D.B. Fitzpatrick & Co. Quarterly Economic Forecast Q2 2013

Economic forecast

Q2 2013 April 5

The Great Rotation Europe and Japan United States Emerging Markets Fixed Income

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ECONOMIC FORECAST | Q2 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 NET OF FEES AND ANNUALIZED.

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INSIDE THIS ISSUE: Quarter One 2013 in Review

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The Great Rotation

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Europe and Japan

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United States

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Emerging Markets

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Fixed Income

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Dennis Fitzpatrick Founder, CEO, and Chairman

Brandon Fitzpatrick President, COO, and Equity Portfolio Manager

Cody Barney, CFA Principal and 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 | Q2 2013

QUARTER ONE 2013 IN REVIEW Stocks rose in the first quarter while bond yields stayed near historic lows. International and emerging market stocks trailed the S&P 500, which was up 10.6%. The MSCI Emerging Market fell 1.9% during the quarter, while the EAFE index rose 5.3%. The U.S. economic recovery is continuing, with improvement in the housing market and strengthening labor demand. Stocks ignored Washington's budget sequester stalemate but fell temporarily in February when election results in Italy failed to produce a decisive winner, and again in mid-March as a banking crisis in Cyprus shook the eurozone. Japan's Nikkei index has been one of the best performing equity indexes this year, as Prime Minister Shinzo Abe's plan to renew quantitative easing has encouraged investors. Fed chairman Ben Bernanke is still promising to keep interest rates low for the foreseeable future, which is keeping bond yields at very low levels. The "flight to quality" trade into sovereigns and safe haven currencies will not last forever, but in the first quarter it was alive and well. All tenors of the U.S. yield curve below 20 years have an implied negative real return.

THE GREAT ROTATION Government bond yields remain at rock bottom levels in virtually all developed economies that print their own currency: the U.S., U.K., Japan, Switzerland, and Canada are some of the more prominent of the group. After inflation is considered the expected real return of 10-year government bonds is negative in all those countries. Investors are continuing to place a very high premium on absolute security with their investments, and show persistent willingness to accept a negative real return on fixed income. This has some market participants — us included — predicting a "great rotation" out of fixed income and into stocks. Considering the continued low yields across fixed income markets and attractive valuations in global equity markets, it’s clear that we’re still in the early stages of the rotation.

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Investors have been searching for yield within the bond market, and are pushing down spreads in the space’s more risky and volatile segments. Corporate spreads are tight and junk yields have dropped dramatically since 2008. Some of this is due to the improving economy, but much of it is a function of risk aversion still evident in the aftermath of the financial crisis of 2008-2009. Many investors are refusing to move money from bonds to stocks, but need positive real yields which they cannot attain with most developed economy sovereign bonds.

Many emerging economy sovereign U.S. dollardenominated bonds have tight spreads, while local currency spreads have shrunk considerably during the last four years. The figure below shows the spreads of Indonesian sovereign U.S.-dollar denominated and local currency (rupiah) bonds today and at the end of 2009.

The dollar-denominated spreads are little changed from 2009, while the local currency bonds have seen spreads tighten. Despite tighter spreads, local currency emerging market sovereign debt is one of the few attractive spaces left in the global bond market, given the yield advantage and possibility of currency appreciation.

Whereas bond investors have shown increased appetite for more risky segments of the bond universe, the opposite has been happening in the stock market. Emerging market stocks underperformed in the first quarter, with the MSCI Emerging Market index down 1.9%, compared to the S&P 500 which rose 10.6%. Emerging market stocks also underperformed in 2011 and most of 2012, before snapping back in the fourth quarter. Within the global stock market investors have favored "safe haven" equities, bidding up U.S. stocks and non-cyclical sectors such as healthcare and consumer staples.

It's not surprising that European stocks have underperformed recently, given the continent's continued lethargic growth and ongoing currency crisis. But emerging market stocks' underperformance is harder to explain, given that throughout most emerging economies growth remains robust and valuations are compelling. Our read is that much of this can be explained by extreme risk aversion, which is a byproduct of the world's brush with economic and financial collapse in 2008-2009. Investors first turned to sovereign debt from countries with their own printing presses as a safe haven and shunned stocks.

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ECONOMIC FORECAST | Q2 2013

Many then moved to more risky parts of the bond universe in a hunt for positive real yields. Money has also flowed to U.S. stocks and value sectors during the last two years, but the big money has yet to move into emerging market stocks and more cyclical sectors of the equity markets. A rotation into emerging market stocks and cyclical sectors may well be the last domino to drop as investors run out of alternatives in their search for returns. Emerging market stocks are trading at a big discount to U.S. and Japanese stocks, despite much faster earnings growth.

A great rotation into stocks is in its early stages, and there is a good chance that it will gain speed soon as global growth picks up, risk aversion decreases as the financial crisis fades further into history, and bond investors finally throw in the towel and refuse to accept negative real returns. We are positioning our fixed income portfolios defensively, overweighting short duration and avoiding high yield corporates. Our equity portfolios are positioned aggressively, with overweight positions in emerging markets and cyclical sectors.

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EUROPE AND JAPAN European leaders, who have been working to calm financial markets for over four years, hit two new bumps in the road in the first quarter. The first occurred in February when elections in Italy produced an inconclusive result. This led to increased political jostling and posturing, and threw into doubt the country's willingness to press forward with economic reforms. Stocks fell after the election but rose again soon afterward as it appeared that Italy would indeed continue with reforms, at least in the short term. The next crisis came in mid-March when eurozone officials floated the idea of instituting a haircut on depositors of

restored to the financial markets, but European stocks – financials among them – have taken a hit.

