Q 4 2014

OCTOBER 13

ECONOMIC FORECAST

INSIDE THIS ISSUE:

Market Summary 4

Risk Reassessed 4-6

Continued Slow Growth 6-7

Fixed Income 7-9

DB Fitzpatrick 800 W. Main Street, Suite 1200

Boise, Idaho 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

ECONOMIC FORECAST | Q4 2014 4

The capital markets were volatile in the third quarter

and early in the fourth quarter, with stocks down and

bonds up since mid-September. Investors today are

grappling with four main issues: 1) a very weak

economy in Europe with little hope of a turnaround in

the near term; 2) a continued slow but steady economic

recovery in the U.S.; 3) disappointing growth in the

emerging markets generally, though a significant

disparity of results between countries; 4) the prospect

of higher interest rates over the medium and long term

as the U.S. Federal Reserve ends its quantitative easing

program and raises interest rates in coming years.

These issues, of course, are interrelated, and how one

develops over time will affect all the others.

Europe’s weakness is the issue dominating investor

sentiment during the equity selloff of the last few

weeks, and fears about Europe’s impact on global

growth have driven low interest rates even lower.

Rising interest rates will be a worry in the future, but

today the issue is on the back burner.

There has been a renewal of “risk on / risk off” trading

– with high volatility, and increased correlations among

different areas of the capital markets — during this

selloff. Sectors that are more sensitive to economic

growth have underperformed, as is almost always the

case when volatility is high.

We believe this is a typical market correction and not a

harbinger of worse things to come, as equity valuations

had gotten a little high earlier in the year. The

macroeconomic environment has not changed enough

in the last four weeks to justify this selloff. Further

downside to equities is of course possible, but equities

today are attractive and offer good value vis-à-vis

bonds. Our fixed income portfolios are positioned

defensively, and in our equity portfolios we have made

tactical moves into hard-hit sectors.

MARKET SUMMARY

The recent selloff in the equity market is ultimately

explained by two factors: 1) economic data in Europe

have been worse than expected and there is concern that

this will impact global growth; 2) equity valuations had

gotten ahead of historical averages in the first half of

the year. New evidence of weakness in Europe does

not substantively change our outlook for global growth,

and we believe this selloff is a

temporary overreaction.

Higher beta sectors – including

industrials, materials, and energy –

began to underperform the broader

market early in the third quarter, and

their underperformance continued into

October as volatility jumped. Sectors

less dependent on economic growth,

such as healthcare and consumer staples,

have outperformed the market.

Among the three main regional world

equity sectors – U.S., EAFE

(international developed), and emerging

markets – emerging market stocks typically are the

worst performers when volatility increases. EAFE

stocks usually outperform emerging markets during

selloffs, while U.S.-based stocks outperform the global

stock market. Part of this is due to investors seeking the

relative safety of the transparent and liquid U.S.

markets, and part is explained by a rising U.S. dollar,

RISK REASSESSED

S&P Global Healthcare Index

S&P Global Energy Index

S&P Global Consumer

Staples Index

S&P Global Materials Index

S&P Global Industrials Index

July September August

5%

0%

-5%

-10%

-15%

5

viewed as a “safe haven” currency.

In the third quarter, however, this

typical pattern was not followed as

EAFE was the worst performer and

emerging markets, though

underperforming U.S. stocks,

performed relatively well and are

even with the global market year-to-

date. The underperformance of

EAFE is explained by further

weakness in the European economy.

Emerging economies are sensitive to

a deterioration of the European

economy too, as many of their

exports are purchased by Europeans,

but emerging market assets also

benefit from low global interest

rates. Europe’s slowdown has led to

falling rates around the world, and

this is helping emerging markets

perform decently in a tough market

environment.

Many emerging market currencies,

however, have been hit hard. This is

due to market anticipation of further

monetary stimulus, combined with

investor belief that the Fed will

eventually raise interest rates in the

U.S. Falling currencies are good for

economic growth in the medium

term, as they result in cheaper and

more competitive exports. It will

take 6-9 months, however, for this

to be reflected in trade data.

