Economic Forecast Q4 2017

Q4 2017 October 12

ECONOMIC FORECAST

DBFitzpatrick

REGISTERED INVESTMENT ADVISORS

INSIDE THIS ISSUE:

Fixed Income: Change at the Fed Could Impact Interest Rates

4—6

Equity Bull Market Continues

6—7

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

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ECONOMIC FORECAST | Q4 2017

FIXED INCOME: CHANGE AT THE FED COULD IMPACT INTEREST RATES The U.S. Treasury yield curve

leadership team. Yellen’s current

during the tenures of Yellen and Ben

steepened in September as inflation

term as chair will end in early

Bernanke, and are viewed by investors

breakeven rates rose, tensions with

February and President Trump has

as quite hawkish. Jerome Powell, a

North Korea diminished, and the

not yet announced her replacement.

current member of the Fed’s Board of

ultimate damage wrought by

The president has not publicly ruled

Governors with a reputation of being

Hurricane Irma was less than feared.

out appointing Yellen to another

moderately dovish, is also rumored to

The other important news in the fixed term, but given his tough criticisms of be a candidate. There are other income market during the month was her during last year’s campaign and

rumored potential nominees with little

a reiteration by Federal Reserve chair

Yellen’s recent defense of increased

or no monetary policy track record,

Janet Yellen that the Fed is planning

financial regulations it seems likely

such as White House adviser Gary

to raise the fed funds rate four times

that President Trump will decide to

Cohn, and investors are largely

by the end of 2018. Yellen also

nominate someone new. Two of the

uncertain regarding their philosophies

pledged that the Fed will press

people the president is rumored to be and outlooks. At present, Warsh

forward this month with its plan to

considering – Kevin Warsh and John

appears to be the favorite for the top

begin unwinding its $4.5 trillion

Taylor – have been critical of the

spot.

balance sheet. $6 billion worth of

Fed’s quantitative easing policies

maturing Treasuries and $4 billion of agency MBS will be allowed to roll off the balance sheet monthly, with both of these figures set to increase during the next year.

Barring an unforeseen shock to the economy during the next few months it appears likely that the Fed will raise

the fed funds rate in December and will stick to its plan to begin gradually unwinding its balance sheet. The exact pace of monetary tightening in 2018, however, is less clear as there is significant uncertainty regarding the makeup of the Federal Reserve’s new

5 President Trump needs to fill three additional vacancies

faces significant turnover at the top of its organization

at the Federal Reserve Board, including the spot of Vice and some of the leading contenders for the top post are Chair as the highly respected academic economist and

significantly more hawkish than Ben Bernanke, Janet

Yellen ally Stanley Fischer recently announced his

Yellen, and Stanley Fischer. This, at the same time the

retirement. How President Trump decides to move

Fed begins to implement its balance sheet reduction

forward with these nominations will have big

plan, could lead to some significant volatility in the fixed

implications for monetary policy, interest rates, and

income markets during the coming months.

economic growth during the next few years. The new Fed leadership team will undoubtedly face difficult choices as it attempts to navigate the unwinding of the Fed’s $4.5 trillion balance sheet – something never before attempted.

Even with the potential for more hawkish leaders at the

In another event that could impact interest rates, the White House is now promoting an outline of a tax reform package and there appears to be a reasonable chance that something meaningful will be enacted. The White House is aiming to lower the marginal income tax rate for many Americans, lower the corporate tax rate to

top of the Federal Reserve, investors remain skeptical of roughly 20%, and encourage U.S.-based corporations to Yellen’s announced plan to raise the fed funds rate four

bring money earned overseas back to the U.S.

times during the next year. As calculated using Treasury Discussions in Congress regarding the plan have only futures prices, investors currently see a 77% probability

recently begun and there is significant uncertainty

that there will be a rate hike in December, but just a

regarding what (if any) reforms will ultimately be

55% probability of a second hike occurring by next

implemented. The potential exists, however, for some

August. Investors see less than a 10% probability that

changes that could provide a modest boost for the U.S.

the Fed will be able to raise the fed funds rate four times economy and might help push interest rates higher. by the end of next year (while seeing a 4% probability of no change at all to the fed funds rate from its current level). A disconnect between the announced long-term plans of Fed policymakers and what investors expect to actually happen has been a mainstay of market dynamics during the last several years. A difference now, however, is that the Fed

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ECONOMIC FORECAST | Q4 2017

Given the dynamics listed, we believe the level of the

factor. There is a good chance the yield curve will

U.S. Treasury yield curve will drift higher in the coming

continue to steepen, but this will depend largely on what

months. The potential for a significant philosophical

tax reform package Congress passes and the exact

change among the Fed’s top leadership is the biggest

makeup of the new leadership team at the Federal

factor driving this forecast, though potential for the

Reserve.

implementation of tax reform is another significant

EQUITY BULL MARKET CONTINUES Equities rose again in the third quarter is up 20.5% year-to-date when

defensively, with full allocations to

with international stocks leading the

measured in U.S. dollars, but has

less cyclical sectors such as consumer

way. The MSCI Emerging Markets

returned just 7.7% when measured in staples and healthcare, and an

Index and MSCI EAFE Index (which euros.

underweight position to international

measures international developed

stocks. The U.S. dollar has fallen

stocks) returned 8.0% and 5.5%

The U.S. and global economies are

considerably this year but may rise in

during the quarter, while the S&P 500 gaining traction and corporate

the coming months if U.S. Federal

(domestic stocks only) returned 4.5%. earnings results this year have been

Reserve policymakers move forward

The MSCI All Country World Index,

with their plan to tighten monetary

solid, but the bull market in equities

a measure of the global stock market, has gotten quite long in the tooth and policy. Domestic equities are likely to has returned 17.7% year-to-date,

an eventual pullback should be

outperform emerging market and

while the S&P 500 has returned

expected. Consequently, our equity

international developed stocks if the

14.2%. The falling U.S. dollar (down

portfolios are positioned somewhat

dollar strengthens.

9.0% this year versus a basket of ten leading global currencies) has been the main factor explaining the recent disparity of foreign and domestic stock performance. The MSCI EAFE Index, for example,

7 Equity valuations remain elevated. The S&P 500 and MSCI All Country World Index are trading at 19.4 and 17.3x expected full-year 2017

earnings, which represent full valuations. These valuations may come under increased scrutiny during the next 3-6 months. The prospect of higher interest rates — possibly caused by policy error — and a reset of equity

and bond prices is real. In the present environment, some caution is in order.

— Brandon Fitzpatrick

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ECONOMIC FORECAST | Q4 2017

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