Economic Forecast Q3 2015

ECONOMIC FORECAST

Q3 2015 JULY 15

INSIDE THIS ISSUE:

Eurozone Turmoil

4-5

China

6

Equities

7

Fixed Income

8-9

Dennis Fitzpatrick CEO and Chairman

Brandon Fitzpatrick COO and President

Prabhab Banskota Fixed Income Portfolio Manager

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

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ECONOMIC FORECAST | Q3 2015

There have been two main dynamics driving investor

As for Europe, the issues are much more tangled, and

sentiment in recent weeks, and the unpredictable nature the plans and calculations of politicians more difficult of both has led to increased volatility in the stock and

to discern. As the third quarter begins, the Greek

bond markets. The first is the approach of interest rate

government has agreed to the demands of the country’s

hikes in the United States, and the second is political

creditors, and the possibility of an immediate exit of

turmoil in the Eurozone. In the case of interest rates,

Greece from the Eurozone has abated. This (albeit

that rates will eventually rise is assured, but the timing

short-term) resolution has been good for risky assets,

of rate hikes in uncertain. The Federal Reserve is

including stocks, and has put pressure on bond prices as

anxious to begin restoring interest rates to more typical

investors unwind some of their ‘safe-haven’ positions.

levels, but sees little inflationary pressure in the

It is unlikely that we have seen the end of the drama in

economy and is wary of slowing economic growth.

Europe, but in the longer term whether Greece remains

Given the recent volatility in the capital markets, we

in the Eurozone is not of much importance to the global

expect the Fed to wait until later this year or early 2016 economy, nor to investors. before raising policy rates.

EUROZONE TURMOIL The markets were shaken by the Greek government’s

million and a gross domestic product of $300 billion,

decision to break off negotiations with Eurozone

which is roughly the size of Connecticut’s economy.

leaders in late June, and as the second quarter

The broader Eurozone, on the other hand, has a

concluded volatility in the capital markets was high.

population of more than 330 million and a GDP of $13

The MSCI All Country Index of global stocks fell 4.8% trillion. Obviously, Greece on its own is not terribly from June 26 to July 8, though stocks gained back some significant to the Eurozone, let alone to the global of those losses in subsequent days. The VIX, a measure economy. Some investors are still wary of the of market volatility, spiked in late June and early July.

possibility, however, that an exit of Greece from the

Markets always hate uncertainty, and the brinksmanship monetary union could cause a new crisis in the shown by Greece’s prime minister produced significant continent’s financial system. This possibility, albeit uncertainty in the minds of investors.

small, is what has driven the spike in market volatility in recent weeks.

When analyzing the situation facing Europe, some perspective is required. Greece has a population of 11

5

Investors’ fears are

MSCI EAFE

exaggerated. The private institutions that hold

106 104

Greek debt have had years to prepare for a possible

102

default and haircut.

Moreover, over 80% of the debt that Greece owes

S&P 500

is held not by private

MSCI All Country World

100

banks and investors, but

98

by other Eurozone governments, the IMF,

April

and the European Central

May

June

July

Bank, who can absorb a

20

loss. The European Central Bank is now deep into its quantitative easing

VIX

Greek Prime Minister announces referendum

program, and, if faced with Greece leaving, is

18 16

almost certain to buy additional bonds to keep interest rates low in the

14

rest of the monetary union. ECB chairman Mario Draghi has not

April

May

June

July

backed down from his pledge to do ‘whatever it takes’ to

European markets in the long run, as worry among investors. In the short

save the euro, and he has credibility the brinkmanship that has become a run, however, a collapse in with bond investors.

Having Greece out of the Eurozone would probably be better for

recurrent theme in the negotiations

negotiations would cause renewed

between Greece and its creditors

volatility in the financial markets.

creates significant uncertainty and

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ECONOMIC FORECAST | Q3 2015

CHINA A few words are in order regarding short-term fall, but this kind of

competence of China’s

the tumultuous ride of the Chinese

meddling is deleterious to investor

leaders. Investors desire

stock market during the last few

confidence in the long run.

predictable policies from political

months. Chinese stocks had an excellent first quarter, with the

leaders, and this has been in short This episode is relevant to investors supply in recent days.

Shanghai Composite Index up 60% because it demonstrates the fragility through mid-June. The gain was

of financial markets in China, and

China’s economy will continue to

driven by speculators and Chinese

offers insight into the thinking of

grow, and the country’s rise as an

retail investors, many of whom

Chinese policymakers. China’s

economic power is little affected by

opened brokerage accounts for the

leaders are clearly wary of markets

these events. The adoption of

first time, seeking to cash in on the

and will continue to interfere when

China’s currency as a global reserve

positive momentum of

they view market results as

currency has been delayed,

stocks. Cracks began appearing in

excessive in any direction. The

however. For investors it will take

early June, and in the following

policies during the last few months

some time for China’s

weeks the Shanghai Composite fell were erratic and have greatly

policymakers to overcome the

30%. The government, alarmed by shaken investor confidence in the

damage recently done to their

the fall, has taken

160

drastic action to prop up the stock market. Initial

Shanghai Composite

public offerings

140

have been suspended, margin rules have been

120

relaxed, and large institutions now face restrictions on

100

the sale of equities.

These actions have helped to arrest the

January

March

May

July

7

EQUITIES Despite heightened

115

Healthcare

volatility in recent

110

weeks, the stock market

is up slightly year-to-

Consumer Disc.

date. There has been significant variance in

100

Energy

the returns among

105

sectors,

95

however. Healthcare, consumer discretionary,

Utilities

90

Transportation

and consumer staples have all performed

January

March

May

July

85

well, while energy, industrials, and utilities have underperformed.

potential to increase supply is obvious. Finally, supply from the U.S. and Iraq continues to increase.