Oil prices are off significantly since

the end of the second quarter,

partially due to increased supply in

the U.S. There is also additional

supply from Iraq and Libya hitting

the market, and expectations for

additional supply from Russia as

tensions between Moscow and the

West have abated somewhat.

Investor anticipation of lower

demand as global economic growth

slows is another important factor.

The market is correct to price in

these developments but the selloff in

oil — and in energy stocks — is

overdone. Geopolitical tensions

could spike suddenly, as tensions

are already high in the Middle East,

and Vladimir Putin remains as

unpredictable as ever. Moreover,

fears of a swift decrease in demand

are exaggerated. The European

economy has been weak for many

years, and recent data are only

consistent with this general trend.

The U.S. economy continues to

grow, albeit at a moderate pace, and

the emerging market economies are

still growing too. All this will buoy

demand for oil.

Bloomberg Dollar Spot Index

(normalized, last 12 months)

Q1 Q4 Q3 Q2

West Texas Intermediate

Crude

Brent Crude

July August September

MSCI Emerging

Markets Index EAFE

S&P 500

Q1 Q2 Q3

$100

$90

$110

100

103

106

ECONOMIC FORECAST | Q4 2014 6

The economy in the U.S. continues to recover, but

recent data have been mixed. The labor market

exemplifies the issue, with the national unemployment

rate falling to 5.9% but labor participation at only 63%

– a 30-year low. It has been five years since the U.S.

economy bottomed out in 2009, and the long hoped-for

resurgence of jobs has not occurred. Instead, it has

been quarter after quarter of slow, though consistent,

growth. Millions remain marginally attached to the

labor force, and millions more have dropped out of the

labor force altogether.

There are positive signs for the future,

however. Housing starts are up and

prices across the country continue to

rise. Retail sales are up 5% year-over-

year, and consumer confidence is as high

is at it’s been in six years. We are

forecasting the U.S. economy to grow a

respectable 2.0-2.5% during the next two

years.

The economy in Europe, however, is in

worse shape, and its disappointing

results are threatening growth elsewhere

around the world. GDP growth in the

Eurozone is currently 0.0%, and there is a good chance

of a recession during the next year. Inflation is down

to only 0.3%, and deflation in 2015 is a real possibility.

Industrial production is down in Germany, which has

investors on edge. Consumer confidence, predictably,

is very low and the unemployment rate across the

Eurozone is 11.5%. There are, of course, significant

differences in unemployment among Eurozone

countries – Spain’s unemployment rate, for example, is

25%, while the figures in France and Germany are

CONTINUED SLOW GROWTH

As almost always happens

during periods of stress in the

equity market, the correlation

of stock price moves has

increased in recent weeks.

The upside to this is that

stock prices of good

companies get dragged down

with the general market.

The S&P 500 is trading at

14.3x expected 2015

earnings, while the EAFE

index trades at 12.6x, and the

MSCI Emerging Market

Index trades at 10.4x. These

are attractive valuations.

Germany Industrial

Production (year-over-year)

Q1 Q3 Q2

0%

2%

-2%

4%

7

FIXED INCOME

The fixed income market has performed better than

expected in 2014, with the U.S. Treasury yield curve

declining and flattening. As a result, 30-year and 10-

year U.S. Treasury bonds returned 17.6% and 6.9%,

respectively, through the end of the third quarter. For

the same period, the

Barclays U.S.

Aggregate index

gained 4.1%, while

the U.S. Mortgage

Back Securities

(MBS) and

Intermediate U.S.

Government indices

returned 4.2% and

1.6%, respectively.

