Economic Forecast Q1 2014

ECONOMIC FORECAST

Q1 2014 JANUARY 13

2013 in Review Equities Global Economy Fixed Income

INSIDE THIS ISSUE: 2013 in Review

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Equities

4-5

Global Economy

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Fixed Income

7-9

Dennis Fitzpatrick Founder, CEO, and Chairman

Brandon Fitzpatrick President, COO, and Equity Portfolio Manager

Prabhab Banskota Fixed Income Portfolio Manager

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

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ECONOMIC FORECAST | Q4 2013

2013 IN REVIEW Global equities, as measured by the MSCI All Country World Index, were up 23.5% last year, and were led by U.S. and Japanese stocks. The S&P 500 rose 32.4%, while the Nikkei Index climbed an astonishing 59% (though only 30.4% in dollar terms, as the yen fell).

European stocks showed new signs of life – rising 20.9% – as investors’ severe pessimism regarding the eurozone abated. Emerging market stocks were the laggard last year, with the MSCI Emerging Markets Index falling 2.4%, as investors bet that rising interest rates in the U.S. would make emerging market assets less competitive in the global contest for capital.

Consistent with the dour mood toward emerging markets, the U.S. dollar rose last year, with the Dow Jones Dollar Index up 6%.

dramatically last year, with the yield on the 10-year Treasury rising from 1.76% at the start of the year to 3.03% by year-end. The Barclays Aggregate Bond Index fell 2% last year, its first fall in 14 years. All of this came in response to announcements that the Federal Reserve would slow down bond purchases, beginning in 2014. Reported inflation, as well as inflation expectations, have remained very low, and the increase in interest rates mainly reflects an increase in the real interest rate. It’s important to note that even with last year’s interest rate increase, rates are still quite low by historical standards. We believe rates will continue to rise in 2014 as economic growth picks up, employment improves, and the Fed slowly but surely ends quantitative easing. That said, rates are likely to remain low on the short end of the yield curve, as the Fed is This steady and consistent rise in global stocks (barring promising to keep the fed funds rate near zero into emerging markets) in 2013 was contrasted with extreme 2015. U.S. stocks are fully valued, and there are better tumult in the bond market. Interest rates rose opportunities in the emerging markets and in Europe.

EQUITIES U.S.-based stocks had a great 2013 and led global equity markets. Some of that was due to increased earnings as the domestic economy improved, but much of the gain was due to an increase in valuation

Equity Returns 2013

multiples, as investors discounted expected earnings at a lower rate. The S&P 500 rose 32.4% (dividends included) in 2013 but reported earnings in the year were up only 6%. The S&P 500’s price-to-earnings ratio

S&P 500 EAFE MSCI Emerging Markets Index

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using trailing earnings was 17.4 at numerous: good demographics, a tremendous run in 2013. Europe the end of December, up from 14.2 growing middle classes, decent is more attractive than either the the year before, and the highest level macroeconomic policies (generally), U.S. or Japan, as depressed earnings since 2009. Both the Nikkei and the and continued strong economic are set to increase significantly as FTSE Developed Europe index saw growth. U.S. stocks, on the other economic growth picks up. an expansion of multiples last year hand, are fully valued. Japanese as well. Meanwhile, the MSCI stocks also look frothy, after having Emerging Market Index saw its P/E ratio fall from 12.6 to 11.8. In short, the underperformance of emerging markets last year was due more to investor perceptions and discounting than actual earnings growth realized.

Looking at forward price to earnings ratios (using market expectations of 2014 earnings), the discount applied to emerging market stocks is also very high relative to domestic stocks. The MSCI Emerging Market Index is trading at 10.3 times forward earnings, compared to 15.5 for the S&P 500, 13.6 for the FTSE Developed Europe Index, and 20.6 for the Nikkei.

Earnings could be hurt in 2014 if the Fed ends up roiling emerging economies, but that possibility is more than factored into current prices.

Market sentiment is strongly against emerging markets, but their long-term positives are

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ECONOMIC FORECAST | Q4 2013

GLOBAL ECONOMY The U.S. economy continues to recover. The unemployment rate has fallen steadily since 2009 and is now at 6.7%. The underemployment rate (which includes part-time workers and those that would like to work but have stopped looking) has fallen to 13%, which is still very high but marks an improvement from 17% in early 2010.

Housing starts are up, as the housing market continues to recover, and consumer confidence rose in late 2013.

U.S. GDP growth was 2.0% in 2013, and we’re forecasting an improvement to 3.0% in 2014.

