Economic Forecast Q1 2016

ECONOMIC FORECAST

Q1 2016 January 22

DBFitzpatrick

REGISTERED INVESTMENT ADVISORS

INSIDE THIS ISSUE:

Darkest Before the Dawn

4

Brandon Fitzpatrick COO

Energy

4-5

Dennis Fitzpatrick CEO

Prabhab Banskota

Global Economy

6-7

Equities

7

Fixed Income

8-9

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

Portfolio Manager

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ECONOMIC FORECAST | Q1 2016

DARKEST BEFORE THE DAWN Three issues are driving the financial markets as 2016 gets underway, and all have conspired to put a cloud over equities. The first is the uncertain path of interest rates in the United States. The U.S. Federal Reserve implemented the first interest rate hike in many years last December, and Fed leaders have announced a goal of four further hikes in 2016 as part of a “normalization” of rate policy. Many market participants are concerned that raising interest rates this quickly would be more than the economy could bear, and might even lead to a new recession. We share the concern, and the possibility has weighed on stocks in the first days of the year.

2016 gets underway.

Despite these three issues, all of which have impacted equities to the downside, we expect the rest of the first quarter and year to be positive for equities. Fed leaders are likely to realize soon that four rate hikes this year would be very risky for the economy (they probably have already made the realization), and if they announce a change in strategy it will be positive for equities. Second, Chinese leaders are likely to implement new stimulus to arrest China’s declining growth rate. They have been hesitant to unleash the full arsenal of stimulus tools out of fear of igniting a new credit boom. Recent news has been bad The second issue concerns global economic enough, however, to make this concern secondary growth, which remains lackluster. Europe and the to worries about economic growth. More stimulus U.S. are both growing moderately, in the 1 - 2% in China would be positive for equities. Finally, range, but cracks have formed in China and lower though we believe the price of oil will continue to demand there has impacted much of the emerging fall, the decrease will have less of an impact on the market world. Uncertainty regarding the way broader stock market than it did last year. The forward for China has been a big part of the recent energy sector makes up only 5% of the S&P 500 weakness in the stock market. today, down from 10% one year ago. And it’s likely that consumer demand will rise this year in The third issue is oil. The price of crude oil has other economic sectors, as consumers spend less fallen from over $100/barrel in late 2014 to $30/ on energy. This will be an important factor for barrel today, as producers in the Middle East have corporate earnings later in the year. flooded the market. Elementary economics concludes that a lower oil price should benefit the Equity valuations, when compared to the yields economy, as consumers have more to spend on available in the bond market, are attractive other goods. But it’s also true that the energy again. The S&P 500 has an earnings yield of sector is an important part of the stock market, and 6.5%, compared to the 2.02% yield available on a many companies in other sectors depend on sales 10-year Treasury bond. This also bodes well for to the energy sector. An extremely difficult period the stock market, as investors will eventually step for energy companies has been a negative force back and take another look at relative value across for the stock market generally during the last year, asset classes. and the dynamic is continuing as the first quarter of

ENERGY When Saudi Arabia’s leadership announced in late 2014 that their country would no longer withhold oil production to maintain a high global oil price, few understood the long-term implications. They

are clear now, with the only remaining question how deep and lasting the devastation will be for private (and some government) energy producers around the world. The strategy

of Saudi Arabia’s leaders is clear: they believe that by allowing the price of oil to fall, the more highly-leveraged energy sector in the U.S. will suffer increasing bankruptcies, and that

5 this will lower production in the U.S. in the medium term.

Government controlled oil producers in Russia, Brazil, and elsewhere are likely targets of the strategy as well. Saudi Arabia hopes to eventually benefit from rising prices, once its leadership position in the global market is reestablished.

An additional goal of the Saudis is to slow the technological development of products that don’t use oil as an energy source, such as electric cars.

There are geopolitical considerations as well, as international sanctions on Iran have been lifted and more Iranian oil is set to come onto the market. Saudi Arabia is involved in proxy wars with Iran in Yemen and Syria, and would like to reassert its leadership as the global swing producer before Iran’s production is fully up and running.

