economic forecast q4 2015

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%


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


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


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

economic forecast q4 2015

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