Economic Forecast Q1 2013

Q1 2013 January 8

Economic forecast

Outperform Bonds Europe China and the Emerging Markets United States Fixed Income

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THIS PUBLICATION IS FOR INFORMATIONAL PURPOSES ONLY. THIS PUBLICATION IS IN NO WAY A SOLICITATION OR OFFER TO SELL SECURITIES OR INVESTMENT ADVISORY SERVICES, EXCEPT WHERE APPLICABLE, IN STATES WHERE D.B. FITZPATRICK & COMPANY IS REGISTERED OR WHERE AN EXEMPTION OR EXCLUSION FROM SUCH REGISTRATION EXISTS. INFORMATION THROUGHOUT THIS PUBLICATION, WHETHER STOCK QUOTES, CHARTS, ARTICLES, OR ANY OTHER STATEMENT OR STATEMENTS REGARDING MARKET OR OTHER FINANCIAL INFORMATION, IS OBTAINED FROM SOURCES WHICH WE, AND OUR SUPPLIERS BELIEVE RELIABLE, BUT WE DO NOT WARRANT OR GUARANTEE THE TIMELINESS OR ACCURACY OF THIS INFORMATION. NEITHER WE NOR OUR INFORMATION PROVIDERS SHALL BE LIABLE FOR ANY ERRORS OR INACCURACIES, REGARDLESS OF CAUSE, OR THE LACK OF TIMELINESS OF, OR FOR ANY DELAY OR INTERRUPTION IN THE TRANSMISSION THEREOF TO THE USER. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION CONTAINED IN THIS PUBLICATION. NOTHING IN THIS PUBLICATION SHOULD BE INTERPRETED TO STATE OR IMPLY THAT PAST RESULTS ARE AN INDICATION OF FUTURE PERFORMANCE. ALL RETURNS ARE ACTUAL RETURNS FROM A COMPOSITE. ALL RETURNS ARE NET OF FEES AND ANNUALIZED.

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INSIDE THIS ISSUE: 4

Outperform Bonds

Europe

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China and the Emerging Markets

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Dennis Fitzpatrick Founder, CEO, and Chairman

Brandon Fitzpatrick President, COO, and United States

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Fixed Income

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Manager

Cody Barney Principal and Fixed Manager

D.B. Fitzpatrick & Co. 225 N. Ninth St. Suite 810 (208) 342-2280 www.dbfitzpatrick.com

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2012 REVIEW AND OUTLOOK: EQUITIES OUTPERFORM BONDS

The

markets strongly outperformed in the fourth quarter. Chinese stocks jumped in the last six weeks of the year, forward with economic reforms.

Fixed income yields remained exceedingly low throughout 2012.

-2009, has kept money in the bond market despite rock longest tenors of the yield curve. Most of the global fixed income markets are very expensive, as investors have pushed down yields in the credit space as well. The yields of some emerging market local currency sovereigns -denominated sovereigns are not overly compelling, especially when compared to stocks.

2013.

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Despite this run, risk aversion remains

yet adequately rewarded them for the prospects for growth in the emerging world. We are maintaining an

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EUROPE

many investors that a bet against markets in the first half of 2012, but the euro and sovereign debt of was early in 2012. Greece is a more peripheral European countries was a moment last July when European Yields fell across need more aid from the eurozone’s Central Bank chairman Mario Draghi the eurozone, including crucial stronger economies, and more debt announced that the ECB would do countries Italy and Spain. writedowns are inevitable. In spite "whatever it takes" to save the of this it’s likely that even Greece euro. The ECB will buy unlimited Meanwhile, the difficult work of will remain in the currency bloc. amounts of sovereign bonds of regulatory and economic reform has eurozone countries that abide by The last sixteen months, from required reforms. The markets had agreed to rules which put the September 2011 to the present, long hoped for such an eurozone’s biggest banks under the announcement, as it takes the risk direct oversight of the ECB, a key for the eurozone. Europe's leaders, of immediate breakup and financial led by German Chancellor Angela meltdown off the table, and gives Italy, Spain, and Greece have been along with economics, and have reforms and build stronger pushing through reforms to adjust persistently pushed for "more their labor markets and improve Europe" (meaning more centralized announcement removed a lot of the It’s obvious that control of fiscal and regulatory fear that surrounded risky assets Italy and Spain need faster around the globe, and convinced economic growth, but the outlook Merkel

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has been careful not to get too far ahead of her

breaking up the currency bloc, it's easy to see why

voters along toward her correct conclusion that the best hope for Germany's future is to stay within a united Europe and eurozone. Merkel’s allies are leading in the polls and she appears well-

why voters, both within core and peripheral countries, have accepted painful reforms. Germany, Italy, Spain, France, and even Greece have thrown their lot in with Europe and the eurozone, and it's clear now that the euro will survive.

which has us bullish on the eurozone’s prospects. have failed to grasp the fact that the eurozone itself, and the project of generally, is about much more than the benefits of free trade or the ease of doing business across crucially, just as much

framework that would make war within Europe impossible. This is why Europe's leaders have pushed ahead to solve the That's the good news. The bad news is that years of Europe’s austerity are ahead for much of Europe, and growth is unity will only gain in importance in the coming years as likely to be slow.

