Economic Forecast Q1 2015

Q 1 2015

JANUARY 16

ECONOMIC FORECAST

INSIDE THIS ISSUE:

Oil Takes a Dive 4-5

Europe 5-6

United States 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 Founder, CEO, and Chairman

Brandon Fitzpatrick President, COO

Prabhab Banskota Fixed Income Portfolio Manager

ECONOMIC FORECAST | Q1 2015 4

Volatility in the equity markets has increased in the last

four months as disinflation in Europe and the falling

price of oil — down 50% since September — have

rattled investor confidence. Cheaper oil is good for the

economy, but the reverberations sent through the energy

sector, as seen in both falling stock prices and rising

corporate bond yields, have impacted the broader

markets.

The Eurozone economy is growing less that 1.0% and

year-over-year inflation reported in December was

-0.2%. Europe’s weak economy has affected growth

elsewhere in the world and disinflation in the Eurozone

has pushed down global interest rates. For example, in

spite of an improving U.S. economy, the 10-year U.S.

Treasury yield has fallen to 1.79%, and 10-year

sovereign bond yields from all Eurozone countries

except Portugal and Greece are even lower.

In many ways the global economy and financial

markets are still grappling with the aftermath of the

recession of 2007-2009. The U.S. economy has come a

long distance during the last six years, but Europe’s

slow progress means the aftershocks of the crisis will be

with us a while longer.

The price of oil has plunged in the

last six months. West Texas

Intermediate crude has fallen from

$100/barrel last June to $47/barrel

today, and the drivers of OPEC

strategy have promised to maintain

production no matter how low the

price falls. Their obvious goal is to

force oil producers around the world

to scuttle marginally profitable

projects, and to force solvency crises

among the most highly-leveraged

producers. Both of these goals have

already been accomplished to a

significant

degree. Oil

services firm

Baker Hughes

announced on

January 9 that

U.S. drillers had

1,420 rigs in use

for oil production,

down from 1,535

in late December.

Some small and

highly leveraged

U.S. exploration

and production

companies have

already seen their

stock prices fall 70-80% since

September.

OPEC’s goal for the medium and

long term is to lower the production

capacity of non-OPEC members,

and, of course, for the price of crude

to eventually rise again. Saudi

Arabia has considerable resources in

reserve as it executes its plan. The

Saudi government announced plans

to spend US$230 billion as part of

its normal budget in 2015, and is

assuming a budget deficit of $40

billion (this figure is an estimate and

will ultimately depend on how the

price of oil evolves during the next

year). The International Monetary

Fund estimates that the Saudi

government has $750 billion in

foreign reserves, so clearly Saudi

leaders have the ability to withstand

low prices for a significant period,

even years if necessary. Many small

and medium-sized producers in the

U.S. and elsewhere could not

survive if oil prices stayed low that

long. Some OPEC countries, such

OIL TAKES A DIVE

Oil Prices West Texas

Intermediate

Brent

July September October August December November

$80

$60

$100

5

as Iran, Venezuela, and Ecuador,

will also suffer extreme

difficulties if there is no recovery

in prices soon (12-year U.S.

dollar bonds of Venezuela’s state

-run oil company PDVSA have a

yield of 20%, implying a high

likelihood of default), but in the

end, Saudi Arabia’s voice is

what matters and Saudi leaders

are evidently not concerned with

these smaller OPEC producers.

Oil prices will remain low until

Saudi leaders decide that their

goals have been achieved. The

timing of this is unpredictable.

In many cases surviving

companies will come out of this

downturn in a stronger position,

as competition is either

eliminated or absorbed. There is

likely to be a round of mergers

and acquisitions in the near

future, as the largest and most

conservatively-managed

companies can still raise capital

at attractive rates.

EUROPE

Europe’s very weak economy remains a source of

concern for investors and lowers the potential for

global economic growth. The Eurozone is on much

more solid ground as a currency bloc than was the case

two years ago when dissolution was a real possibility,

but its economy is on the precipice of a new recession

and year-over-year inflation dipped below zero in

December. Political realities in Europe have made

badly needed fiscal stimulus impossible and monetary

stimulus very difficult. It has taken actual deflation for

quantitative easing to become politically palatable, and

even today the opposition is loud and rancorous.

