ECONOMIC FORECAST Q4 2015 October 9 DBF itzpatrick REGISTERED INVESTMENT ADVISORS
ECONOMIC FORECAST
Q4 2015 October 9
DBFitzpatrick REGISTERED INVESTMENT ADVISORS
INSIDE THIS ISSUE:
China’s Economy 4-5
Interest Rates and the U.S. Economy 6-7
Equities 7
Fixed Income 7-9
DB Fitzpatrick 800 W. Main Street, Suite 1200
Boise, Idaho 83702 (208) 342-2280
www.dbfitzpatrick.com
Dennis Fitzpatrick CEO
Brandon Fitzpatrick COO
Prabhab Banskota Portfolio Manager
ECONOMIC FORECAST | Q4 2015 4
Continued weakness in China’s economy and the
clearly stated desire of the U.S. Federal Reserve to raise
interest rates are the two principal dynamics driving
markets today. Both have coincided to cause market
turbulence in the third quarter, though stocks have
rallied in the first days of the fourth quarter. The good
news is that the U.S. economy is continuing to exhibit
consistent improvement, and the European economy is
also showing signs of life. Further growth will be
required before global interest rates return to more
normal levels, however, and until this occurs there is
likely be to a continuation of elevated volatility in the
financial markets.
Most of the discussion in the financial press during the
third quarter addressed the Federal Reserve and interest
rates. The real mover of markets during the quarter,
however, was news out of China. Chinese
policymakers surprised investors by depreciating their
pegged currency in August, and this was taken as
evidence that China’s economy had weakened beyond
the expectations of the leadership. China today is
closely linked to the global economy and investors
believe that further slowdown there will impact global
growth. The depreciation led to a selloff of equities and
heightened volatility continued in September. The
MSCI All Country World Index, a measure of the
global stock market,
fell 9.3% during the
third quarter, erasing
gains from the first
half of the year, and
was down 6.6% year-
to-date through
September. Stocks
have rallied in the first
days of October,
however.
China’s GDP growth
rate has fallen
consistently since
2010, and this year is
expected to breach 7.0%. Growth of 7.0% would be a
fantastic result for almost any country, of course, but in
this case investors are concerned. China’s political
leaders have been forced to lower their own estimates
and 7.0% was seen as a number they didn’t want
crossed. Investors are worried that the issues facing the
Chinese economy might be deeper and harder to
manage than originally thought. Industrial production
growth has been falling since 2010, as has retail sales
growth. It is not to say that the data in China are all
terrible – definitely there is much to encourage
optimism as well – but a bottom to this cycle of
economic slowdown has not yet been reached, and this
CHINA’S ECONOMY
Chinese yuan vs. U.S.
dollar (normalized)
MSCI All Country
World Index
(normalized)
July August September
100
96
92
88
5
has investors somewhat nervous.
Additionally, Chinese
policymakers’ responses to a
falling stock market earlier this
year have further shaken investor
confidence. A series of
unorthodox measures which
most investors viewed as
destined to fail, including
restrictions on sales and a ban on
short selling, were implemented
in the spring and summer as
Chinese stocks began to fall after
a big increase earlier in the year.
Predictably, the new rules failed
to arrest the descent and have
left the leadership with
diminished credibility in the eyes
of the global investing
community.
The repercussions of China’s
slowdown for the global
economy are clear, as China’s
trade with the rest of the world
(including imports) has grown
steadily and today amounts to
over 3.5% of global GDP.
Commodity producing countries in
southeast Asia and Latin America
are especially vulnerable to
diminished demand from China, but
many American and European
companies also have considerable
exposure to sales in China. All of
this led to a dour mood in the global
equity markets in the third quarter.
There is reason for optimism in the
fourth quarter and into 2016,
however. The Chinese government
has reserves of US$3.5 trillion, and
can dip into this both to stabilize the
Chinese currency and to spend on
fiscal stimulus. In fact, it has
already begun doing so.
Chinese policymakers have
considerable control over the levers
that drive growth in the short-term,
including bank lending, and there is
much more they can try in the
coming months. Ultimately,
economic growth is one of the
pillars of the government’s
legitimacy, and the political
leadership is likely to do what it
takes to turn the tide in the
economy. We expect additional
stimulus to be announced in the
fourth quarter.
GDP growth
Industrial production growth
Retail sales growth
China’s
Economy
2011 2012 2013 2014 2015
8%
12%
16%
20%
ECONOMIC FORECAST | Q4 2015 6
During the last five years the U.S.
economy never did exhibit the brisk
growth that is typical after a
recession, but it continues to report
strong and steady progress
nonetheless. The labor market is
improving, with the unemployment
rate down to 5.1% and the
underemployment rate falling to
10.0%, its lowest level since 2008.
Consumer confidence is up, and the
housing sector, such a critical part of
the economy, continues to
strengthen. Home prices, as
measured by the Case-Shiller index
are up 5.0% year-over-year, and
housing starts are also up.
The improved domestic economy
has encouraged Federal Reserve
policymakers to begin raising
interest rates, which have been near
zero since 2008. During the last year
Fed leaders have repeatedly declared
their intention to raise rates to more
normal levels, and investors’
expectations of higher rates have
already had a major effect on asset
prices. The U.S. dollar has risen
considerably versus almost all major
currencies during the last 12 months,
and this has resulted in weakened
profits (in dollar terms) for
companies with sales outside the
U.S. The strong dollar has also
resulted in lower inflation in the
U.S., as import prices have fallen.
