Economic Forecast Q2 2016
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Transcript of Economic Forecast Q2 2016
DBFitzpatrick REGISTERED INVESTMENT ADVISORS
ECONOMIC FORECAST
Q2 2016
April 15
DB Fitzpatrick 800 W. Main Street, Suite 1200 Boise, Idaho 83702
(208) 342-2280 www.dbfitzpatrick.com
INSIDE THIS ISSUE:
The Fed is Still Driving the Markets 4-5
China is a Wildcard 6-7
Equities Bounce Back on Fed Comments
7-8
Fixed Income: Real Rates are Down as Inflation Expectations Perk Up
8-9
ECONOMIC FORECAST | Q2 2016 4
The first quarter was choppy in the financial
markets as investors reacted to the statements of
U.S. Federal Reserve policymakers. The Fed, it is
safe to say, is still driving the markets. The mood
was grim for the first six weeks of the quarter as
the equity market reacted negatively to Fed
commentary in December that proposed a target of
four 25 basis point hikes to the fed funds rate in
2016. Investors believed that the U.S. economy
was not strong enough to absorb such a policy,
and risky assets suffered most. The MSCI All
Country World Index fell 9% through February 11
as the U.S. dollar climbed and inflation
expectations dropped.
February marked the bottom of the selloff as Fed
leaders, clearly disappointed with moves in the
capital markets, began to
indicate that a change in
strategy might be in
order. The hints
continued to build in
March until a new plan of
two 25 basis point hikes
(two fewer than before) to
the benchmark interest
rate was announced.
During an interview in
late March Fed chair
Janet Yellen took more
control of the narrative,
emphasizing that slowing global growth and the
strong U.S. dollar were important factors for
policymakers to consider, and argued against
faster increases in interest rates. Investors
approved this analysis and stocks continued to rise
after Yellen’s comments. By April 15th the MSCI
All Country World Index was up 1.9% year-to-date,
while the S&P 500 had risen 2.5%.
There is a complicated dynamic in place between
the capital markets and Federal Reserve policy.
Fed policymakers – pushed by some hawkish
members – want to raise interest rates. They
believe the economy is strong enough to absorb it,
and view a continuation of very low rates as
unhealthy and possibly inflationary over the long
term. Investors do not share this optimism
THE FED IS STILL DRIVING THE MARKETS
Mar 2014 Mar 2015 Mar 2016
The Fed is concerned
about the dollar’s rise.
100
105
110
115
120
125 Bloomberg Dollar Index
5
regarding the
underlying strength
of the economy, and
react negatively
every time it
appears the Fed is
planning to raise
rates. Fed leaders
understand that this
dynamic is in place
and, though often
forced by market
moves to backtrack
on previously
announced plans,
continue to push forward when they can. They
have had some successes: they were able to
raise the fed funds rate one time late last year,
and bond investors today see a good chance of an
additional rate hike this year, with two hikes also
seen as a possibility. This is a small but important
victory for the Fed, as for years after the financial
crisis of 2008-2009 any hint of a slowdown to
monetary stimulus was viewed by the capital
markets with virtual panic (the “Taper Tantrum” of
2013 being the best example). The process
toward normalization is likely to last longer than
Fed leaders would like, however. In the
meantime, Fed statements will continue to be a
big (and possibly the most important) factor in
short term capital market movements.
Futures markets today are predicting only a 50%
probability that the Fed will raise interest rates this
year. Our view is that recent positive economic
data, combined with a rally in the equity market,
falling U.S. dollar, and increased expectations for
inflation during the last two months, are likely to
give the Fed more room to raise rates than
investors currently anticipate. This argues for
more volatility in the markets later this year, and
would be bullish for the dollar and bearish for risky
assets. There is also the potential for falling
inflation expectations, as investors would again
fear that the Fed is pushing things too far. A
careful balancing act will continue for at least the
rest of 2016.
16
20
24
28 VIX Index
Jan 2016 Feb 2016 Mar 2016 Apr 2016
Volatility is down as
Fed turns dovish.
ECONOMIC FORECAST | Q2 2016 6
The Chinese economy’s
transition toward increased
dependence on internal
demand continues to be
bumpy, and this is the
wildcard facing both
investors and policymakers.
Official government figures
say that China’s economy is
growing 6.5 – 7.0%, but this
is below market
expectations and doubts
overhang the veracity of the
numbers. Other (official)
data describing the
economy are mixed.
Industrial production is
growing but the rate of
growth has declined.
Freight traffic has seen
declines during the last two
years, while manufacturing
growth has been flat since
2012. Retail sales are up but the rate of growth
has been down recently, and there are continued
fears of a bubble in real estate. In summary, the
news is not all bad but the bottom has not yet
been reached and more investors are beginning to
believe that China’s economic transition could take
years. China’s importance to the world economy
(and especially to commodity producing countries)
has grown dramatically during the last decade,
and Chinese imports have risen from $1 trillion in
2009 to almost $2 trillion in 2013. Imports were
flat in 2014 and fell in 2015, while the early data
from 2016 are not encouraging.
