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To proclaim that geopolitics played a role in global markets in 2016 could qualify as a massive understatement. Not to be outdone, the fourth quarter of 2016 was perhaps the most politically charged period of the year. The U.S. presidential election was the flagship event in during the fourth quarter that touched practically every asset class around the globe.
This is not to suggest that there were no other keynote events in the reporting period. Truthfully, most other economic affairs were simply vying for second place. For instance, Italy opted to reject existing constitutional reforms, which triggered the resignation of its Prime Minister in October. The European Central Bank (ECB) also extended its quantitative easing program by nine months. Lastly, and after much anticipation, the U.S. Federal Reserve finally raised interest rates. Overall, if one were to strip out the Trump presidential victory, global economic developments were slightly improved at the margins, both in the U.S. and abroad.
Early on, buoyant U.S. economic data helped to reenergize U.S. dollar (USD) bulls as a December rate hike from the U.S. central bank began to look more promising. Consequently, the USD started to strengthen against a host of developed and emerging economies. Galvanizing the strong USD further, new expansionary policies from the forthcoming U.S. government regime ushered in a massive USD rally as inflation expectations began to shift. For example, the Japanese yen lost 13.35% to the USD, relinquishing over 80% of its 2016 gains in just three months. Overall, the U.S. Dollar Index (DXY) was up 7.07% during the reporting period.
Equity markets found new life with prospects of U.S. tax reforms and repatriation incentives. Having previously exhibited symptoms of price fatigue, the Trump presidential victory re-energized the S&P 500, which ended up gaining 3.25% in the fourth quarter of 2016. Contrasting the equity jubilation, global bond markets fell victim to rising inflation expectations and sustained a fairly sharp sell-off. The JPM Global Government Bond Index declined 3.24%.
In the three weeks following the U.S. election, the Japanese yen proceeded to freefall -8.5% in November alone. The dramatic rise in U.S. borrowing costs, in conjunction with the Bank of Japan’s (BOJ) curve control policy, allowed interest rate differentials between the two countries to widen materially. This divergence increased the yield pickup in U.S. Treasuries and reignited the yen carry trade. By anchoring 10-year yields around zero, the BOJ also succeeded in extracting volatility out of the Japanese bond market. Ten-year Japanese yields remained in a 10 basis-point range for most of the reporting period.
On the data front, real gross domestic product (GDP) in Japan rose 2.2% quarter-over-quarter; significantly stronger than consensus forecast. Net trade was the main reason for the upside surprise; the stronger exports and weaker imports left a 1.7% point contribution to growth. Also, the Tankan large firm survey posted its third consecutive rise to 14; the highest level since August 2015. These results may suggest that the economy is beginning to gain momentum after a sluggish start to this year. On a relative basis, the Japanese bond market was one of the better-performing among the G10, down only -1.76% in the fourth quarter. In sharp contrast, the Japanese yen fared far worse to USD strength and lost -13.35% in the fourth quarter of 2016.
Commodity Linked Countries:
Few economies were spared from USD strength during the reporting period, and the commodity bloc economies of Canada, Australia and New Zealand were no exception. However, with an umbilical tie to U.S. growth and rising oil prices, Canada fared much better than many of its commodity-centric contemporaries. The Bank of Canada left rates unchanged at 0.50% throughout the period and expressed the view that the inflation outlook looked fairly balanced. However, the central bank did downgrade future growth prospects; the overall message was generally balanced and in-line with most economic predictions. The Canadian dollar was down -2.34% during the fourth quarter, while local benchmark bonds lost 4.08%.
In Australia, headline unemployment actually improved during the fourth quarter of 2016, but as is sometimes the case, the devil was imbedded in the details. The lower unemployment rate was mainly driven by a decline in the labor force participation rate, which fell to its lowest level in three years. Overall, the brittle nature of the Australian labor force was more worrisome than the ornamental improvement in the headline rate. Surprisingly, the central bank of Australia (RBA) left the cash rate unchanged, but omitted language pointing at future easing measures. Effectively, the Australian economy continued to evolve in line with the RBA’s expectations, providing little fodder for the central bank to alter its neutral tone. The biggest changes acknowledged that employment composition was imbalanced and that house prices were again “rising briskly.” Unsteady economic statistics were mainly behind the Australian dollar’s 5.95% decline in the fourth quarter of 2016.
Politics were also inescapable in New Zealand, as Prime Minister John Key unexpectedly resigned in December. The New Zealand dollar was largely unaffected by the decision, and the political limbo was short lived as the former finance minister was sworn in swiftly. Furthermore, GDP data showed strong growth at 3.5% year-over-year, broadly in line with most official expectations. Growth was supported by strong consumption and the ongoing housing construction boom. In the fourth quarter of 2016, the New Zealand Dollar depreciated -4.83%.
Norway’s mainland GDP expanded 0.6% quarter-over-quarter but was below most targets and the Norges Bank’s 1.75% forecast (based on its annual projection). Looking at the details, stagnant household consumption partly explained this weak performance. Government consumption also was weaker than it was in the first half of the year. The weaker GDP data was a stark reminder of how dependent Norway is on oil production as lower oil prices resonated for the better part of the past three years. However, the recent OPEC agreement is a promising backstop for West Texas Intermediate Crude prices and should keep the Norwegian central bank at bay from cutting interest rates. Despite the late November rally in oil prices the krone still lost -7.59% to the USD in the fourth quarter of 2016.
