Economic forecast Q3 2013

ECONOMIC FORECAST

Q3 2013 JULY 11

Fixed Income Equities U.S. Economy Emerging Markets Europe DBF Strategies

INSIDE THIS ISSUE: Summary

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Fixed Income

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Equities

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U.S. Economy

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Emerging Markets

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Europe

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DBF Strategies

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

Dennis Fitzpatrick Founder, CEO, and Chairman

Brandon Fitzpatrick President, COO, and Equity Portfolio Manager

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ECONOMIC FORECAST | Q3 2013

SUMMARY Fed chairman Ben Bernanke’s comments in mid-May that the Fed would “taper” monetary stimulus as the economic recovery gains strength spooked the financial markets, sending both stocks and bonds lower in the last weeks of the second quarter. Bernanke’s announcement was meant to be innocuous, and in truth was not much different from what he had said in previous speeches. Nonetheless, the bond market was shaken by the prospect of an early end to the quantitative easing program, and the yield curve steepened. The yield on a 10-year Treasury rose from 1.60% in April to 2.60% in June. The yield on a 30-year Treasury rose from 3.10% at the end of March to 3.50% at the end of June. The real interest rate (the nominal rate minus the rate of inflation) rose in the quarter, as market expectations for inflation fell and nominal yields rose. The real rate on a 10-year Treasury was –0.67% at the end of March, before rising to 0.46% at the end of June.

We expect interest rates to fall somewhat from current levels, as bond investors take a break from the selling. In the longer term, however, interest rates are very likely to climb further as the economy continues to heal from the financial crisis, housing bust, and recession of 2008-2011. There is still a lot of danger in the fixed income markets, and we’re avoiding low quality credits and long duration bonds. Stocks are more attractive than bonds today, with attractive value in industrials, financials, and some out of favor emerging markets.

FIXED INCOME The big action in the second quarter occurred in the bond market. Bernanke’s comments prompted bond selling and sent interest rates sharply higher. The yield curve steepened and long duration bonds bore the brunt of the damage. TIPS (Treasury Inflation Protected Securities), were not spared, with inflation breakeven rates falling dramatically in the second quarter. Market expectations for inflation during the next year fell from 2.35% at the end of March to 0.74% at the end of June, while inflation expectations during the next 10 years fell from an annualized rate of 2.52% to 1.99%. The market is sending a message that it doesn’t expect much inflation without continued large-scale monetary stimulus. The market is also sending a clear warning that interest rates are set to rise as the unemployment rate falls, Fed bond purchases slow down, and the economy finally returns to a more

10-year inflation expectations 1-year inflation expectations

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Q2

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“normal” environment, five years after the financial crisis began.

Barclays High Yield Very Liquid Bond Index

Bonds of lower credit quality were hit even harder than Indonesia U.S. dollar Treasuries in the second sovereign due 2019 quarter. The Barclays High Yield Very Liquid Bond Index, Colombia local currency sovereign due 2022 which tracks high-yield corporate bonds, was down 5% from early May to late June. Emerging market sovereigns – both U.S. dollar denominated and local currency – were down sharply in the quarter, and the damage was widespread. A Mexico sovereign U.S. dollar bond maturing in 2022, for on a 30-year mortgage rose from 3.40% at the end of example, fell 7% in the quarter, while an Indonesian April to 4.61% on July 10.

U.S. dollar bond due in 2019 fell 8%. Local currency debt was hit even harder. A Colombian local currency In the beginning days of the third quarter interest rates sovereign due 2022 was off 12% in the three months have continued their march higher, with the 10-year through June, while a Philippines 10-year local currency Treasury yield reaching 2.60% on July 11. Recent sovereign fell 12%. Additionally, emerging market economic data have generally been positive, which the currencies were down virtually across the board. bond market views as giving the Fed more justification to slow down its purchase of Treasuries and MBS. We The MBS (mortgage backed securities) market also fell expect interest rates to pause somewhat, taking a break in the second quarter. Mortgage rates rose, following from their steady increase. The yield curve is likely to Treasury yields, and prices of low coupon pools fell the flatten by the end of the year, however, and in the longer most as duration extended. The expected maturity of term interest rates are very likely to rise. Our fixed low coupon pools increased significantly, as the income portfolios are positioned defensively, with an underlying mortgages are much less likely to be emphasis on high quality and short duration bonds. refinanced now that mortgage rates have risen. The rate

Lower quality bonds were hit hard in the second quarter

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ECONOMIC FORECAST | Q3 2013

EQUITIES Stocks, as measured by the MSCI All Country World will result in lower capital flows to the emerging Index, fell 0.2% in the second quarter, after being up world. There is also a nagging concern in the financial over 5% in mid-May. Stocks were affected by two markets that the economic slowdown in China will principal factors late in the quarter: 1) the prospect of worsen. Southeast Asian equities were hit especially less central bank stimulus made investors somewhat less hard in the second quarter, with the Thai, Indonesian, sanguine about economic growth and corporate profits, and Philippine stock markets all down sharply. and 2) the market’s discount rate rose along with bond Brazilian and Turkish stocks were down as well, though yields, pressuring stock prices. Rising bond yields had with these countries investors were responding more to their most severe impact on utility and consumer staple protests and political uncertainty, not to slower growth stocks, which are viewed by the market as substitutes in China and lower commodity prices. We took for bonds, due to their steady cash flows and nonadvantage of the turmoil in the stock markets to add cyclical businesses. These sectors had outperformed exposure to Indonesian and Brazilian stocks. recently, starting in 2012, but in the second quarter fell further than more cyclical sectors such as financials and The longer term story of the emerging economies is industrials. intact: growing middle classes, increased dependence on domestic demand, and strong government balance European stocks are flat for the year and, though they sheets. Emerging market valuations are compelling, fell at the end of the second quarter with the broader with the MSCI Emerging Markets Index trading at 10.2 global stock market, have by and large shrugged off times 2013 earnings, versus 14.8 for the S&P 500 and recent worries about political turmoil in Portugal. The 13.2 for EAFE (international developed stocks). With Nikkei index had a volatile second quarter but is still up slower growth in China, however, managers will have to 37% since the end of 2012 (though this is only 15% in be more choosy with their EM positions as the tide of U.S. dollar terms, as the yen has seen a sharp rising commodity prices seen in the 2000s is unlikely to depreciation). be repeated in the next decade. We have exposure to Chilean, Colombian, Brazilian, Indonesian, and Chinese Emerging market stocks fell 9% in the second quarter stocks. and are down 11% since the start of the year, as investors worry that less monetary stimulus in the U.S.

