Columbus Circle Investors - Quarterly Equity Investment Report

General Outlook

Economic Activity: Snow Jobs
Interest Rates: In God We Trust
Inflation: Another BRIC from the Wall
Currencies: The Grass isn't Always Greener
Investors: A License to Speculate

A License to Speculate
Excess liquidity helped small cap stocks lead the market higher during the first quarter as the Federal Reserve continued to forecast "exceptionally low levels of the federal funds rate for an extended period". The rising money tide lifted a wide range of leaky boats as could be seen in the outperformance of value stocks and the rapid rise of the smallest market capitalization and lowest priced shares. Although the maturing of the economic recovery and stock market rebound from the depths reached a year ago should produce a gradual rotation away from deeply cyclical stocks and towards sustainable growth company shares, the current easy money regime gives investors a license to speculate on the recovery of the most troubled companies.

The Grass isn't Always Greener
Massive budget deficits, bankrupt social safety nets, widespread political protests and the risk of credit rating downgrades do not normally make for a favorable investment backdrop. And that proved to be the case during the first quarter. For just when the U.S. Dollar looked likely to sink below the horizon and pundits prepared to write about the fall of the American empire, Greece's financial problems reminded investors that the Euro Zone is not a risk free alternative to the United States. The Euro lost almost 6% of its value against the dollar during the quarter, leading to losses for most European markets in dollar terms.

Facing its worst crisis since being formed a decade ago, the severe financial strains facing the weakest European countries (Portugal, Italy, Ireland, Greece and Spain) have threatened to split the Zone asunder. Having locked themselves into a single currency, a classic round of devaluation and inflation was not an option available to resolve the crisis. And with many Greeks able to retire with full benefits at age 55, financial aid from Germans facing retirement at age 67 was not a viable option for politicians in the stronger member states. Unable to resolve the crisis internally, Europe has turned to the International Monetary Fund to lead a solution, perversely making the U.S., with its own financial problems, one of the leading donors to a Greek/Eurozone bailout.

In God We Trust
Despite the dollar's rally and a significant recovery in the stock market, the United States' financial condition continues to deteriorate. With the current Federal budget deficit approximating 10% of GDP, total government debt outstanding could reach 100% of GDP within the next five years, at which point it becomes a foot race between economic growth and interest rates to determine whether the U.S. can avoid following in Greece's footsteps.

Although current interest rates on Treasury paper are extremely low, ranging from almost zero for 3-month T-bills to 4% for 10-yr Treasury bonds, the amount of new funds that must be raised have caused recent Treasury debt auctions to go poorly, causing the 10-yr yield to rise 30 basis points in just a fortnight. Perhaps more ominous, the 10-yr swap spread recently turned negative for the first time, implying that high grade corporate borrowers are theoretically less risky than the U.S. Government. It may be absurd to believe that a government that owns its own printing press can run out of money, but the massive borrowing needs of the Federal Government may already be straining the financial markets and, as the economy recovers, could crowd out private sector borrowers. As Treasury bond rates rise, mortgage rates are likely to climb as well, stalling any housing recovery.

Another BRIC from the Wall
The recent delay in the Treasury report that could have declared China a "Currency Manipulator" gives politicians on both sides of the Pacific several months to defuse the issue. During that timeframe, it is likely that China will allow the RMB to resume the gradual appreciation that ended with the onset of the global financial crisis in 2008. It is also likely that the Chinese economy will begin to slow from its recent torrid pace, responding to both the "command and control" demand that banks restrain their lending and the recent increase in reserve requirements aimed at tightening money supply growth.

Although Chinese inflation has remained well below the levels of 2005-2006, when rising food prices caused rates to reach 10%, China's consumer price index accelerated to a 4.5% annual rate in February. China is not the only emerging market to begin overheating. India's wholesale price index has risen 10% over the last year and recent monthly inflation data have accelerated further, prompting India's central bank to post a surprise 25 basis point rate increase during March. And Brazil's 8.4% fourth quarter real GDP growth rate has helped accelerate inflation in that country to a 6.6% annual pace, prompting its central bank to signal that rates would rise in April.

Snow Jobs
Having led the global economic recovery, the prospects for tighter monetary policy in the emerging economies is somewhat unnerving, especially as the European economies have yet to show the broader implications of the Greek financial crisis. Fortunately, the American consumer appears to be coming to the rescue. Despite widespread major snowstorms in February that should have had consumers sipping hot chocolate in front of their fireplaces, comparable store sales exceeded forecasts at many major retailers. Government statistics place February retail spending growth at an almost 4% year-to-year pace and ISI Group believes that March may have accelerated to an almost 6% rate, aided by automobile sales incentives and strong tax refunds. Although the acceleration in consumer spending has come at the expense of the savings rate, which dropped to 3.1% in February from a 4.3% average during 2009, such a drop is consistent with classic early cycle behavior, where consumers spend some of their increased savings to satisfy pent-up demand. Should consumer spending prove sustainable, capital spending could easily follow, as business profits have recovered sharply and corporate cash flows and debt levels are the healthiest in many years.

March's Purchasing Managers index seemed to validate improving demand and lean inventories, reaching almost 60, a level consistent with prior economic recoveries. And, aided by temporary census takers and the return of construction workers, who really did have to sip their cocoa in February, the March employment report finally revealed job growth. Whether the recent improvement proves to be sustainable and robust is difficult to determine given the many financial imbalances facing the U.S. economy, but for the first time in several years CCI's economic survey shows a greater improvement for the U.S. real GDP forecast than for international growth.

Outlook
It is often said that bull markets "climb a wall of worry". Such is certainly the case at the moment. Having entered the recent recession with a "structural" Federal budget deficit amounting to 5% or 6% of GDP, the deficit has ballooned to 10% due to lost tax revenues and higher spending on the social safety net. Although economic recovery will restore some of the lost revenues, government spending has taken a major jump higher, rising to almost a quarter of the economy from a level closer to 20% over the last several decades.

Although the end of the current healthcare reform battle will provide at least a few months of peace until the election season enters high gear, few believe that the cobbled-together legislation will reduce costs, lacking both the "just-say-no" benefits of a single-payer system and the steely efficiency of a true market mechanism. Already responsible for almost half of healthcare spending, the 30 million new dependents under reform will almost certainly expand the government's share of the economic pie still further.

Having sworn against raising taxes on the middle class, taxes on the upper class and on investment gains and income are set to rise sharply. But as history shows, as marginal tax rates approach 50%, the incentive to earn an extra dollar of income falls sharply, while the incentive to shield an extra dollar of income from taxes soars. The result is likely to be a tax harvest far smaller than expected, with the unfunded burden falling back onto the middle class, probably in the form of a Value Added Tax. Placing higher taxes on the back of consumers whose savings rate is still closer to historical lows than the long term average is sure to place a burden on economic growth.

How these problems are resolved remains unclear, but the critical moment that will force policy-makers' hands is probably several years away. In the meantime, corporate profits are rising, interest rates are low and the economy is gradually recovering. There are large amounts of cash earning almost nothing sitting on the sidelines in short term funds. As the stock market rises, the temptation to invest may prove irresistible, despite the long term concerns. So, at least until the Federal Reserve decides that it needs to take some of its liquidity punch away from investors, the party is likely to continue.

While the liquidity punch tends to cloud investor judgment, causing them to prefer marginal, cyclical companies to secular growth stocks, the more mature the economic and stock market cycles become and the closer the time when the Federal Reserve begins to drain the punch bowl, the more likely investors will be to regain their senses and appreciate the merits of positively surprising growth stocks.