Economic Forecast Q4 2016

Q4 2016 October 21

ECONOMIC FORECAST

DBFitzpatrick

REGISTERED INVESTMENT ADVISORS

INSIDE THIS ISSUE:

A Rate Hike Is Likely

4

Fixed Income

4-6

Equities

6-7

Outlook

7

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

4

ECONOMIC FORECAST | Q4 2016

A RATE HIKE IS LIKELY Low interest rates have provided fuel for equities and other risky assets in 2016, and all eyes are on the Federal Reserve as we enter the final months of the year. Fed policymakers originally wanted to raise the fed funds rate (their target interest rate) four times this year, but were forced to hold rates steady in the spring after the dollar surged and equity prices fell in January and February. The unexpected ‘Brexit’ vote in June, in which voters in the United Kingdom opted to leave the European Union, made a rate hike during the summer inopportune as well, and in the end the fed funds

rate has not been changed all year. An increasingly vocal group of inflation hawks is clamoring for a return to ‘normal’ interest rate policy, however, and, barring an unforeseen shock to the financial markets, a policy change is in the offing. We are forecasting a rate hike in December, and believe that this will lead to heightened volatility in the equity and bond markets in the fourth quarter, as the hike is not fully factored into today’s prices.

The hike is bullish for the U.S. dollar and bearish for commodities and more risky sectors of the equity market.

FIXED INCOME The bull market in fixed income has continued unabated this year.

Europe has been a major factor, with the European Central Bank’s €80 billion monthly purchase of sovereign and corporate bonds pushing global interest rates lower. Bond yields in Europe have fallen significantly this year, with yields of 10-year sovereign bonds of France, Germany, and Holland all below 0.30% today.

Remarkably, a 10-year Swiss government bond today yields -0.55%. This dearth of yield available in Europe has pushed money into the U.S. bond market, and the yield on a 10-year Treasury bond fell from 2.27% at the start of the year to 1.36% in

5

July. The yield of a 10-year Treasury bond today sits at 1.74%. The United Kingdom represents a special case in Europe, as its yield curve has risen significantly since August. The British pound has sold off, and is down 18% against the U.S. dollar since the day the Brexit vote was held. Inflation in the U.K has spiked since June, with investors expecting inflation during the next five years to be 3.0%, up from 2.2% in June.

As yields of safe haven bonds have fallen, credit spreads have tightened. The spread of the 5-7 year BBB U.S. Corporate Index fell from 2.80% in January to 1.80% at the end of September, and higher rated corporate indices have shown similar, if less pronounced, moves. Agency mortgage backed securities have also performed well this year, as spreads over Treasuries have held steady in spite of falling Treasury yields.

Monetary policy in the U.S. will also play an important role. The Federal Reserve has faced a familiar pattern during the last few years: inflation breakeven rates – the inflation rate investors are predicting for the future – have typically fallen as the Fed neared a decision to raise rates. As the inflation hawks at the Fed have grown louder during the last six weeks, however, inflation breakeven rates have risen. The 5-year inflation Whether this dynamic continues during the next breakeven rate rose from 1.29% at the end of year will depend largely on the decisions of central August to 1.59% in mid-October, while the 10bankers in Europe and the U.S. The bond market year inflation breakeven rate rose from 1.47% to received a minor jolt in early October, with yields 1.68% during the same period. Much of this rising, as media reports stoked rumors that increase is explained by the rising price of oil, with European Central Bank policymakers were the price of a barrel of WTI crude rising above $50 considering a slowdown of their bond purchase today versus $44 at the end of August. Even so, program. The bond market has calmed since then, higher inflation breakeven rates might convince however, as ECB leaders have reassured investors some Fed governors that a rate hike in December that no immediate policy change is forthcoming. would be palatable for investors. Additionally,

6

ECONOMIC FORECAST | Q4 2016

‘core’ inflation in the U.S., which removes the effect of food and energy prices, was up 2.2% at the end of September, near a 5-year high. Fed leaders closely watch core inflation, and this number gives the hawks at the Fed additional ammunition in their push for a rate hike this year.

EQUITIES The stock market was up in the third quarter as global interest rates remained low. The MSCI All Country World Index, which measures the global stock market, returned 5.4% in the quarter and 7.1% year-to-date through the end of September. The S&P 500 returned 7.8% year-to-date through September while the MSCI Emerging Markets Index returned 16.3%. All of these indices have benefited from falling safe-haven bond yields, with emerging market

stocks benefitting most of all.

The earnings yield of the broader stock market has followed bond yields lower, and the earnings yield (using 2016 earnings) of the S&P 500, MSCI All Country

World Index, and MSCI Emerging Market Index is currently 5.5%, 6.0%, and 7.3%, respectively. These yields are reasonable given the state of the bond market, and we think equity

7

valuations today are reasonable, though not cheap.

Earnings Yield (‘16 earnings)

The energy sector has outperformed this year, with the Dow Jones U.S. Energy Sector Index returning 15%. The industrial and materials sectors have also outperformed, both MSCI Emerging returning more than 8%, Market Index as lower interest rates have weakened the dollar and boosted commodity prices. Healthcare has underperformed, as investors have priced in an increasing likelihood of policy changes in Washington. Medical device stocks have largely been immune to investor worries, but pharmaceutical and biotech stocks have felt the brunt of the changing outlook for

MSCI All Country World Index

S&P 500

healthcare spending in the U.S. Finally, consumer staple stocks have given up much of their outperformance from the first half of the year as interest rates have risen since the end of the second quarter, and some investors have begun to rotate out of the sector.

OUTLOOK We anticipate increased volatility in the fourth quarter as investors brace for an interest rate hike in December. We are forecasting a flattening of the U.S. Treasury yield curve, with yields on the short end rising during the next two months.

Within the fixed income market, we prefer agency mortgage backed securities to Treasuries, corporates, and TIPS, all of which will face headwinds through December.

Despite the potential for trouble in the remaining months of 2016, our outlook for equities next year is positive, as further rate hikes in the U.S. are likely to be few and far between. Additionally, the European Central Bank’s quantitative easing program will likely continue far into 2017. Both of these dynamics are positive for stocks.

— Brandon Fitzpatrick

8

ECONOMIC FORECAST | Q4 2016

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.

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