ECONOMIC FORECAST
Prabhab Banskota
BULLMARKETCONTINUES
Both bonds and stocks rose in the first half of the year as investors took heart from GDP data. Economic growth in the U.S. has not been slow enough to convince investors that the post-crisis recovery is off-track, and has not been fast enough to convince central bankers to raise interest rates. Additionally, growth in the emerging economies has been decent and consistent with expectations so far this year. Interest rates in the U.S. have fallen significantly, and the Barclays Aggregate Bond Index rose 3.9% year-to-date through June, while the global stock market as measured by the MSCI All Country World Index was up 6.5%. The “decoupling” of emerging market stocks from U.S. and EAFE stocks seen in 2013 has abated, and all major international indices have recorded similar returns this year. The S&P 500 was up 7.1%, the EAFE index rose 5.2%, and the MSCI Emerging Market Index was up 6.1% year-todate through June.
Both the bond and stock markets were very calm in the second quarter,
Year-to-date
even in the face of heightened instability in the Middle East. Financial markets have been ignoring geopolitical risk and have been focusing instead on two other issues: slow but steady growth in the global economy, and promises of continued monetary stimulus in Europe and Japan. The stimulus has created some “bubble” like conditions in parts of the bond market – high yield corporates and peripheral European sovereigns are notable examples – and has pushed U.S. stocks to full valuations. European and emerging market stocks still have room to run as their valuations remain attractive.
S&P500
Equity Returns
MSCIAll Country World Index
MSCI Emerging Markets Index
EAFE Index
STIMULUSSTILLDRIVINGRETURNS
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.
There are two major factors underlying this tranquil environment. The first is that the U.S. economy, though 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 Q1 Q2
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 with this hoped-for scenario so far this year, and the Fed has reacted calmly and resolutely.
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.
This good news notwithstanding, there are some storm clouds gathering for the stock market. Geopolitical risk has clearly increased in recent weeks as turmoil has spread in Syria and Iraq, and threatens to erupt in other parts of the Middle East. The biggest risk regarding the Middle East from the view of the financial markets is, as usual, the prospect of a disruption of oil supplies. Iraq’s oil fields are of increased importance to global supplies, and their huge reserves makes them very important to the market’s forecast of global production over the next 5-10 years. Surprisingly, oil prices have been relatively calm in spite of the recent negative headlines out of Iraq. Brent crude rose to
$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.
Despite the recent equanimity regarding the various conflicts in the Middle East, financial markets could
be jolted to attention with a seriously negative headline. The market is correct that, in the longer run, the complicated issues in Iraq and the broader Middle East will likely not prove damaging to the global economy. But today much of the stock market is close to fully valued and unexpected bad news could cause a jolt.
EQUITYVALUATIONS
The U.S. stock market strongly outperformed both EAFE and emerging market stocks in 2012-2013, though this was primarily due to an increase of “earnings multiples”, not earnings growth. The market’s discount rate for U.S. corporate earnings fell during those years, while the discount rate on emerging market corporate earnings stayed roughly unchanged. There has been a change this year, however, as the three main regional equity sectors have all risen roughly the same amount. In other words, investors’ discount rates for stocks from these three regions have moved similarly this year. This change in market sentiment bodes well for emerging market stocks going forward, as they are still trading at a sharp discount to both U.S. and EAFE stocks. Continued
Earnings
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
stimulus out of Japan and Europe strengthens the case for emerging market equities, since they’re one of the last sectors trading at cheap valuations.
Brandon Fitzpatrick
FIXEDINCOME
U.S. Government indices have returned 4.03% and 1.55%, respectively.
There are multiple reasons driving the decline in the U.S Treasury yield curve:
With the surge in equity markets in 2013, investors rebalanced their portfolios or took profits by selling equities and buying bonds, especially Treasury bonds.
U.S. GDP grew at a dismal -2.9% (annualized) in the first quarter of
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%. Inflation has not picked up despite easy monetary policy, especially in Europe and Japan. This remains a major concern for central bankers. The financial markets are forecasting prolonged accommodative monetary policy.
Geopolitical risk, heightened tension in Iraq, continued unrest in Syria, and uncertainty regarding Putin’s next adventure have helped
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.
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.
U.S. Treasury Yield Curve
Year-over-Year Change in Consumer Price Index (CPI)
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.
In addition to the growth momentum, as the Federal 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
2.7% to 3.2% through the end of 2014.
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.
Prabhab Banskota
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 RETURNS FROM A COMPOSITE. ALL RETURNS ARE GROSS OF FEES AND ANNUALIZED.