The market expects, as we do, that the European

Central Bank will begin a bond buying scheme in the

first or second quarter of this year. This quantitative

easing project will include the purchase of Eurozone

sovereign bonds and might include corporate bonds.

This will provide a short-term boost to European and

global equity markets, but is unlikely to be enough to

give the real economy in Europe the shot in the arm

that is desperately needed. The success of the

program, ultimately, will depend on the credibility of

the ECB regarding the size of purchases and how long

the program will last. The prospects for an

overwhelmingly large and long-lived QE project, as

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

Exxon (2024) EOG Resources(2024)

NewfieldExploration

(2024)

Linn Energy(2022)

Corporate Bond Yields of U.S. Oil Producers (date of maturity in parenthesis)

Baker Hughes U.S.

Crude Oil Rig Count

November October December January

1600

1550

1500

1450


was implemented in the U.S.,

are not good, however. ECB

leaders have to build a

consensus with politicians who

are absolutely averse to

monetary stimulus, thus the

plan is likely to be

underwhelming from the point

of view of the financial

markets. Most of the Eurozone

economy’s fundamental

problems – notable among

them an utter aversion to fiscal

and monetary stimulus among

key political groups and

policymakers – are unchanged,

and present a headwind to

European growth prospects.

One piece of good news for Europe, however, is the

euro, which has fallen 14% vis-à-vis the U.S. dollar

since last June. The lower euro should begin to have

an important effect on Eurozone exports in the months

ahead. Exports of goods and services represent 27% of

the Eurozone’s GDP. The weaker euro may prove to

be the most important achievement of the ECB’s QE

program.

UNITED STATES

The U.S. economy continues to show considerable

strength. GDP growth is accelerating and will be close

to 2.5% for 2014 when the final data come in. The

unemployment rate has fallen to 5.6%, industrial

production was up 5.2% year-over-year in November,

and consumer confidence is as high as it’s been since

2007. Retail sales in

December were weak,

but this does not change

the clear story of a

significant and

continued improvement

in the U.S. economy.

The ultimate source of

these encouraging

numbers is the steady

improvement in the U.S.

housing sector. Housing

starts and new building

permits both are back to

levels last seen in 2008,

and the Case-Shiller

National Home Price Index was last up 4.5%, and has

been mostly positive since 2010 (the index was negative

in 2011, and this was a result of prices falling after a

temporary tax incentive scheme was ended in 2010).

Consumers’ personal balance sheets have improved

substantially during the last few years and it is clear that

2011 2012 2013 2014

Eurozone

GDP % growth

year-over-year

Consumer Price

Index

Case-Shiller Home

Price Index

2009 2011 2010 2012 2013 2014

3%

1%

-1%

0%

2%

-20%

-15%

-10%

-5%

0%

5%

15%

10%

7

the economy has turned a corner.

We expect the U.S. economy to

continue building momentum and

GDP growth to reach 3.0% in 2015.

The U.S dollar was up significantly

in the second half of 2014 as the

U.S. economy strengthened and the

likelihood of a new monetary

stimulus regime in the Eurozone has

been factored into currency prices.

The higher dollar will be a drag on

economic growth, but that drag

should be relatively slight as foreign

trade makes up only 15% of U.S.

GDP.

EQUITIES

U.S. equities have

performed well in 2014

but at 16.4x estimated

2015 earnings are fully

valued. The MSCI

EAFE Index of

international developed

countries is trading at

14.4x forward earnings

and the MSCI Emerging

Market Index is trading

at 11.4x. Very low

interest rates in the U.S.,

Europe, and Japan have

pushed money into the

safest areas of the equity

market, including

utilities and healthcare, as the “search for yield” in the

bond markets has bled into select equity sectors. This is

likely to continue during the first quarter of 2015 as

interest rates remain low.

We see long-term value in healthcare stocks and

industrials. International exposure will be important to

generate returns in the long run, though pessimism

regarding emerging market assets is high today. The

valuations are compelling and the pessimism among

investors will not last forever.

