Q4 2014 OCTOBER 13 ECONOMIC FORECAST
Apr 05, 2016
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