Economic Forecast Q2 2016

Q2 2016

ECONOMIC FORECAST

April 15

DBFitzpatrick

REGISTERED INVESTMENT ADVISORS

INSIDE THIS ISSUE:

The Fed is Still Driving the Markets

4-5

China is a Wildcard

6-7

Equities Bounce Back on Fed Comments

7-8

Fixed Income: Real Rates are Down 8-9 as Inflation Expectations Perk Up

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

4

ECONOMIC FORECAST | Q2 2016

THE FED IS STILL DRIVING THE MARKETS The first quarter was choppy in the financial

emphasizing that slowing global growth and the

markets as investors reacted to the statements of

strong U.S. dollar were important factors for

U.S. Federal Reserve policymakers. The Fed, it is policymakers to consider, and argued against safe to say, is still driving the markets. The mood

faster increases in interest rates. Investors

was grim for the first six weeks of the quarter as

approved this analysis and stocks continued to rise

the equity market reacted negatively to Fed

after Yellen’s comments. By April 15th the MSCI

commentary in December that proposed a target of All Country World Index was up 1.9% year-to-date, four 25 basis point hikes to the fed funds rate in

while the S&P 500 had risen 2.5%.

2016. Investors believed that the U.S. economy was not strong enough to absorb such a policy,

There is a complicated dynamic in place between

and risky assets suffered most. The MSCI All

the capital markets and Federal Reserve policy.

Country World Index fell 9% through February 11

Fed policymakers – pushed by some hawkish

as the U.S. dollar climbed and inflation

members – want to raise interest rates. They

expectations dropped.

believe the economy is strong enough to absorb it, and view a continuation of very low rates as

February marked the bottom of the selloff as Fed

unhealthy and possibly inflationary over the long

leaders, clearly disappointed with moves in the

term. Investors do not share this optimism

capital markets, began to

125

Bloomberg Dollar Index

indicate that a change in

120

strategy might be in order. The hints continued to build in

115

March until a new plan of two 25 basis point hikes

110

(two fewer than before) to

The Fed is concerned about the dollar’s rise.

the benchmark interest rate was announced.

105

During an interview in

100

late March Fed chair Janet Yellen took more control of the narrative,

Mar 2014

Mar 2015

Mar 2016

5 regarding the

VIX Index

underlying strength

28

of the economy, and react negatively

Volatility is down as Fed turns dovish.

every time it

appears the Fed is

24

planning to raise rates. Fed leaders

20

understand that this dynamic is in place and, though often

16

forced by market

moves to backtrack on previously

Jan 2016

Feb 2016

Mar 2016

Apr 2016

announced plans, continue to push forward when they can. They

Futures markets today are predicting only a 50%

have had some successes: they were able to

probability that the Fed will raise interest rates this

raise the fed funds rate one time late last year,

year. Our view is that recent positive economic

and bond investors today see a good chance of an data, combined with a rally in the equity market, additional rate hike this year, with two hikes also

falling U.S. dollar, and increased expectations for

seen as a possibility. This is a small but important inflation during the last two months, are likely to victory for the Fed, as for years after the financial

give the Fed more room to raise rates than

crisis of 2008-2009 any hint of a slowdown to

investors currently anticipate. This argues for

monetary stimulus was viewed by the capital

more volatility in the markets later this year, and

markets with virtual panic (the “Taper Tantrum” of

would be bullish for the dollar and bearish for risky

2013 being the best example). The process

assets. There is also the potential for falling

toward normalization is likely to last longer than

inflation expectations, as investors would again

Fed leaders would like, however. In the

fear that the Fed is pushing things too far. A

meantime, Fed statements will continue to be a

careful balancing act will continue for at least the

big (and possibly the most important) factor in

rest of 2016.

short term capital market movements.

6

ECONOMIC FORECAST | Q2 2016

CHINA IS A WILDCARD The Chinese economy’s transition toward increased

China Industrial Production Growth

9.5%

dependence on internal demand continues to be

8.5%

bumpy, and this is the wildcard facing both

7.5%

investors and policymakers.

Official government figures

6.5%

say that China’s economy is growing 6.5 – 7.0%, but this is below market

Mar 2014

expectations and doubts

Aug 2014

Apr 2015

China Freight Traffic Growth

overhang the veracity of the

Dec 2015

0%

numbers. Other (official) data describing the

-5%

economy are mixed.

Industrial production is

-10%

growing but the rate of growth has declined.

