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Q 2 2015 APRIL 16
ECONOMIC FORECAST
INSIDE THIS ISSUE:
Calm Markets, For Now 4-6
Equities 6-7
Fixed Income 7-9
DB Fitzpatrick 800 W. Main Street, Suite 1200
Boise, Idaho 83702 (208) 342-2280
www.dbfitzpatrick.com
Dennis Fitzpatrick Founder, CEO, and Chairman
Brandon Fitzpatrick President, COO
Prabhab Banskota Fixed Income Portfolio Manager
ECONOMIC FORECAST | Q2 2015 4
In the first quarter interest rates continued to be the
dominant factor in the capital markets, as investors
guessed at the timing of rate increases in the U.S. and
grappled with the implications of the European Central
Bank’s quantitative easing program. This divergence of
monetary policies in the world’s two most important
economies has already created significant turbulence in
the currency markets, though both the bond and equity
markets have been relatively calm so far this year. The
yield of a 10-year Treasury had risen from 1.64% on
January 31 to 2.24% on March 6, but has since fallen as
investors now anticipate that the Federal Reserve will
delay interest rate hikes until the third or fourth quarter.
The strength of the dollar likely surprised Federal
Reserve leaders, and they assumed a more dovish tone
in mid-March. The likely delay of interest rate
increases in the U.S. has prompted a rally in the equity
market, coupled with a fall in the dollar.
When it became clear in mid-March that
the Federal Reserve would delay its plan to
begin raising rates, investors turned their
attention to the low yields of European
bonds and pushed Treasury yields down.
Sovereign bond yields in Europe today are
at rock bottom levels — a French
government 10-year bond yields just
0.35%, for example, down from 1.70% at
the end of the second quarter 2014, while
Swiss 10-year bonds actually yield
—0.17%. Bond yields in Europe will probably stay
low, but a continued decline is unlikely as there is little
additional room to fall.
Given this, there is potential for turbulence in both the
fixed income and equity markets during the rest of 2015
as the timing of interest rate increases in the U.S. comes
more clearly into focus. In 2013 Fed leaders suggested
that the Fed might slow down bond purchases, and this
provoked a violent reaction in both the bond and stock
markets. The reaction this time is likely to be less
severe, as Fed chair Janet Yellen has been very careful
to telegraph her intentions. That said, this will be the
first rate increase since 2008, and it could still provide a
jolt to the markets. Equities are not immune, as
developed market stocks, at least, are fully valued. The
S&P 500 and MSCI EAFE indexes are trading at 17.9x
and 16.8x expected 2015 earnings, respectively. This is
not cheap by historical standards.
CALM MARKETS, FOR NOW
Volatility Index (VIX): Markets were calm in the first quarter
January February March
14
16
18
20
22
12
5
The U.S. economy, while not yet
fully recovered from the recession
of 2008-2009, continues to show
improvement. Home prices are
rising, consumer confidence is up,
and initial jobless claims are down.
The unemployment rate has fallen to
5.5%, but the low participation rate
— which measures the percentage
of working-age adults in the
workforce — demonstrates that
there is still slack in the labor
market (the U.S. participation rate is
at a 30-year low of 62.7%).
Inflation in the U.S. is very low, and
well below the Federal Reserve’s
target of 2.0%. This
notwithstanding, the Fed believes
that the economy is strong enough
to withstand higher interest rates,
and is determined to begin the long
path to a more normal interest rate
environment.
Europe, on the other hand, is
deepening its commitment to
monetary stimulus, and this
divergence of monetary policies has
caused big moves in the currency
markets. The U.S. dollar has risen
significantly against most major
Case-Shiller U.S.
Home Price Index 10%
5%
0%
-5% 2010 2011 2012 2013 2014
Conference Board
Consumer Confidence
2010 2011 2012 2013 2014
100
80
60
40
2013 2009 2012 2011 2010 2014
10%
9%
8%
6%
7% U.S. Unemployment Rate
ECONOMIC FORECAST | Q2 2015 6
Consumer discretionary stocks have performed well
this year, as investors take heart from an improving
U.S. economy and some positive signs in Europe. The
S&P Consumer Discretionary Sector Index is up 8.2%
year-to-date. The energy sector, as measured by the
S&P Energy Sector Index, is up only slightly year-to-
date, but is up significantly since crude oil prices
bottomed in mid-March. Utilities are the worst
performing sector so far this year, with the S&P
Utilities Index down 5.5%, as investors have priced in
the likelihood of higher interest rates. The healthcare
sector has continued to be a strong performer, while
consumer staples have also outperformed the market.