-the big emerging economies -- Brazil, India, China, Germany, for example, and parts of eastern Europe -Indonesia, and others -but generally the outlook for economic growth on the the balance of global power, both in economics and There are values to be had in some When looked at in this context, and while keeping in mind the unpredictable cost of remains sour despite recent gains.

CHINA AND THE EMERGING MARKETS

Emerging market economies now produce about half the world's GDP, and prospects for future growth are bright. The biggest and most important emerging economy, of course, is China, and its economy is recovering as 2013 begins. Growth had slowed to around 7.5% last year, which for most of the world would be an excellent number, but investors were nervous since the drop in GDP growth had yet to be

Manufacturing and trade data in November and December, however, were higher than expected, China's new leadership was announced in November, disappointed by the new team. There is hope for economic reform, however, as Communist Party leader

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liberalizing China’s economy. Deng Xiaoping made Shenzhen a special economic zone in 1980, one of the first in China as part of Deng’s economic reform policies. The Chinese government recently announced moves to further liberalize its financial markets, and will allow more foreign money managers to invest in local capital markets. Policymakers are clearly looking to boost China's stock market, which has been anemic the last three years.

China will undoubtedly have hiccups along the way, but over the longer run the country's economy will be one of the world's top performers. of people in the countryside eager to place themselves into the modern global economy, as they work to build a higher than some other fast-growing emerging economies, and clearly the government has misallocated resources in some well-8% during the next

The real has fallen during the last ten months to a more reasonable level, however, and this should jumpstart exports in 2013. finally set to take effect and increasing demand from China for exports will provide a boost. Brazilian stocks are cheap — the Brazil.

-term growth, including Mexico, Colombia, and Chile. Colombia slowed in 2012, but has the best prospects of the three.

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UNITED STATES

The compromise that prevented the U.S. from falling off the fiscal cliff, reached just hours before the deadline, will slightly lower economic growth increased taxes on top earners, but economic growth over the longer lack of demand, and demand will be Policymakers will now look to lower government spending, and will begin work toward a broad agreement on tax reform. A "grand bargain" seems very unlikely, however, given the and the basic tax structure as it stands now, with myriad loopholes persist for the foreseeable future. Some spending cuts will likely be agreed to, but they will prove hawks. as a severe drop in government spending in the short term could push the economy back into recession, which would make present debt levels more onerous.

It's clear that economic growth will be the key to the sustainability of government debt levels in the U.S. Growth at 2.2% was moderate in 2012, but there are reasons to be The

This will have a

unemployment drops below 8.0%. There is a lot of pent up demand in the economy and when consumer We think this will begin to occur early in 2013. 3% GDP growth is not a stellar number, especially given the severity of the recession in 2008and would do a lot to ease the country's debt troubles in the coming years. — Brandon Fitzpatrick

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FIXED INCOME

The U.S. Treasury market ended the year on a down 2-year yield to approach 0.50%. note as yields increased in the intermediate and long -year yield stayed flat at 0.25%, but the 10-year yield rose 14 basis points to end the month at 1.76%. The 30-year bond yield also rose 14 basis points to finish the year at 2.95%.

The broad investment grade bond market as measured by the Barclays Capital US Aggregate Index was down -0.14% for December and finished the year up 4.22%.

Corporate bonds were the big winners in fixed income in 2012, returning 9.82%. Spreads came down significantly for corporates as investors scoured the returned 1.99% for the year, while agency mortgage-

-term

federal funds rate and instead opted to set forth economic hurdles that must be met for the Fed to consider raising rates. The two primary thresholds that must be met are: 1) unemployment at or below 6.5%, more than 2.5%. Ben Bernanke and other Fed officials will obviously weigh other factors in their decision-

we expect interest rates to rise along with an improving hurdles gives the financial markets more clarity and U.S. employment outlook. We expect the 10-year U.S. Treasury yield to hit 2.5% by the end of 2013 and the

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Barclays Government to maintain a defensive posture the rest in agency mortgageyears is well under the average grade bond market (over 5 years). return in long-term bonds as very asymmetrical and are avoiding

forward. Year-overas we head into 2013. Even at a historically modest curve are under 2%. returned 2.31% in 2012, compared to 1.73% for the

composite returned 1.63% in 2012, well ahead of the benchmark 1-3 Year Treasury Index which returned -term TIPS , while we maintain a yield advantage with -term agency mortgage— Cody Barney

D.B. Fitzpatrick & Co. 225 N. Ninth St., Suite 810 Boise, ID 83702 www.dbfitzpatrick.com | (208) 342-2280