Q 3 2014 JULY 11

ECONOMIC FORECAST

INSIDE THIS ISSUE:

Bull Market Continues 3

Stimulus Still Driving Returns 3-4

Equity Valuations 5

Fixed Income 5-6

D.B. Fitzpatrick & Co. 800 W. Main Street, Suite 1200

Boise, ID 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

3 ECONOMIC FORECAST | Q3 2014

Both bonds and stocks rose in the first half of the year as

investors took heart from GDP data. Economic growth

in the U.S. has not been slow enough to convince

investors that the post-crisis recovery is off-track, and

has not been fast enough to convince central bankers to

raise interest rates. Additionally, growth in the

emerging economies has been decent and consistent

with expectations so far this year. Interest rates in the

U.S. have fallen significantly, and the Barclays

Aggregate Bond Index rose 3.9% year-to-date through

June, while the global stock market as measured by the

MSCI All Country World Index was up 6.5%. The

“decoupling” of

emerging market stocks

from U.S. and EAFE

stocks seen in 2013 has

abated, and all major

international indices

have recorded similar

returns this year. The

S&P 500 was up 7.1%,

the EAFE index rose

5.2%, and the MSCI

Emerging Market Index

was up 6.1% year-to-

date through June.

Both the bond and stock

markets were very calm

in the second quarter,

even in the face of heightened instability in the Middle

East. Financial markets have been ignoring geopolitical

risk and have been focusing instead on two other

issues: slow but steady growth in the global economy,

and promises of continued monetary stimulus in Europe

and Japan. The stimulus has created some “bubble” like

conditions in parts of the bond market – high yield

corporates and peripheral European sovereigns are

notable examples – and has pushed U.S. stocks to full

valuations. European and emerging market stocks still

have room to run as their valuations remain attractive.

BULL MARKET CONTINUES

STIMULUS STILL DRIVING RETURNS

The financial markets have been calm so far this year.

The VIX Index, a measure of the stock market’s

volatility, has fallen and is as low as it’s been in seven

years. Consistent with this placid atmosphere, the stock

market has risen steadily this year through June, with

only a short-lived drop in January and February.

There are two major factors underlying this tranquil

environment. The first is that the U.S. economy, though

slowly strengthening, remains weak enough that the

Federal Reserve is unlikely to begin raising interest rates

for another year. The economy is performing well from

the point of view of the stock market – steady and

moderate growth combined with low inflation is

preferred. Eventually the Fed will have to raise interest

rates, but the stock market is hoping the transition will

be slow and clearly explained with maximum

anticipation. U.S. economic growth has been consistent

with this hoped-for scenario so far this year, and the Fed

has reacted calmly and resolutely.

The second important factor driving the calm and rising

Q1 Q2

Year-to-date

Equity Returns

MSCI Emerging

Markets Index

EAFE Index

S&P 500

MSCI All Country

World Index

ECONOMIC FORECAST | Q3 2014 4

stock market is monetary

stimulus in Japan and

Europe. The Bank of

Japan has continued on its

push to fight deflation and

stimulate the country’s

torpid economy, and the

European Central Bank has

instituted further easing

(with a negative interest

rate charged on bank funds

held at the ECB) and

promises to do more if

economic growth requires

it. This increase in global

liquidity has been good for

risky assets – especially

corporate bonds and

sovereign bonds from peripheral

Europe, in addition to stocks.

This good news notwithstanding,

there are some storm clouds

gathering for the stock market.

Geopolitical risk has clearly

increased in recent weeks as turmoil

has spread in Syria and Iraq, and

threatens to erupt in other parts of

the Middle East. The biggest risk

regarding the Middle East

from the view of the

financial markets is, as

usual, the prospect of a

disruption of oil

supplies. Iraq’s oil fields

are of increased

importance to global

supplies, and their huge

reserves makes them very

important to the market’s

forecast of global

production over the next

5-10 years. Surprisingly,

oil prices have been

relatively calm in spite of

the recent negative

headlines out of

Iraq. Brent crude rose to

$115 in the days after rebels

captured Mosul in northern Iraq, but

has since fallen to $108. The

market seems to be predicting that,

whatever the ultimate solution to

Iraq’s imbroglio, oil production in

the country will not be disturbed.

Despite the recent equanimity

regarding the various conflicts in the

Middle East, financial markets could

be jolted to attention with a

seriously negative headline. The

market is correct that, in the longer

run, the complicated issues in Iraq

and the broader Middle East will

likely not prove damaging to the

global economy. But today much of

the stock market is close to fully

valued and unexpected bad news

could cause a jolt.