Equity valuations in the developed market economies
are not cheap. The earnings yield (the reciprocal of the
price to earnings ratio) of the S&P 500 Index is 5.6%,
which is not high by historical standards, though it
compares favorably with the yields available in the
bond market. As interest rates begin to rise, however,
the earnings yield on stocks is likely to rise as well. As
this occurs stock prices will fall unless earnings get a
big boost. Both equity and fixed income investors are
demonstrating a high degree of equanimity even as
currencies during the
last nine months. The
dollar’s strength is
likely to impact
economic growth across
the world in the next 6-
12 months, as
consumers adjust their
consumption patterns.
The Eurozone and most
emerging market
economies are likely to get a
substantial boost, as for many of
these economies foreign trade
represents a high share of gross
domestic product. The strong dollar
will hurt U.S. exports and domestic
growth, as foreign trade makes up
30% of U.S. GDP. As for the future
path of the dollar, in previous cycles
of interest rate increases the dollar
often gained as the date of the
Federal Reserve’s first increase
approached, then fell after the
increase occurred. Given the
dramatic increase in the dollar seen
recently, the odds are against much
more dollar strength.
Bloomberg Dollar Spot Index
2014 2015
Q4 Q1 Q3 Q2 100
105
110
115
120
EQUITIES
7
FIXED INCOME
U.S. Treasury
yields declined
in March as
bond investors
reassessed the
chances of
interest rate
hikes occurring
this summer.
The Federal
Open Market
Committee
(FOMC) was dovish during their
March meeting, and this lowered the
implied probability that the Federal
Reserve will increase the Fed Funds
rate by September from 48% in
February to 34% today.
The Federal Reserve’s increased
dovishness is caused by two main
factors. The first is the recent
higher interest rates approach. This calm is likely to
be put to the test in the coming months.
— Brandon Fitzpatrick
Evolution of Treasury Yield Curve (year-to-date)
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
S&P 500 MSCI EAFE Index MSCI All CountryWorld Index
10-year TreasuryYield
Earnings Yield
ECONOMIC FORECAST | Q2 2015 8
strength of the dollar, which
threatens the
competitiveness of U.S.
exporters. Second, with
year-over-year inflation at
0.0% in March there is no
imminent inflationary threat
in the U.S. The Fed knows
there is risk to raising rates
too soon, and is likely to
delay a few more months
with inflation this low.
Agency MBS underperformed Treasuries by 0.19% year-to-date through March 31, as demonstrated by the
Barclays U.S. Government Intermediate Index and the Barclays U.S. MBS Index. The underperformance was
due to higher volatility in the fixed income market, which led to higher prepayments and higher MBS supply
during the first quarter. $287 billion of agency MBS were issued in the first quarter, $91 billion more than a
year earlier. Within the MBS sector,
Ginnie Mae securities underperformed
Fannie Mae and Freddie Mac MBS as the
FHA reduced annual MIP (mortgage
insurance premium) from 1.35% to
0.85%, prompting investors to expect a
rise in prepayments.
Corporate bonds have performed well
despite record debt issuance. Falling
yields have prompted corporations to
issue debt to finance acquisitions, lower
financing costs, and improve liquidity.
While doing so they have provided
investors the extra yield they crave. $204
billion of investment grade corporate debt
U.S. Consumer Price Index
(urban consumers)
2.0%
1.5%
1.0%
0.5%
0.0%
2014 2015
Q1 Q4 Q3 Q2
U.S. Treasury Yield Curve
Spain Sovereign Curve
German Sovereign Curve
1.0%
0.5%
0.0%
2.5%
2.0%
1.5%
-0.5% 10Y 20Y 30Y 4Y
9
was issued through February 28, led by Actavis ($21
billion) and Medtronic ($17 billion). Corporations are
taking advantage of the low yield environment to lock
in cheap financing for longer periods. The maturity of
recently issued corporate bonds averages 15 years vis-à-
vis 12 years for debt issued during 2004-2013.
TIPS have underperformed Treasuries year-to-date as
the Merrill Lynch 3-5 year U.S. TIPS Index returned
1.03% through March, while the Merrill Lynch 3-5 year
U.S. Treasuries Index gained 1.48%. Inflation
expectations have increased recently, however, as oil
prices have stabilized. Annual expected inflation
during the next three years is 1.35%, up from 0.75% at
year-end. We expect inflation will continue to rise to
the Federal Reserve’s stated goal of 2% in the next 2-3
years. — Prabhab Banskota
ECONOMIC FORECAST | Q2 2015 10
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