Q 12013

January 8

OutperformBonds

Europe

China and theEmerging Markets

United States

Fixed Income

Economic forecast

ECONOMIC FORECAST | Q1 2013 2

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ECONOMIC FORECAST | Q1 3

INSIDE THIS ISSUE:

Dennis FitzpatrickFounder, CEO, andChairman

Brandon FitzpatrickPresident, COO, and

Manager

Cody BarneyPrincipal and Fixed

Manager

Outperform Bonds4

Europe 6

China and the Emerging Markets 7

United States 9

Fixed Income 10

D.B. Fitzpatrick & Co.225 N. Ninth St.

Suite 810(208) 342-2280

www.dbfitzpatrick.com

ECONOMIC FORECAST | Q1 2013 42012REVIEWANDOUTLOOK:EQUITIESOUTPERFORMBONDSThe

markets strongly outperformed in the fourth quarter. Chinese stocks jumped in the last six weeks of the year,

forward with economic reforms.

Fixed income yields remained exceedingly low throughout 2012.-2009, has kept money in the bond market despite rock

longest tenors of the yield curve. Most of the global fixed income markets are very expensive, as investors havepushed down yields in the credit space as well. The yields of some emerging market local currency sovereigns

-denominated sovereigns are not overlycompelling, especially when compared to stocks.2013.

ECONOMIC FORECAST | Q1 5

Despite this run, risk aversion remains

yet adequately rewarded them for the prospects for growth in the emerging world. We are maintaining an

ECONOMIC FORECAST | Q1 2013 6EUROPEmarkets in the first half of 2012, but

moment last July when EuropeanCentral Bank chairman Mario Draghiannounced that the ECB would do"whatever it takes" to save theeuro. The ECB will buy unlimitedamounts of sovereign bonds ofeurozone countries that abide byrequired reforms. The markets hadlong hoped for such anannouncement, as it takes the riskof immediate breakup and financialmeltdown off the table, and gives

reforms and build stronger

announcement removed a lot of thefear that surrounded risky assetsaround the globe, and convinced

many investors that a bet againstthe euro and sovereign debt ofperipheral European countries was a

Yields fell acrossthe eurozone, including crucialcountries Italy and Spain.

Meanwhile, the difficult work ofregulatory and economic reform has

agreed to rules which put theeurozone’s biggest banks under thedirect oversight of the ECB, a key

Italy, Spain, and Greece have beenpushing through reforms to adjusttheir labor markets and improve

It’s obvious thatItaly and Spain need fastereconomic growth, but the outlook

was early in 2012. Greece is a more

need more aid from the eurozone’sstronger economies, and more debtwritedowns are inevitable. In spiteof this it’s likely that even Greecewill remain in the currency bloc.

The last sixteen months, fromSeptember 2011 to the present,

for the eurozone. Europe's leaders,led by German Chancellor Angela

along with economics, and havepersistently pushed for "moreEurope" (meaning more centralizedcontrol of fiscal and regulatory

Merkel

ECONOMIC FORECAST | Q1 7

has been careful not to get too far ahead of her

voters along toward her correct conclusion that thebest hope for Germany's future is to stay within aunited Europe and eurozone. Merkel’s allies areleading in the polls and she appears well-

which has us bullish on theeurozone’s prospects.

have failed to grasp thefact that the eurozoneitself, and the project of

generally, is about muchmore than the benefits offree trade or the ease ofdoing business across

crucially, just as much

framework that wouldmake war within Europeimpossible. This is whyEurope's leaders have pushed ahead to solve the

Europe’sunity will only gain in importance in the coming years asthe big emerging economies -- Brazil, India, China,Indonesia, and others --the balance of global power, both in economics and

When looked at in this context, andwhile keeping in mind the unpredictable cost of

breaking up the currency bloc, it's easy to see why

why voters, both within core and peripheral countries,have accepted painful reforms. Germany, Italy, Spain,France, and even Greece have thrown their lot in withEurope and the eurozone, and it's clear now that theeuro will survive.