— Brandon Fitzpatrick

15.116.4

14.4

11.4

0

5

10

15

MSCI All CountryWorld Index

S&P 500 EAFE MSCI EmergingMarkets Index

Forward price to earnings ratio(current price, expected 2015 earnings)

FIXED INCOME

The fixed income market performed

better than expected in 2014 as the

U.S. Treasury yield curve declined

and flattened. 2-year and 3-year

U.S. Treasury rates increased 0.28%

and 0.31%, respectively, while 10-

year and 30-year U.S. Treasury rates

decreased 0.86% and 1.22%. As a

result, longer duration bonds fared

better than short duration bonds.

The Barclays U.S. Aggregate index

gained 5.97% for the year, while the

U.S. Mortgage Back Securities

(MBS) and Intermediate U.S.

Government indices returned 6.08%

and 2.52%, respectively.

The Fed took unprecedented steps to

spur growth in the U.S. economy

after the financial crisis of 2007-

2008, including decreasing the Fed

Funds rate to 0.25% and embarking

on multiple asset purchase

programs. The Fed ended its final

bond purchase program in October

2014, and with the unemployment

rate at 5.6% and two quarters of


solid growth, the market expects

the Fed to increase short-term

rates in 2015. The Fed, however,

“frets that a premature tightening

of policy may damage an

economy that is still bearing the

scars of the financial crisis of

2007-2008”. An anemic global

economy and disinflation in

Europe add to those fears.

Fixed income markets and

inflation (and inflationary

expectations) are normally highly

correlated; as inflation declines

yields fall and bonds appreciate.

In 2013, however, the opposite

occurred as yields soared in an

environment of declining

inflation expectations. This

divergence of nominal bond

yields and inflation was a result

of the Fed’s “unwinding” of its

extraordinary monetary stimulus.

The real interest rate rose on the

shorter tenors of the yield curve

in 2014 as inflation declined with

slumping energy prices and a

stronger dollar. The real interest

rate on the higher tenors has

fallen. Investors expect an

annual inflation rate of 1.55%

during 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).

The MBS sector outperformed Treasury and corporate

bonds in 2014 as the Merrill Lynch 3-5 year U.S. MBS

index returned 3.9%, while the Merrill Lynch 3-5 U.S.

Treasury and 3-5 year U.S. Corporate bond indices

returned 2.1% and 3.1%, respectively. The MBS sector

outperformed as lower mortgage refinancing led to a

decrease in gross issuance to $0.98 trillion in 2014,

down from $1.6 trillion in 2013.

Most bond investors expect the Federal Reserve to raise

the Fed Funds rate in the second half of 2015. Such an

increase, however, would threaten U.S growth and

would depress already low inflation. We believe the

Fed will move slowly, if at all, to raise rates in the last

quarter of 2015, and that the U.S. 10-year Treasury

yield will be between 2.2% to 2.7% by the end of this

year. If energy prices recover, inflation and inflation

expectations should edge higher in the second half of

2015.

We see value in longer maturity corporate bonds vis-à-

vis MBS and we are increasing our allocation to high

quality credit securities. Additionally, we are

0.00%

2.00%

4.00%

6.00%

8.00%

Feb

-12

Ap

r-1

2

Jun

-12

Au

g-1

2

Oct

-12

De

c-1

2

Feb

-13

Ap

r-1

3

Jun

-13

Au

g-1

3

Oct

-13

De

c-1

3

Feb

-14

Ap

r-1

4

Jun

-14

Au

g-1

4

Oct

-14

De

c-1

4

10-year Government Bond Yields

U.S Spain Germany Japan

U.S. Treasury Yield Curve:

January 2014—December 2014

9

maintaining our TIPS

positions, as we expect

inflation expectations to

rise in the coming year.

MBS remain an attractive

sector for the long term,

but the risk of increased

prepayments as interest

rates have fallen makes

MBS somewhat less

attractive in the present

environment.

— Prabhab Banskota

U.S. Treasury Inflation

Indexed Curve 12/31/2013

1/15/15

2013 2014

Real Yield

3-year inflation

expectation

U.S. 3-year nominal

Treasury Yield


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

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Economic Forecast Q1 2015