Energy stocks began to fall at the end of last year,

Given these dynamics, we expect oil prices to remain

after Saudi Arabia announced that it would bring new

low for some time.

supply on the market, and the price of oil has fallen from over $100 per barrel to around $50. Demand is

The most attractive equity sectors are industrials and,

increasing, but this has been outweighed by new

specifically, transportation stocks, which have

supply. Additionally, the recently announced deal

underperformed recently and are trading at deep

between Iran and the West is likely to have a big

discounts to the broader market. Healthcare continues

impact on global oil supply during the coming

to be attractive despite the recent run-up, and

years. Iran has the fourth largest oil reserves

consumer discretionary stocks are poised to make

worldwide, but sanctions have prevented the country

further gains as the U.S. economy continues to report

from accessing cutting-edge production technology

decent growth numbers. Utilities will face further

and from selling to most of the world. That

pressure in the coming period of Fed tightening.

technology will now be in reach. Iran produced 6 million barrels per day in the 1970s and today produces about 3 million barrels per day, so the

— Brandon Fitzpatrick

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ECONOMIC FORECAST | Q3 2015

FIXED INCOME U.S. Treasury yields rose in June as bond investors

demonstrated by the MOVE index. We expect

anticipated interest rate hikes in the U.S. Yields fell in elevated volatility to persist for the remainder of the the first days of July, however, as investors braced for a year as investors interpret the impact of divergent

possible exit of Greece from the Eurozone. While the

monetary policies around the world, economic data

Federal Open Market Committee (FOMC) has

from the U.S. and abroad, and grapple with the fallout

reiterated its position to raise the Fed Funds rate in

of the latest crisis in Europe.

2015, the financial markets now calculate only a 57% chance of a rate increase by December. The Fed wants As interest rates rose in June, the Barclays U.S. to begin raising rates, but will do so only when it is

Aggregate index returned -1.09% during the month.

confident that rate hikes will not cause excessive

Within the U.S. Aggregate Index, corporates returned

turbulence in the financial markets.

-1.84%, while Treasuries and MBS returned -0.88% and -0.76%, respectively. Year-to-date, the Barclays

The U.S economy added two hundred and eighty

US Aggregate index has returned -0.10%.

thousand jobs in May, bringing the unemployment rate to 5.5%. Average hourly wages and housing data also improved, as did consumer confidence. As the economic outlook has improved in the U.S., the yield

Agency MBS have slightly underperformed Treasuries year-to-date, as demonstrated by the Barclays U.S. Government Intermediate Index and the Barclays U.S.

of the benchmark 10-year Treasury bond rose to 2.35% at the end of June from 2.12% a month earlier. Similarly, yields were up in Europe despite the European Central Bank’s ongoing quantitative easing program. 10-year German bunds jumped from 0.05% in mid-April to 0.90%

in June. The increase was not steady or gradual, however. The bond market seesawed amid the standoff between Greece and its creditors.

The turbulence in Europe has added to volatility in the fixed income market, as

Treasury Yield Curve 7/14/15 3/31/15

9 MBS Index. This relative underperformance

Merrill Lynch Option Volatility Estimate (MOVE) Index

can be attributed to higher agency MBS issuance, a steeping of the yield curve, and

100 80

higher interest rate volatility. Agency MBS issuance has increased by 58% to $661 billion

as of June 2015, up from $419 billion in the same period last year. Within the MBS sector, Ginnie Mae securities have underperformed

60 Q3

Q4

Q1

Q2

Fannie Mae and Freddie Mac MBS, as the FHA reduced annual MIP (mortgage insurance

through May, vis-à-vis $511 billion in the same period

premium) from 1.35% to 0.85% earlier this year,

last year. Corporations have been taking advantage of

prompting a rise in prepayments. With the recent

the low yield environment to lock in cheap financing for

underperformance, MBS now offer better value than

longer periods. The maturity of recently-issued

U.S. Treasuries.

corporate bonds averages 16.5 years vis-à-vis 12 years for debt issued during 2004-2014. Utilities have been

TIPS have outperformed Treasuries year-to-date, as the the worst-performing corporate bond sector, returning Merrill Lynch 3-5 year U.S. TIPS Index is up 1.58%,

-2.74% year-to-date. Meanwhile, the industrial and

while the Merrill Lynch 3-5 year U.S. Treasuries Index

financial sectors have returned -1.12% and -0.14%,

has gained 1.34%. Year-to-date inflation, demonstrated respectively, through June.

by U.S. CPI Urban Consumer NSA Index, has increased by 1.27%. Inflation expectations have also increased as As the third quarter begins investment grade corporate oil prices stabilized around $60 a barrel in May and

bonds are attractive vis-à-vis agency MBS, as corporate

June. Annual expected inflation during the next three

spreads have widened. We prefer corporate credits over

years is 1.35%, up from 0.75% at year-end 2014. We

MBS in the intermediate duration space, as MBS have

expect inflation to rise to 2.0% to 2.5 % in the next 2-3

extension risk.

years.

maturity corporate bonds offered in the metals &

We see significant value in longer

mining, energy, communications, and financial sectors.

Investment grade corporate bonds were hit the hardest in June, with the Barclays Corporate bond index returning -1.84% during the month. The index has returned -0.92% for the year. $592 billion of investment grade corporate debt has been issued

— Prabhab Banskota

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ECONOMIC FORECAST | Q3 2015

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