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The third quarter of 2016 was generally a recovery period for most developed markets as investors digested the aftermath of Brexit. It soon became clear to many that the U.K.’s decision to opt out of the European Union (EU) would not necessarily translate into systematic financial shock. Accordingly, most developed equity markets reaped healthy gains; the MSCI World Index was up 4.38% in the past three months. Higher equities could have easily lead one to conclude that bond markets must have fared out poorly in during the quarter. However, in a world drenched with monetary stimulus, the JPM Global Government Bond Index surrendered only -0.26% during the same reporting period.
This is not to suggest, however, that global financial markets in the past three months were devoid of incident. In the closing weeks of the quarter, both the European Central Bank (ECB) and the Bank of Japan (BOJ) refrained from major changes to their respective monetary programs. Ironically, the sheer absence of additional stimulus began to fuel conclusions that the era of endless quantitative easing was possibly coming to an end. Consequently, benchmark yields in most developed bond markets began to rise at the conclusion of the reporting period. “If you choose not to decide, then you still have made a choice,” was in essence the markets’ interpretation.
Generally speaking, the U.S. dollar was on the defensive against most of its developed peers during the reporting period. As risk aversion receded, so did the demand for U.S. dollars (USD) as a haven vehicle. Once again, the Federal Reserve (Fed) proved ultra-cautious at the prospect of a rate hike, while the BOJ and the ECB left benchmark rates unaltered. This added to the USD’s weakness by effectively narrowing the “bank divergence” narrative, which has driven so much of USD strength in recent years. In context, however, the USD losses were fairly reserved during the quarter; the Dollar Index (DXY) was only down -0.71%.
The BOJ this year has essentially turned the act of disappointing investors into an art form. To date, the BOJ has consistently over-promised and under-delivered with its monetary objectives. The current reporting period was no exception to that rule. During the quarter, the central bank refrained from further easing, but did introduce “yield curve control,” an initiative aimed at re-steepening the Japanese yield curve. The central bank also increased its purchases of exchange-traded funds (ETFs). Unfortunately, the announcement was nowhere near what investors had anticipated, or what the BOJ had previously telegraphed. The outcome led many to conclude that Japanese monetary policy was nearing exhaustion. To the dismay of the BOJ, the Japanese yen appreciated further during the period, gaining nearly 2% against the USD.
Commodity Linked Countries:
Economic developments in the commodity bloc countries of Australia, New Zealand and Canada were largely mixed in the third quarter of 2016. However, all three continued to share a common dilemma: stubbornly rich currency valuations. Central banking authorities for each of the three countries have been very explicit in denouncing currency appreciation. Despite the verbal opposition, currency strength has been a common ailment for all three countries. In fact, the Australian dollar was the second-best-performing G10 currency during the quarter; New Zealand followed closely behind.
Early in the period the RBA (Reserve Bank of Australia) cut rates to 1.5% in response to waning inflation. However, the central bank failed to stifle Australian dollar appreciation with the announcement as investors viewed the rate cut as being final. Shortly after, the Central Bank of New Zealand (RBNZ) cut the Official Cash Rate (OCR) by 25 basis points to 2.00%. Indeed, the bank devoted an entire paragraph outlining how a higher trade-weighted exchange rate is likely to make it difficult for the central bank to meet its inflation objective. The RBNZ later added that further easing “will be required;” a statement most likely directed at excessive currency appreciation.
In Canada, gross domestic product fell at a 1.6% annualized pace, the single biggest contraction since 2009. Additionally, exports plunged 16.7% (annualized). Most troubling perhaps, was that the drop in exports extended well beyond the oil industry. Accordingly, the Bank of Canada held its overnight rate at 0.5%, and acknowledged that risks to inflation had tilted to the downside. The bank also recognized that the drop in exports was the main catalyst behind its more cautious shift. Meanwhile, the Canadian dollar lost some ground against the USD during the quarter (-1.55%), but is still one of the better-performing G10 currencies on a year-to-date time horizon.
Economic progress was somewhat bifurcated among the Nordic countries of Sweden and Norway, especially in terms of currency valuations. This year, the Norwegian krone has been one of the best-performing developed currencies. Meanwhile, the Swedish krona has joined the British pound as the only two G10 currencies to have actually lost ground to the U.S. dollar in 2016.
There is a growing opinion that the Swedish Central Bank will begin to roll back monetary stimulus, but the ongoing Sek weakness has been challenging that outlook. Strong credit growth, rising inflation, low unemployment and higher resource utilization all argue in favor of a reduction in Swedish monetary stimulus. In theory, this should have translated into currency strength. However, Swedish central bank authorities seem adamant, and unabashed, about outright currency management. Stefan Ingves, Governor of the Riksbank, openly testified recently that the “Krona plays a pretty big role in policy.” In the modern era, this is as close to a concession of verbal currency manipulation as any central banker will care to admit.
In contrast, the Norwegian Central Bank (Norges Bank) left its benchmark deposit rates unaltered last period. Most notably, the Norges Bank clearly communicated a more balanced economic agenda. In context, this was a much more upbeat economic viewpoint than most market practitioners had anticipated. The neutral outcome defied market consensus that was eagerly anticipating yet another interest rate cut by the central bank. Consequently, it was little surprise that the Norwegian krone was the second-best-performing G10 currency last month.
