Q1 2018 January 5
ECONOMIC FORECAST
DBFitzpatrick
REGISTERED INVESTMENT ADVISORS
INSIDE THIS ISSUE:
Yield Curve Flattening Likely to Continue
3–4
Equity Bull Market Rolls On
5–6
DB Fitzpatrick 800 W. Main Street, Suite 1200 Boise, Idaho 83702 (208) 342-2280 www.dbfitzpatrick.com
3
YIELD CURVE FLATTENING LIKELY TO CONTINUE The big story in the fixed income
spreads on mortgage-backed
MBS and Bloomberg Barclays U.S.
market in 2017 was the flattening of securities also declined as interest
3-5 Year Corporate indices returned
the U.S. Treasury yield curve. The
rate volatility was relatively muted
2.47% and 3.28%, respectively.
U.S. Federal Reserve Bank raised
throughout the year (Exhibit 3). The Federal Reserve policymakers are
the fed funds rate three times during Bloomberg Barclays U.S. Aggregate promising to raise the fed funds rate the year as policymakers began the
Bond Index returned 3.54% in 2017, three additional times in 2018 and,
long process of interest rate
while the Bloomberg Barclays U.S.
given their successful follow-
normalization, resulting in higher yields on the short end of
Exhibit 1: U.S. Treasury Yield Curve
the curve (Exhibit 1). In spite of a strengthening economy, however, inflation (as measured by the core consumer price index) fell in the first and second quarters and remained low for the rest of the year (Exhibit 2). Low inflation readings were the
driving force behind the curve’s overall flattening, with the yield of a 30-year Treasury bond actually falling in 2017. The 10year Treasury yield reached a low of 2.04% in early September and bounced back in the fourth
quarter to end the year at 2.41%, virtually unchanged since January 1. Corporate spreads fell throughout 2017 as the equity market rallied, and nominal
Exhibit 2: U.S. Consumer Price Indices
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ECONOMIC FORECAST | Q1 2018 through on similar promises in 2017, there is a high likelihood that they will fulfill this promise. It is also
We are forecasting an upward shift of the U.S.
likely that policymakers continue the process of
Treasury yield curve in 2018, with a slight flattening
shrinking the Federal Reserve’s $4.5 trillion balance
as the short end continues to be pushed higher with
sheet that began in October. The Fed is still
rising fed funds rates. A strengthening economy
reinvesting much of the proceeds of maturing
should push inflation higher and result in higher yields
Treasuries and agency MBS bought during the last
on the long end of the curve, but the move on the long
several years, but has lowered the rate of reinvestment. end will be tempered by the continuation of the Currently only $6 billion of Treasury debt and $4
shrinking of the Federal Reserve’s balance sheet and
billion of mortgage-backed securities are rolling off of its mollifying impact on inflation. A stronger the Fed’s balance sheet each month, but this ‘roll-off’
economy would normally benefit corporate bonds
rate is scheduled to increase in 2018.
broadly as a relative value play versus Treasuries, but given the very tight corporate spreads today we
Fed policymakers face a serious dilemma as they
believe it prudent to avoid lower quality corporates.
decide on the speed of the balance sheet unwind
We have positioned our fixed income portfolios with
process. If they move to unwind the balance sheet too this overall forecast in mind, lowering duration slowly inflation could conceivably rise to slightly in most strategies and holding only high uncomfortably high levels as the economy strengthens. quality names within our exposure to corporate bonds. If they move too quickly, Exhibit 3: Corporate and MBS Spreads however, the real economy could be negatively impacted – perhaps pushed into a recession – and inflation could fall even further below the Fed’s 2.0% target. The recent flattening of the yield curve shows that this is the bigger risk, but Fed leaders seem determined to press ahead with the reinvestment rate previously announced.
5
EQUITIES: BULL MARKET ROLLS ON 2017 was a great year for equities as sales were up in 2017 as well. The
However, the outlook for equities in
a strengthening economy inspired
U.S. unemployment rate is 4.1%, a
2018 is cloudy. The U.S. economy
investor optimism. The MSCI All
level last seen in 2000.
has been strengthening and the
Country World Index (which
recently passed tax reform package
measures the global stock market)
Technology stocks were the best
will bolster corporate earnings in
returned 25% during the year.
performers in 2017, with the Dow
most sectors. On the other hand, tax
International stocks led the way,
Jones U.S. Technology Sector Index reform impacts are almost certainly
with the MSCI Emerging Market
returning 37%. Material stocks also already priced into the market, the
Index up 38% and the MSCI EAFE
had a banner year, with the S&P
U.S. Federal Reserve has begun a
Index returning 26%. Domestic
Global Materials Index up 30%.
rate tightening cycle, the U.S.
stocks had a good year but
Consumer staple stocks had a good
Treasury yield curve has flattened
underperformed the global stock
year but underperformed the broader and equity valuations are high by
market with the S&P 500 returning
market, with the S&P Global
historical standards (the S&P 500 is
22% (Exhibit 1).
Consumer Staples Index returning
trading at 18.1x expected 2018
18%. Energy was the worst
earnings).
Strong economic fundamentals are
performing equity sector by far, with
behind much of this solid
the S&P Global Energy Index up
We believe it prudent to be
performance. Industrial production, just 6% in 2017 (Exhibit 2).
somewhat defensive in positioning
manufacturing, and retail sales data
our equity portfolios, and today hold
in the U.S. all accelerated in the second half of the year, and U.S GDP growth rose at an annualized rate of 3.2% in the third quarter. Housing data have also exhibited excellent results. The Case-Shiller National Home Price Index increased by 6% in 2017 (having risen every year since 2011) and is approaching its all-time high reached in 2006. Housing starts and existing home
Exhibit 1: Global Stock Indices
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ECONOMIC FORECAST | Q1 2018 overweight positions in the healthcare and consumer staple
Exhibit 2: All Country World Index Sectors
sectors. We are underweight technology and consumer discretionary stocks, and neutral
financials and industrials. If the equity market corrects in the near term we will rebalance into the industrial and consumer discretionary sectors, which tend to be more cyclical than the broader market. However expensive or cheap the overall stock market appears, investors should stay invested and near asset allocation targets that are consistent with their longterm goals. Doing so results in the highest probability of reaching long-term performance targets.
— Brandon Fitzpatrick
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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 MODEL RETURNS FROM A COMPOSITE.
DB Fitzpatrick 800 W. Main Street, Suite 1200 Boise, Idaho 83702 www.dbfitzpatrick.com | (208) 342-2280