Economic Forecast Q3 2014

ECONOMIC FORECAST

Q3 2014 JULY 11

INSIDE THIS ISSUE:

Bull Market Continues

3

Stimulus Still Driving Returns

3-4

Equity Valuations

5

Fixed Income

5-6

Dennis Fitzpatrick Founder, CEO, and Chairman

Brandon Fitzpatrick President, COO, and Equity Portfolio Manager

Prabhab Banskota Fixed Income Portfolio Manager

D.B. Fitzpatrick & Co. 800 W. Main Street, Suite 1200 Boise, ID 83702 (208) 342-2280 www.dbfitzpatrick.com

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ECONOMIC FORECAST | Q3 2014

BULL MARKET CONTINUES Both bonds and stocks rose in the first half of the year as even in the face of heightened instability in the Middle investors took heart from GDP data. Economic growth East. Financial markets have been ignoring geopolitical in the U.S. has not been slow enough to convince risk and have been focusing instead on two other investors that the post-crisis recovery is off-track, and issues: slow but steady growth in the global economy, has not been fast enough to convince central bankers to and promises of continued monetary stimulus in Europe raise interest rates. Additionally, growth in the and Japan. The stimulus has created some “bubble” like emerging economies has been decent and consistent conditions in parts of the bond market – high yield with expectations so far this year. Interest rates in the corporates and peripheral European sovereigns are U.S. have fallen significantly, and the Barclays notable examples – and has pushed U.S. stocks to full Aggregate Bond Index rose 3.9% year-to-date through valuations. European and emerging market stocks still June, while the global stock market as measured by the have room to run as their valuations remain attractive.

MSCI All Country World Index was up 6.5%. The “decoupling” of emerging market stocks S&P 500 from U.S. and EAFE stocks seen in 2013 has MSCI All Country abated, and all major World Index international indices have recorded similar returns this year. The S&P 500 was up 7.1%, EAFE Index the EAFE index rose 5.2%, and the MSCI Emerging Market Index was up 6.1% year-toMSCI Emerging date through June.

Markets Index

Year-to-date Equity Returns

Both the bond and stock markets were very calm in the second quarter,

Q1

Q2

STIMULUS STILL DRIVING RETURNS The financial markets have been calm so far this year.

The VIX Index, a measure of the stock market’s volatility, has fallen and is as low as it’s been in seven years. Consistent with this placid atmosphere, the stock market has risen steadily this year through June, with only a short-lived drop in January and February.

for another year. The economy is performing well from the point of view of the stock market – steady and moderate growth combined with low inflation is preferred. Eventually the Fed will have to raise interest rates, but the stock market is hoping the transition will be slow and clearly explained with maximum anticipation. U.S. economic growth has been consistent There are two major factors underlying this tranquil with this hoped-for scenario so far this year, and the Fed environment. The first is that the U.S. economy, though has reacted calmly and resolutely. slowly strengthening, remains weak enough that the Federal Reserve is unlikely to begin raising interest rates The second important factor driving the calm and rising

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ECONOMIC FORECAST | Q3 2014

stock market is monetary stimulus in Japan and Europe. The Bank of Japan has continued on its push to fight deflation and stimulate the country’s torpid economy, and the European Central Bank has instituted further easing (with a negative interest rate charged on bank funds held at the ECB) and promises to do more if economic growth requires it. This increase in global liquidity has been good for risky assets – especially corporate bonds and sovereign bonds from peripheral Europe, in addition to stocks.

Volatility Index (VIX)

2011

2012

$115 in the days after rebels captured Mosul in northern Iraq, but has since fallen to $108. The market seems to be predicting that, whatever the ultimate solution to Iraq’s imbroglio, oil production in the country will not be disturbed.

2013

2014

be jolted to attention with a seriously negative headline. The market is correct that, in the longer This good news notwithstanding, run, the complicated issues in Iraq there are some storm clouds and the broader Middle East will gathering for the stock market. likely not prove damaging to the Geopolitical risk has clearly global economy. But today much of increased in recent weeks as turmoil the stock market is close to fully has spread in Syria and Iraq, and Despite the recent equanimity valued and unexpected bad news threatens to erupt in other parts of regarding the various conflicts in the could cause a jolt. the Middle East. The biggest risk Middle East, financial markets could regarding the Middle East from the view of the financial markets is, as usual, the prospect of a 3.0% disruption of oil supplies. Iraq’s oil fields are of increased importance to global 2.5% supplies, and their huge reserves makes them very important to the market’s 2.0% forecast of global production over the next 5-10 years. Surprisingly, oil prices have been 1.5% relatively calm in spite of the recent negative 2011 2012 2013 2014 headlines out of Iraq. Brent crude rose to