In our prior quarterly review, fund management concluded that Brexit risk was generally overstated in a host of asset classes. The resulting months in the third quarter seemed to corroborate that conclusion. Soon after Brexit, investors came to the understanding that the fallout from the event would not be realized for months, if not years. U.S. equity markets led the charge in the recovery and helped to anchor sentiment across a broad array of asset classes. Additionally, British Prime Minister David Cameron resigned during the reporting period and paved the way for Home Secretary Theresa May to take the reins as the new British Prime Minister. The expediency and orderly nature of this regime shift also helped to buttress investor confidence.
From an economic standpoint, data was fairly mixed during the reporting period, but was not as dire as initially thought. For instance, PMI services experienced its single largest monthly decline since the financial crisis of 2008. On the other hand, consumer confidence rebounded materially, albeit from depressed levels.
During the reporting period, the Bank of England (BOE) delivered a multi-dimensional package of measures that exceeded most outlooks. The comprehensive package of measures was justified by a sharp downgrade to the BOE’s growth forecast. Additionally, the benchmark rate was cut by 25 basis points to 0.25%. Most importantly, the BOE opted to purchase £70 billion of additional assets, (4% of GDP) comprising £60 billion of gilts over six months and up to £10 billion of corporate bonds over 18 months.
As a direct consequence of the BOE’s announcement, U.K. government bonds outperformed most of their developed counterparts. In contrast, the British pound (GBP) returned -2.55% during the quarter and its year-to-date losses still overwhelm all other currency losses among the G10.
“Ready, willing and able to act” were the words echoed by the ECB early in the reporting period. A statement most likely geared at relieving investor apprehension over Brexit. In practice, fallout from the U.K. opting to leave the EU was relatively muted; this provided little fodder for the ECB to take any further action. Specifically, the ECB maintained its easing bias, but did not ease rates further, nor did it implement additional quantitative easing. The ECB also emphasized that interest rates were to remain low for an almost indefinite time period, or until the Governing Council saw it fit to conclude. Ironically, in a world acclimatized for central bank intervention, the lack of new stimulus by the ECB triggered a fairly steep rise in G3 yields as the quarter drew to a close.
Despite the absence of new easing measures, the ECB’s posture of “ready to act” fortified holders of European debt. Once more, in the third quarter of 2016, the euro was a ballast, appreciating 1.16% against the U.S. dollar.
For the third quarter of 2016, Federated Prudent Dollar Bear Fund had a total return of 0.00% (A Shares at NAV). The return for the inverse of the U.S. Dollar Index (DXY) was up 0.71% for the same period. The fund’s absolute return was largely the effect of U.S. dollar weakness against the majority of G10 economies.
Performance quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than what is stated. Other share classes may have experienced different returns than the share class presented. To view performance current to the most recent month-end and for after tax returns, click on the Performance tab. Performance does not reflect the maximum 4.5% sales charge for A Shares. If included, it would reduce the performance quoted.
Click the Performance tab for standard fund performance.
Relative to the inverse of fund’s index (DXY), currency selection mostly detracted from return.
“The beginning of the end for global quantitative easing (QE), or is it just the beginning?” This is likely to become the leading macro narrative in the months to follow. The resolution to this working thesis will inevitably redefine risk premiums across a host of global asset classes. QE is inherently a volatility-dampening force; it effectively floods markets with liquidity. Should, and when, the leading central banks begin to unwind QE, volatility is almost an ensured byproduct. It’s simply an address of time, but one that fund management believes not to be imminent.
Fund management also feels that global monetary accommodation is neither at the beginning, nor the end, of its cycle. More likely, we are at an inflection point; an economic fork in the road. Global disinflationary forces are too deeply entrenched to allow for a sudden freeze of QE. Meanwhile the cost/benefit analysis for more quantitative easing is growing more imbalanced. Contrary to current consensus, fund management does not foresee a looming halt to monetary accommodation by either the ECB or the BOJ. Reassessing quantitative easing, or tapering, are polar considerations; we believe we are somewhere in between these two extremes.
Possibly, current Japanese monetary policy is at the frontier of this evolving macro narrative. ‘Abenomics’ is now nearly a half decade old economic policy, and its impact appears to be diminishing with time. Despite the BOJ doubling its purchases of ETFs to 6 trillion yen, inflows into the nation’s mutual funds have fallen to their lowest levels in four years. Japanese stocks are the third-worst performers this year among 20 developed markets. Furthermore, in less than one year, the yen has retraced nearly half of the depreciation that the BOJ has so desperately tried to engineer. To say the least, recent market reaction has been counterproductive to Japan’s ultimate economic objectives. Bluntly, the BOJ’s credibility is under scrutiny.
The U.S. dollar has been steadily appreciating for three years now; its current valuation has already factored in a host of economic conditions. In other words, USD downside has grown more elastic to negative economic developments. To add, longer-term inflation expectations are already at historical lows, which has motivated the U.S. Federal Reserve Bank to become hypersensitive to excessive USD strength. Consequently, there is an inherent feedback loop built into U.S. monetary policy that should prevent protracted USD strength. In contrast, USD downside has no such obstacle. This naturally leaves the balance of risks pointing downward for the U.S. dollar over the investable time horizon.