Cypriot banks as part of a broader bailout of that country’s financial sector. Cyprus is a very small country and a bank bailout there should have been a minor issue for the broader eurozone. But the arbitrary nature of the original proposal sent shockwaves through the continent. If Cypriot depositors can be forced to take a haircut, who might be next? There was no apparent or predictable rule to answer that question, other than it would depend on the political calculations of negotiators at the moment. This lack of predictability commonly leads to bank runs, and European stocks declined when the plan was announced. The market’s negative reaction forced European negotiators to back away from their first plan, and in the end deposits of €100,000 or less were left untouched. As the quarter ended calm had been

economic growth in Europe and bad for European stocks. Europe can’t cut its way to prosperity in its current economic malaise, as the U.K. has thoroughly demonstrated. The fact that France is pushing Germany to ease up on austerity is good news, but in the end Merkel, who remains the most powerful politician in Europe, will respond to the political realities in Germany. Barring dramatic political upheaval in Germany this year, however, Merkel appears set to win the elections, and after earning a new mandate will continue negotiations toward a more unified eurozone.

There is risk of further turbulence in Europe later this year. German elections are scheduled for September, and Chancellor Angela Merkel and her allies are currently leading comfortably in the polls. There is risk, however, that German parties pushing for more severe austerity measures across Europe will gain political traction this summer. If this happens, Merkel could be forced to move her already pro-austerity positions even further into the austerity camp. This would be bad for

The Japanese government has created some excitement in the country’s financial markets for the first time in many years by promising a new round of

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ECONOMIC FORECAST | Q2 2013

quantitative easing to end deflation and spur growth. Prime Minister Shinzo Abe has yet to take any concrete action but his words alone prompted a 20% gain in the Nikkei index in the first quarter, and a 8% depreciation of the yen vis-à-vis the dollar. Whether macroeconomic policy can end Japan’s low growth and deflation, or if instead the country’s economic mire is an inevitable outcome of an aging population with very little immigration, is not yet clear. But after two decades of deflation and stagnation Abe is right to try. Japanese stocks, usually considered "deep value" in the equity universe have had a good run but are expensive now, trading at 19 times forward earnings.

UNITED STATES Economic data were encouraging in the first quarter, and indicated that the U.S. economy is continuing to recover. Housing prices are rising across the country, foreclosures are down considerably, labor demand is increasing, and inflation remains under control. Fed chairman Ben Bernanke has promised to keep interest rates low for the foreseeable future, and will only be pushed to raise rates by one of two things: unemployment near 5-6% or a prolonged surge in inflation. Without that, Bernanke will keep the spigot open as the recovery is still fragile and is threatened by slow growth in Europe and tremors in the European financial system. The U.S. economy has clearly turned the corner, but growth of 3% will prelude us for another year. Consumers' financial footing has improved significantly, but the broad deleveraging that began in 2008 is not over yet. We expect the US economy to grow 2.5% in 2013.

EMERGING MARKETS The emerging economies, broadly speaking, are continuing to exhibit robust growth. China's policymakers are still working to transition the Chinese economy to one more reliant on consumption than investment – a job that's not near complete – but the Chinese economy continues to grow above 7%. Most of Latin America will grow at least 3.5% this year, with the notable exception of Brazil, whose policymakers have been unable to successfully jumpstart growth despite 12 months of trying. Indonesia is growing close to 5%, while Malaysia will grow 4% this year. Sub-Sahara Africa is the new bright spot in the emerging market universe, with investors looking to take advantage of growth of 5%-7% in many countries. Ghana, Nigeria, and Zambia are doing especially well. — Brandon Fitzpatrick

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FIXED INCOME

It was a volatile quarter for the U.S. Treasury market.

After reaching a high of 2.06% on March 11, the 10year U.S. Treasury yield declined and ended the first quarter at 1.83%. This was up 7 basis points from its year-end level of 1.76%. The 2-year Treasury yield remained tightly range-bound during the quarter and settled at a yield of 0.24%, down a basis point from its December yield. The broad U.S. investment grade bond market, as measured by the Barclays U.S. Aggregate Index, was up 0.08% for March and was down -0.12% for the quarter. U.S. Treasuries have returned -0.19% so far this year, while agency mortgage-backed securities were down 0.05%, and corporate bonds were down -0.11%.

accommodation is likely to result in higher inflation and growth expectations, which should result in further increases in long-term yields.

Our Short Duration Govt/Agency portfolios have experienced strong year-to-date outperformance versus the benchmark Merrill Lynch 1-3 Year Treasury Index. We continue to harvest the relatively high yields and stability of short-term agency mortgage-backed securities. In addition, our allocation to Treasury Inflation-Protected Securities (TIPS) continues to do well as inflation expectations increased substantially during the first quarter. Our Intermediate Duration Govt/Agency portfolio have trailed the benchmark indices so far this year as yield spreads widened on low It would appear that the 30-year bull market run of coupon 30yr. agency mortgage-backed securities. long-term Treasuries is over as evidenced by their However, we are capturing these higher yield spreads return of -2.38% for the first quarter this year. We through timely reinvestment of portfolio cash flows. expect U.S. interest rates to remain on a rising trend for Given the tight yield spreads on corporate bonds and 2013, although event risk in Europe may result in some the very low yields on Treasuries, agency mortgage“safety rallies” in U.S. Treasuries along the way. The backed securities are likely to enjoy a sustained period Federal Reserve shows little sign of stopping its bond of relative outperformance, especially in a rising rate purchases, which are running at a pace of $85 billion environment. We continue to maintain a defensive per month of mortgage-backed securities and posture, with portfolio duration approximately 3.5 Treasuries. Such a significant amount of monetary years at quarter-end. — Cody Barney, CFA

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