Early in the quarter, U.K. Prime Minister Theresa May voiced that she would trigger the formal process for Britain’s exit from the European Union by the end of March; setting in motion the U.K.’s severing of a 40-year-old tie to the region. The announcement, further intensified British pound (GBP) weakness and, at one point, triggered a 6% decline in a matter of seconds—a “flash crash” as it is now coined. Although the GBP immediately reversed most of that loss in another blink of an eye, the fact that such a whirlwind pricing event even happened unleashed a host of questions regarding that currency. After all, a reserve currency like the GBP is not supposed to trade like a penny stock.
Remarkably, the U.K. labor market continued to show resilience and posted the lowest unemployment rate since September 2005. However, the improvement in the headline employment statistic may have been more cosmetic than substantive. Beneath the veil, job growth slowed and the participation rate deteriorated meaningfully; both strong indicators of a weakening trend. Admittedly, it is still too early to gauge the full impact of Brexit on the U.K. labor market. Despite the backward-looking nature of the statistic, GDP results beat most official forecasts as well. Finally, U.K. PMI went a step further by showing a gain, a reading that was very close to normal levels.
The Bank of England MPC (Monetary Policy Committee) left monetary policy unchanged during the reporting period, after material easing post-the referendum in August. The GBP lost -4.87% during the reporting period.
European Union (EU) economic data in October was mixed, but at the margin was fairly promising. Both euro area composite PMI and consumer confidence jumped in November, potentially signaling for 2% GDP growth in the fourth quarter. Additionally, a prominent German investor survey (ZEW) surprised to the upside, rising by 7.6 points and continuing the recovery since Brexit. Recent surveys are sending a clear message of rising economic momentum in Europe; the increase in PMI to 54.1 just reinforced this message.
Europe has been a hot bed of political instability for the past few years, and the fourth quarter of 2016 found little respite from that unfortunate precedent. The populism wave that first made its way to the U.K. in June, then moved over to the United States in November, was back in Europe by December. In early December, Italy voted to halt sweeping constitutional reforms that were originally aimed at rehabilitating governmental policy and procedure. As a consequence, Prime Minister Matteo Renzi was effectively forced to resign his post, but more importantly the vote roused more political uncertainty for the region as a whole. Growing political uncertainty and widening interest rate differentials were too much for the euro to shoulder. The euro lost -6.39% to the U.S. dollar during the quarter.
During the reporting period, Federated Prudent Dollar Bear Fund had a total return of ‑6.97% (A Shares at NAV). The return for the inverse of the U.S. Dollar Index (DXY) returned ‑7.07% for the same period. The fund’s absolute return was largely the effect of U.S. dollar strength against the majority of G10 economies.
Performance data 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 Class A Shares. If included, it would reduce the performance quoted.
Click the Performance tab for standard fund performance. Click on Portfolio Characteristics for information on quality ratings.
Relative to the inverse of fund’s index (DXY), currency selection modestly improved performance. The fund’s removal of all gold holdings helped to better performance relative to the inverse of DXY.
As we close the final chapter of 2016, many narratives from that period will likely remain a reminiscence of the past; relegated to financial history books. However, some elements will likely continue to resonate in the months and quarters to come. Geopolitical events stand out as a prime candidates, and are bound to resume their role in modeling macro narratives and risk premiums worldwide.
Most importantly, a host of new economic forces, which have been virtually absent in the past, are likely to debut in 2017. The upcoming Trump presidential regime has pledged unprecedented change to the alchemy of the U.S. economy. Fiscal spending, repatriation incentives and corporate tax reforms are formidable forces that could have a profound effect on the global financial system. Fiscal policy will become a key determinant to capital markets; a variable that has laid dormant for years. U.S. corporate tax reforms could further energize equity markets, help to boost wages and anchor inflation expectations. Repatriation incentives could bolster corporate coffers and catalyze a migration of capital back to the U.S. These are some of the highest macro-economic forces that could ultimately re-shape the path of bond, equity and currency markets in 2017. Fund management is keenly aware of this potential regime change and is repositioning fund risk accordingly.
Thus far, economic activity in the U.K. has proven resilient to the effects of Brexit, but seismic change follows an equally sizable time frame. Rejecting market access to the EU bears many long term risks to the U.K. and materially increases the uncertainty over future returns on investment. Making matters worse, the U.K. shoulders a 6% current account deficit that needs to be funded through either a supply boost or demand moderation. A weaker pound remains the primary conduit by which to rebalance that current account imbalance. These structural disparities are central to the fund’s underweight allocation to the GBP and U.K. bonds.
Earlier this year, the BOJ’s efforts to catalyze inflation through negative interest rates (NIRP) had one failing component: a stubbornly strong yen. Arguably, the Trump presidential victory may have done more service for the Japanese economy than the BOJ’s own monetary efforts. In the months to come, the Japanese yen will have to contend with the prospects of U.S. tax reforms, repatriation incentives and rising U.S. interest rates, a toxic mix for any currency let alone the yen. The current situation whereby bond yields are being engineered by the BOJ is distorting traditional valuation metrics. This is evidenced by 10-year borrowing costs deliberately anchored around 0.0%, but allowing longer-dated bond yields to float more freely. Consequently, the fund remains underweight the super long end (30-year) of the Japanese bond market on the premise that the BOJ’s “curve control” policy will continue to steepen the Japanese yield curve.
Most volatility events tend to be transient in nature, but in rare instances, they can also be game changers. For the USD, the Trump presidential victory was just that, a game changer. Fiscal spending, repatriation incentives and corporate tax reforms are formidable forces that very few currencies will be able to defend against if implemented in the U.S. Just one of the former factors can arguably be enough to support a country’s currency; the USD has a trinity of them now. On this premise, fund management will likely remain overweight the USD.