Q 3

2013

JULY 11

ECONOMIC FORECAST

Fixed Income

Equities

U.S. Economy

Emerging Markets

Europe

DBF Strategies

INSIDE THIS ISSUE:

Summary 4

Fixed Income 4

Equities 6

U.S. Economy 7

Emerging Markets 8

Europe

9

DBF Strategies 9

D.B. Fitzpatrick & Co. 225 N. Ninth St.

Suite 810 (208) 342-2280

www.dbfitzpatrick.com

Dennis Fitzpatrick Founder, CEO, and Chairman

Brandon Fitzpatrick President, COO, and Equity Portfolio Manager

ECONOMIC FORECAST | Q3 2013 4

Fed chairman Ben Bernanke’s comments in mid-May that the Fed would “taper” monetary stimulus as the

economic recovery gains strength spooked the financial markets, sending both stocks and bonds lower in the last

weeks of the second quarter. Bernanke’s announcement was meant to be innocuous, and in truth was not much

different from what he had said in previous speeches. Nonetheless, the bond market was shaken by the prospect

of an early end to the quantitative easing program, and the yield curve steepened. The yield on a 10-year Treasury

rose from 1.60% in April to 2.60% in June. The yield on a 30-year Treasury rose from 3.10% at the end of March

to 3.50% at the end of June. The real interest rate (the nominal rate minus the rate of inflation) rose in the quarter,

as market expectations for inflation fell and nominal yields rose. The real rate on a 10-year Treasury was –0.67%

at the end of March, before rising to 0.46% at the end of June.

We expect interest rates to fall somewhat from current levels, as bond investors take a break from the selling. In

the longer term, however, interest rates are very likely to climb further as the economy continues to heal from the

financial crisis, housing bust, and recession of 2008-2011. There is still a lot of danger in the fixed income

markets, and we’re avoiding low quality credits and long duration bonds. Stocks are more attractive than bonds

today, with attractive value in industrials, financials, and some out of favor emerging markets.

The big action in the second quarter occurred in the bond market. Bernanke’s comments prompted bond selling

and sent interest rates sharply higher. The yield curve steepened and long duration bonds bore the brunt of the

damage. TIPS (Treasury Inflation Protected Securities), were not spared, with inflation breakeven rates falling

dramatically in the second quarter. Market expectations for inflation during the next year fell from 2.35% at the

end of March to 0.74% at the end of June, while inflation expectations during the next 10 years fell from an

annualized rate of 2.52% to 1.99%. The market is sending a message that it doesn’t expect much inflation without

continued large-scale monetary stimulus. The market is also sending a clear warning that interest rates are set to

rise as the unemployment rate falls, Fed bond purchases slow down, and the economy finally returns to a more

SUMMARY

FIXED INCOME

1-year inflation

expectations

10-year inflation

expectations

Q1 Q2

5

“normal” environment, five

years after the financial crisis

began.

Bonds of lower credit quality

were hit even harder than

Treasuries in the second

quarter. The Barclays High

Yield Very Liquid Bond Index,

which tracks high-yield

corporate bonds, was down 5%

from early May to late

June. Emerging market

sovereigns – both U.S. dollar

denominated and local currency

– were down sharply in the

quarter, and the damage was

widespread. A Mexico

sovereign U.S. dollar bond maturing in 2022, for

example, fell 7% in the quarter, while an Indonesian

U.S. dollar bond due in 2019 fell 8%. Local currency

debt was hit even harder. A Colombian local currency

sovereign due 2022 was off 12% in the three months

through June, while a Philippines 10-year local currency

sovereign fell 12%. Additionally, emerging market

currencies were down virtually across the board.

The MBS (mortgage backed securities) market also fell

in the second quarter. Mortgage rates rose, following

Treasury yields, and prices of low coupon pools fell the

most as duration extended. The expected maturity of

low coupon pools increased significantly, as the

underlying mortgages are much less likely to be

refinanced now that mortgage rates have risen. The rate

on a 30-year mortgage rose from 3.40% at the end of

April to 4.61% on July 10.

