Q 2 2015 APRIL 16

ECONOMIC FORECAST

INSIDE THIS ISSUE:

Calm Markets, For Now 4-6

Equities 6-7

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 | Q2 2015 4

In the first quarter interest rates continued to be the

dominant factor in the capital markets, as investors

guessed at the timing of rate increases in the U.S. and

grappled with the implications of the European Central

Bank’s quantitative easing program. This divergence of

monetary policies in the world’s two most important

economies has already created significant turbulence in

the currency markets, though both the bond and equity

markets have been relatively calm so far this year. The

yield of a 10-year Treasury had risen from 1.64% on

January 31 to 2.24% on March 6, but has since fallen as

investors now anticipate that the Federal Reserve will

delay interest rate hikes until the third or fourth quarter.

The strength of the dollar likely surprised Federal

Reserve leaders, and they assumed a more dovish tone

in mid-March. The likely delay of interest rate

increases in the U.S. has prompted a rally in the equity

market, coupled with a fall in the dollar.

When it became clear in mid-March that

the Federal Reserve would delay its plan to

begin raising rates, investors turned their

attention to the low yields of European

bonds and pushed Treasury yields down.

Sovereign bond yields in Europe today are

at rock bottom levels — a French

government 10-year bond yields just

0.35%, for example, down from 1.70% at

the end of the second quarter 2014, while

Swiss 10-year bonds actually yield

—0.17%. Bond yields in Europe will probably stay

low, but a continued decline is unlikely as there is little

additional room to fall.

Given this, there is potential for turbulence in both the

fixed income and equity markets during the rest of 2015

as the timing of interest rate increases in the U.S. comes

more clearly into focus. In 2013 Fed leaders suggested

that the Fed might slow down bond purchases, and this

provoked a violent reaction in both the bond and stock

markets. The reaction this time is likely to be less

severe, as Fed chair Janet Yellen has been very careful

to telegraph her intentions. That said, this will be the

first rate increase since 2008, and it could still provide a

jolt to the markets. Equities are not immune, as

developed market stocks, at least, are fully valued. The

S&P 500 and MSCI EAFE indexes are trading at 17.9x

and 16.8x expected 2015 earnings, respectively. This is

not cheap by historical standards.

CALM MARKETS, FOR NOW

Volatility Index (VIX): Markets were calm in the first quarter

January February March

14

16

18

20

22

12

5

The U.S. economy, while not yet

fully recovered from the recession

of 2008-2009, continues to show

improvement. Home prices are

rising, consumer confidence is up,

and initial jobless claims are down.

The unemployment rate has fallen to

5.5%, but the low participation rate

— which measures the percentage

of working-age adults in the

workforce — demonstrates that

there is still slack in the labor

market (the U.S. participation rate is

at a 30-year low of 62.7%).

Inflation in the U.S. is very low, and

well below the Federal Reserve’s

target of 2.0%. This

notwithstanding, the Fed believes

that the economy is strong enough

to withstand higher interest rates,

and is determined to begin the long

path to a more normal interest rate

environment.

Europe, on the other hand, is

deepening its commitment to

monetary stimulus, and this

divergence of monetary policies has

caused big moves in the currency

markets. The U.S. dollar has risen

significantly against most major

Case-Shiller U.S.

Home Price Index 10%

5%

0%

-5% 2010 2011 2012 2013 2014

Conference Board

Consumer Confidence

2010 2011 2012 2013 2014

100

80

60

40

2013 2009 2012 2011 2010 2014

10%

9%

8%

6%

7% U.S. Unemployment Rate

ECONOMIC FORECAST | Q2 2015 6

Consumer discretionary stocks have performed well

this year, as investors take heart from an improving

U.S. economy and some positive signs in Europe. The

S&P Consumer Discretionary Sector Index is up 8.2%

year-to-date. The energy sector, as measured by the

S&P Energy Sector Index, is up only slightly year-to-

date, but is up significantly since crude oil prices

bottomed in mid-March. Utilities are the worst

performing sector so far this year, with the S&P

Utilities Index down 5.5%, as investors have priced in

the likelihood of higher interest rates. The healthcare

sector has continued to be a strong performer, while

consumer staples have also outperformed the market.

