Economic Forecast Q1 2015

ECONOMIC FORECAST

Q1 2015 JANUARY 16

INSIDE THIS ISSUE:

Oil Takes a Dive

4-5

Europe

5-6

United States

6-7

Equities

7

Dennis Fitzpatrick Founder, CEO, and Chairman

Brandon Fitzpatrick President, COO

Fixed Income

7-9

Prabhab Banskota Fixed Income Portfolio Manager

DB Fitzpatrick 800 W. Main Street, Suite 1200 Boise, Idaho 83702 (208) 342-2280 www.dbfitzpatrick.com

4

ECONOMIC FORECAST | Q1 2015

Volatility in the equity markets has increased in the last has pushed down global interest rates. For example, in four months as disinflation in Europe and the falling spite of an improving U.S. economy, the 10-year U.S. price of oil — down 50% since September — have Treasury yield has fallen to 1.79%, and 10-year rattled investor confidence. Cheaper oil is good for the sovereign bond yields from all Eurozone countries economy, but the reverberations sent through the energy except Portugal and Greece are even lower. sector, as seen in both falling stock prices and rising corporate bond yields, have impacted the broader In many ways the global economy and financial markets. markets are still grappling with the aftermath of the recession of 2007-2009. The U.S. economy has come a The Eurozone economy is growing less that 1.0% and long distance during the last six years, but Europe’s year-over-year inflation reported in December was slow progress means the aftershocks of the crisis will be -0.2%. Europe’s weak economy has affected growth with us a while longer. elsewhere in the world and disinflation in the Eurozone

OIL TAKES A DIVE The price of oil has plunged in the stock prices fall 70-80% since billion (this figure is an estimate and last six months. West Texas September. will ultimately depend on how the Intermediate crude has fallen from price of oil evolves during the next $100/barrel last June to $47/barrel OPEC’s goal for the medium and year). The International Monetary today, and the drivers of OPEC long term is to lower the production Fund estimates that the Saudi strategy have promised to maintain capacity of non-OPEC members, government has $750 billion in production no matter how low the and, of course, for the price of crude foreign reserves, so clearly Saudi price falls. Their obvious goal is to to eventually rise again. Saudi leaders have the ability to withstand force oil producers around the world Arabia has considerable resources in low prices for a significant period, to scuttle marginally profitable reserve as it executes its plan. The even years if necessary. Many small projects, and to force solvency crises Saudi government announced plans and medium-sized producers in the among the most highly-leveraged to spend US$230 billion as part of U.S. and elsewhere could not producers. Both of these goals have its normal budget in 2015, and is survive if oil prices stayed low that already been accomplished to a assuming a budget deficit of $40 long. Some OPEC countries, such significant degree. Oil services firm Baker Hughes $100 announced on January 9 that U.S. drillers had Brent 1,420 rigs in use $80 for oil production, down from 1,535 in late December.

West Texas Some small and Intermediate $60 highly leveraged U.S. exploration and production July August September October November December companies have already seen their

Oil Prices

5

as Iran, Venezuela, and Ecuador, will also suffer extreme difficulties if there is no recovery in prices soon (12-year U.S. dollar bonds of Venezuela’s state -run oil company PDVSA have a yield of 20%, implying a high likelihood of default), but in the end, Saudi Arabia’s voice is what matters and Saudi leaders are evidently not concerned with these smaller OPEC producers.

Oil prices will remain low until Saudi leaders decide that their goals have been achieved. The timing of this is unpredictable.

In many cases surviving companies will come out of this downturn in a stronger position, as competition is either eliminated or absorbed. There is likely to be a round of mergers and acquisitions in the near future, as the largest and most conservatively-managed companies can still raise capital at attractive rates.

