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Q 2 2014 APRIL 16
ECONOMIC FORECAST
Stocks Bounce Back
Monetary Policy in Europe
Fixed Income
INSIDE THIS ISSUE:
Stocks Bounce Back 4
Monetary Policy in Europe 5-6
Fixed Income 7
D.B. Fitzpatrick & Co. 225 N. Ninth St.
Suite 810 (208) 342-2280
www.dbfitzpatrick.com
Dennis Fitzpatrick Founder, CEO, and Chairman
Brandon Fitzpatrick President, COO, and Equity Portfolio Manager
Prabhab Banskota Fixed Income Portfolio Manager
ECONOMIC FORECAST | Q2 2014 4
The stock market was volatile in the first quarter, with
stocks down around 5% in late January, before rallying
in February and again in late March. Stocks are now
being driven primarily by economic growth data and
their resultant impact on earnings expectations, a
healthy change from last year’s market moves which
were driven more by expected changes in interest rate
policy. Higher interest rates will present a headwind for
stocks, but equity investors today are more comfortable
with their inevitable rise, and with the timing hinted at
by central bank leaders.
Policymakers at the U.S. Federal
Reserve are continuing with their stated
plan to slow and eventually end
quantitative easing (the purchase of
Treasury bonds and agency mortgage
backed securities), and this plan is now
well understood by market participants.
The important issue in the financial
markets going forward will be the
Federal Reserve’s ability to manage
investors’ expectations of the timing of
interest rate rises. If the Fed moves too
quickly, the stock market will suffer
short-term losses, which if severe
enough could threaten economic growth
(something the Fed is very anxious to
avoid). If, on the other hand, the Fed
raises rates in line with or slower than
investors’ expectations, stocks will
instead be driven by economic data and
earnings, as is the case in more normal
times. This would bode well for stocks
since the economy – both globally and
in the U.S. – is gaining strength.
The good news from the perspective of
the equity market is that Fed chair Janet
Yellen is known as an inflation dove.
In recent speeches she has spoken about
the weak state of the U.S. economy and
the still fragile labor market. We view
this as increasing the probabilities that
the Fed will raise rates on the slow side
of market expectations.
Despite the recent increase in stock prices, equities are
still attractive when compared to bonds. Treasury
yields fell in the first quarter, and a 10-year Treasury
currently yields 2.64% (barely a positive real return, as
market expectations for inflation during the next 10
years are 2.14%). Emerging market equities are still
cheap, as are European shares, while U.S. stocks are
fully valued.
STOCKS BOUNCE BACK
0
2
4
6
8
10
12
14
16
18
S&P 500 EAFE (International
Developed)
MSCI Emerging Market
Index
Price to Earnings Ratio (expected 2014 earnings)
MSCI Emerging Market Index
S&P 500
EAFE
Year-to-date returns
5 ECONOMIC FORECAST | Q2 2014
The U.S. economy continues its
slow but steady recovery. GDP
growth was 1.9% in 2013 and is set
to accelerate to the 2.5%-2.7% range
this year. The unemployment rate
has fallen to 6.7% and the
underemployment rate (which
includes discouraged workers) is
currently 12.7%, its lowest level
since late 2008. Data out of China
have been mixed, though the
Chinese economy is still set to grow
around 7% this year. The Eurozone
has returned to positive economic
growth for the first time since 2011,
though growth was only 0.5% last
year and the European economy is
obviously still very weak.
How European policymakers react
to this continued malaise will be
very important for global financial
markets in the remaining nine
months of 2014. It is well
understood that the U.S. Federal
Reserve is set to raise interest rates
during the next few years, the only
question is the timing. In Europe,
however, economic growth has been
much weaker and policymakers at
the European Central Bank are
considering increased monetary
stimulus. Due to political
constraints, fiscal stimulus was
never tried in Europe during this
recession, which has left the ECB as
the only government institution with
the power to encourage growth in
the short term. In recent days ECB
leaders have been preparing the
market for a new policy, and one
that has been seldom used: negative
interest rates.
The ECB is floating the idea of
lowering the deposit rate – the rate
the ECB pays on private bank
reserves held at the central bank –
below zero. The hope is that this
will encourage banks to remove
their money from the ECB and lend
it to businesses, thereby spurring
economic growth. A secondary goal
is to weaken the euro, which is at a
three year high against the U.S.
dollar. A weaker euro would make
imports more expensive, and would
help to achieve the goal of higher
inflation (which is below 1.0%).
There are also rumors that the
European Central Bank is
considering even more stimulus
later in the year. Specifically, the
ECB is considering implementing
its own quantitative easing program
to buy Eurozone sovereign debt just
as the Federal Reserve has been
buying Treasuries and mortgage
backed securities during the last five
years. The ECB is said to be
running models to see how such a
policy could work, and how to
optimize its implementation. This
would be a watershed event for
Europe, and would be very good for
risky assets, especially emerging
market and European equities.