Underemployment Rate Unemployment Rate

United States 2008

2009

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2013

U.S. Housing Starts

The eurozone suffered a mild recession in 2013, and we expect growth to increase to 1.0% in 2014. The dark days of 2011 – when a breakup of the currency bloc appeared possible – are definitely behind us, and Europe is on its way to recovery. The bond market has already come to this realization, and Spanish bonds are trading at 2009 spreads not seen in three years. Yields on Italian and Greek bonds (which also spiked in 2011) are down as well. Most of the easy money in European debt has already been made, but there is still good potential in European equities. The FTSE Developed Europe Index is trading as 13.6 times 2014 earnings, a 12% discount to the S&P 500.

GDP growth in the emerging markets, despite some notable lagging countries, remains good. China grew 7.8% in 2013 and should achieve a similar number in

2010

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2014. Indonesia’s GDP growth has slowed but was still 5.6% last year, and is likely to be 4.0-5.0% next year, in spite of market jitters over the effect of Fed tapering on its capital account. Latin America has slowed, largely as a result of falling commodity prices, but investment-grade countries Colombia and Chile grew 4.5% and 4.7% last year, respectively. Both countries should achieve similar results this year. The region’s laggard has been Brazil, with growth at a very

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Yield on 10-year bond

Spain Germany

Spread 2010

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disappointing 2.2%. Even there, though, there are signs — Brandon Fitzpatrick of life with growth picking up in the fourth quarter.

FIXED INCOME The fixed income markets declined again in December volatility seen in 2013 in the Treasury market was as the Federal Reserve initiated the long anticipated historic and was caused mainly by speculation about “tapering” of its Quantitative Easing (QE3) bond tapering, supplemented by spectacle in Washington as buying program from $85 billion to $75 billion per politicians clashed over the debt ceiling and budget month. Although this was a very modest reduction, the deficit.

Fed also stated that it may completely terminate QE3 by year -end 2014 if economic Exhibit 1: U.S. Treasury Rates (%) conditions are sufficiently strong.

Treasury benchmark yields have surged since the Fed started publicly discussing tapering in May (see Exhibit 1). The

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ECONOMIC FORECAST | Q4 2013

Exhibit 2: Federal Reserve’s Balance Sheet (in trillions)

As a result of the increase in intermediate and long term rates, the bond market suffered its first annual loss in 14 years, as measured by the Barclays U.S. Aggregate Index. 30-year U.S. Treasury bonds returned a negative 15.0% in 2013, while the 10-year bond was off 7.8%. The Barclays U.S. Aggregate index declined 2.02%, while the U.S. Mortgage Back Securities (MBS) and Intermediate U.S. Government

indices were off 1.41% and 1.25%, respectively. The DBF Short and Intermediate portfolios generated returns of negative 0.14% and negative 1.69%, respectively, in 2013.

Since the financial crisis and Great Recession that started in 2008, the Federal Reserve has been actively supporting the bond market with the goal of stimulating the housing sector and the general

Exhibit 3: Total Return of U.S. Treasury Securities

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Exhibit 4: Divergence of Treasury yield and change in Consumer Price Index (CPI)

economy. As a result, the Fed’s balance sheet has soared from less than $1 trillion in 2007 to $4 trillion by 2013. This emergency action by the Fed may well have averted a major financial/economic collapse, but has also injected significant distortions in the financial markets, as can be seen in the sharp increase in the volatility of fixed income prices since 2008 (Exhibit 3).

We anticipate that a modest increase in inflationary expectations (resulting from a stronger economy) will result in the 10-year US treasury yield increasing to the 3.25 – 3.75% range in 2014. Additionally, we expect short term rates to increase modestly in 2014. As a result, we expect DBF Short duration portfolios to perform relatively well in 2014 as portfolio cash flows are reinvested in a rising yield environment.

Fixed income markets and inflation (and inflationary expectations) are normally highly correlated; i.e., as inflation declines yields decline and bonds appreciate.

DBF Intermediate duration portfolios are positioned to In 2013, however, the opposite occurred as yields “cushion” the effects of moderately rising yields in soared in an environment of declining inflation (Exhibit early 2014. During the next 2 – 3 years we expect DBF 4). This divergence of nominal bond yields from Intermediate duration portfolios to generate 2.5 – 4.0% inflation is clearly an effect of the Fed’s “unwinding” annualized returns. — Prabhab Banskota of its extraordinary monetary stimulus.

We believe that these atypical effects of tapering will be reversed as the Fed terminates QE3 by the end of 2014. If U.S. economic growth continues to strengthen, as we expect, yields may continue to increase but only if inflationary pressures build. If inflationary pressures remain subdued, the fixed income markets will improve.

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ECONOMIC FORECAST | Q4 2013

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 MODEL RETURNS FROM A COMPOSITE. ALL RETURNS ARE GROSS OF FEES AND ANNUALIZED.

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