1600 1550

Baker Hughes U.S. Crude Oil Rig Count

1500 1450

October

November

December

January

Corporate Bond Yields of U.S. Oil Producers (date of maturity in parenthesis) 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Exxon (2024)

EOG Resources (2024)

Newfield Exploration (2024)

Linn Energy (2022)

EUROPE Europe’s very weak economy remains a source of The market expects, as we do, that the European concern for investors and lowers the potential for Central Bank will begin a bond buying scheme in the global economic growth. The Eurozone is on much first or second quarter of this year. This quantitative more solid ground as a currency bloc than was the case easing project will include the purchase of Eurozone two years ago when dissolution was a real possibility, sovereign bonds and might include corporate bonds. but its economy is on the precipice of a new recession This will provide a short-term boost to European and and year-over-year inflation dipped below zero in global equity markets, but is unlikely to be enough to December. Political realities in Europe have made give the real economy in Europe the shot in the arm badly needed fiscal stimulus impossible and monetary that is desperately needed. The success of the stimulus very difficult. It has taken actual deflation for program, ultimately, will depend on the credibility of quantitative easing to become politically palatable, and the ECB regarding the size of purchases and how long even today the opposition is loud and rancorous. the program will last. The prospects for an overwhelmingly large and long-lived QE project, as

6

ECONOMIC FORECAST | Q1 2015

was implemented in the U.S., are not good, however. ECB leaders have to build a consensus with politicians who are absolutely averse to monetary stimulus, thus the plan is likely to be underwhelming from the point of view of the financial markets. Most of the Eurozone economy’s fundamental problems – notable among them an utter aversion to fiscal and monetary stimulus among key political groups and policymakers – are unchanged, and present a headwind to European growth prospects.

3%

Eurozone 2%

Consumer Price Index

1%

GDP % growth year-over-year

0% -1% 2011

2012

One piece of good news for Europe, however, is the euro, which has fallen 14% vis-à-vis the U.S. dollar since last June. The lower euro should begin to have an important effect on Eurozone exports in the months

2014

2013

ahead. Exports of goods and services represent 27% of the Eurozone’s GDP. The weaker euro may prove to be the most important achievement of the ECB’s QE program.

UNITED STATES The U.S. economy continues to show considerable strength. GDP growth is accelerating and will be close to 2.5% for 2014 when the final data come in. The unemployment rate has fallen to 5.6%, industrial production was up 5.2% year-over-year in November, and consumer confidence is as high as it’s been since 2007. Retail sales in December were weak, but this does not change the clear story of a significant and continued improvement in the U.S. economy.

The ultimate source of these encouraging numbers is the steady improvement in the U.S. housing sector. Housing starts and new building permits both are back to levels last seen in 2008, and the Case-Shiller

National Home Price Index was last up 4.5%, and has been mostly positive since 2010 (the index was negative in 2011, and this was a result of prices falling after a temporary tax incentive scheme was ended in 2010).

Consumers’ personal balance sheets have improved substantially during the last few years and it is clear that 15% 10% 5% 0%

Case-Shiller Home Price Index 2009

2010

2011

2012

2013

-5% -10% -15%

2014 -20%

7

the economy has turned a corner.

We expect the U.S. economy to continue building momentum and GDP growth to reach 3.0% in 2015.

The U.S dollar was up significantly in the second half of 2014 as the U.S. economy strengthened and the likelihood of a new monetary stimulus regime in the Eurozone has been factored into currency prices.

The higher dollar will be a drag on economic growth, but that drag should be relatively slight as foreign trade makes up only 15% of U.S. GDP.

EQUITIES U.S. equities have Forward price to earnings ratio performed well in 2014 but at 16.4x estimated (current price, expected 2015 earnings) 2015 earnings are fully valued. The MSCI 16.4 15.1 EAFE Index of 14.4 15 international developed 11.4 countries is trading at 14.4x forward earnings 10 and the MSCI Emerging Market Index is trading 5 at 11.4x. Very low interest rates in the U.S., 0 Europe, and Japan have MSCI All Country S&P 500 EAFE MSCI Emerging pushed money into the World Index Markets Index safest areas of the equity market, including utilities and healthcare, as the “search for yield” in the generate returns in the long run, though pessimism bond markets has bled into select equity sectors. This is regarding emerging market assets is high today. The likely to continue during the first quarter of 2015 as valuations are compelling and the pessimism among interest rates remain low. investors will not last forever.

