economic forecast q1 2015
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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
ECONOMIC FORECAST | Q1 2015 6
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
ECONOMIC FORECAST | Q1 2015 8
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
ECONOMIC FORECAST | Q1 2015 10
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DB Fitzpatrick 800 W. Main Street, Suite 1200
Boise, Idaho 83702 www.dbfitzpatrick.com | (208) 342-2280