DBFitzpatrick REGISTERED INVESTMENT ADVISORS

ECONOMIC FORECAST

Q2 2016

April 15

DB Fitzpatrick 800 W. Main Street, Suite 1200 Boise, Idaho 83702

(208) 342-2280 www.dbfitzpatrick.com

INSIDE THIS ISSUE:

The Fed is Still Driving the Markets 4-5

China is a Wildcard 6-7

Equities Bounce Back on Fed Comments

7-8

Fixed Income: Real Rates are Down as Inflation Expectations Perk Up

8-9

ECONOMIC FORECAST | Q2 2016 4

The first quarter was choppy in the financial

markets as investors reacted to the statements of

U.S. Federal Reserve policymakers. The Fed, it is

safe to say, is still driving the markets. The mood

was grim for the first six weeks of the quarter as

the equity market reacted negatively to Fed

commentary in December that proposed a target of

four 25 basis point hikes to the fed funds rate in

2016. Investors believed that the U.S. economy

was not strong enough to absorb such a policy,

and risky assets suffered most. The MSCI All

Country World Index fell 9% through February 11

as the U.S. dollar climbed and inflation

expectations dropped.

February marked the bottom of the selloff as Fed

leaders, clearly disappointed with moves in the

capital markets, began to

indicate that a change in

strategy might be in

order. The hints

continued to build in

March until a new plan of

two 25 basis point hikes

(two fewer than before) to

the benchmark interest

rate was announced.

During an interview in

late March Fed chair

Janet Yellen took more

control of the narrative,

emphasizing that slowing global growth and the

strong U.S. dollar were important factors for

policymakers to consider, and argued against

faster increases in interest rates. Investors

approved this analysis and stocks continued to rise

after Yellen’s comments. By April 15th the MSCI

All Country World Index was up 1.9% year-to-date,

while the S&P 500 had risen 2.5%.

There is a complicated dynamic in place between

the capital markets and Federal Reserve policy.

Fed policymakers – pushed by some hawkish

members – want to raise interest rates. They

believe the economy is strong enough to absorb it,

and view a continuation of very low rates as

unhealthy and possibly inflationary over the long

term. Investors do not share this optimism

THE FED IS STILL DRIVING THE MARKETS

Mar 2014 Mar 2015 Mar 2016

The Fed is concerned

about the dollar’s rise.

100

105

110

115

120

125 Bloomberg Dollar Index

5

regarding the

underlying strength

of the economy, and

react negatively

every time it

appears the Fed is

planning to raise

rates. Fed leaders

understand that this

dynamic is in place

and, though often

forced by market

moves to backtrack

on previously

announced plans,

continue to push forward when they can. They

have had some successes: they were able to

raise the fed funds rate one time late last year,

and bond investors today see a good chance of an

additional rate hike this year, with two hikes also

seen as a possibility. This is a small but important

victory for the Fed, as for years after the financial

crisis of 2008-2009 any hint of a slowdown to

monetary stimulus was viewed by the capital

markets with virtual panic (the “Taper Tantrum” of

2013 being the best example). The process

toward normalization is likely to last longer than

Fed leaders would like, however. In the

meantime, Fed statements will continue to be a

big (and possibly the most important) factor in

short term capital market movements.

Futures markets today are predicting only a 50%

probability that the Fed will raise interest rates this

year. Our view is that recent positive economic

data, combined with a rally in the equity market,

falling U.S. dollar, and increased expectations for

inflation during the last two months, are likely to

give the Fed more room to raise rates than

investors currently anticipate. This argues for

more volatility in the markets later this year, and

would be bullish for the dollar and bearish for risky

assets. There is also the potential for falling

inflation expectations, as investors would again

fear that the Fed is pushing things too far. A

careful balancing act will continue for at least the

rest of 2016.

16

20

24

28 VIX Index

Jan 2016 Feb 2016 Mar 2016 Apr 2016

Volatility is down as

Fed turns dovish.

ECONOMIC FORECAST | Q2 2016 6

The Chinese economy’s

transition toward increased

dependence on internal

demand continues to be

bumpy, and this is the

wildcard facing both

investors and policymakers.

Official government figures

say that China’s economy is

growing 6.5 – 7.0%, but this

is below market

expectations and doubts

overhang the veracity of the

numbers. Other (official)

data describing the

economy are mixed.

Industrial production is

growing but the rate of

growth has declined.

Freight traffic has seen

declines during the last two

years, while manufacturing

growth has been flat since

2012. Retail sales are up but the rate of growth

has been down recently, and there are continued

fears of a bubble in real estate. In summary, the

news is not all bad but the bottom has not yet

been reached and more investors are beginning to

believe that China’s economic transition could take

years. China’s importance to the world economy

(and especially to commodity producing countries)

has grown dramatically during the last decade,

and Chinese imports have risen from $1 trillion in

2009 to almost $2 trillion in 2013. Imports were

flat in 2014 and fell in 2015, while the early data

from 2016 are not encouraging.