Saudi Arabia’s strategy is working, at least with respect to its impact on private oil producers. The most highly leveraged producers have already entered or are rapidly approaching bankruptcy, and cracks are forming in the bonds of some mid-size (market capitalization of $5-$15 billion) private oil companies in the U.S. Many projects in the U.S., especially in the Bakken area of North Dakota, are not profitable at current prices.

Oil Production (barrels per day)

10.5m

Saudi Arabia

10.0m

9.5m

United States Q3

Q4

Q1

Q2

2014

9.0m Q3

Q4

2015 $90 $80

Brent Crude

$70 $60 $50 $40

West Texas Intermediate

$30 Q1

Q2

Q3

Q4

2015

– something that could prove devastating for many companies – will stay low for an extended period. In 2008-2009 the price of oil collapsed but rebounded quickly, as the crisis was driven by falling demand that returned relatively quickly as governments initiated emergency measures to boost the global economy. The current price collapse, however, is supply driven, and this doesn’t Investors are factoring into their bode well for oil prices, as the models an increasing chance that Saudi leadership is very likely to the price of oil will fall further and try to finish what they have

started. Falling production in the U.S. is likely to be offset by increased production elsewhere, and Saudi Arabia will be able to make up the difference if production growth slows in Iran or Iraq. The energy sector in the U.S. is down but not yet out. Saudi leaders surely understand this and will keep the pressure on. This means prices are likely to keep falling this year, possibly to $20/per barrel or even lower, and will stay low for 2016.

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ECONOMIC FORECAST | Q1 2016

GLOBAL ECONOMY Economic growth in the U.S. continues to be steady in the range of 2.0 – 2.5%, which is decent, though somewhat disappointing given the severity of the last recession. Housing continues to be a bright spot, with the Case Shiller House Price Index up 6% during the last 12 months, and 30% during the last five years. Consumer confidence is up and household income has risen 4.4% during the last year. Retail sales were up 2.2% in 2015, but the rate of growth has dropped from a year earlier.

higher wages.

Europe and Japan continue to exhibit fairly low rates of economic growth and are unlikely to provide the spark to demand the global economy needs today. The European Central Bank is likely to continue its quantitative easing program this year, as the unemployment rate in Europe is 10.5% and economic growth is near 1.5%, significantly beneath what the ECB would consider a healthy recovery. This continuation of monetary stimulus will keep downward pressure on the euro.

The unemployment rate has continued to fall steadily, and is now at 5.0%.

This is near what most 18% economists consider a 16% “normal” rate of unemployment, but behind this 14% headline number the situation is more complex. When Underemployment Rate 12% people marginally attached to the labor force and those 10% working part time are included in the analysis, the figure rises 8% to 9.9%. This “underemployment” figure has Unemployment Rate 6% also shown steady improvement during the last five years, but is still higher 2007 2009 2011 2013 2015 than pre-crisis levels. In addition, the participation rate, which measures the 67% percentage of working age people active in the labor force (either working or looking for 66% work) is just 63%. This figure has continued to fall since 65% 2009 and sits at a 40-year low.

Clearly there is still considerable slack in the labor 64% Labor Force Participation Rate market, and this has important implications for inflation and interest rates. The Fed keeps 63% predicting that inflation will materialize, but it hasn’t yet 2000 2005 2015 1985 1990 1995 2010 and is unlikely to be driven by

United States

7 The Chinese economy will be the one to watch this year, as it faces the most uncertainty. China’s leadership has been attempting to transition the Chinese economy away from an export-led model to one emphasizing more internal demand and value-added production. The road has been bumpy, however, and the economy’s growth rate, though still excellent by most standards, has continued for fall. Most troubling for investors is that growth has fallen beneath the Chinese leaders’ stated goals, creating the worry that the issues facing the country are more complex than was originally thought. This fear has manifested itself in the Chinese stock market, which has been highly volatile during the last 18 months and is down sharply in the first weeks of 2016. Initiatives designed to lower stock market volatility, such restrictions on selling and short selling, have only

increased investor anxiety.

Chinese leaders are famous for their caution, and are both slow to start a project and slow to alter course once a project has begun. Recent results have been bad enough, however, that they are likely to alter course this year. It is likely that more stimulus will be implemented, and that some aspects of the broader reform package designed to open the economy to market forces will be delayed. It’s also likely that the tightly-controlled Chinese currency, which is already down 6.0% versus the U.S. dollar during the last five months, will be allowed to depreciate further. These moves would be positive for commodity prices and for the many emerging economies that supply China with raw materials. They would also provide a boost for Chinese and global stocks.