Volatility Index (VIX)

2011 2012 2013 2014

U.S. GDP

Growth Rate 3.0%

2.5%

2.0%

1.5%

2011 2012 2013 2014

5 ECONOMIC FORECAST | Q3 2014

The U.S. stock market

strongly outperformed

both EAFE and

emerging market stocks

in 2012-2013, though

this was primarily due to

an increase of “earnings

multiples”, not earnings

growth. The market’s

discount rate for U.S.

corporate earnings fell

during those years, while

the discount rate on

emerging market

corporate earnings

stayed roughly

unchanged. There has

been a change this year,

however, as the three main regional equity sectors have

all risen roughly the same amount. In other words,

investors’ discount rates for stocks from these three

regions have moved similarly this year. This change in

market sentiment bodes well for emerging market

stocks going forward, as they are still trading at a sharp

discount to both U.S. and EAFE stocks. Continued

stimulus out of Japan and Europe strengthens the case

for emerging market equities, since they’re one of the

last sectors trading at cheap valuations.

— Brandon Fitzpatrick

EQUITY VALUATIONS

FIXED INCOME

14.813.3

10.5

0

2

4

6

8

10

12

14

16

S&P 500 EAFE MSCI EmergingMarkets Index

Price to Earnings Ratio (expected 2015 earnings)

At the end of 2013 the financial

markets as well as most economists

were expecting rising rates and the

end of the bull run in the fixed

income market. However, the

opposite happened. U.S. Treasury

yields declined and the fixed income

market performed well in the first

half of 2014. As of June 30, 2014,

the 30-year U.S. Treasury bond has

returned 13.77% while the 10-year

bond has returned 6.13%. For the

same period, the Barclays U.S.

Aggregate index has gained 3.93%,

while the U.S. Mortgage Back

Securities (MBS) and Intermediate

U.S. Government indices have

returned 4.03% and 1.55%,

respectively.

There are multiple reasons driving

the decline in the U.S Treasury yield

curve:

With the surge in equity markets in

2013, investors rebalanced their

portfolios or took profits by selling

equities and buying bonds,

especially Treasury bonds.

U.S. GDP grew at a dismal -2.9%

(annualized) in the first quarter of

2014, revised from earlier stated

-1.0%. Policymakers have now

reduced their growth forecast for the

U.S. economy from 2.9% to 2.2%.

Inflation has not picked up despite

easy monetary policy, especially in

Europe and Japan. This remains a

major concern for central bankers.

The financial markets are

forecasting prolonged

accommodative monetary policy.

Geopolitical risk, heightened

tension in Iraq, continued unrest in

Syria, and uncertainty regarding

Putin’s next adventure have helped

ECONOMIC FORECAST | Q3 2014 6

to keep yields low.

Nominal yields on European

sovereign bonds have been

decreasing as investors are

“searching for yield”. 10-year

Spanish bonds, which yielded

7.62% in July 2012, yielded

2.58%, 0.03% less than

comparable duration U.S.

Treasuries on June 9, 2014.

Financial markets are not

factoring in the credit risk

associated with European

sovereign bonds.

Finally, monetary policy from the

Federal Reserve will be

accommodative. The Fed anchors

the short term Treasury rates with

the Fed Funds rate. The financial

markets expect the Federal Funds

rates to increase no sooner than the

second half of 2015. The Fed is

also keeping the long end of the

Treasury yield curve depressed by

buying long-term U.S. Treasury

bonds through the Quantitative

Easing (QE3) program.

We anticipate U.S. growth momentum to accelerate

during the second half of 2014 and 2015. With a

modest increase in inflationary expectations (resulting

from a stronger economy), U.S. growth should prompt

rates to rise.

In addition to the growth momentum, as the Federal

Reserve unwinds the current bond buying program

there will be upward pressure on Treasury yields.

However, other parameters described above will work

against rising yields. Overall, we expect the yield curve

to steepen slightly in the next two quarters and the U.S.

10-year Treasury yield to be range-bound between

2.7% to 3.2% through the end of 2014.

DBF short duration and intermediate duration

portfolios have performed well in 2014. At the same

time, the portfolios are positioned to “cushion” the

effects of moderately rising yields.

— Prabhab Banskota

Year-over-Year Change in

Consumer Price Index (CPI)

U.S. Treasury Yield Curve

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D.B. Fitzpatrick & Co. 800 W. Main Street, Suite 1200

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