Economic Forecast Q3 2015

ECONOMIC FORECAST Q3

2015 JULY 15

INSIDE THIS ISSUE:

Eurozone Turmoil 4-5

China 6

Equities 7

Fixed Income 8-9

DB Fitzpatrick 800 W. Main Street, Suite 1200

Boise, Idaho 83702 (208) 342-2280

www.dbfitzpatrick.com

Dennis Fitzpatrick CEO and Chairman

Brandon Fitzpatrick COO and President

Prabhab Banskota Fixed Income Portfolio Manager

ECONOMIC FORECAST | Q3 2015 4

There have been two main dynamics driving investor

sentiment in recent weeks, and the unpredictable nature

of both has led to increased volatility in the stock and

bond markets. The first is the approach of interest rate

hikes in the United States, and the second is political

turmoil in the Eurozone. In the case of interest rates,

that rates will eventually rise is assured, but the timing

of rate hikes in uncertain. The Federal Reserve is

anxious to begin restoring interest rates to more typical

levels, but sees little inflationary pressure in the

economy and is wary of slowing economic growth.

Given the recent volatility in the capital markets, we

expect the Fed to wait until later this year or early 2016

before raising policy rates.

As for Europe, the issues are much more tangled, and

the plans and calculations of politicians more difficult

to discern. As the third quarter begins, the Greek

government has agreed to the demands of the country’s

creditors, and the possibility of an immediate exit of

Greece from the Eurozone has abated. This (albeit

short-term) resolution has been good for risky assets,

including stocks, and has put pressure on bond prices as

investors unwind some of their ‘safe-haven’ positions.

It is unlikely that we have seen the end of the drama in

Europe, but in the longer term whether Greece remains

in the Eurozone is not of much importance to the global

economy, nor to investors.

The markets were shaken by the Greek government’s

decision to break off negotiations with Eurozone

leaders in late June, and as the second quarter

concluded volatility in the capital markets was high.

The MSCI All Country Index of global stocks fell 4.8%

from June 26 to July 8, though stocks gained back some

of those losses in subsequent days. The VIX, a measure

of market volatility, spiked in late June and early July.

Markets always hate uncertainty, and the brinksmanship

shown by Greece’s prime minister produced significant

uncertainty in the minds of investors.

When analyzing the situation facing Europe, some

perspective is required. Greece has a population of 11

million and a gross domestic product of $300 billion,

which is roughly the size of Connecticut’s economy.

The broader Eurozone, on the other hand, has a

population of more than 330 million and a GDP of $13

trillion. Obviously, Greece on its own is not terribly

significant to the Eurozone, let alone to the global

economy. Some investors are still wary of the

possibility, however, that an exit of Greece from the

monetary union could cause a new crisis in the

continent’s financial system. This possibility, albeit

small, is what has driven the spike in market volatility

in recent weeks.

EUROZONE TURMOIL

5

Investors’ fears are

exaggerated. The private

institutions that hold

Greek debt have had years

to prepare for a possible

default and haircut.

Moreover, over 80% of

the debt that Greece owes

is held not by private

banks and investors, but

by other Eurozone

governments, the IMF,

and the European Central

Bank, who can absorb a

loss. The European

Central Bank is now deep

into its quantitative easing

program, and, if faced

with Greece leaving, is

almost certain to buy

additional bonds to keep

interest rates low in the

rest of the monetary

union. ECB chairman

Mario Draghi has not

backed down from his

pledge to do ‘whatever it takes’ to

save the euro, and he has credibility

with bond investors.

Having Greece out of the Eurozone

would probably be better for

European markets in the long run, as

the brinkmanship that has become a

recurrent theme in the negotiations

between Greece and its creditors

creates significant uncertainty and

worry among investors. In the short

run, however, a collapse in

negotiations would cause renewed

volatility in the financial markets.

VIX

April May June July

Greek Prime Minister

announces referendum

April May June July

S&P 500

MSCI EAFE

MSCI All

Country World 100

102

104

106

98

16

18

20

14


A few words are in order regarding

the tumultuous ride of the Chinese

stock market during the last few

months. Chinese stocks had an

excellent first quarter, with the

Shanghai Composite Index up 60%

through mid-June. The gain was

driven by speculators and Chinese

retail investors, many of whom

opened brokerage accounts for the

first time, seeking to cash in on the

positive momentum of

stocks. Cracks began appearing in

early June, and in the following

weeks the Shanghai Composite fell

30%. The government, alarmed by

the fall, has taken

drastic action to

prop up the stock

market. Initial

public offerings

have been

suspended, margin

rules have been

relaxed, and large

institutions now

face restrictions on

the sale of equities.

These actions have

helped to arrest the

short-term fall, but this kind of

meddling is deleterious to investor

confidence in the long run.

This episode is relevant to investors

because it demonstrates the fragility

of financial markets in China, and

offers insight into the thinking of

Chinese policymakers. China’s

leaders are clearly wary of markets

and will continue to interfere when

they view market results as

excessive in any direction. The

policies during the last few months

were erratic and have greatly

shaken investor confidence in the

competence of China’s

leaders. Investors desire

predictable policies from political

leaders, and this has been in short

supply in recent days.

China’s economy will continue to

grow, and the country’s rise as an

economic power is little affected by

these events. The adoption of

China’s currency as a global reserve

currency has been delayed,

however. For investors it will take

some time for China’s

policymakers to overcome the

damage recently done to their

CHINA

January March May July

Shanghai Composite

160

140

120

100

7

Despite heightened

volatility in recent

weeks, the stock market

is up slightly year-to-

date. There has been

significant variance in

the returns among

sectors,

however. Healthcare,

consumer discretionary,

and consumer staples

have all performed

well, while energy,

industrials, and utilities have underperformed.

