ECONOMIC FORECAST
Q4 2014 OCTOBER 13
INSIDE THIS ISSUE: Market Summary
4
Risk Reassessed
4-6
Continued Slow Growth
6-7
Fixed Income
7-9
Dennis Fitzpatrick Founder, CEO, and Chairman
Brandon Fitzpatrick President, COO, and Equity Portfolio Manager
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 | Q4 2014
MARKET SUMMARY The capital markets were volatile in the third quarter and early in the fourth quarter, with stocks down and bonds up since mid-September. Investors today are grappling with four main issues: 1) a very weak economy in Europe with little hope of a turnaround in the near term; 2) a continued slow but steady economic recovery in the U.S.; 3) disappointing growth in the emerging markets generally, though a significant disparity of results between countries; 4) the prospect of higher interest rates over the medium and long term as the U.S. Federal Reserve ends its quantitative easing program and raises interest rates in coming years. These issues, of course, are interrelated, and how one develops over time will affect all the others. Europe’s weakness is the issue dominating investor sentiment during the equity selloff of the last few weeks, and fears about Europe’s impact on global growth have driven low interest rates even lower.
Rising interest rates will be a worry in the future, but today the issue is on the back burner. There has been a renewal of “risk on / risk off” trading – with high volatility, and increased correlations among different areas of the capital markets — during this selloff. Sectors that are more sensitive to economic growth have underperformed, as is almost always the case when volatility is high. We believe this is a typical market correction and not a harbinger of worse things to come, as equity valuations had gotten a little high earlier in the year. The macroeconomic environment has not changed enough in the last four weeks to justify this selloff. Further downside to equities is of course possible, but equities today are attractive and offer good value vis-à-vis bonds. Our fixed income portfolios are positioned defensively, and in our equity portfolios we have made tactical moves into hard-hit sectors.
RISK REASSESSED The recent selloff in the equity market is ultimately explained by two factors: 1) economic data in Europe have been worse than expected and there is concern that this will impact global growth; 2) equity valuations had gotten ahead of historical averages in the first half of the year. New evidence of weakness in Europe does not substantively change our outlook for global growth, and we believe this selloff is a temporary overreaction. Higher beta sectors – including industrials, materials, and energy – began to underperform the broader market early in the third quarter, and their underperformance continued into October as volatility jumped. Sectors less dependent on economic growth, such as healthcare and consumer staples, have outperformed the market. Among the three main regional world equity sectors – U.S., EAFE (international developed), and emerging
markets – emerging market stocks typically are the worst performers when volatility increases. EAFE stocks usually outperform emerging markets during selloffs, while U.S.-based stocks outperform the global stock market. Part of this is due to investors seeking the relative safety of the transparent and liquid U.S. markets, and part is explained by a rising U.S. dollar, S&P Global Healthcare Index
5%
S&P Global Consumer Staples Index 0% -5%
S&P Global Industrials Index S&P Global Materials Index S&P Global Energy Index
July
August
September
-10%
-15%
5
viewed as a “safe haven” currency. In the third quarter, however, this typical pattern was not followed as EAFE was the worst performer and emerging markets, though underperforming U.S. stocks, performed relatively well and are even with the global market year-todate. The underperformance of EAFE is explained by further weakness in the European economy. Emerging economies are sensitive to a deterioration of the European economy too, as many of their exports are purchased by Europeans, but emerging market assets also benefit from low global interest rates. Europe’s slowdown has led to falling rates around the world, and this is helping emerging markets perform decently in a tough market environment. Many emerging market currencies, however, have been hit hard. This is due to market anticipation of further monetary stimulus, combined with investor belief that the Fed will eventually raise interest rates in the U.S. Falling currencies are good for economic growth in the medium term, as they result in cheaper and more competitive exports. It will take 6-9 months, however, for this to be reflected in trade data. Oil prices are off significantly since the end of the second quarter, partially due to increased supply in the U.S. There is also additional supply from Iraq and Libya hitting the market, and expectations for additional supply from Russia as tensions between Moscow and the West have abated somewhat. Investor anticipation of lower demand as global economic growth
S&P 500
MSCI Emerging Markets Index Q1
Q2
EAFE Q3 106
Bloomberg Dollar Spot Index (normalized, last 12 months)
103
100
Q4
Q1
Q2
Q3 $110
Brent Crude
$100
West Texas Intermediate Crude July
August
slows is another important factor.
$90
September
fears of a swift decrease in demand are exaggerated. The European The market is correct to price in economy has been weak for many these developments but the selloff in years, and recent data are only oil — and in energy stocks — is consistent with this general trend. overdone. Geopolitical tensions The U.S. economy continues to could spike suddenly, as tensions grow, albeit at a moderate pace, and are already high in the Middle East, the emerging market economies are and Vladimir Putin remains as still growing too. All this will buoy unpredictable as ever. Moreover, demand for oil.
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ECONOMIC FORECAST | Q4 2014
As almost always happens during periods of stress in the equity market, the correlation of stock price moves has increased in recent weeks. The upside to this is that stock prices of good companies get dragged down with the general market. The S&P 500 is trading at 14.3x expected 2015 earnings, while the EAFE index trades at 12.6x, and the MSCI Emerging Market Index trades at 10.4x. These are attractive valuations.
