Economic Forecast Q1 2017

Q1 2017 January 5

ECONOMIC FORECAST

DBFitzpatrick

REGISTERED INVESTMENT ADVISORS

INSIDE THIS ISSUE:

2016 In Review

4—5

Bonds Are Attractive After Big Move

5—7

Politics Will Dominate in 2017

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

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ECONOMIC FORECAST | Q1 2017

2016 IN REVIEW 2016 was an eventful year in the The end of 2016 provided a new through Congress and that it will financial markets, with much of twist, with Donald Trump winning have a positive impact on the action driven by policy the U.S. presidential election in a economic growth. At the same changes and political shocks. The major upset. Many predicted time the market is skeptical that year began with the stock market that a Trump victory would be Trump will be able to institute the down sharply, as investors disastrous for equities, but stocks protectionist trade policies he worried that a slow‐growing held up in the days after the promoted on the campaign trail, economy could not bear the election and continued rising and this skepticism has allowed multiple interest rate hikes the through year‐end. Investors are the bull market in equities to Federal Reserve was promising to betting that a fiscal stimulus bill continue. implement in 2016. The Fed has a good chance of getting backed away from its plan in mid‐February and this sparked a recovery in equities that lasted through year‐end. In the end the Fed was able to raise rates only one time in 2016, at its last policy meeting in December.

The next big event of 2016 was the unexpected result of the ‘Brexit’ vote in June, in which British voters voted for withdrawal from the European Union.

There was a brief jolt to stocks around the world, but the recovery was fast as investors ultimately predicted that Britain’s exit was unlikely to lead to greater contagion in Europe. Britain’s departure will be a drawn‐ out process, but it appears that most of the damage will be contained to the U.K.

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The market has taken an optimistic view of the new political reality in the U.S., with interest rates up sharply since the election, inflation breakeven rates also higher, and cyclical equity sectors such as industrials and materials up significantly as well. Higher interest rates have been tough on bond market indices and equity sectors more correlated with bonds, such as consumer staples and utilities.

BONDS ARE ATTRACTIVE AFTER BIG MOVE The move in the fixed income market since the The second reason for optimism regarding bonds U.S. election in November has been dramatic, with is the fact that the European Central Bank has the yield of the 10‐year Treasury bond climbing promised to continue its bond buying program from 1.86% on November 8th to 2.45% at the end of December. The yield curve has steepened considerably. The principal driver of this bond sell‐off has been the expectation that increased government spending on infrastructure projects will spur economic growth in the U.S. There are good reasons to believe that the bond market has moved too far, too fast, however. The first is that it is not clear what kind of spending bill President‐ elect Trump will be able to get Congress to approve. Trump will almost certainly face opposition from many in his own party who have campaigned for years on the virtues of fiscal austerity. The ultimate political compromise might produce a disappointing result for investors.

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ECONOMIC FORECAST | Q1 2017

through all of 2017 (though monthly purchases are set to fall from €80 billion per month to €60 billion in April). Economic growth in Europe remains below 2.0% and inflation is subdued. ‘Core’ inflation (ex‐food and energy) has risen recently but is still below 1.0%, and significantly below ECB policymakers’ 2.0% target.

Quantitative easing is keeping bond yields in Europe very low: 10‐year sovereign bond yields in Germany, Holland, and France are 0.26%, 0.41%, and 0.77%, respectively, significantly beneath the 2.40% a 10‐year Treasury offers today. The low yield environment in Europe is likely to continue, at least through mid‐2017, and this should provide a tether for yields in the U.S. Finally, there will be a presidential election in France in April and parliamentary elections in Germany later in the year, both of which represent significant risks for the financial markets. The Brexit vote and Donald Trump’s victory show that the populist threat in the developed world is real, and that the status quo of economic integration and open markets is under severe threat. If populist politicians prevail in either France or Germany, it is very likely that safe‐haven assets will rally considerably

and risky assets will suffer.

Given these dynamics, Treasuries and agency mortgage‐backed securities are especially attractive today, and we expect them to recover after their recent underperformance. Corporate

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spreads have continued to tighten recently and there is less relative value in credit.

Additionally, the stock market appears somewhat extended as 2017 begins. The S&P 500 is currently trading at 17.4x

expected 2017 earnings. This is Treasury which is 2.40%. The somewhat high by historical difference between these two standards and harder to justify yields (a higher figure argues for on a relative valuation basis given relative value in stocks) has the recent increase in bond shrunk significantly during the yields. The earnings yield of the last eight weeks.

S&P 500 (using 2017 earnings) is 5.75% vs. the yield of a 10‐year

POLITICS WILL DOMINATE IN 2017 Given the seismic shifts taking place in Washington and their importance for the financial markets, we must make some predictions regarding political dynamics and policy outcomes in the U.S. The first issue is President‐elect Trump’s proposed $1 trillion infrastructure program. Despite opposition from some Republican elected officials, it is likely that a significant figure (in the hundreds of billions of dollars) will be approved by Congress and new infrastructure projects implemented. This spending will provide a needed spark for the real economy, though it’s likely that the financial markets will be disappointed with the ultimate figure agreed to, which will be far below $1 trillion.

This prediction argues against risky assets, which have risen in anticipation of a bigger number, and in favor of safe‐havens.

it seems likely that he’ll push forward on the issue.

Resistance to protectionism in Congress is likely to be fierce, however, and the broader business community has yet to begin fighting back in force (this is sure to happen soon). There will be a significant political tussle in the months ahead, but in the end we don’t expect the president‐elect to achieve significant restrictions to trade, though the browbeating of individual companies through the media is almost certain to continue.

In conclusion, we see headwinds for stocks in the near term, though within the equity sector there is decent value in defensive sectors such as consumer staples and healthcare. More cyclical equity sectors such as industrials and materials, on the other hand, are less attractive after their recent run. We expect Treasury yields to The second issue is Donald Trump’s promised trade consolidate in the near term, with elevated restrictions, which, if implemented, would be volatility as the market digests the changing extremely deleterious for economic growth and political dynamics. Treasuries and agency MBS would almost certainly lead to higher inflation.

They would also be decidedly negative for both the look especially attractive in the near‐term. stock and bond markets. Some had predicted that — Brandon Fitzpatrick Trump would soften his rhetoric regarding trade after he won the election. He has not done so and

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ECONOMIC FORECAST | Q1 2017

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.

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