Post on 01-Apr-2016
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Q 3 2014 JULY 11
ECONOMIC FORECAST
INSIDE THIS ISSUE:
Bull Market Continues 3
Stimulus Still Driving Returns 3-4
Equity Valuations 5
Fixed Income 5-6
D.B. Fitzpatrick & Co. 800 W. Main Street, Suite 1200
Boise, ID 83702 (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
3 ECONOMIC FORECAST | Q3 2014
Both bonds and stocks rose in the first half of the year as
investors took heart from GDP data. Economic growth
in the U.S. has not been slow enough to convince
investors that the post-crisis recovery is off-track, and
has not been fast enough to convince central bankers to
raise interest rates. Additionally, growth in the
emerging economies has been decent and consistent
with expectations so far this year. Interest rates in the
U.S. have fallen significantly, and the Barclays
Aggregate Bond Index rose 3.9% year-to-date through
June, while the global stock market as measured by the
MSCI All Country World Index was up 6.5%. The
“decoupling” of
emerging market stocks
from U.S. and EAFE
stocks seen in 2013 has
abated, and all major
international indices
have recorded similar
returns this year. The
S&P 500 was up 7.1%,
the EAFE index rose
5.2%, and the MSCI
Emerging Market Index
was up 6.1% year-to-
date through June.
Both the bond and stock
markets were very calm
in the second quarter,
even in the face of heightened instability in the Middle
East. Financial markets have been ignoring geopolitical
risk and have been focusing instead on two other
issues: slow but steady growth in the global economy,
and promises of continued monetary stimulus in Europe
and Japan. The stimulus has created some “bubble” like
conditions in parts of the bond market – high yield
corporates and peripheral European sovereigns are
notable examples – and has pushed U.S. stocks to full
valuations. European and emerging market stocks still
have room to run as their valuations remain attractive.
BULL MARKET CONTINUES
STIMULUS STILL DRIVING RETURNS
The financial markets have been calm so far this year.
The VIX Index, a measure of the stock market’s
volatility, has fallen and is as low as it’s been in seven
years. Consistent with this placid atmosphere, the stock
market has risen steadily this year through June, with
only a short-lived drop in January and February.
There are two major factors underlying this tranquil
environment. The first is that the U.S. economy, though
slowly strengthening, remains weak enough that the
Federal Reserve is unlikely to begin raising interest rates
for another year. The economy is performing well from
the point of view of the stock market – steady and
moderate growth combined with low inflation is
preferred. Eventually the Fed will have to raise interest
rates, but the stock market is hoping the transition will
be slow and clearly explained with maximum
anticipation. U.S. economic growth has been consistent
with this hoped-for scenario so far this year, and the Fed
has reacted calmly and resolutely.
The second important factor driving the calm and rising
Q1 Q2
Year-to-date
Equity Returns
MSCI Emerging
Markets Index
EAFE Index
S&P 500
MSCI All Country
World Index
ECONOMIC FORECAST | Q3 2014 4
stock market is monetary
stimulus in Japan and
Europe. The Bank of
Japan has continued on its
push to fight deflation and
stimulate the country’s
torpid economy, and the
European Central Bank has
instituted further easing
(with a negative interest
rate charged on bank funds
held at the ECB) and
promises to do more if
economic growth requires
it. This increase in global
liquidity has been good for
risky assets – especially
corporate bonds and
sovereign bonds from peripheral
Europe, in addition to stocks.
This good news notwithstanding,
there are some storm clouds
gathering for the stock market.
Geopolitical risk has clearly
increased in recent weeks as turmoil
has spread in Syria and Iraq, and
threatens to erupt in other parts of
the Middle East. The biggest risk
regarding the Middle East
from the view of the
financial markets is, as
usual, the prospect of a
disruption of oil
supplies. Iraq’s oil fields
are of increased
importance to global
supplies, and their huge
reserves makes them very
important to the market’s
forecast of global
production over the next
5-10 years. Surprisingly,
oil prices have been
relatively calm in spite of
the recent negative
headlines out of
Iraq. Brent crude rose to
$115 in the days after rebels
captured Mosul in northern Iraq, but
has since fallen to $108. The
market seems to be predicting that,
whatever the ultimate solution to
Iraq’s imbroglio, oil production in
the country will not be disturbed.
Despite the recent equanimity
regarding the various conflicts in the
Middle East, financial markets could
be jolted to attention with a
seriously negative headline. The
market is correct that, in the longer
run, the complicated issues in Iraq
and the broader Middle East will
likely not prove damaging to the
global economy. But today much of
the stock market is close to fully
valued and unexpected bad news
could cause a jolt.