The Federal Reserve

took unprecedented

steps to spur growth in the U.S. economy after the

credit crisis of 2008-2009. It decreased the Federal

Funds rate to 0.25% in 2008 and embarked on multiple

asset purchase programs. The asset purchase programs

were aimed at decreasing long-term borrowing costs,

9.7% and 6.7%, respectively. One

recent positive development for

Europe is the devaluation of the euro,

down 9% vs. the U.S. dollar since

May. This will provide a boost to

exports, though it will take some time

before this benefit finds its way into

economic data.

Europe is trapped by its politics. What

is needed is further quantitative easing

— including purchases of sovereign

bonds — as was done in the U.S., in

addition to fiscal stimulus and, of

course, structural reforms. Mario

Draghi, the chair of the European

Central Bank, has not ruled out sovereign bond

purchases, but he is constrained by politicians who are

adamantly against using monetary policy to boost

growth.

In spite of recent negative headlines, the most likely

scenario for Europe is largely unchanged. Mario

Draghi will eventually institute additional quantitative

easing, including unconventional measures, but it will

take further disappointing growth numbers and possibly

a dip into deflation before he gets room to maneuver

within Europe’s political arena. We expect growth in

Europe to be 0-1% during the next year, though it

should increase to 2.0% in 2016 in the wake of a new

round of QE. The risk for Europe is that Draghi isn’t

aggressive enough with QE in 2015.

— Brandon Fitzpatrick

Consumer Prices

(year-over-year %)

Q1 Q3 Q2

Spain

France

Eurozone

Germany

0.0%

1.0%

0.5%

-0.5%

1.5%

Treasury Yield Curve

ECONOMIC FORECAST | Q4 2014 8

while the lowered Fed Funds rate helped keep down

short-term borrowing rates. With the U.S. economy

improving, the Federal Reserve is set to end the latest

bond buying program (QE3) in October. Additionally,

the Fed is gearing up to increase short-term rates by mid

-2015.

The European Union is battling very low inflation and

the European Central Bank is embarking on a new

round of expansive monetary policy. Two year

sovereign bond yields in France, Germany, and Italy are

-0.02%, -0.09%, and 0.34%, respectively. Reflected in

these yields is the distinct possibility of deflation in

Europe. Meanwhile, the economic growth rate in Japan

is bleak, with GDP contracting 1.7% quarter-over-

quarter between April and June. Japan’s two year

sovereign bond yields 0.06% and expected inflation

during the next two

years is 3.8%. In

summary, the two year

U.S. Treasury note

yields 0.53%, which,

although very low,

looks appealing when

compared to other

sovereign bonds.

Year-over-year

inflation in the U.S, as

measured by

Consumer Price Index

Urban Consumers

NSA (non-seasonally

adjusted), was 1.7% in

August after increasing

2% in previous

months. With

commodity prices

falling and the dollar

strengthening, financial

markets expect an

annual inflation rate of

1.98% for the next 10

years as measured by

the difference between

the yields of 10-year

U.S. Treasury and 10-

year TIPS (Treasury

Inflation Protected

Securities). This expectation comes in spite of the fact

that corporations in the U.S. are flooded with cash and

the Federal Reserve is continuing to supply ample

liquidity to the financial markets.

Geopolitical unrest affects Treasury yields, as Treasury

securities are considered a global safe haven. U.S.

involvement in Iraq to counter the ISIS uprising, unrest

in Syria, continued squabbles between China and its

neighbors, and uncertainty regarding Putin’s next

adventure will pressure the yield curve downward.

We forecast the U.S. 10-year Treasury yield to be

2.25% - 2.50% by the end of 2014, and it should inch

up gradually to 2.5% - 3.0% by the end of 2015. The

belly of the curve should rise as early as the start of

2015, guided by the Fed Funds rate. We anticipate U.S.

U.S. Government Debt

($ billions)

2-year bond yields

9

growth momentum to continue for the remainder of

2014 and 2015 and expect inflation in 2015-2016 to be

higher than current market expectations.

— Prabhab Banskota

U.S. Consumer Price Index (NSA)

ECONOMIC FORECAST | Q4 2014 10

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DB Fitzpatrick 800 W. Main Street, Suite 1200

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