Fed policymakers are facing a
conundrum. As they prepare the
market for higher interest rates, the
dollar is pushed higher and,
subsequently, inflation falls as
import prices drop. Lower inflation
then makes the case for raising rates
less compelling. This is the dynamic
today: inflation has fallen this year
and is significantly below the Fed’s
2.0% target, which makes a rate
increase difficult to justify.
Further complicating the issue is the
fact that the U.S. is the only major
country today whose central bank is
preparing to tighten monetary policy.
Both the European Central Bank
(ECB) and the Bank of Japan are
implementing their own quantitative
easing programs, and the ECB in
particular has no plans to end the
program any time soon. Continued
loose monetary policy abroad has
helped to boost the dollar, and has
INTEREST RATES AND U.S. ECONOMY
Bloomberg Dollar Spot Index
(normalized)
2014 2015 Q4 Q1 Q2 Q3 Q3
100
110
120
2015 2014 2013 2012
U.S. Housing Starts
Conference Board
Consumer Confidence 100
80
60
40
900k
1100k
700k
7
Stocks today are trading at
attractive valuations,
especially given the very low
interest rates available in the
bond market. The S&P 500 is
trading at 15.4x expected
2016 earnings, while the
MSCI All Country World
Index is trading at 14.5x.
Heightened volatility in the
stock market is likely to
continue until the path of
interest rates is more clear, but
prices today represent good
value for investors with a longer
time horizon.
Companies with international sales
have underperformed this year, as a
strong U.S. dollar has made sales
abroad relatively less valuable than
domestic sales. Currency
movements of the type we are
seeing, however, are transitory.
Most of the best-run companies, and
those with the best long-term
prospects, have international
exposure, and will be good
performers over the long term.
Industrials are especially attractive
today. The earnings multiples of
most industrial stocks today are far
below the broader market (often in
the range of 20 – 40%), and also
lower than their historic averages.
The healthcare sector is also
attractive, as demographic changes
both domestically and abroad offer
significant growth potential for
companies throughout the sector.
— Brandon Fitzpatrick
EQUITIES
made the Federal Reserve’s position increasingly
precarious and delicate.
In the end it will take a boost in global growth to escape
the present trap. If the global economy picks up in
2016, deflationary pressures will ease and the Fed will
have considerably more room to maneuver. If global
growth remains muted, the Fed will be forced to delay
interest rate hikes deep into next year.
U.S. Treasury yields declined after the frustrated
Federal Open Market Committee (FOMC) left the
federal funds rate unchanged at 25 basis points on
September 17. As yields declined, the Barclays U.S.
Aggregate index returned 0.68% for the month. Within
the U.S. Aggregate Index, corporates returned 0.75%,
while Treasuries and MBS returned 0.88% and 0.58%,
respectively. Energy and metals and the mining sector
dragged down performance, returning -1.88% and
-0.60%, respectively. The metals and mining sectors
have been hurt by the slowdown in China, which
consumes almost half of the world’s steel, nickel, zinc,
FIXED INCOME
ECONOMIC FORECAST | Q4 2015 8
copper, and aluminum production.
Energy sector credits have been
impacted by the drop of the price
of oil during the last year.
Credit spreads have widened
steadily in the last six months.
For example, the yield to maturity
of the Merrill Lynch U.S. Corp 5 -
7 year index has widened by 44
basis points since April. As a
result, investment grade credits
today offer yield pick-up as high as
1.5% over similar duration
Treasuries. However, caution is
warranted. We see pockets of
opportunity but investors should
realize that financial markets are
discounting the possibility of rising
default rates.
Agency MBS underperformed
Treasuries by 0.17% in September
as demonstrated by the Barclays
U.S. Government Intermediate
Index and the Barclays U.S. MBS
Index. This relative
underperformance can be
attributed to higher agency MBS
issuance and expectations of higher
prepayments due to the recent
decline in yields. Agency MBS
issuance has increased by 46% to
$1,025 billion as of September 2015, up from $701
billion in the same period last year. With the recent
underperformance, MBS now offer better value with a
yield pick-up as high as 1% vis-à-vis similar duration
U.S. Treasuries.
Market-based inflation expectations have declined
dramatically since June, and the latest year-over-year
non-seasonally adjusted CPI Urban Consumer index
was just 0.2%. The market is forecasting annualized
deflation during the next 6 months of 1.49%, and a
1.22% annualized inflation rate during the next five
years.
Declining inflation expectations have resulted in
negative returns from Treasury Inflation Protected
U.S. Treasury Yield Curve
8/31/2015
9/30/2015
Inflation Breakeven
Rates
1-year
5-year
2.0%
0.0%
-2.0%
1.8%
1.4%
9
Securities (TIPS) in recent months. In the long run,
however, we don’t expect very low inflation in the U.S.
to persist. This bodes well for TIPS in 2016 and
beyond.
— Prabhab Banskota
ECONOMIC FORECAST | Q4 2015 10
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. ALL RETURNS ARE NET OF FEES AND ANNUALIZED.
DB Fitzpatrick 800 W. Main Street, Suite 1200
Boise, Idaho 83702 www.dbfitzpatrick.com | (208) 342-2280