher.
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Bulls, Bears and PIIGS
The consensus anticipates moderate global economic growth in 2010, held back by a weaker than normal U.S. recovery and mixed overseas prospects. High unemployment, a rising savings rate, low capacity utilization and higher taxes are all bona fide concerns for the U.S. Internationally, the Japanese economy continues to suffer from adverse demographic trends and, in Europe, the PIIGS (Portugal, Ireland, Italy, Greece and Spain) have severe economic and financial problems.
In spite of these concerns, recent economic data raise the possibility that growth could significantly top forecasts. The weaker than expected December U.S. employment report included a fifth consecutive month of temporary job creation and Challenger, Gray shows a decline in layoffs to levels not seen since prior to the Lehman bankruptcy sixteen months ago. While politicians bemoan anemic bank lending, junk bond yields have collapsed 1400 basis points from the peak of the financial crisis, including a 50 basis point drop in just the first week of 2010, suggesting a massive easing of credit conditions. And despite the body blow taken by consumer net worth and the apparent need for savings rates to double from current levels, holiday spending topped forecasts and ISI Group's auto manufacturer and retailer surveys have jumped to the best level in years.
With better demand having dragged the inventory-to-sales ratio down to near historic lows, the ISM Manufacturing Survey's new order component has jumped to 65.5, the highest level since the end of 2004. The surge in manufacturing orders is not unique to the U.S. Every major economic block, including Europe, Japan and the BRICs (Brazil, Russia, India and China), has posted new order indexes above the neutral 50 level, driving the global index to near a record high. Confirming this strength, the OECD leading indicator has also approached prior highs.
With the emerging markets having entered the recession in sound financial shape, China and India's early return to growth should not have surprised investors. What has proved extraordinary is the explosive growth of internal consumption. Both countries saw auto sales rise more than 50% during 2009 and China became the largest car market in the world, topping depressed U.S. sales.
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Coming Home to Roost
Much of the rapid recovery from financial conditions that screamed "depression" less than a year ago can be attributed to extremely aggressive monetary policy around the globe. In the U.S., rates were cut to zero and the Federal Reserve embarked on a program of "quantitative easing", buying Treasury bonds to finance part of the Federal budget deficit and mortgage backed securities to subsidize housing. The U.K., Euro Zone, Switzerland and Japan all implemented similar aggressive easing and China unleashed its ever-aggressive bankers to lend.
Even before economic activity exhibited a stronger tone, commodities scented the risk to fiat currencies and began to rally. Gold, a currency alternative, surged through $1,000 per ounce, advancing 20% before pulling back, and oil and copper, industrial commodities, remained strong despite plentiful supplies. Now, with new manufacturing orders rising, just as bureaucratically-delayed stimulus spending begins to kick in, inflation could rear its head.
In the emerging markets, inflation is already an issue. With its money supply growing at an almost 20% pace, India's consumer inflation rate hit 14.5% in November. In China, where money supply and loans have been growing at a 30% to 35% rate, inflation is still under 4%. But with a normal six to nine month lag and slack manufacturing capacity being consumed by domestic demand, a surge of inflation over the next few months may prove inevitable.
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Walk, Do Not Run, to the Nearest Exit
Although the early stage of the economic recovery in the U.S. has many economists believing that a tightening cycle will not begin until 2011, the Federal Reserve has already started to take steps towards its "exit strategy". Treasury bond purchases were discontinued last fall after reaching the $300 billion goal and mortgage backed security acquisitions have been scaled back as the portfolio approaches the March 31 goal of $1.5 trillion. While the Federal Reserve has shown no inclination yet to raise the Funds Rate above its current "Zero Interest Rate Policy", China has allowed its interbank lending rate to rise by 50 basis points over the last six months and in January raised reserve requirements to slow lending activity.
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The Grass is Always Greener
Competitively, the dollar's slide was arrested by the recent financial troubles in some of the weaker European countries, such as Greece, which undermined confidence in the Euro. But a firmer tone to U.S. monetary policy would go much further towards bolstering the dollar and relieving the inflation psychology that has haunted it recently. Unfortunately, the ghost of the Great Depression, with its double-dip recession in 1937, haunts American central bankers, suggesting that they will err on the side of inflation rather than risk a return to economic contraction.
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Outlook
The last year proved quite difficult for Columbus Circle Investors' discipline, due to the economic turmoil, which had investors fearing depression during the first quarter and chasing economic recovery thereafter. Aided by massive financial liquidity and temporarily more dynamic earnings, secular growth stocks took a back seat to highly-leveraged and economically-depressed companies.
Although many of 2009's winners benefited from unexpectedly strong earnings generated by economic recovery which leveraged lean cost structures, the best of those results have now passed. Depressed expectations have rebounded after three quarters of easy hurdles and we are now beginning to see evidence of higher costs, as factories reopen, raw material costs rise and compensation levels are restored. As the most cyclical and financially leveraged companies begin to see their earnings growth decelerate, secular growth stocks should begin to regain their appeal.
The political situation should also begin to stabilize during 2010 as the rapid decline in popularity forces the Democratic Party back towards the center. Healthcare reform, whose process depressed healthcare stocks, has proved widely unpopular as a political issue and massive federal deficits concern voters of all stripes. Already, senior senators are announcing their retirement rather than face likely defeat, a sign that greater balance should return after the mid-term elections. While a return to Congressional gridlock may not appeal to those seeking "change", it is comforting to equity investors who despise uncertainty.
Greater economic and political stability should produce a better environment for stock picking. Companies participating in strong secular trends and those exposed to the emerging markets and the improving trade balance could stand out. Even healthcare may prove more fruitful, as the uncertainty caused by healthcare reform passes. While the new year is sure to bring its share of surprises, CCI will remain focused on its investment discipline, selecting companies with strong fundamentals and the potential to exceed investors' expectations.
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