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The second quarter of 2016 was a month riddled with volatility, and the bulk of the instability was a byproduct of the U.K. referendum vote (Brexit) to either leave or remain in the European Union (EU). Lurking in the shadow of Brexit, economic data among the developed economies was generally tepid, and despite the run-up in oil prices, disinflationary pressures remained stubbornly anchored. With all the uncertainty looming around the U.K., most major central banks wisely adopted a “wait and see” posture and kept their mandates unchanged. The wave of uncertainty further galvanized the demand for secure investment vehicles, and nowhere was this more evident than in the relative safety of developed government bonds.
Throughout the reporting period, the foreign exchange market was focused on a blended interest rate policy and risk aversion considerations. As Brexit neared, carry strategies fell victim to the rise in market volatility. Nowhere was this manifestation more marked than in the Japanese yen, which appreciated against every single G10 economy. At the height of the market unrest, the yen had gained in excess of 15% against a host of other countries. However, if there was a single asset that best resonated the instability generated by the U.K. referendum, it would almost certainly be the British pound (GBP). GBP price variations were unprecedented in June, violently fluctuating as voting dynamics shifted. Incredibly, 1-month sterling-implied-volatility reached levels not seen since the height of the 2008 financial crisis.
Notwithstanding its station as the preeminent reserve currency, a decidedly reserved Federal Reserve (Fed) outlook still resonated to some degree in the U.S. dollar (USD) exchange. A defensive Fed, coupled with the lowest monthly increase to U.S. employment since 2011, contributed to some isolated USD weakness. Broadly speaking however, the USD was an overall beneficiary from the escalating risk aversion.
In the second quarter of 2016 alone, the Japanese yen was up 9.08% against the USD; further stifling the objectives of Japan’s reflationary mandate (Abenomics). A more reserved Fed and heightened risk aversion were the chief reasons behind yen strength in June. Despite initial success, Prime Minister Shinzo Abe’s trademark ‘three-arrow’ economic policy seemed to be unraveling. Central to this dilemma had been the rapid appreciation of the Japanese yen, which could ultimately derail the objectives of Abenomics. Simply, a strong yen and a negative interest rate policy is akin to what oil is to vinegar; the two just don’t mix well.
Even with its formidable current account surplus, business conditions in Japan began to deteriorate; the Tankan sentiment index marked its lowest reading since 2013. Lastly, consumer spending remained weak despite rising employment; in part due to the continued pressure on real wage growth. In-step with the Fed, the Bank of Japan left its monetary policy unaltered as well. Most Japanese government borrowing costs remained anchored under zero for most of the reporting period.
Commodity-Linked Countries & Gold:
Surprisingly, the commodity-linked economies fared relatively well in the second quarter of 2016. Despite being inherently higher beta, and thus more sensitive to volatility, commodity-linked valuations found solace in steadying economic data out of China. In some areas of the Chinese economy, data began to hint at a potential recovery, particularly in housing construction projects. Consequently, those economies heavily associated with commodities were equally influenced by Chinese economic prospects as they were by the uncertainty surrounding the U.K. Both the Canadian and New Zealand dollars even managed to advance against the USD.
New Zealand’s central bank (RBNZ) kept its key rates on hold at 2.25%, but maintained its easing bias. Nonetheless, the economic forecast, and overall tone, was more upbeat than in previous quarters. However, the downturn in the dairy sector and strength in the New Zealand dollar (NZD) were cited as ongoing concerns. To the dismay of the central bank, the NZD appreciated 3.26% against the USD late in the second quarter of 2016.
Similarly, domestic activity in Australia was generally mixed. Retail data revealed further deterioration, and income growth remained persistently weak. Surprisingly, real GDP growth actually accelerated to 1.1% quarter-over-quarter. The main drivers of growth remained broadly unchanged: primarily mining, private consumption and residential investment. The RBA (Australian Central Bank) stopped short of pointing towards yet another rate cut. The potential for further easing was the underlying reason why the Australian dollar lost 2.69% to the USD during the reporting period.
Canadian economic activity was somewhat irregular last month, largely due to the effects of the devastating fires in Alberta. The Bank of Canada (BOC) echoed this unbalance by keeping key rates on hold at 0.50%, but at the same time was cautiously optimistic about growth. Like so many other central banks, the BOC also expressed concern about the implications of renewed financial stress due to the U.K. referendum. On the economic data front, consumer price inflation was generally flat. In contrast, retail sales continued to surprise to the upside and posted sequential gains. The Canadian dollar advanced 0.62% against the USD.
