DBFitzpatrick REGISTERED INVESTMENT ADVISORS

ECONOMIC FORECAST

Q3 2016

July 15

DB Fitzpatrick 800 W. Main Street, Suite 1200

Boise, Idaho 83702 (208) 342-2280

www.dbfitzpatrick.com

INSIDE THIS ISSUE:

Risk On as Rates Fall Further 4

Bull Market In Bonds Continues 4-6

Equities 6-7

ECONOMIC FORECAST | Q2 2016 4

Global economic growth remains lackluster, but in

an ironic twist this has been positive for equities as

falling interest rates have provided fuel for the

stock market. The U.S. economy grew a

disappointingly slow 2.1% during the last year,

while the Eurozone’s economy expanded 1.7% and

growth in Japan was close to zero. China’s

economy grew 6.7% (at least according to the

government’s official figures), but this is down

from previous years and the government has been

repeatedly forced to lower its economic growth

target. With this backdrop of disappointing growth,

investors are also grappling with the U.K.’s

unexpected decision to

leave the European Union,

and a renewed

protectionist movement in

the U.S. All of these

factors have conspired to

push interest rates

downward, and this has

sent ripples throughout

other areas of the financial markets, including

equities, commodities, corporate bonds, and even

commercial real estate. All of these groups have

benefitted as yields on safe-haven bonds sit at rock

bottom levels and investors rotate into more risky,

and potentially more lucrative areas of the capital

markets. We think this is a good time to be

cautious, however, both in bond and equity

portfolios. We favor mortgage backed securities in

the fixed income market and healthcare, consumer

staples, and industrials (one of the last sectors with

attractive valuations) in the equity market.

RISK ON AS RATES FALL FURTHER

BULL MARKET IN BONDS CONTINUES The bull market in fixed income

continued in the second quarter,

with yields falling on all but the

shortest tenors of the yield curve.

The U.S. Federal Reserve’s

stated plan in late 2015 to raise

interest rates four times this year

is now a distant memory, as

disappointing economic data in

the U.S. and continued weakness

in Europe have convinced Fed

policymakers that holding rates

5

steady is a safer bet. The Brexit decision

in late June further cemented the Fed’s

new strategy, and now bond investors

see a roughly 40% probability that the

fed funds rate will be unchanged through

all of 2017.

Continued malaise in Europe has been an

especially important factor in the fixed

income market this year. GDP growth in

the Eurozone has not reached 2.0% since

2011 and the unemployment rate remains

in the double digits. The European

Central Bank has been buying at

least €60 billion per month of euro-area

bonds from central governments,

agencies, and European institutions since

early 2015 in a bid to jumpstart the

economy, and plans to continue the

purchases until at least September of this

year. This quantitative easing program

has pushed European sovereign yields

downward, while the Brexit vote and the

uncertainty it unleashed in late June

pushed yields even lower in the last

week of the quarter. Many of the shorter

tenors of European sovereign yield curves are

negative, while Swiss sovereign bonds — the most

extreme case — have negative yields on all

maturities less than 50 years. The extremely low

yields in Europe’s bond market have depressed

yields in virtually all sectors of the U.S. fixed

ECONOMIC FORECAST | Q2 2016 6

income market.

Despite the sluggish global economy, corporate

bonds have performed well this year as investors

have looked to credit in the increasingly difficult

search for yield. The Barclays U.S. Investment

Grade Corporate Index returned 7.7% year-to-date

through June, outpacing the Barclays Aggregate

Index, which returned 5.3%. The Barclays U.S.

MBS Index returned 3.1% year-to-date through the

second quarter, underperforming the Barclays

Aggregate, as investors expect MBS prepayments

to increase in the third quarter, and this has

subdued price gains. MBS are attractive today,

however, and it’s highly likely that they will

outperform the broader bond market if interest rates

bounce back from their current very low levels.

Given the significant drop of bond yields during

the last month, this is the time to be defensive in

the bond market.

EQUITIES

There was heightened activity in

the stock market during the last

weeks of the second quarter, as

investors grappled with the

implications of the Brexit vote.

Equities were down sharply in the

immediate aftermath of the

decision, but have

gained back all their

losses as it became

clear that monetary

authorities worldwide,

in an effort to

stimulate growth, will

keep interest rates low

for the indefinite

future. Brexit and its

implications for Europe represent

a cloud over the stock market as

the third quarter begins, but

investors believe (correctly, in

our view) that interest rates

remain the dominant factor for

equities.

After all the tumult of the last

week of June, the stock market

was up in the second quarter.

The MSCI All Country World

Index, a measure of the global

stock market, ended the second

quarter up 1.2%, and has returned

7

4.8% year-to-date. The

S&P 500, a measure of

U.S.-based companies,

returned 2.5% in the

second quarter and is up

7.1% this year.

Consumer staples,

utilities, and energy

stocks have outperformed

the broader market, while

financials and consumer

discretionary stocks have

underperformed this

year. We think it’s best

to stay somewhat

defensive in this

environment, and we

favor healthcare and

consumer staple stocks,

despite their lofty

valuations. Industrial

stocks are also attractive today, as their valuations

remain depressed.

Equity valuations are above historic averages (the

MSCI All Country World Index is trading at 16.7x

expected full year 2016 earnings, while the S&P

500 is trading at 18.4x), though these valuations

are roughly neutral when considered in the context

of extremely low interest rates. That said, given

the recent run-up caution is advised.

— Brandon Fitzpatrick

16.718.4

15.313.0

0

5

10

15

20

MSCI All CountryWorld Index

S&P 500 EAFE MSCI EmergingMarkets Index

Price to Earnings Ratio(current price, expected 2016 earnings)

ECONOMIC FORECAST | Q2 2016 8

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.

DB Fitzpatrick 800 W. Main Street, Suite 1200

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