Economic Forecast Q2 2015 Final

ECONOMIC FORECAST

Q2 2015 APRIL 16

INSIDE THIS ISSUE:

Calm Markets, For Now

4-6

Equities

6-7

Fixed Income

7-9

Dennis Fitzpatrick Founder, CEO, and Chairman

Brandon Fitzpatrick President, COO

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 | Q2 2015

CALM MARKETS, FOR NOW In the first quarter interest rates continued to be the

—0.17%. Bond yields in Europe will probably stay

dominant factor in the capital markets, as investors

low, but a continued decline is unlikely as there is little

guessed at the timing of rate increases in the U.S. and

additional room to fall.

grappled with the implications of the European Central Bank’s quantitative easing program. This divergence of monetary policies in the world’s two most important economies has already created significant turbulence in the currency markets, though both the bond and equity markets have been relatively calm so far this year. The yield of a 10-year Treasury had risen from 1.64% on

January 31 to 2.24% on March 6, but has since fallen as investors now anticipate that the Federal Reserve will delay interest rate hikes until the third or fourth quarter.

The strength of the dollar likely surprised Federal Reserve leaders, and they assumed a more dovish tone in mid-March. The likely delay of interest rate increases in the U.S. has prompted a rally in the equity

market, coupled with a fall in the dollar.

Given this, there is potential for turbulence in both the fixed income and equity markets during the rest of 2015 as the timing of interest rate increases in the U.S. comes more clearly into focus. In 2013 Fed leaders suggested that the Fed might slow down bond purchases, and this provoked a violent reaction in both the bond and stock markets. The reaction this time is likely to be less severe, as Fed chair Janet Yellen has been very careful to telegraph her intentions. That said, this will be the first rate increase since 2008, and it could still provide a jolt to the markets. Equities are not immune, as developed market stocks, at least, are fully valued. The S&P 500 and MSCI EAFE indexes are trading at 17.9x and 16.8x expected 2015 earnings, respectively. This is not cheap by historical standards.

When it became clear in mid-March that the Federal Reserve would delay its plan to begin raising rates, investors turned their

Volatility Index (VIX):

attention to the low yields of European

Markets were calm in the first quarter

22 20

bonds and pushed Treasury yields down.

18

Sovereign bond yields in Europe today are at rock bottom levels — a French

16

government 10-year bond yields just 0.35%, for example, down from 1.70% at the end of the second quarter 2014, while Swiss 10-year bonds actually yield

14

January

February

March

12

5

The U.S. economy, while not yet fully recovered from the recession

Case-Shiller U.S. Home Price Index

of 2008-2009, continues to show improvement. Home prices are

10%

rising, consumer confidence is up,

5%

and initial jobless claims are down.

The unemployment rate has fallen to

0%

5.5%, but the low participation rate — which measures the percentage of working-age adults in the

2010

2011

2013

2012

2014

-5%

workforce — demonstrates that there is still slack in the labor market (the U.S. participation rate is at a 30-year low of 62.7%).

100

Conference Board Consumer Confidence

80

Inflation in the U.S. is very low, and well below the Federal Reserve’s

60

target of 2.0%. This notwithstanding, the Fed believes that the economy is strong enough to withstand higher interest rates,

2010

2011

2012

2014

2013

40

and is determined to begin the long

10%

path to a more normal interest rate environment.

9% Europe, on the other hand, is

8%

deepening its commitment to monetary stimulus, and this divergence of monetary policies has

7%

U.S. Unemployment Rate

caused big moves in the currency markets. The U.S. dollar has risen significantly against most major

6% 2009

2010

2011

2012

2013

2014

6

ECONOMIC FORECAST | Q2 2015

currencies during the

120

last nine months. The dollar’s strength is

Bloomberg Dollar Spot Index

115

likely to impact economic growth across

110

the world in the next 612 months, as

105

consumers adjust their consumption patterns.

The Eurozone and most

Q3

Q2

emerging market

Q4

2014

Q1

100

2015

economies are likely to get a

growth, as foreign trade makes up

substantial boost, as for many of

30% of U.S. GDP. As for the future increase occurred. Given the

these economies foreign trade

path of the dollar, in previous cycles dramatic increase in the dollar seen

represents a high share of gross

of interest rate increases the dollar

domestic product. The strong dollar often gained as the date of the will hurt U.S. exports and domestic

approached, then fell after the

recently, the odds are against much more dollar strength.