Much can be written about U.K. economic affairs in June, but no one subject could have competed with the impact that Brexit exuded on financial markets. The potential for the U.K. to abandon its membership in the EU not only dictated events in the U.K., but also defined risk premiums globally. Brexit aside, British economic data in the second quarter was lackluster by its own merit. For instance, U.K. construction PMI was softer at 51.2 versus 52.0 expectations; this continued a pre-existing trend that became evident months before Brexit risk emerged. The country’s manufacturing output also shrank for the first time in three years, adding to existing signs that growth had slowed. On the other hand, U.K. retail sales in June came in much better than expected, but was completely ignored by investors who were entirely consumed with Brexit-related risks. In late June, British voters validated the heightened market anxiety and shocked the world by opting to leave the EU.
It goes without saying that Great Britain pound (GBP) valuations in the second quarter were anything but routine. In the two days following the vote to leave the EU, the pound fell 15% against the yen and 11% against the USD. Additionally, one-month GBP volatility reached levels not seen since the apex of the 2008 financial crisis. By the conclusion of the reporting period, the GBP was officially down 7.31% against the USD—the worst-performing developed currency by a fairly large margin. Surprising to some, U.K. benchmark government bonds outperformed most other developed debt markets.
As widely expected, the European Central Bank (ECB) kept its monetary policy unchanged throughout the reporting period while macroeconomic projections were broadly untouched. ECB president Mario Draghi noted that downside risks had receded to some degree; crediting ECB monetary policy for the improvement. Somewhat contradictory, however, the central bank also lowered its core inflation projections. Core inflation proved unkind to Mr. Draghi’s optimism and continued to recede throughout the period. Remarkably, ZEW (German investor survey) surprised strongly to the upside, increasing by 12.8 points to 19.2 by the end of the reporting period. The survey indicated that financial investors were markedly more optimistic about the prospects for the German economy over the coming months. The outcome of this survey was rather perplexing given all the volatility and uncertainty associated with the U.K. opting to leave the EU.
Remarkably, despite its umbilical tie to the U.K. crisis, the euro’s haven status helped to counterbalance some of the selling pressure associated with the crisis. In the second quarter of 2016, losses to the USD were limited to a commonplace -2.41%.
During the reporting period, Federated Prudent Dollar Bear Fund had a total return of -0.50% (A Shares at NAV). The return for the inverse of the U.S. Dollar Index (DXY) was -1.65% for the same period. The fund’s absolute return was largely the effect of USD appreciation 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), an overweight allocation to the Japanese yen improved returns. A modest underweight to the euro benefited performance as well. Lastly, gold equity holdings greatly benefitted fund performance relative to the inverse of the DXY.
Looking forward, the first order priority for most global investors will likely be to autopsy the risks that have emerged from Brexit. As important as the analysis itself, the prioritization of these risks will prove paramount. The path by which the U.K. leaves the EU should prove to be a long and complex process; it will undoubtedly engender both short- and long-term risks. The shorter-term risks will likely be more volatility centric as markets recalibrate to this new reality.
Justifiably so, investors are still fairly biased from the 2008 financial crisis and have been quick to react to the slightest change in market equilibrium. This behavior has repeatedly manifested itself in a variety of volatility shocks in the past few years. However, as the U.K. referendum dust settles, markets may realize that Brexit is not a financially-based crisis, and hence less inclined to overwhelm global capital markets. While the effects on the U.K. economy are relatively straightforward, it will take a considerable time for the impact of Brexit to be known to the rest of the world. This is likely to be a long and arduous evolution, and one that does not necessarily have to imply imminent financial gloom.
The fallout from the British referendum has also opened up a Pandora’s Box of geopolitical worry; mainly that other European members would begin to entertain the same fate as the U.K. While being a viable risk, the actual execution of the idea is far more complex in reality than the rhetoric suggests. In Germany. for instance, the likelihood for a referendum is legally impossible and publicly unpopular. In France, the current party leader advocating for a referendum has a trivial chance of winning the presidential election, greatly reducing the potential for a referendum. In Italy, on the other hand, a referendum is simply illegal. This is not to relegate the importance of geopolitical risk by any measure. In fact, geopolitical market disturbances are likely to become a common narrative in the years to come. Fund management is acutely aware of this growing paradigm and has embedded specific risk-management protocols to address the matter.
By definition, risk management is the evaluation of unaccounted risk, and by that measure the U.K. referendum is now accounted for. As we highlighted in prior correspondence, the impact of negative interest rate policies (NIRP) has all the hallmarks of becoming the next market focus. To date, negative interest rates have given birth to as many questions as they have answers; their impact has been mixed at best. In Japan, for instance, NIRP has led to decisively lower equity valuations and a markedly stronger Japanese yen. Lower equities and stronger currency are deflationary forces, the exact opposite of what NIRP was intended to accomplish. Global central bank officials even recognize that negative interest rates are part practice and part hypothesis. Fund management feels that NIRP presents a potentially understated risk that requires extreme scrutiny.