EQUITIES The first three weeks of 2016 have been tough for equities, with the S&P 500 down 8% and volatility very high.

Valuations were not able to provide much support for stocks during the tumult of the last few weeks, as they were close to historic averages as the year began, if not slightly above.

The good news is that now valuations are more attractive.

The S&P 500 is trading at 15.4x expected 2016 earnings, which is attractive when compared to the very low yields available in the bond market. Additionally, we

expect Federal Reserve leaders to signal new caution regarding the timing of interest rate hikes, and China’s leaders to implement new stimulus this year. Both issues – fears over Fed tightening and weakness in China – have equity markets on

edge and positive news regarding either issue could propel the stock market upward, and quickly.

— Brandon Fitzpatrick

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ECONOMIC FORECAST | Q1 2016

FIXED INCOME The Federal Reserve finally raised the fed funds rate in December and the focus in 2016 will be on anticipating the speed and frequency of further rate hikes. Fed chair Janet Yellen announced her desire for four additional rate hikes this year and, as a result, the U.S Treasury yield curve has flattened. 2-year Treasury rates have increased 0.33% from a year ago, while the benchmark 10-year Treasury has risen just 0.17%.

125 120 110

Bloomberg Dollar Spot Index

110 105

Q3

Q4

Q1

Q2

2014

As much as Fed chair Janet Yellen would like to raise rates four times this 3.00% year, doing so is likely to be difficult as inflation is significantly below the Fed’s 2.50% target of 2.0%. The market currently 2.00% expects annual inflation during the next five years to be just 1.07%.

1.50% Additionally, the global economy is not particularly strong and virtually all major 1.00% trading partners of the U.S. are nowhere near raising interest rates.

0.50% If the Fed raises rates four additional times this year the dollar is likely to be 0.00% pushed even higher, and this would be -0.50% harmful for exports. It is more likely that there will be two rate hikes.

Q3

Q4

100

2015

Sovereign Yield Curves

Although long term interest rates are low in the U.S., they still offer considerable yield pick-up vis-à-vis sovereign bond yields of other developed economies such as Germany, Switzerland, and Japan.

Germany’s sovereign 10-year nominal bond yield, for example, is 0.45% vis-à-vis 2.03% for the 10year U.S. Treasury. This yield advantage will keep long term Treasury rates from drifting much higher in 2016. The yield curve should flatten further in 2016, with the 10-year rate range-bound between 2.20% and 2.50%, while the 2-year, anchored by the Fed, will be between 1.10% and 1.30%.

United States Germany

Japan

Spread

2015 was a year of low returns for fixed income markets, with the Barclays U.S. Aggregate index returning only 0.55%. Within the U.S. Aggregate Index, investment grade corporates returned -0.68%, while intermediate Treasuries and MBS gained 1.18% and 1.51%, respectively. Following a selloff late in the year, the Barclays U.S. Corporate High Yield index returned -4.47%.

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Agency MBS, as demonstrated by the Barclays U.S. MBS index, held up well despite the rate hike in December, and returned 1.51% for the year.

This good performance came in spite of $1.3 trillion of MBS (gross) issuance, while the Federal Reserve did not add any MBS on a net basis.

Agency MBS are well positioned for the next 12 to 18 months, as they offer healthy yield pick-up versus Treasuries. The Fed’s continued reinvestment coupled with slightly decreased issuance of agency MBS should help keep spreads tight in 2016.

U.S. Corporate Investment Grade index. Within this index, industrials were hit the hardest, returning -1.75%. Falling commodity prices, weakness in the emerging markets, and a strong dollar have combined to create a difficult environment for many industrial companies.

Financials returned 1.51% for the year, while consumer non-cyclicals returned 0.81%. We see ample opportunity in the credit sector today as spreads have widened amid higher supply and volatility in the equity market. — Prabhab Banskota

Investment grade corporate bonds returned -0.68% in 2015 as demonstrated by the Barclays

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ECONOMIC FORECAST | Q1 2016

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