That's the good news. The bad news is that years ofausterity are ahead for much of Europe, and growth islikely to be slow. --Germany, for example, and parts of eastern Europe --but generally the outlook for economic growth on the

There are values to be had in some

remains sour despite recent gains.CHINAANDTHEEMERGINGMARKETSEmerging market economies now produce about halfthe world's GDP, and prospects for future growth arebright. The biggest and most important emergingeconomy, of course, is China, and its economy isrecovering as 2013 begins. Growth had slowed toaround 7.5% last year, which for most of the worldwould be an excellent number, but investors werenervous since the drop in GDP growth had yet to be

Manufacturing and trade data in Novemberand December, however, were higher than expected,

China's new leadership was announced in November,

disappointed by the new team. There is hope foreconomic reform, however, as Communist Party leader

ECONOMIC FORECAST | Q1 2013 8

liberalizing China’s economy. Deng Xiaoping made Shenzhen a special economic zone in 1980, one of the first inChina as part of Deng’s economic reform policies. The Chinese government recently announced moves tofurther liberalize its financial markets, and will allow more foreign money managers to invest in local capitalmarkets. Policymakers are clearly looking to boost China's stock market, which has been anemic the last threeyears.

China will undoubtedly have hiccups along the way, but over the longer run the country's economy will be one ofthe world's top performers.of people in the countryside eager to place themselves into the modern global economy, as they work to build a

higher than some other fast-growing emerging economies, and clearly the government has misallocatedresources in some well-

-8% during the next

The real has fallen during the last ten months to a more reasonable level, however, and this shouldjumpstart exports in 2013. finally set to takeeffect and increasing demand from China for exports will provide a boost. Brazilian stocks are cheap — the

Brazil. -term growth, including Mexico,Colombia, and Chile. Colombia slowed in 2012, but has the best prospects of the three.

ECONOMIC FORECAST | Q1 9

UNITEDSTATESThe compromise that prevented the U.S. from falling off the fiscal cliff, reached just hours before the deadline,will slightly lower economic growth

increased taxes on top earners, but

economic growth over the longer

lack of demand, and demand will be

Policymakers will now look to lowergovernment spending, and will beginwork toward a broad agreement ontax reform. A "grand bargain" seemsvery unlikely, however, given the

and the basic tax structure as itstands now, with myriad loopholes

persist for the foreseeablefuture. Some spending cuts will likelybe agreed to, but they will prove

hawks.as a severe drop in governmentspending in the short term couldpush the economy back intorecession, which would make presentdebt levels more onerous.

It's clear that economic growth willbe the key to the sustainability ofgovernment debt levels in theU.S. Growth at 2.2% was moderate in2012, but there are reasons to be

TheThis will have a

unemployment drops below 8.0%. There is a lot of pent up demand in the economy and when consumerWe think this will begin to occur early in 2013. 3%

GDP growth is not a stellar number, especially given the severity of the recession in 2008-and would do a lot to ease the country's debt troubles in the coming years.— Brandon Fitzpatrick

ECONOMIC FORECAST | Q1 2013 10

FIXEDINCOMEThe U.S. Treasury market ended the year on a downnote as yields increased in the intermediate and long

-year yield stayedflat at 0.25%, but the 10-year yield rose 14 basis pointsto end the month at 1.76%. The 30-year bond yieldalso rose 14 basis points to finish the year at 2.95%.

The broad investment grade bond market as measuredby the Barclays Capital US Aggregate Index was down-0.14% for December and finished the year up 4.22%.Corporate bonds were the big winners in fixed incomein 2012, returning 9.82%. Spreads came downsignificantly for corporates as investors scoured the

returned 1.99% for the year, while agency mortgage-

we expect interest rates to rise along with an improvingU.S. employment outlook. We expect the 10-year U.S.Treasury yield to hit 2.5% by the end of 2013 and the

2-year yield to approach 0.50%.

-term

federal funds rate and instead opted to set fortheconomic hurdles that must be met for the Fed toconsider raising rates. The two primary thresholds thatmust be met are: 1) unemployment at or below 6.5%,

more than 2.5%. Ben Bernanke and other Fed officialswill obviously weigh other factors in their decision-

hurdles gives the financial markets more clarity and

ECONOMIC FORECAST | Q1 11

forward. Year-over-

as we head into 2013. Even at a historically modest

curve are under 2%.

returned 2.31% in 2012, compared to 1.73% for the

Barclays Government

to maintain a defensive posture

the rest in agency mortgage-

years is well under the average

grade bond market (over 5 years).

return in long-term bonds as veryasymmetrical and are avoiding

composite returned 1.63% in2012, well ahead of the

benchmark 1-3 Year Treasury Index which returned-term

TIPS , while we maintain a yield advantage with-term agency mortgage-

— Cody Barney

D.B. Fitzpatrick & Co.225 N. Ninth St., Suite 810

Boise, ID 83702www.dbfitzpatrick.com | (208) 342-2280