Federal Reserve’s first increase

EQUITIES Consumer discretionary stocks have performed well

consumer staples have also outperformed the market.

this year, as investors take heart from an improving U.S. economy and some positive signs in Europe. The Equity valuations in the developed market economies S&P Consumer Discretionary Sector Index is up 8.2%

are not cheap. The earnings yield (the reciprocal of the

year-to-date. The energy sector, as measured by the

price to earnings ratio) of the S&P 500 Index is 5.6%,

S&P Energy Sector Index, is up only slightly year-to-

which is not high by historical standards, though it

date, but is up significantly since crude oil prices

compares favorably with the yields available in the

bottomed in mid-March. Utilities are the worst

bond market. As interest rates begin to rise, however,

performing sector so far this year, with the S&P

the earnings yield on stocks is likely to rise as well. As

Utilities Index down 5.5%, as investors have priced in

this occurs stock prices will fall unless earnings get a

the likelihood of higher interest rates. The healthcare

big boost. Both equity and fixed income investors are

sector has continued to be a strong performer, while

demonstrating a high degree of equanimity even as

7

higher interest rates approach. This calm is likely to

— Brandon Fitzpatrick

be put to the test in the coming months.

Earnings Yield 7.0% 6.0% 5.0% 4.0% 3.0% 2.0%

1.0% 0.0%

S&P 500

MSCI EAFE Index

MSCI All Country World Index

10-year Treasury Yield

FIXED INCOME U.S. Treasury yields declined in March as bond investors reassessed the chances of interest rate hikes occurring this summer.

The Federal Open Market Committee

Evolution of Treasury Yield Curve (year-to-date)

(FOMC) was dovish during their

Reserve will increase the Fed Funds The Federal Reserve’s increased

March meeting, and this lowered the rate by September from 48% in

dovishness is caused by two main

implied probability that the Federal

factors. The first is the recent

February to 34% today.

8

ECONOMIC FORECAST | Q2 2015

strength of the dollar, which

2.0%

threatens the competitiveness of U.S.

1.5%

exporters. Second, with year-over-year inflation at

0.0% in March there is no imminent inflationary threat in the U.S. The Fed knows there is risk to raising rates too soon, and is likely to

1.0%

U.S. Consumer Price Index (urban consumers) Q2

delay a few more months

Q3

0.5%

Q4

2014

Q1

0.0%

2015

with inflation this low.

Agency MBS underperformed Treasuries by 0.19% year-to-date through March 31, as demonstrated by the Barclays U.S. Government Intermediate Index and the Barclays U.S. MBS Index. The underperformance was due to higher volatility in the fixed income market, which led to higher prepayments and higher MBS supply during the first quarter. $287 billion of agency MBS were issued in the first quarter, $91 billion more than a year earlier. Within the MBS sector, Ginnie Mae securities underperformed Fannie Mae and Freddie Mac MBS as the FHA reduced annual MIP (mortgage insurance premium) from 1.35% to 0.85%, prompting investors to expect a rise in prepayments.

Corporate bonds have performed well despite record debt issuance. Falling yields have prompted corporations to issue debt to finance acquisitions, lower

2.5%

U.S. Treasury Yield Curve

2.0% 1.5%

Spain Sovereign Curve 1.0%

0.5% 0.0%

German Sovereign Curve

financing costs, and improve liquidity.

While doing so they have provided investors the extra yield they crave. $204 billion of investment grade corporate debt

-0.5%

4Y

10Y

20Y

30Y

9 was issued through February 28, led by Actavis ($21 billion) and Medtronic ($17 billion). Corporations are taking advantage of the low yield environment to lock in cheap financing for longer periods. The maturity of recently issued corporate bonds averages 15 years vis-à-

vis 12 years for debt issued during 2004-2013.

TIPS have underperformed Treasuries year-to-date as the Merrill Lynch 3-5 year U.S. TIPS Index returned 1.03% through March, while the Merrill Lynch 3-5 year U.S. Treasuries Index gained 1.48%. Inflation expectations have increased recently, however, as oil prices have stabilized. Annual expected inflation during the next three years is 1.35%, up from 0.75% at year-end. We expect inflation will continue to rise to the Federal Reserve’s stated goal of 2% in the next 2-3 years. — Prabhab Banskota

10

ECONOMIC FORECAST | Q2 2015

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