The MSCI All Country World Index ended the second quarter down slightly

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U.S. ECONOMY The U.S. economic recovery is continuing with many positive signs, but without the breakthrough growth number many have been waiting for since the recession ended in 2011. Probably the brightest sign is the housing market, which has shown continued strength during the last 12 months. Housing prices are up across the country, including previously very hard hit areas such as south Florida and Las Vegas. Housing starts are also up. Higher mortgage interest rates in the second quarter threaten to lower housing demand somewhat, but we think a robust housing recovery will continue in spite of higher rates. In fact, higher rates may be the impetus needed to get marginal buyers off the fence, as they fear the prospect of missing out on still low rates.

The Case Shiller index of house prices is up as the housing sector improves

2010

2011

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Durable goods orders were up in the second quarter

Durable goods orders are up, as is consumer Q1 Q2 confidence as consumers feel more upbeat about the housing market and their personal balance sheets. Initial jobless claims have might be positive if they prompt banks to increase been consistently below 400k, which most economists lending. believe indicates that the economy is adding jobs. Higher interest rates typically are bad for We expect the U.S. economy to grow 2.0% this year economic growth, but in the present environment they before accelerating to 2.5% in 2014.

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ECONOMIC FORECAST | Q3 2013

EMERGING MARKETS There was significant political turmoil in some notable emerging market countries in the second quarter. Higher bus fares in São Brazil’s GDP growth is below 2%.

Paulo sparked what turned into a Policymakers are working to stimulate nationwide protest against endemic corruption, political as the 2014 election looms. atrophy, and massive inequality.

Aspirations have been raised as the country’s middle class grows, and change is not coming fast enough for many. President Rousseff was caught off guard by the strength of the protests, but 2011 2012 2013 seems now to have regained her political footing. She has promised a series of reforms that, at least for now, have assuaged protestors. President Rousseff is facing reelection next year, and the political situation is becoming dire, as it will be very difficult to win without a stronger economy. Further complicating the situation is the fact that inflation is above the central bank’s target, which limits the policies available to both Rousseff and the central bank. Brazilian policymakers are now trying to encourage foreign investment and strengthen the real, though they are surely hopeful that the real’s recent depreciation will boost exports in the short run. Investors have soured on Brazilian securities -- both stocks and bonds -- and there are currently some good values in Brazil. Taking advantage of this opportunity, we recently added exposure to Brazilian stocks to our equity portfolios.

Most economies in Latin America have slowed down, largely as a result of lower commodity prices, but some countries such as Colombia and Chile are still set to grow at least 4% this year. The largest economies in southeast Asia Brazil’s Bovespa Index is have also slowed down, but down sharply this year growth there is still much better than what the U.S. and Europe can muster. Indonesia is set to grow 5% this year, while Malaysia’s economy will expand 4%. The correlation among equities in these countries has been very high in the last few weeks, and many good stocks are trading at very attractive valuations. We’ve also recently added exposure to Indonesian stocks.

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EUROPE European markets have been fairly quiet this year, with investors satisfied that the European Central Bank will serve as a backstop to prevent sovereign bond yields from spiraling out of control. Recent troubles in Portugal have not spread to the rest of Europe, and it appears that there is little risk of a further conflagration in the near term. Economic growth, however, is anemic across the continent and unemployment rates are unacceptably high.

There seems to have been somewhat of a change in attitude across the continent against “austerity” – fiscal tightening designed to bring national budgets under control – though admittedly not in Germany. There is

certainly a lot of empirical evidence indicating that austerity has not helped spur economic growth, and probably has even worsened national budget deficits (the UK is a case in point).

German elections in August offer new hope, as Chancellor Merkel, after winning a new mandate, may feel freer to inch away from austerity and instead support measures designed to encourage economic growth. Certainly that would be beneficial for Europe. We have an underweight in European stocks, though there are some good European value stocks with decent valuations, and we do have some exposure within our equity portfolios.

GDP growth in Europe

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UK

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France Spain

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DBF STRATEGIES U.S. stocks are fairly valued while Japanese stocks and other deep value sectors still look overpriced. Emerging market stocks are generally attractive, but careful country and security selection is needed as growth in China slows down. We’re overweighting emerging market stocks, though we’re not emphasizing BRIC countries (Brazil, Russia, India, China). We have a neutral weight in financials, an underweight in utilities, healthcare, and consumer staples, and an overweight in industrials.

There is still a lot of risk in the bond market, even after the recent dramatic rise in interest rates. We are steering clear of low quality bonds and have positioned our fixed income portfolios defensively as we expect interest rates to rise further.

— Brandon Fitzpatrick

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ECONOMIC FORECAST | Q3 2013

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