In the beginning days of the third quarter interest rates

have continued their march higher, with the 10-year

Treasury yield reaching 2.60% on July 11. Recent

economic data have generally been positive, which the

bond market views as giving the Fed more justification

to slow down its purchase of Treasuries and MBS. We

expect interest rates to pause somewhat, taking a break

from their steady increase. The yield curve is likely to

flatten by the end of the year, however, and in the longer

term interest rates are very likely to rise. Our fixed

income portfolios are positioned defensively, with an

emphasis on high quality and short duration bonds.

Barclays High Yield Very

Liquid Bond Index

Lower quality bonds were hit

hard in the second quarter

Indonesia U.S. dollar

sovereign due 2019

Colombia local currency sovereign due 2022

ECONOMIC FORECAST | Q3 2013 6

Stocks, as measured by the MSCI All Country World

Index, fell 0.2% in the second quarter, after being up

over 5% in mid-May. Stocks were affected by two

principal factors late in the quarter: 1) the prospect of

less central bank stimulus made investors somewhat less

sanguine about economic growth and corporate profits,

and 2) the market’s discount rate rose along with bond

yields, pressuring stock prices. Rising bond yields had

their most severe impact on utility and consumer staple

stocks, which are viewed by the market as substitutes

for bonds, due to their steady cash flows and non-

cyclical businesses. These sectors had outperformed

recently, starting in 2012, but in the second quarter fell

further than more cyclical sectors such as financials and

industrials.

European stocks are flat for the year and, though they

fell at the end of the second quarter with the broader

global stock market, have by and large shrugged off

recent worries about political turmoil in Portugal. The

Nikkei index had a volatile second quarter but is still up

37% since the end of 2012 (though this is only 15% in

U.S. dollar terms, as the yen has seen a sharp

depreciation).

Emerging market stocks fell 9% in the second quarter

and are down 11% since the start of the year, as

investors worry that less monetary stimulus in the U.S.

will result in lower capital flows to the emerging

world. There is also a nagging concern in the financial

markets that the economic slowdown in China will

worsen. Southeast Asian equities were hit especially

hard in the second quarter, with the Thai, Indonesian,

and Philippine stock markets all down sharply.

Brazilian and Turkish stocks were down as well, though

with these countries investors were responding more to

protests and political uncertainty, not to slower growth

in China and lower commodity prices. We took

advantage of the turmoil in the stock markets to add

exposure to Indonesian and Brazilian stocks.

The longer term story of the emerging economies is

intact: growing middle classes, increased dependence on

domestic demand, and strong government balance

sheets. Emerging market valuations are compelling,

with the MSCI Emerging Markets Index trading at 10.2

times 2013 earnings, versus 14.8 for the S&P 500 and

13.2 for EAFE (international developed stocks). With

slower growth in China, however, managers will have to

be more choosy with their EM positions as the tide of

rising commodity prices seen in the 2000s is unlikely to

be repeated in the next decade. We have exposure to

Chilean, Colombian, Brazilian, Indonesian, and Chinese

stocks.

EQUITIES

The MSCI All Country World Index ended

the second quarter down slightly

7

The U.S. economic

recovery is continuing

with many positive signs,

but without the

breakthrough growth

number many have been

waiting for since the

recession ended in

2011. Probably the

brightest sign is the

housing market, which

has shown continued

strength during the last

12 months. Housing

prices are up across the

country, including

previously very hard hit

areas such as south

Florida and Las

Vegas. Housing starts

are also up. Higher

mortgage interest rates in

the second quarter

threaten to lower housing

demand somewhat, but

we think a robust

housing recovery will

continue in spite of

higher rates. In fact,

higher rates may be the

impetus needed to get

marginal buyers off the

fence, as they fear the

prospect of missing out

on still low rates.

Durable goods orders are

up, as is consumer

confidence as consumers

feel more upbeat about

the housing market and

their personal balance sheets. Initial jobless claims have

been consistently below 400k, which most economists

believe indicates that the economy is adding

jobs. Higher interest rates typically are bad for

economic growth, but in the present environment they

might be positive if they prompt banks to increase

lending.