CONTINUED SLOW GROWTH The economy in the U.S. continues to recover, but recent data have been mixed. The labor market exemplifies the issue, with the national unemployment rate falling to 5.9% but labor participation at only 63% – a 30-year low. It has been five years since the U.S. economy bottomed out in 2009, and the long hoped-for resurgence of jobs has not occurred. Instead, it has been quarter after quarter of slow, though consistent, growth. Millions remain marginally attached to the labor force, and millions more have dropped out of the labor force altogether. There are positive signs for the future, however. Housing starts are up and prices across the country continue to rise. Retail sales are up 5% year-overyear, and consumer confidence is as high is at it’s been in six years. We are forecasting the U.S. economy to grow a respectable 2.0-2.5% during the next two years. The economy in Europe, however, is in worse shape, and its disappointing results are threatening growth elsewhere around the world. GDP growth in the
Eurozone is currently 0.0%, and there is a good chance of a recession during the next year. Inflation is down to only 0.3%, and deflation in 2015 is a real possibility. Industrial production is down in Germany, which has investors on edge. Consumer confidence, predictably, is very low and the unemployment rate across the Eurozone is 11.5%. There are, of course, significant differences in unemployment among Eurozone countries – Spain’s unemployment rate, for example, is 25%, while the figures in France and Germany are
4%
2%
Germany Industrial Production (year-over-year)
0% -2%
Q1
Q2
Q3
7
9.7% and 6.7%, respectively. One recent positive development for Europe is the devaluation of the euro, down 9% vs. the U.S. dollar since May. This will provide a boost to exports, though it will take some time before this benefit finds its way into economic data.
Consumer Prices (year-over-year %)
Germany
1.0%
0.5%
France
Europe is trapped by its politics. What is needed is further quantitative easing — including purchases of sovereign bonds — as was done in the U.S., in addition to fiscal stimulus and, of Q1 course, structural reforms. Mario Draghi, the chair of the European Central Bank, has not ruled out sovereign bond purchases, but he is constrained by politicians who are adamantly against using monetary policy to boost growth. In spite of recent negative headlines, the most likely scenario for Europe is largely unchanged. Mario Draghi will eventually institute additional quantitative easing, including unconventional measures, but it will
1.5%
Spain Q2
Eurozone Q3
0.0% -0.5%
take further disappointing growth numbers and possibly a dip into deflation before he gets room to maneuver within Europe’s political arena. We expect growth in Europe to be 0-1% during the next year, though it should increase to 2.0% in 2016 in the wake of a new round of QE. The risk for Europe is that Draghi isn’t aggressive enough with QE in 2015. — Brandon
Fitzpatrick
FIXED INCOME The fixed income market has performed better than expected in 2014, with the U.S. Treasury yield curve declining and flattening. As a result, 30-year and 10year U.S. Treasury bonds returned 17.6% and 6.9%, respectively, through the end of the third quarter. For the same period, the Barclays U.S. Aggregate index gained 4.1%, while the U.S. Mortgage Back Securities (MBS) and Intermediate U.S. Government indices returned 4.2% and 1.6%, respectively.
steps to spur growth in the U.S. economy after the credit crisis of 2008-2009. It decreased the Federal Funds rate to 0.25% in 2008 and embarked on multiple asset purchase programs. The asset purchase programs were aimed at decreasing long-term borrowing costs,
Treasury Yield Curve
The Federal Reserve took unprecedented
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ECONOMIC FORECAST | Q4 2014
while the lowered Fed Funds rate helped keep down short-term borrowing rates. With the U.S. economy improving, the Federal Reserve is set to end the latest bond buying program (QE3) in October. Additionally, the Fed is gearing up to increase short-term rates by mid -2015.
Securities). This expectation comes in spite of the fact that corporations in the U.S. are flooded with cash and the Federal Reserve is continuing to supply ample liquidity to the financial markets.
Geopolitical unrest affects Treasury yields, as Treasury securities are considered a global safe haven. U.S. The European Union is battling very low inflation and involvement in Iraq to counter the ISIS uprising, unrest in Syria, continued squabbles between China and its the European Central Bank is embarking on a new neighbors, and uncertainty regarding Putin’s next round of expansive monetary policy. Two year sovereign bond yields in France, Germany, and Italy are adventure will pressure the yield curve downward. -0.02%, -0.09%, and 0.34%, respectively. Reflected in We forecast the U.S. 10-year Treasury yield to be these yields is the distinct possibility of deflation in Europe. Meanwhile, the economic growth rate in Japan 2.25% - 2.50% by the end of 2014, and it should inch up gradually to 2.5% - 3.0% by the end of 2015. The is bleak, with GDP contracting 1.7% quarter-overbelly of the curve should rise as early as the start of quarter between April and June. Japan’s two year 2015, guided by the Fed Funds rate. We anticipate U.S. sovereign bond yields 0.06% and expected inflation during the next two years is 3.8%. In summary, the two year U.S. Treasury note U.S. Government Debt yields 0.53%, which, ($ billions) although very low, looks appealing when compared to other sovereign bonds. Year-over-year inflation in the U.S, as measured by Consumer Price Index Urban Consumers NSA (non-seasonally adjusted), was 1.7% in August after increasing 2% in previous months. With commodity prices falling and the dollar strengthening, financial markets expect an annual inflation rate of 1.98% for the next 10 years as measured by the difference between the yields of 10-year U.S. Treasury and 10year TIPS (Treasury Inflation Protected
2-year bond yields
9
U.S. Consumer Price Index (NSA)
growth momentum to continue for the remainder of — Prabhab 2014 and 2015 and expect inflation in 2015-2016 to be higher than current market expectations.
Banskota
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ECONOMIC FORECAST | Q4 2014
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DB Fitzpatrick 800 W. Main Street, Suite 1200 Boise, Idaho 83702 www.dbfitzpatrick.com | (208) 342-2280