Energy stocks began to fall at the end of last year,

after Saudi Arabia announced that it would bring new

supply on the market, and the price of oil has fallen

from over $100 per barrel to around $50. Demand is

increasing, but this has been outweighed by new

supply. Additionally, the recently announced deal

between Iran and the West is likely to have a big

impact on global oil supply during the coming

years. Iran has the fourth largest oil reserves

worldwide, but sanctions have prevented the country

from accessing cutting-edge production technology

and from selling to most of the world. That

technology will now be in reach. Iran produced 6

million barrels per day in the 1970s and today

produces about 3 million barrels per day, so the

potential to increase supply is obvious. Finally,

supply from the U.S. and Iraq continues to increase.

Given these dynamics, we expect oil prices to remain

low for some time.

The most attractive equity sectors are industrials and,

specifically, transportation stocks, which have

underperformed recently and are trading at deep

discounts to the broader market. Healthcare continues

to be attractive despite the recent run-up, and

consumer discretionary stocks are poised to make

further gains as the U.S. economy continues to report

decent growth numbers. Utilities will face further

pressure in the coming period of Fed tightening.

— Brandon Fitzpatrick

EQUITIES

January March May July

Healthcare

Consumer Disc.

Energy

Utilities Transportation

100

95

90

105

110

115

85


U.S. Treasury yields rose in June as bond investors

anticipated interest rate hikes in the U.S. Yields fell in

the first days of July, however, as investors braced for a

possible exit of Greece from the Eurozone. While the

Federal Open Market Committee (FOMC) has

reiterated its position to raise the Fed Funds rate in

2015, the financial markets now calculate only a 57%

chance of a rate increase by December. The Fed wants

to begin raising rates, but will do so only when it is

confident that rate hikes will not cause excessive

turbulence in the financial markets.

The U.S economy added two hundred and eighty

thousand jobs in May, bringing the unemployment rate

to 5.5%. Average hourly wages and housing data also

improved, as did consumer confidence. As the

economic outlook has improved in the U.S., the yield

of the benchmark 10-year Treasury bond

rose to 2.35% at the end of June from

2.12% a month earlier. Similarly, yields

were up in Europe despite the European

Central Bank’s ongoing quantitative

easing program. 10-year German bunds

jumped from 0.05% in mid-April to 0.90%

in June. The increase was not steady or

gradual, however. The bond market

seesawed amid the standoff between

Greece and its creditors.

The turbulence in Europe has added to

volatility in the fixed income market, as

demonstrated by the MOVE index. We expect

elevated volatility to persist for the remainder of the

year as investors interpret the impact of divergent

monetary policies around the world, economic data

from the U.S. and abroad, and grapple with the fallout

of the latest crisis in Europe.

As interest rates rose in June, the Barclays U.S.

Aggregate index returned -1.09% during the month.

Within the U.S. Aggregate Index, corporates returned

-1.84%, while Treasuries and MBS returned -0.88%

and -0.76%, respectively. Year-to-date, the Barclays

US Aggregate index has returned -0.10%.

Agency MBS have slightly underperformed Treasuries

year-to-date, as demonstrated by the Barclays U.S.

Government Intermediate Index and the Barclays U.S.

FIXED INCOME

Treasury Yield Curve

3/31/15

7/14/15

9

MBS Index. This relative underperformance

can be attributed to higher agency MBS

issuance, a steeping of the yield curve, and

higher interest rate volatility. Agency MBS

issuance has increased by 58% to $661 billion

as of June 2015, up from $419 billion in the

same period last year. Within the MBS sector,

Ginnie Mae securities have underperformed

Fannie Mae and Freddie Mac MBS, as the

FHA reduced annual MIP (mortgage insurance

premium) from 1.35% to 0.85% earlier this year,

prompting a rise in prepayments. With the recent

underperformance, MBS now offer better value than

U.S. Treasuries.

TIPS have outperformed Treasuries year-to-date, as the

Merrill Lynch 3-5 year U.S. TIPS Index is up 1.58%,

while the Merrill Lynch 3-5 year U.S. Treasuries Index

has gained 1.34%. Year-to-date inflation, demonstrated

by U.S. CPI Urban Consumer NSA Index, has increased

by 1.27%. Inflation expectations have also increased as

oil prices stabilized around $60 a barrel in May and

June. Annual expected inflation during the next three

years is 1.35%, up from 0.75% at year-end 2014. We

expect inflation to rise to 2.0% to 2.5 % in the next 2-3

years.

Investment grade corporate bonds were hit the hardest

in June, with the Barclays Corporate bond index

returning -1.84% during the month. The index has

returned -0.92% for the year. $592 billion of

investment grade corporate debt has been issued

through May, vis-à-vis $511 billion in the same period

last year. Corporations have been taking advantage of

the low yield environment to lock in cheap financing for

longer periods. The maturity of recently-issued

corporate bonds averages 16.5 years vis-à-vis 12 years

for debt issued during 2004-2014. Utilities have been

the worst-performing corporate bond sector, returning

-2.74% year-to-date. Meanwhile, the industrial and

financial sectors have returned -1.12% and -0.14%,

respectively, through June.

As the third quarter begins investment grade corporate

bonds are attractive vis-à-vis agency MBS, as corporate

spreads have widened. We prefer corporate credits over

MBS in the intermediate duration space, as MBS have

extension risk. We see significant value in longer

maturity corporate bonds offered in the metals &

mining, energy, communications, and financial sectors.

— Prabhab Banskota

Q3 Q4 Q1 Q2

Merrill Lynch Option Volatility

Estimate (MOVE) Index

80

100

60


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DB Fitzpatrick 800 W. Main Street, Suite 1200

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

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Economic Forecast Q3 2015