We expect the U.S. economy to grow 2.0% this year

before accelerating to 2.5% in 2014.

U.S. ECONOMY

The Case Shiller index of house prices is

up as the housing sector improves

2010 2011 2012 2013

Durable goods orders were

up in the second quarter

Q1 Q2

ECONOMIC FORECAST | Q3 2013 8

There was significant political

turmoil in some notable emerging

market countries in the second

quarter. Higher bus fares in São

Paulo sparked what turned into a

nationwide protest against

endemic corruption, political

atrophy, and massive inequality.

Aspirations have been raised as

the country’s middle class grows,

and change is not coming fast

enough for many. President

Rousseff was caught off guard by

the strength of the protests, but

seems now to have regained her

political footing. She has

promised a series of reforms that,

at least for now, have assuaged protestors. President Rousseff is facing reelection next year, and the political

situation is becoming dire, as it will be very difficult to win without a stronger economy. Further complicating the

situation is the fact that inflation is above the central bank’s target, which limits the policies available to both

Rousseff and the central bank. Brazilian policymakers are now trying to encourage foreign investment and

strengthen the real, though they are surely hopeful that the real’s recent depreciation will boost exports in the short

run. Investors have soured on Brazilian securities -- both stocks and bonds -- and there are currently some good

values in Brazil. Taking advantage of this opportunity, we recently added exposure to Brazilian stocks to our

equity portfolios.

Most economies in Latin

America have slowed down,

largely as a result of lower

commodity prices, but some

countries such as Colombia and

Chile are still set to grow at least

4% this year. The largest

economies in southeast Asia

have also slowed down, but

growth there is still much better

than what the U.S. and Europe

can muster. Indonesia is set to

grow 5% this year, while

Malaysia’s economy will expand

4%. The correlation among

equities in these countries has

been very high in the last few

weeks, and many good stocks are trading at very attractive valuations. We’ve also recently added exposure to

Indonesian stocks.

EMERGING MARKETS

Brazil’s GDP growth is below 2%.

Policymakers are working to stimulate

as the 2014 election looms.

2013 2012 2011

Brazil’s Bovespa Index is

down sharply this year

9

U.S. stocks are fairly valued while Japanese stocks and other deep value sectors still look overpriced. Emerging

market stocks are generally attractive, but careful country and security selection is needed as growth in China

slows down. We’re overweighting emerging market stocks, though we’re not emphasizing BRIC countries

(Brazil, Russia, India, China). We have a neutral weight in financials, an underweight in utilities, healthcare, and

consumer staples, and an overweight in industrials.

There is still a lot of risk in the bond market, even after the recent dramatic rise in interest rates. We are steering

clear of low quality bonds and have positioned our fixed income portfolios defensively as we expect interest rates

to rise further.

— Brandon Fitzpatrick

EUROPE European markets have been fairly quiet this year, with

investors satisfied that the European Central Bank will

serve as a backstop to prevent sovereign bond yields

from spiraling out of control. Recent troubles in

Portugal have not spread to the rest of Europe, and it

appears that there is little risk of a further conflagration

in the near term. Economic growth, however, is anemic

across the continent and unemployment rates are

unacceptably high.

There seems to have been somewhat of a change in

attitude across the continent against “austerity” – fiscal

tightening designed to bring national budgets under

control – though admittedly not in Germany. There is

certainly a lot of empirical evidence indicating that

austerity has not helped spur economic growth, and

probably has even worsened national budget deficits

(the UK is a case in point).

German elections in August offer new hope, as

Chancellor Merkel, after winning a new mandate, may

feel freer to inch away from austerity and instead

support measures designed to encourage economic

growth. Certainly that would be beneficial for

Europe. We have an underweight in European stocks,

though there are some good European value stocks with

decent valuations, and we do have some exposure

within our equity portfolios.

GDP growth in Europe

Germany

Spain UK France

2013 2012 2011 2010

DBF STRATEGIES

ECONOMIC FORECAST | Q3 2013 10

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D.B. Fitzpatrick & Co. 225 N. Ninth St., Suite 810

Boise, ID 83702 www.dbfitzpatrick.com | (208) 342-2280