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The lead-in to the third quarter of 2015 commenced with a toxic mix of potentially disastrous macro events. A Greek referendum shocked global investors with a “No” resolution and opened the prospect for a Greek exit out of the European Union (EU). Unprecedented Chinese equity volatility further strained investor confidence. However, as the reporting period progressed, the global macro narrative grew exceedingly focused on a single risk, China. In our last correspondence, fund management maintained that events in Europe were potentially masking a far greater risk to financial markets and that investor interests would be better served by focusing less on Greece and more on China. Unfortunately, this prediction became reality in the third quarter as instability in Chinese equity markets unleashed a massive global risk unwind.
Early in the reporting period, the People’s Bank of China (PBOC) unexpectedly relaxed currency exchange protocols and allowed natural market forces to determine daily exchange rates. The announcement lead to a 2% devaluation in the Chinese won (CNY); the largest one-day adjustment in 20 years. Plausibly, the regime shift on currency exchange management was a form of quasi-quantitative easing. Global equity and commodity markets, however, did not process this news lightly as investors began to handicap the effects of a lower CNY on export-driven economies. Hardest hit were the emerging economies that have an umbilical tie to both exports and commodities. As volatility premiums intensified, so did the demand for the relative safety of government bonds. In local terms, the developed global Government Bond Index (GBI) was up 2.01% for the reporting period. Despite heightened instability during the quarter, developed foreign exchange returns were actually quite muted by quarter end.
As a whole, currency returns were fairly mixed in the third quarter. For example, the euro/U.S. dollar trading range was nearly 8.5% in the third quarter, but was only up 0.27% at the conclusion of the period. In contrast, emerging- market returns were anything but benign. An inverse example, the Brazilian real (BRL), lost nearly 22% in the third quarter alone. This divergence in foreign exchange markets summarizes the bifurcated nature of the U.S. dollar during the quarter.
When compared to other global markets, economic activity in Japan was fairly subdued in the third quarter. This relative calm provided a much needed refuge for investors seeking both stable and liquid alternatives. The spike in volatility last month also caught long carry investors by surprise, many of whom were using borrowed yen to fund higher-yielding investments. As risky assets began to falter, many of these short yen positions were reversed, particularly against EM and commodity centric holdings. As a consequence, the yen gained 2.19% against the USD.
Both the narrative and the price action remained the same for many commodity-centric countries, and both were overwhelmingly negative. The currencies of Australia, Canada and New Zealand proved to be some of the worst-performing developed market currencies; a pattern that has by now become routine.
A slowing economy in Canada drove the Bank of Canada (BOC) to cut rates to 0.50%. The BOC also downwardly revised its GDP forecasts for 2015 (1.1% from 1.9%) with downgrades in energy sector investments the main culprits. In similar fashion, the central bank of New Zealand (RBNZ) cut rates to 2.75%, but this cut was more dovish than the market expected. The RBNZ maintained “further easing as a likely probability.” Foreign exchange losses for this trio ranged anywhere from -5.4% to nearly -9% during the quarter.
The European narrative during the third quarter could be summarized in two chapters. Early in the period, practically every asset class in Europe fell hostage to Greek-related events. The “No” referendum in early July generated a spike in peripheral borrowing costs, while inducing steep declines in European equity markets. No sooner had the selling pressure peaked, but Greek authorities complied to EU creditors’ requirements, and an equally impressive rebound ensued. In response, the European Central Bank (ECB) kept its monetary policy unchanged and repeated that it would continue its asset purchase program at least until September 2016, or as long as necessary to restore price stability. This declaration made it clear that the ECB would not tolerate further sell-offs in European rates. Unfortunately, just as Greek uncertainties reached accord, Chinese growth concerns hurriedly became the new source of market stress.
The euro-area composite PMI rose 0.2 points to 54.1 in August, with promising gains in German manufacturing and further acceleration in the periphery areas. Among the highlights, German export orders jumped 3.4 points to a 19-month high, and the composite PMI for the peripheries rose to a very strong 56.1. However, matters took a turn for the worse as the reporting period drew to a close. Retail sales in Germany, Europe’s largest economy, fell by 0.4%. Additionally, French consumer spending revealed the same lackluster demand and marked the lowest reading in five months. Meanwhile, eurozone unemployment was stubbornly stagnant at 11.0%.
Remarkably, the euro navigated all the volatility with ease and posted a modest 0.27% gain against the U.S. dollar.
Mixed signals were the hallmark characteristic for economic developments in the U.K., as was rhetoric from the Monetary Policy Committee (MPC). Early in the quarter, manufacturing rose due to stronger consumer goods, which provided a more reassuring picture for the sector. Most notably, U.K. wages grew at their fastest pace in more than six years, lending further evidence of inflation in the labor markets. Conversely, manufacturing output began to wane late in the period; a byproduct of tepid Chinese demand and a resilient British pound.
Global macro forces were the main motives behind the MPC’s decision to keep key rates at a record low of 0.50%. By September, minutes from the MPC disclosed an 8-1 vote against raising interest rates. The MPC cited that China’s effort to devalue its currency and stock market panic as the overriding downside risks behind its decision. Blunted by the dovish statements, the British pound lost 3.72% to the U.S. dollar, but is still one of the better performing currencies on a year-to-date basis.
For the third quarter of 2015, Federated Prudent DollarBear Fund (Class A Shares at NAV) had a total return of -1.41%. The return for the inverse of the USD Index (DXY) was -0.91% for the same period. The fund’s absolute return was largely the result of U.S. dollar strength against most of the fund’s currency holdings.
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Largely speaking, U.S. and European economic affairs were a sideshow this past reporting period with China stealing most of the headlines. Arguably, global risk premiums are well on their way to repricing Chinese growth to between 2% and 5%. Fund management believes that such a soft-landing-scenario is nearly behind us and that most markets have appropriately rebalanced. The greater risk to most global markets now is the one that is yet to be vetted, mainly a hard landing in China. Simply put, China has become the common denominator to the global macro total return formula. Fund management is exceedingly aware of this risk and will proactively address the implications should they advance.
The slowdown in China and drop in global energy prices has cast some doubt over the U.S. Federal Reserve’s (Fed) tightening schedule. While we remain vigilant on Fed policy, we recognize that it has now become a second derivate to the Chinese narrative. Even Fed Chair Janet Yellen attested to this new reality at the last Federal Open Market Committee (FOMC) meeting.
Local commodity valuations are beginning to look exceedingly attractive, but there are still some external factors collaborating against them—namely volatility and Chinese growth. Should evidence arise that either of these two risks are retreating, fund management may begin to reinstate commodity-linked holdings back into the portfolio.
The ECB’s reference to “an unwarranted tightening in monetary policy stance” was a bullish message for peripheral bonds. Additionally, the current macro uncertainty is a breeding ground for higher volatility; yet one more reason to remain bullish on EU government bonds. It has also become abundantly evident that the euro thrives in environments of elevated volatility. Rounds of heightened market turbulence naturally incite deleveraging, and a substantial source of that leverage has been funded by euros. Responding to these dynamics, fund management curtailed euro underweights and successfully avoided outsized drawdowns and currency variance. However, the stark central bank divergence between the U.S. and Europe will ultimately trump this period of euro strength. Once global markets navigate through the current instability, the growth challenges handicapping Europe cannot possibly accommodate a strong currency. We remain structurally negative on euro valuations and may scale up the existing underweight should market volatility subside.