European sovereign bonds have
rallied significantly in the last six
months, and have already priced in
the likelihood of an ECB
quantitative easing program. For
example, the yield of a 10-year
MONETARY POLICY IN EUROPE
Eurozone Unemployment Rate
2010 2012 2013 2011
2013 2012 2011 2010
Eurozone Inflation
3.0%
2.0%
1.0%
10.0%
11.0%
12.0%
ECONOMIC FORECAST | Q2 2014 6
Spanish government bond has
fallen to 3.07%, down almost 200
basis points since last summer to its
lowest level since 2005. Italian
government bonds have moved
similarly. The yield of a 10-year
Italian sovereign bond has fallen to
3.10%, off 150 basis points since
last summer. This is also its lowest
level since 2005.
European and emerging market
stocks have not fully priced in the
likelihood of ECB action. The
FTSE Developed
Europe equity
index is up only
slightly more than
the S&P 500
during the last
year, and currently
trades at 14.5
times expected
2014 earnings, a
significant
discount to the
S&P 500, which
trades at a
multiple of 15.7.
That discount is
even bigger when
using the market’s
expectation for
2015 earnings.
The case is even
more stark with
emerging market
stocks, which have
underperformed
U.S. stocks during
the last year. The
MSCI Emerging
Market Index is
trading at 10x
2014 earnings, and
just 8.4x 2015
earnings. If the
ECB decides to go ahead with a
quantitative easing program, both
European and emerging market
stocks are very likely to outperform
as investors seek higher returns in
areas deemed of higher risk.
Emerging market stocks may have
begun to react to this dynamic, as
the MSCI Emerging Market index
is up 9% since mid-March. Some
emerging market indices have
performed even better. The MSCI
Indonesia Index, for example,
which was hit hard last year in the
wake of Fed “tapering”, is up 28%
year-to-date in U.S. dollar terms.
Emerging market currencies have
also risen in recent weeks. The
Colombian peso is up 6% vs. the
U.S. dollar since the end of
February, and the Brazilian real is
up 5%.
— Brandon Fitzpatrick
2009 2011 2010 2013 2012
Yield of 10-year
government bond Portugal
Italy
Currencies vs. U.S. dollar
March April
Indonesia
India
Colombia
Brazil
Spain
7 ECONOMIC FORECAST | Q2 2014
The fixed income market, after
surging in the first two months of
the year, declined in March. Yields
increased significantly for U.S.
Treasury notes with three to seven
year maturities as Federal Reserve
Chairwoman Janet Yellen changed
financial markets’ expectation for
benchmark interest rates.
The financial markets were
expecting short term rates, guided
by the target Fed Funds rate, to be at
the current rate, 0.25%, until the end
of 2015. However, Janet Yellen
said on March 19th that the Fed
Funds rate hike may come as soon
as April 2015, about six months
after the end of the Fed’s
quantitative easing program. This
spooked the financial markets with
3, 5, and 7-year U.S. Treasury rates
increasing by approximately 0.20%.
As a result, 30-year U.S. Treasury
bonds returned 0.90% in March
while the 10-year bond declined
0.34%. The Barclays U.S.
Aggregate index lost 0.17%, as the
U.S. Mortgage Backed Securities
(MBS) and Intermediate U.S.
Government indices declined 0.32%
and 0.39%, respectively.
There will be an upward pressure on
yields as the Federal Reserve
unwinds the current bond buying
program. However, if the U.S.
economy’s growth momentum stalls
(with or without low inflation), rates
may stay at current levels or even
fall. Additionally, increased
geopolitical risk in Russia/Ukraine
and disappointing economic data
from China may lead investors to
seek safety in U.S. Treasuries,
thereby keeping rates low for the
remainder of 2014.
We anticipate U.S. growth
momentum picking up to offset
other concerns (slowdown in China,
currency problems in emerging
countries, and geopolitical risks)
and that U.S. Treasuries rates will
increase gradually in the coming
months. With a modest increase in
inflationary expectations (resulting
from a stronger economy), we
expect the 10-year U.S. Treasury
yield to increase to 3.0 - 3.5% range
by the end of 2014. We expect
spreads (to Treasury securities) on
Agency MBS bonds to increase 15
to 20 bps, as triggered by increased
MBS issuance and flat or decreasing
MBS bond demand as the Federal
Reserve unwinds its current bond
buying program.
We took advantage of lower yields
in February to reduce duration of the
DBF Short Duration and DBF
Intermediate Duration portfolios,
with the goal of cushioning the
effects of probable rising rates in
2014. We reiterate our expectation
that both short duration and
intermediate duration portfolios will
perform relatively well in 2014 and
beyond as portfolio cash flows are
reinvested in a rising yield
environment.
— Prabhab Banskota
FIXED INCOME
Exhibit 1: U.S. Treasury Rates (%)
ECONOMIC FORECAST | Q2 2014 8
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 RETURNS FROM A COMPOSITE. ALL RETURNS ARE GROSS OF FEES AND ANNUALIZED.
D.B. Fitzpatrick & Co. 225 N. Ninth St., Suite 810
Boise, ID 83702 www.dbfitzpatrick.com | (208) 342-2280