Economic forecast Q3 2013
-
Upload
brandon-fitzpatrick -
Category
Documents
-
view
217 -
download
1
description
Transcript of Economic forecast Q3 2013
Q 3
2013
JULY 11
ECONOMIC FORECAST
Fixed Income
Equities
U.S. Economy
Emerging Markets
Europe
DBF Strategies
INSIDE THIS ISSUE:
Summary 4
Fixed Income 4
Equities 6
U.S. Economy 7
Emerging Markets 8
Europe
9
DBF Strategies 9
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
ECONOMIC FORECAST | Q3 2013 4
Fed chairman Ben Bernanke’s comments in mid-May that the Fed would “taper” monetary stimulus as the
economic recovery gains strength spooked the financial markets, sending both stocks and bonds lower in the last
weeks of the second quarter. Bernanke’s announcement was meant to be innocuous, and in truth was not much
different from what he had said in previous speeches. Nonetheless, the bond market was shaken by the prospect
of an early end to the quantitative easing program, and the yield curve steepened. The yield on a 10-year Treasury
rose from 1.60% in April to 2.60% in June. The yield on a 30-year Treasury rose from 3.10% at the end of March
to 3.50% at the end of June. The real interest rate (the nominal rate minus the rate of inflation) rose in the quarter,
as market expectations for inflation fell and nominal yields rose. The real rate on a 10-year Treasury was –0.67%
at the end of March, before rising to 0.46% at the end of June.
We expect interest rates to fall somewhat from current levels, as bond investors take a break from the selling. In
the longer term, however, interest rates are very likely to climb further as the economy continues to heal from the
financial crisis, housing bust, and recession of 2008-2011. There is still a lot of danger in the fixed income
markets, and we’re avoiding low quality credits and long duration bonds. Stocks are more attractive than bonds
today, with attractive value in industrials, financials, and some out of favor emerging markets.
The big action in the second quarter occurred in the bond market. Bernanke’s comments prompted bond selling
and sent interest rates sharply higher. The yield curve steepened and long duration bonds bore the brunt of the
damage. TIPS (Treasury Inflation Protected Securities), were not spared, with inflation breakeven rates falling
dramatically in the second quarter. Market expectations for inflation during the next year fell from 2.35% at the
end of March to 0.74% at the end of June, while inflation expectations during the next 10 years fell from an
annualized rate of 2.52% to 1.99%. The market is sending a message that it doesn’t expect much inflation without
continued large-scale monetary stimulus. The market is also sending a clear warning that interest rates are set to
rise as the unemployment rate falls, Fed bond purchases slow down, and the economy finally returns to a more
SUMMARY
FIXED INCOME
1-year inflation
expectations
10-year inflation
expectations
Q1 Q2
5
“normal” environment, five
years after the financial crisis
began.
Bonds of lower credit quality
were hit even harder than
Treasuries in the second
quarter. The Barclays High
Yield Very Liquid Bond Index,
which tracks high-yield
corporate bonds, was down 5%
from early May to late
June. Emerging market
sovereigns – both U.S. dollar
denominated and local currency
– were down sharply in the
quarter, and the damage was
widespread. A Mexico
sovereign U.S. dollar bond maturing in 2022, for
example, fell 7% in the quarter, while an Indonesian
U.S. dollar bond due in 2019 fell 8%. Local currency
debt was hit even harder. A Colombian local currency
sovereign due 2022 was off 12% in the three months
through June, while a Philippines 10-year local currency
sovereign fell 12%. Additionally, emerging market
currencies were down virtually across the board.
The MBS (mortgage backed securities) market also fell
in the second quarter. Mortgage rates rose, following
Treasury yields, and prices of low coupon pools fell the
most as duration extended. The expected maturity of
low coupon pools increased significantly, as the
underlying mortgages are much less likely to be
refinanced now that mortgage rates have risen. The rate
on a 30-year mortgage rose from 3.40% at the end of
April to 4.61% on July 10.
