ECONOMIC FORECAST Q3 2015 JULY 15
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
ECONOMIC FORECAST | Q3 2015 6
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
ECONOMIC FORECAST | Q3 2015 8
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
ECONOMIC FORECAST | Q3 2015 10
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DB Fitzpatrick 800 W. Main Street, Suite 1200
Boise, Idaho 83702 www.dbfitzpatrick.com | (208) 342-2280