economic forecast q2 2014

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%


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 (%)


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

economic forecast q2 2014

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