In the beginning days of the third quarter interest rates
have continued their march higher, with the 10-year
Treasury yield reaching 2.60% on July 11. Recent
economic data have generally been positive, which the
bond market views as giving the Fed more justification
to slow down its purchase of Treasuries and MBS. We
expect interest rates to pause somewhat, taking a break
from their steady increase. The yield curve is likely to
flatten by the end of the year, however, and in the longer
term interest rates are very likely to rise. Our fixed
income portfolios are positioned defensively, with an
emphasis on high quality and short duration bonds.
Barclays High Yield Very
Liquid Bond Index
Lower quality bonds were hit
hard in the second quarter
Indonesia U.S. dollar
sovereign due 2019
Colombia local currency sovereign due 2022
ECONOMIC FORECAST | Q3 2013 6
Stocks, as measured by the MSCI All Country World
Index, fell 0.2% in the second quarter, after being up
over 5% in mid-May. Stocks were affected by two
principal factors late in the quarter: 1) the prospect of
less central bank stimulus made investors somewhat less
sanguine about economic growth and corporate profits,
and 2) the market’s discount rate rose along with bond
yields, pressuring stock prices. Rising bond yields had
their most severe impact on utility and consumer staple
stocks, which are viewed by the market as substitutes
for bonds, due to their steady cash flows and non-
cyclical businesses. These sectors had outperformed
recently, starting in 2012, but in the second quarter fell
further than more cyclical sectors such as financials and
industrials.
European stocks are flat for the year and, though they
fell at the end of the second quarter with the broader
global stock market, have by and large shrugged off
recent worries about political turmoil in Portugal. The
Nikkei index had a volatile second quarter but is still up
37% since the end of 2012 (though this is only 15% in
U.S. dollar terms, as the yen has seen a sharp
depreciation).
Emerging market stocks fell 9% in the second quarter
and are down 11% since the start of the year, as
investors worry that less monetary stimulus in the U.S.
will result in lower capital flows to the emerging
world. There is also a nagging concern in the financial
markets that the economic slowdown in China will
worsen. Southeast Asian equities were hit especially
hard in the second quarter, with the Thai, Indonesian,
and Philippine stock markets all down sharply.
Brazilian and Turkish stocks were down as well, though
with these countries investors were responding more to
protests and political uncertainty, not to slower growth
in China and lower commodity prices. We took
advantage of the turmoil in the stock markets to add
exposure to Indonesian and Brazilian stocks.
The longer term story of the emerging economies is
intact: growing middle classes, increased dependence on
domestic demand, and strong government balance
sheets. Emerging market valuations are compelling,
with the MSCI Emerging Markets Index trading at 10.2
times 2013 earnings, versus 14.8 for the S&P 500 and
13.2 for EAFE (international developed stocks). With
slower growth in China, however, managers will have to
be more choosy with their EM positions as the tide of
rising commodity prices seen in the 2000s is unlikely to
be repeated in the next decade. We have exposure to
Chilean, Colombian, Brazilian, Indonesian, and Chinese
stocks.
EQUITIES
The MSCI All Country World Index ended
the second quarter down slightly
7
The U.S. economic
recovery is continuing
with many positive signs,
but without the
breakthrough growth
number many have been
waiting for since the
recession ended in
2011. Probably the
brightest sign is the
housing market, which
has shown continued
strength during the last
12 months. Housing
prices are up across the
country, including
previously very hard hit
areas such as south
Florida and Las
Vegas. Housing starts
are also up. Higher
mortgage interest rates in
the second quarter
threaten to lower housing
demand somewhat, but
we think a robust
housing recovery will
continue in spite of
higher rates. In fact,
higher rates may be the
impetus needed to get
marginal buyers off the
fence, as they fear the
prospect of missing out
on still low rates.
Durable goods orders are
up, as is consumer
confidence as consumers
feel more upbeat about
the housing market and
their personal balance sheets. Initial jobless claims have
been consistently below 400k, which most economists
believe indicates that the economy is adding
jobs. Higher interest rates typically are bad for
economic growth, but in the present environment they
might be positive if they prompt banks to increase
lending.
We expect the U.S. economy to grow 2.0% this year
before accelerating to 2.5% in 2014.