-15%

Freight traffic has seen declines during the last two years, while manufacturing

Mar 2014

Sep 2014

Jun 2015

Dec 2015

growth has been flat since 2012. Retail sales are up but the rate of growth

has grown dramatically during the last decade,

has been down recently, and there are continued

and Chinese imports have risen from $1 trillion in

fears of a bubble in real estate. In summary, the

2009 to almost $2 trillion in 2013. Imports were

news is not all bad but the bottom has not yet

flat in 2014 and fell in 2015, while the early data

been reached and more investors are beginning to from 2016 are not encouraging. believe that China’s economic transition could take years. China’s importance to the world economy

China’s policymakers are trying to encourage

(and especially to commodity producing countries) growth but are wary that deploying too much

7 stimulus will result in

China Imports (Monthly)

asset bubbles down the

$180 b

road. Ultimately,

$160 b

economic growth is one

$140 b

of the pillars of the

$120 b

government’s legitimacy, and policymakers are

$100 b

trying to achieve lasting

$80 b

growth with incremental

$60 b

reforms. The efficacy of their actions is one of the biggest uncertainties

2005

2007

2009

2011

2013

2015

facing the global economy. The most likely case for the near term

markets appear to be predicting this, and it is one

is a continuation of the status quo, with somewhat

of the reasons global interest rates are still so low.

disappointing economic growth numbers. The

EQUITIES BOUNCE BACK ON FED COMMENTS The energy sector has led the

Financials Index was down 5%

underperforming sector this year,

equity markets this year, as

through mid-April. Investors fear with the S&P Global Healthcare

investor fears regarding

that banks have more exposure

Index down 3%. Within the

oversupply turned to hope that

to the energy sector than was

healthcare sector,

suppliers may agree to cap

previously believed, as many

pharmaceutical stocks have been

output. WTI crude is up 9% this

small energy producers currently especially out of favor as U.S.

year to $40 and the S&P Global

under financial strain are

politicians target the industry.

Energy Index has risen 9%. The accessing previously awarded industrial and consumer staple

lines of credit. Not all banks face The stock market is trading at

sectors have also outperformed

the same level of risk, of course,

valuations that are somewhat

the market, both rising 5% this

but until more clarity is achieved

higher than historical averages,

year. The financial sector has

investors will remain cautious

with the S&P 500 trading at 17.7x

been dragged down by U.S. bank toward the sector. Healthcare

expected 2016 earnings, and the

stocks, and the S&P Global

MSCI All Country World Index

has been another

8

ECONOMIC FORECAST | Q2 2016

trading at 16.2x.

S&P Global Energy Index

Stocks have continued to climb the “wall of worry” in the first half of

110

Dow Jones U.S. Industrial Sector Index

105 100

April, as the comments

of Fed policymakers

95

remain dovish. A change in tone would

90 S&P Global Financials Index

likely pressure stocks.

Jan 2016

S&P Healthcare Index Mar 2016 Feb 2016

85 Apr 2016

FIXED INCOME: REAL RATES ARE DOWN AS INFLATION EXPECTATIONS PERK UP The bond market rallied in the first quarter, as

underperformed the Barclays Aggregate Index

investor concern regarding interest rate hikes

during the first quarter, with the U.S. MBS Index

turned into relief after Federal Reserve

policymakers turned dovish midway through

3.50%

the quarter. The Treasury yield curve flattened, with the yield of the 10-year

2.50%

U.S. Treasury Yield Curve 12/31/2015

Treasury bond falling from 2.27% on December 31 to 1.79% on April 14. Yields

2.00%

4/14/2016

have fallen across the curve, apart from the shortest tenors. The Barclays U.S.

1.50%

Aggregate Index finished the first quarter with a return of 3.03%, led by the U.S. Treasury Index (+3.20%) and U.S. Investment Grade Corporate Bond Index

1.00% 0.50%

(+3.97%), as corporate spreads have tightened since mid-February. Agency mortgage backed securities

2Y 5Y 7Y 10Y

30Y

9

returning 1.98%.

Inflation Expectations

The real rate of interest has fallen

1.40%

5 Year

since the start of the year, and is now negative on all maturities

2 Year

shorter than seven years. The

1.20% 1.00%

falling real yield curve seems to be

0.80%

signaling renewed concerns

0.60%

regarding the health of the U.S. and global economies, while at the

1.60%

Jan 2016

Feb 2016

Mar 2016

Apr 2016

same time bond investors are predicting that Fed policymakers will respond to an economic slowdown by maintaining interest

U.S. Treasury Inflation Indexed Curve 1.00%

12/31/2015

rates at current levels (or barely above) for the rest of the year. It is this prediction that has led to rising

0.50%

inflation expectations (from very low levels earlier in the year) and to a

4/14/2016 0.00%

tightening of corporate spreads.

Moves in the bond market were

-0.50%

fairly large in the first quarter.

There is potential for a reversal of

-1.00%

some of these recent trends if the economy begins to show signs of

3Y 5Y 7Y 9Y

15Y

20Y

30Y

strength. Positive economic data would likely lead to higher interest rates, and could lead to lower inflation expectations if it appears that the Fed will be able

on the bond market, as market expectations for the

to raise interest rates two times this year, as is still short run are already pessimistic. policymakers’ stated goal. Data indicating a slowing economy may not have as much impact

— Brandon Fitzpatrick

10

ECONOMIC FORECAST | Q2 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