U.S. GDP Growth Rate

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ECONOMIC FORECAST | Q3 2014

EQUITY VALUATIONS The U.S. stock market Price to Earnings Ratio strongly outperformed (expected 2015 earnings) both EAFE and emerging market stocks 16 14.8 in 2012-2013, though 13.3 14 this was primarily due to 12 an increase of “earnings 10.5 multiples”, not earnings 10 growth. The market’s 8 discount rate for U.S. 6 corporate earnings fell 4 during those years, while the discount rate on 2 emerging market 0 corporate earnings S&P 500 EAFE MSCI Emerging stayed roughly Markets Index unchanged. There has been a change this year, however, as the three main regional equity sectors have stimulus out of Japan and Europe strengthens the case all risen roughly the same amount. In other words, for emerging market equities, since they’re one of the investors’ discount rates for stocks from these three last sectors trading at cheap valuations. regions have moved similarly this year. This change in market sentiment bodes well for emerging market — Brandon Fitzpatrick stocks going forward, as they are still trading at a sharp discount to both U.S. and EAFE stocks. Continued

FIXED INCOME At the end of 2013 the financial markets as well as most economists were expecting rising rates and the end of the bull run in the fixed income market. However, the opposite happened. U.S. Treasury yields declined and the fixed income market performed well in the first half of 2014. As of June 30, 2014, the 30-year U.S. Treasury bond has returned 13.77% while the 10-year bond has returned 6.13%. For the same period, the Barclays U.S. Aggregate index has gained 3.93%, while the U.S. Mortgage Back Securities (MBS) and Intermediate

U.S. Government indices have returned 4.03% and 1.55%, respectively.

2014, revised from earlier stated -1.0%. Policymakers have now reduced their growth forecast for the U.S. economy from 2.9% to 2.2%.

There are multiple reasons driving Inflation has not picked up despite the decline in the U.S Treasury yield easy monetary policy, especially in curve: Europe and Japan. This remains a major concern for central bankers.

With the surge in equity markets in The financial markets are 2013, investors rebalanced their forecasting prolonged portfolios or took profits by selling accommodative monetary policy. equities and buying bonds, especially Treasury bonds.

Geopolitical risk, heightened tension in Iraq, continued unrest in U.S. GDP grew at a dismal -2.9% Syria, and uncertainty regarding (annualized) in the first quarter of Putin’s next adventure have helped

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ECONOMIC FORECAST | Q3 2014

to keep yields low.

Nominal yields on European sovereign bonds have been decreasing as investors are “searching for yield”. 10-year Spanish bonds, which yielded 7.62% in July 2012, yielded 2.58%, 0.03% less than comparable duration U.S. Treasuries on June 9, 2014.

Financial markets are not factoring in the credit risk associated with European sovereign bonds.

U.S. Treasury Yield Curve

Finally, monetary policy from the Federal Reserve will be accommodative. The Fed anchors the short term Treasury rates with the Fed Funds rate. The financial markets expect the Federal Funds rates to increase no sooner than the second half of 2015. The Fed is also keeping the long end of the Treasury yield curve depressed by buying long-term U.S. Treasury bonds through the Quantitative Easing (QE3) program.

Year-over-Year Change in Consumer Price Index (CPI)

2.7% to 3.2% through the end of 2014.

We anticipate U.S. growth momentum to accelerate during the second half of 2014 and 2015. With a modest increase in inflationary expectations (resulting from a stronger economy), U.S. growth should prompt rates to rise.

DBF short duration and intermediate duration portfolios have performed well in 2014. At the same time, the portfolios are positioned to “cushion” the effects of moderately rising yields.

In addition to the growth momentum, as the Federal — Prabhab Banskota Reserve unwinds the current bond buying program there will be upward pressure on Treasury yields.

However, other parameters described above will work against rising yields. Overall, we expect the yield curve to steepen slightly in the next two quarters and the U.S. 10-year Treasury yield to be range-bound between

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D.B. Fitzpatrick & Co. 800 W. Main Street, Suite 1200 Boise, ID 83702 www.dbfitzpatrick.com | (208) 342-2280