U.S. ECONOMY
The Case Shiller index of house prices is
up as the housing sector improves
2010 2011 2012 2013
Durable goods orders were
up in the second quarter
Q1 Q2
ECONOMIC FORECAST | Q3 2013 8
There was significant political
turmoil in some notable emerging
market countries in the second
quarter. Higher bus fares in São
Paulo sparked what turned into a
nationwide protest against
endemic corruption, political
atrophy, and massive inequality.
Aspirations have been raised as
the country’s middle class grows,
and change is not coming fast
enough for many. President
Rousseff was caught off guard by
the strength of the protests, but
seems now to have regained her
political footing. She has
promised a series of reforms that,
at least for now, have assuaged protestors. President Rousseff is facing reelection next year, and the political
situation is becoming dire, as it will be very difficult to win without a stronger economy. Further complicating the
situation is the fact that inflation is above the central bank’s target, which limits the policies available to both
Rousseff and the central bank. Brazilian policymakers are now trying to encourage foreign investment and
strengthen the real, though they are surely hopeful that the real’s recent depreciation will boost exports in the short
run. Investors have soured on Brazilian securities -- both stocks and bonds -- and there are currently some good
values in Brazil. Taking advantage of this opportunity, we recently added exposure to Brazilian stocks to our
equity portfolios.
Most economies in Latin
America have slowed down,
largely as a result of lower
commodity prices, but some
countries such as Colombia and
Chile are still set to grow at least
4% this year. The largest
economies in southeast Asia
have also slowed down, but
growth there is still much better
than what the U.S. and Europe
can muster. Indonesia is set to
grow 5% this year, while
Malaysia’s economy will expand
4%. The correlation among
equities in these countries has
been very high in the last few
weeks, and many good stocks are trading at very attractive valuations. We’ve also recently added exposure to
Indonesian stocks.
EMERGING MARKETS
Brazil’s GDP growth is below 2%.
Policymakers are working to stimulate
as the 2014 election looms.
2013 2012 2011
Brazil’s Bovespa Index is
down sharply this year
9
U.S. stocks are fairly valued while Japanese stocks and other deep value sectors still look overpriced. Emerging
market stocks are generally attractive, but careful country and security selection is needed as growth in China
slows down. We’re overweighting emerging market stocks, though we’re not emphasizing BRIC countries
(Brazil, Russia, India, China). We have a neutral weight in financials, an underweight in utilities, healthcare, and
consumer staples, and an overweight in industrials.
There is still a lot of risk in the bond market, even after the recent dramatic rise in interest rates. We are steering
clear of low quality bonds and have positioned our fixed income portfolios defensively as we expect interest rates
to rise further.
— Brandon Fitzpatrick
EUROPE European markets have been fairly quiet this year, with
investors satisfied that the European Central Bank will
serve as a backstop to prevent sovereign bond yields
from spiraling out of control. Recent troubles in
Portugal have not spread to the rest of Europe, and it
appears that there is little risk of a further conflagration
in the near term. Economic growth, however, is anemic
across the continent and unemployment rates are
unacceptably high.
There seems to have been somewhat of a change in
attitude across the continent against “austerity” – fiscal
tightening designed to bring national budgets under
control – though admittedly not in Germany. There is
certainly a lot of empirical evidence indicating that
austerity has not helped spur economic growth, and
probably has even worsened national budget deficits
(the UK is a case in point).
German elections in August offer new hope, as
Chancellor Merkel, after winning a new mandate, may
feel freer to inch away from austerity and instead
support measures designed to encourage economic
growth. Certainly that would be beneficial for
Europe. We have an underweight in European stocks,
though there are some good European value stocks with
decent valuations, and we do have some exposure
within our equity portfolios.
GDP growth in Europe
Germany
Spain UK France
2013 2012 2011 2010
DBF STRATEGIES
ECONOMIC FORECAST | Q3 2013 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.
D.B. Fitzpatrick & Co. 225 N. Ninth St., Suite 810
Boise, ID 83702 www.dbfitzpatrick.com | (208) 342-2280