China’s policymakers are trying to encourage
growth but are wary that deploying too much
CHINA IS A WILDCARD
China Industrial Production Growth
Mar 2014 Aug 2014 Apr 2015 Dec 2015
6.5%
7.5%
8.5%
9.5%
China Freight Traffic Growth
Mar 2014 Sep 2014 Jun 2015 Dec 2015
-15%
-10%
-5%
0%
7
stimulus will result in
asset bubbles down the
road. Ultimately,
economic growth is one
of the pillars of the
government’s legitimacy,
and policymakers are
trying to achieve lasting
growth with incremental
reforms. The efficacy of
their actions is one of the
biggest uncertainties
facing the global
economy. The most likely case for the near term
is a continuation of the status quo, with somewhat
disappointing economic growth numbers. The
markets appear to be predicting this, and it is one
of the reasons global interest rates are still so low.
The energy sector has led the
equity markets this year, as
investor fears regarding
oversupply turned to hope that
suppliers may agree to cap
output. WTI crude is up 9% this
year to $40 and the S&P Global
Energy Index has risen 9%. The
industrial and consumer staple
sectors have also outperformed
the market, both rising 5% this
year. The financial sector has
been dragged down by U.S. bank
stocks, and the S&P Global
Financials Index was down 5%
through mid-April. Investors fear
that banks have more exposure
to the energy sector than was
previously believed, as many
small energy producers currently
under financial strain are
accessing previously awarded
lines of credit. Not all banks face
the same level of risk, of course,
but until more clarity is achieved
investors will remain cautious
toward the sector. Healthcare
has been another
underperforming sector this year,
with the S&P Global Healthcare
Index down 3%. Within the
healthcare sector,
pharmaceutical stocks have been
especially out of favor as U.S.
politicians target the industry.
The stock market is trading at
valuations that are somewhat
higher than historical averages,
with the S&P 500 trading at 17.7x
expected 2016 earnings, and the
MSCI All Country World Index
EQUITIES BOUNCE BACK ON FED COMMENTS
China Imports (Monthly)
2005 2007 2009 2015 2011 2013
$60 b
$80 b
$100 b
$120 b
$140 b
$160 b
$180 b
ECONOMIC FORECAST | Q2 2016 8
The bond market rallied in the first quarter, as
investor concern regarding interest rate hikes
turned into relief after Federal Reserve
policymakers turned dovish midway through
the quarter. The Treasury yield curve
flattened, with the yield of the 10-year
Treasury bond falling from 2.27% on
December 31 to 1.79% on April 14. Yields
have fallen across the curve, apart from the
shortest tenors. The Barclays U.S.
Aggregate Index finished the first quarter
with a return of 3.03%, led by the U.S.
Treasury Index (+3.20%) and U.S.
Investment Grade Corporate Bond Index
(+3.97%), as corporate spreads have
tightened since mid-February. Agency
mortgage backed securities
underperformed the Barclays Aggregate Index
during the first quarter, with the U.S. MBS Index
FIXED INCOME: REAL RATES ARE DOWN AS INFLATION
EXPECTATIONS PERK UP
trading at 16.2x.
Stocks have continued
to climb the “wall of
worry” in the first half of
April, as the comments
of Fed policymakers
remain dovish. A
change in tone would
likely pressure stocks.
S&P Global Energy Index
Dow Jones U.S. Industrial
Sector Index
Jan 2016 Feb 2016
S&P Healthcare Index
Mar 2016 Apr 2016
85
90 S&P Global Financials Index
95
100
105
110
U.S. Treasury Yield Curve
12/31/2015
4/14/2016
10Y 7Y 5Y 2Y
0.50%
1.00%
1.50%
2.00%
2.50%
3.50%
30Y
9
returning 1.98%.
The real rate of interest has fallen
since the start of the year, and is
now negative on all maturities
shorter than seven years. The
falling real yield curve seems to be
signaling renewed concerns
regarding the health of the U.S. and
global economies, while at the
same time bond investors are
predicting that Fed policymakers
will respond to an economic
slowdown by maintaining interest
rates at current levels (or barely
above) for the rest of the year. It is
this prediction that has led to rising
inflation expectations (from very low
levels earlier in the year) and to a
tightening of corporate spreads.
Moves in the bond market were
fairly large in the first quarter.
There is potential for a reversal of
some of these recent trends if the
economy begins to show signs of
strength. Positive economic data
would likely lead to higher interest
rates, and could lead to lower inflation
expectations if it appears that the Fed will be able
to raise interest rates two times this year, as is still
policymakers’ stated goal. Data indicating a
slowing economy may not have as much impact
on the bond market, as market expectations for the
short run are already pessimistic.
— Brandon Fitzpatrick
20Y 30Y 15Y 9Y 7Y 5Y 3Y
-1.00%
-0.50%
0.00%
0.50%
1.00%
U.S. Treasury Inflation Indexed Curve
Inflation Expectations
5 Year
2 Year
0.60%
0.80%
1.00%
1.20%
1.40%
1.60%
Jan 2016 Feb 2016 Mar 2016 Apr 2016
4/14/2016
12/31/2015
ECONOMIC FORECAST | Q2 2016 10
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