Volatility Index (VIX)
2011 2012 2013 2014
U.S. GDP
Growth Rate 3.0%
2.5%
2.0%
1.5%
2011 2012 2013 2014
5 ECONOMIC FORECAST | Q3 2014
The U.S. stock market
strongly outperformed
both EAFE and
emerging market stocks
in 2012-2013, though
this was primarily due to
an increase of “earnings
multiples”, not earnings
growth. The market’s
discount rate for U.S.
corporate earnings fell
during those years, while
the discount rate on
emerging market
corporate earnings
stayed roughly
unchanged. There has
been a change this year,
however, as the three main regional equity sectors have
all risen roughly the same amount. In other words,
investors’ discount rates for stocks from these three
regions have moved similarly this year. This change in
market sentiment bodes well for emerging market
stocks going forward, as they are still trading at a sharp
discount to both U.S. and EAFE stocks. Continued
stimulus out of Japan and Europe strengthens the case
for emerging market equities, since they’re one of the
last sectors trading at cheap valuations.
— Brandon Fitzpatrick
EQUITY VALUATIONS
FIXED INCOME
14.813.3
10.5
0
2
4
6
8
10
12
14
16
S&P 500 EAFE MSCI EmergingMarkets Index
Price to Earnings Ratio (expected 2015 earnings)
At the end of 2013 the financial
markets as well as most economists
were expecting rising rates and the
end of the bull run in the fixed
income market. However, the
opposite happened. U.S. Treasury
yields declined and the fixed income
market performed well in the first
half of 2014. As of June 30, 2014,
the 30-year U.S. Treasury bond has
returned 13.77% while the 10-year
bond has returned 6.13%. For the
same period, the Barclays U.S.
Aggregate index has gained 3.93%,
while the U.S. Mortgage Back
Securities (MBS) and Intermediate
U.S. Government indices have
returned 4.03% and 1.55%,
respectively.
There are multiple reasons driving
the decline in the U.S Treasury yield
curve:
With the surge in equity markets in
2013, investors rebalanced their
portfolios or took profits by selling
equities and buying bonds,
especially Treasury bonds.
U.S. GDP grew at a dismal -2.9%
(annualized) in the first quarter of
2014, revised from earlier stated
-1.0%. Policymakers have now
reduced their growth forecast for the
U.S. economy from 2.9% to 2.2%.
Inflation has not picked up despite
easy monetary policy, especially in
Europe and Japan. This remains a
major concern for central bankers.
The financial markets are
forecasting prolonged
accommodative monetary policy.
Geopolitical risk, heightened
tension in Iraq, continued unrest in
Syria, and uncertainty regarding
Putin’s next adventure have helped
ECONOMIC FORECAST | Q3 2014 6
to keep yields low.
Nominal yields on European
sovereign bonds have been
decreasing as investors are
“searching for yield”. 10-year
Spanish bonds, which yielded
7.62% in July 2012, yielded
2.58%, 0.03% less than
comparable duration U.S.
Treasuries on June 9, 2014.
Financial markets are not
factoring in the credit risk
associated with European
sovereign bonds.
Finally, monetary policy from the
Federal Reserve will be
accommodative. The Fed anchors
the short term Treasury rates with
the Fed Funds rate. The financial
markets expect the Federal Funds
rates to increase no sooner than the
second half of 2015. The Fed is
also keeping the long end of the
Treasury yield curve depressed by
buying long-term U.S. Treasury
bonds through the Quantitative
Easing (QE3) program.
We anticipate U.S. growth momentum to accelerate
during the second half of 2014 and 2015. With a
modest increase in inflationary expectations (resulting
from a stronger economy), U.S. growth should prompt
rates to rise.
In addition to the growth momentum, as the Federal
Reserve unwinds the current bond buying program
there will be upward pressure on Treasury yields.
However, other parameters described above will work
against rising yields. Overall, we expect the yield curve
to steepen slightly in the next two quarters and the U.S.
10-year Treasury yield to be range-bound between
2.7% to 3.2% through the end of 2014.
DBF short duration and intermediate duration
portfolios have performed well in 2014. At the same
time, the portfolios are positioned to “cushion” the
effects of moderately rising yields.
— Prabhab Banskota
Year-over-Year Change in
Consumer Price Index (CPI)
U.S. Treasury Yield Curve
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D.B. Fitzpatrick & Co. 800 W. Main Street, Suite 1200
Boise, ID 83702 www.dbfitzpatrick.com | (208) 342-2280