Equity valuations in the developed market economies

are not cheap. The earnings yield (the reciprocal of the

price to earnings ratio) of the S&P 500 Index is 5.6%,

which is not high by historical standards, though it

compares favorably with the yields available in the

bond market. As interest rates begin to rise, however,

the earnings yield on stocks is likely to rise as well. As

this occurs stock prices will fall unless earnings get a

big boost. Both equity and fixed income investors are

demonstrating a high degree of equanimity even as

currencies during the

last nine months. The

dollar’s strength is

likely to impact

economic growth across

the world in the next 6-

12 months, as

consumers adjust their

consumption patterns.

The Eurozone and most

emerging market

economies are likely to get a

substantial boost, as for many of

these economies foreign trade

represents a high share of gross

domestic product. The strong dollar

will hurt U.S. exports and domestic

growth, as foreign trade makes up

30% of U.S. GDP. As for the future

path of the dollar, in previous cycles

of interest rate increases the dollar

often gained as the date of the

Federal Reserve’s first increase

approached, then fell after the

increase occurred. Given the

dramatic increase in the dollar seen

recently, the odds are against much

more dollar strength.

Bloomberg Dollar Spot Index

2014 2015

Q4 Q1 Q3 Q2 100

105

110

115

120

EQUITIES

7

FIXED INCOME

U.S. Treasury

yields declined

in March as

bond investors

reassessed the

chances of

interest rate

hikes occurring

this summer.

The Federal

Open Market

Committee

(FOMC) was dovish during their

March meeting, and this lowered the

implied probability that the Federal

Reserve will increase the Fed Funds

rate by September from 48% in

February to 34% today.

The Federal Reserve’s increased

dovishness is caused by two main

factors. The first is the recent

higher interest rates approach. This calm is likely to

be put to the test in the coming months.

— Brandon Fitzpatrick

Evolution of Treasury Yield Curve (year-to-date)

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

S&P 500 MSCI EAFE Index MSCI All CountryWorld Index

10-year TreasuryYield

Earnings Yield

ECONOMIC FORECAST | Q2 2015 8

strength of the dollar, which

threatens the

competitiveness of U.S.

exporters. Second, with

year-over-year inflation at

0.0% in March there is no

imminent inflationary threat

in the U.S. The Fed knows

there is risk to raising rates

too soon, and is likely to

delay a few more months

with inflation this low.

Agency MBS underperformed Treasuries by 0.19% year-to-date through March 31, as demonstrated by the

Barclays U.S. Government Intermediate Index and the Barclays U.S. MBS Index. The underperformance was

due to higher volatility in the fixed income market, which led to higher prepayments and higher MBS supply

during the first quarter. $287 billion of agency MBS were issued in the first quarter, $91 billion more than a

year earlier. Within the MBS sector,

Ginnie Mae securities underperformed

Fannie Mae and Freddie Mac MBS as the

FHA reduced annual MIP (mortgage

insurance premium) from 1.35% to

0.85%, prompting investors to expect a

rise in prepayments.

Corporate bonds have performed well

despite record debt issuance. Falling

yields have prompted corporations to

issue debt to finance acquisitions, lower

financing costs, and improve liquidity.

While doing so they have provided

investors the extra yield they crave. $204

billion of investment grade corporate debt

U.S. Consumer Price Index

(urban consumers)

2.0%

1.5%

1.0%

0.5%

0.0%

2014 2015

Q1 Q4 Q3 Q2

U.S. Treasury Yield Curve

Spain Sovereign Curve

German Sovereign Curve

1.0%

0.5%

0.0%

2.5%

2.0%

1.5%

-0.5% 10Y 20Y 30Y 4Y

9

was issued through February 28, led by Actavis ($21

billion) and Medtronic ($17 billion). Corporations are

taking advantage of the low yield environment to lock

in cheap financing for longer periods. The maturity of

recently issued corporate bonds averages 15 years vis-à-

vis 12 years for debt issued during 2004-2013.

TIPS have underperformed Treasuries year-to-date as

the Merrill Lynch 3-5 year U.S. TIPS Index returned

1.03% through March, while the Merrill Lynch 3-5 year

U.S. Treasuries Index gained 1.48%. Inflation

expectations have increased recently, however, as oil

prices have stabilized. Annual expected inflation

during the next three years is 1.35%, up from 0.75% at

year-end. We expect inflation will continue to rise to

the Federal Reserve’s stated goal of 2% in the next 2-3

years. — Prabhab Banskota

ECONOMIC FORECAST | Q2 2015 10

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DB Fitzpatrick 800 W. Main Street, Suite 1200

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