We see long-term value in healthcare stocks and industrials. International exposure will be important to

— Brandon Fitzpatrick

FIXED INCOME The fixed income market performed better than short duration bonds. spur growth in the U.S. economy better than expected in 2014 as the The Barclays U.S. Aggregate index after the financial crisis of 2007U.S. Treasury yield curve declined gained 5.97% for the year, while the 2008, including decreasing the Fed and flattened. 2-year and 3-year U.S. Mortgage Back Securities Funds rate to 0.25% and embarking U.S. Treasury rates increased 0.28% (MBS) and Intermediate U.S. on multiple asset purchase and 0.31%, respectively, while 10- Government indices returned 6.08% programs. The Fed ended its final year and 30-year U.S. Treasury rates and 2.52%, respectively. bond purchase program in October decreased 0.86% and 1.22%. As a 2014, and with the unemployment result, longer duration bonds fared The Fed took unprecedented steps to rate at 5.6% and two quarters of

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ECONOMIC FORECAST | Q1 2015

solid growth, the market expects the Fed to increase short-term rates in 2015. The Fed, however, “frets that a premature tightening of policy may damage an economy that is still bearing the scars of the financial crisis of 2007-2008”. An anemic global economy and disinflation in Europe add to those fears.

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

In 2013, however, the opposite occurred as yields soared in an environment of declining inflation expectations. This 8.00% divergence of nominal bond yields and inflation was a result 6.00% of the Fed’s “unwinding” of its extraordinary monetary stimulus.

U.S. Treasury Yield Curve: January 2014—December 2014

10-year Government Bond Yields

4.00%

Dec-14

Oct-14

Aug-14

Jun-14

Apr-14

Feb-14

Dec-13

Oct-13

Aug-13

Jun-13

Apr-13

Feb-13

Dec-12

Oct-12

Aug-12

Jun-12

Apr-12

Feb-12

The real interest rate rose on the 2.00% shorter tenors of the yield curve in 2014 as inflation declined with slumping energy prices and a 0.00% stronger dollar. The real interest rate on the higher tenors has fallen. Investors expect an annual inflation rate of 1.55% U.S Spain Germany Japan during the next 10 years as measured by the difference between the yields of 10-year U.S. Treasury and 10the Fed Funds rate in the second half of 2015. Such an year TIPS (Treasury Inflation Protected Securities). increase, however, would threaten U.S growth and would depress already low inflation. We believe the The MBS sector outperformed Treasury and corporate Fed will move slowly, if at all, to raise rates in the last bonds in 2014 as the Merrill Lynch 3-5 year U.S. MBS quarter of 2015, and that the U.S. 10-year Treasury index returned 3.9%, while the Merrill Lynch 3-5 U.S. yield will be between 2.2% to 2.7% by the end of this Treasury and 3-5 year U.S. Corporate bond indices year. If energy prices recover, inflation and inflation returned 2.1% and 3.1%, respectively. The MBS sector expectations should edge higher in the second half of outperformed as lower mortgage refinancing led to a 2015. decrease in gross issuance to $0.98 trillion in 2014, down from $1.6 trillion in 2013.

We see value in longer maturity corporate bonds vis-àvis MBS and we are increasing our allocation to high Most bond investors expect the Federal Reserve to raise quality credit securities. Additionally, we are

9 maintaining our TIPS positions, as we expect inflation expectations to rise in the coming year.

MBS remain an attractive sector for the long term, but the risk of increased prepayments as interest rates have fallen makes MBS somewhat less attractive in the present environment.

3-year inflation expectation

U.S. 3-year nominal Treasury Yield

— Prabhab Banskota

Real Yield

2013

2014

1/15/15

12/31/2013

U.S. Treasury Inflation Indexed Curve

10

ECONOMIC FORECAST | Q1 2015

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 NET OF FEES AND ANNUALIZED.

DB Fitzpatrick 800 W. Main Street, Suite 1200 Boise, Idaho 83702 www.dbfitzpatrick.com | (208) 342-2280