China’s policymakers are trying to encourage

growth but are wary that deploying too much

CHINA IS A WILDCARD

China Industrial Production Growth

Mar 2014 Aug 2014 Apr 2015 Dec 2015

6.5%

7.5%

8.5%

9.5%

China Freight Traffic Growth

Mar 2014 Sep 2014 Jun 2015 Dec 2015

-15%

-10%

-5%

0%

7

stimulus will result in

asset bubbles down the

road. Ultimately,

economic growth is one

of the pillars of the

government’s legitimacy,

and policymakers are

trying to achieve lasting

growth with incremental

reforms. The efficacy of

their actions is one of the

biggest uncertainties

facing the global

economy. The most likely case for the near term

is a continuation of the status quo, with somewhat

disappointing economic growth numbers. The

markets appear to be predicting this, and it is one

of the reasons global interest rates are still so low.

The energy sector has led the

equity markets this year, as

investor fears regarding

oversupply turned to hope that

suppliers may agree to cap

output. WTI crude is up 9% this

year to $40 and the S&P Global

Energy Index has risen 9%. The

industrial and consumer staple

sectors have also outperformed

the market, both rising 5% this

year. The financial sector has

been dragged down by U.S. bank

stocks, and the S&P Global

Financials Index was down 5%

through mid-April. Investors fear

that banks have more exposure

to the energy sector than was

previously believed, as many

small energy producers currently

under financial strain are

accessing previously awarded

lines of credit. Not all banks face

the same level of risk, of course,

but until more clarity is achieved

investors will remain cautious

toward the sector. Healthcare

has been another

underperforming sector this year,

with the S&P Global Healthcare

Index down 3%. Within the

healthcare sector,

pharmaceutical stocks have been

especially out of favor as U.S.

politicians target the industry.

The stock market is trading at

valuations that are somewhat

higher than historical averages,

with the S&P 500 trading at 17.7x

expected 2016 earnings, and the

MSCI All Country World Index

EQUITIES BOUNCE BACK ON FED COMMENTS

China Imports (Monthly)

2005 2007 2009 2015 2011 2013

$60 b

$80 b

$100 b

$120 b

$140 b

$160 b

$180 b

ECONOMIC FORECAST | Q2 2016 8

The bond market rallied in the first quarter, as

investor concern regarding interest rate hikes

turned into relief after Federal Reserve

policymakers turned dovish midway through

the quarter. The Treasury yield curve

flattened, with the yield of the 10-year

Treasury bond falling from 2.27% on

December 31 to 1.79% on April 14. Yields

have fallen across the curve, apart from the

shortest tenors. The Barclays U.S.

Aggregate Index finished the first quarter

with a return of 3.03%, led by the U.S.

Treasury Index (+3.20%) and U.S.

Investment Grade Corporate Bond Index

(+3.97%), as corporate spreads have

tightened since mid-February. Agency

mortgage backed securities

underperformed the Barclays Aggregate Index

during the first quarter, with the U.S. MBS Index

FIXED INCOME: REAL RATES ARE DOWN AS INFLATION

EXPECTATIONS PERK UP

trading at 16.2x.

Stocks have continued

to climb the “wall of

worry” in the first half of

April, as the comments

of Fed policymakers

remain dovish. A

change in tone would

likely pressure stocks.

S&P Global Energy Index

Dow Jones U.S. Industrial

Sector Index

Jan 2016 Feb 2016

S&P Healthcare Index

Mar 2016 Apr 2016

85

90 S&P Global Financials Index

95

100

105

110

U.S. Treasury Yield Curve

12/31/2015

4/14/2016

10Y 7Y 5Y 2Y

0.50%

1.00%

1.50%

2.00%

2.50%

3.50%

30Y

9

returning 1.98%.

The real rate of interest has fallen

since the start of the year, and is

now negative on all maturities

shorter than seven years. The

falling real yield curve seems to be

signaling renewed concerns

regarding the health of the U.S. and

global economies, while at the

same time bond investors are

predicting that Fed policymakers

will respond to an economic

slowdown by maintaining interest

rates at current levels (or barely

above) for the rest of the year. It is

this prediction that has led to rising

inflation expectations (from very low

levels earlier in the year) and to a

tightening of corporate spreads.

Moves in the bond market were

fairly large in the first quarter.

There is potential for a reversal of

some of these recent trends if the

economy begins to show signs of

strength. Positive economic data

would likely lead to higher interest

rates, and could lead to lower inflation

expectations if it appears that the Fed will be able

to raise interest rates two times this year, as is still

policymakers’ stated goal. Data indicating a

slowing economy may not have as much impact

on the bond market, as market expectations for the

short run are already pessimistic.

— Brandon Fitzpatrick

20Y 30Y 15Y 9Y 7Y 5Y 3Y

-1.00%

-0.50%

0.00%

0.50%

1.00%

U.S. Treasury Inflation Indexed Curve

Inflation Expectations

5 Year

2 Year

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

Jan 2016 Feb 2016 Mar 2016 Apr 2016

4/14/2016

12/31/2015

ECONOMIC FORECAST | Q2 2016 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