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In the opening quarter of 2017, most global risk premiums continued to trade around the “Trump” reflation narrative. However, in the early days of the reporting period, there was one asset class that seemed to dissent from this macro theme. Foreign exchange markets in January decoupled from their equity and bond siblings and began to reconsider some of the propositions outlined by the new Trump administration. In all fairness, currency markets may not have been rejecting the notion of higher inflation as much as they were re-pricing the scalability of it. By quarter end, foreign exchange markets were vindicated when the new Trump administration failed to deliver on their first initiative to reform health care in the U.S. This was a damaging blow to the “reflation thesis.” Subsequently, the dollar extended its decline, and stocks fell as investor doubts grew over the U.S. political and economic agenda. Additionally, global bond yields began to drop, gold advanced and the commodity center began to waver.
In the first reporting quarter, the U.S. dollar not only defied general consensus, but also a stream of robust U.S. economic data and reasonably hawkish rhetoric from Federal Reserve (Fed) officials. Having had ample reason to materially advance, the U.S. dollar’s performance was underwhelming to say the least. When gauged from a broader context, the U.S. dollar forfeited ground to the entire G10 complex and endured sizable losses to a host of emerging currencies. As measured by the U.S. Trade Weighted Broad Dollar Index, the U.S. dollar returned -3.01% during the first quarter.
In Europe, politics remained in focus ahead of the April French election. Attention was briefly given to the March Dutch election as a possible barometer of the populist movement within Europe. As the Dutch election neared, investors found solace in the safety of German bonds and drove 2-year borrowing costs down to an astonishing ‑96 basis points. Subsequently, the populist campaign in the Netherlands found little favor by voters and quickly dissolved out of investor focus and risk premiums.
It was a fairly quiet period for Japan from both an economic and market standpoint. On the economic front, GDP statistics further highlighted the ongoing softness in core domestic demand. Given the country’s shrinking and aging population, slower consumption may simply be unavoidable. However, this recent softness appears at odds with the tight labor market. During the period, Japanese unemployment reached 2.8%, the lowest reading since 1995. Additionally, CPI inflation started to exhibit some bottoming symptoms. In fact, inflation expectations have been improving gradually; likely a byproduct of yen depreciation and higher oil prices. As the quarter drew to a close, risk appetite began to wane and the Japanese yen began to benefit as carry strategies unwound. Consequently, the Japanese yen gained 5.00% during the quarter. In context, however, this appreciation was merely a sliver of the ground the yen lost since the Trump presidential victory.
Commodity-Linked Countries and Gold:
On both a total return and relative basis, most commodity-centric bond markets out-performed many of their G20 peers. On the other hand, foreign exchange valuations were mixed, but for the most part, nearly all posted gains against the U.S. dollar. In New Zealand, the story remained the same. For nearly three years now, the RBNZ (central bank of New Zealand) has been faced with a bipolar economic disorder of skyrocketing house prices and falling inflation expectations. The RBNZ left key benchmark rates steady at 1.75% throughout the first quarter. Specifically, the central bank kept interest rates at a record low and forecasted them to remain there for a prolonged period, quoting that “inflation will return only gradually to target”. Despite the soft tone from the central bank, the New Zealand dollar managed to post a 1.0% gain against the U.S. dollar.
Since the Bank of Canada signaled an ongoing dovish bias back in 2016, market participants have been closely scrutinizing data that would compel the Bank of Canada to cut interest rates. However, economic statistics in the first quarter of 2017 were surprisingly robust. Real GDP rose during the reporting period and the PMI figures moved to their highest level in two years. The employment index also increased and recovered nearly all of its declines from last year. Growth like this is not exactly a recipe for cutting interest rates. During the three-month reporting period, the Canadian dollar returned .92% against the U.S. dollar.
Some currencies in the commodity-centric universe are presently thought to be rich in value, yet many continue to defy gravity. Nowhere is this evidenced better than in the Australian dollar (Aud). Practically every pricing model currently measures the Aud to be around 10% overvalued, yet in the first quarter the currency was the best-performing in the G10, up 5.84%. The Australian central bank (RBA) remained trapped between soft inflation pressures and the inability to cut rates due to surging housing prices. Consequently, the RBA kept its cash rate on hold at 1.50%.
Declining inflation was the focal topic in Norway during the past three months. Despite the continued rise in world oil prices, inflation in Norway contracted materially during the quarter, and has actually been waning since last summer. The pace of the decline was even more rapid than the Norwegian Central Bank (Norges) envisaged. Accordingly, it was little surprise why the Norwegian Krone (Nok) underperformed all of its G10 peers in the first quarter of 2017. However, the Nok still eked out a .49% gain versus the U.S. dollar.
Nine months after the European Union (EU) referendum, Brexit was formally activated in March of this year. On March 29, Prime Minister May triggered Article 50 of the Lisbon Treaty. This “irrevocable” notification started the countdown of a two-year negotiation period, after which the U.K. will cease to be an EU member. Additionally, politics continued to plague the country as talk for yet another Scottish referendum began to gain traction. In March, the Scottish Parliament voted for an independence referendum that is due to take place in 2019.
From an economic standpoint, data releases in the United Kingdom proved resilient once again. The unemployment rate fell to its lowest level since 2005, and inflation surpassed expectations; 2.3% versus 2% year-over-year). British consumer confidence remained strong and seemingly undeterred by the prospect of leaving the EU. Specifically, growth averaged 0.6% per quarter for the last three quarters. Not to be outshined, both the services and construction PMIs delivered upside surprises in the quarter as well.
Responding to the robust economic data, the Monetary Policy Committee (MPC) left interest policy unchanged throughout the reporting period. The MPC reinforced its neutral policy, insisting that it can move in either direction. The economic reality, however, is that the Bank of England will likely move in neither direction for now. During the quarter, the British pound appreciated 1.70%.
Economic activity in the EU continued to show promise, but that optimism was countered to a degree by political concerns surrounding the French and Dutch elections. These dueling forces kept both 10-year bund yields and the euro entrapped in a range, be it a very volatile one. The euro spent much of the quarter encapsulated in a 4% range between 1.04 and 1.08. After leaving policy unchanged, ECB President Mario Draghi indicated that the central bank’s outlook had become less negative. Investors decoded this message as possibly being the beginning of the end for European quantitative easing. Right or wrong, this message sent both the euro and German yields reeling higher.
Conversely, as the Dutch election drew closer, German 2-year borrowing costs fell to nearly -1%. Astonishingly, as European government bonds telegraphed severe distress, equity markets across the Atlantic did not even flinch. It was as if the European financial volatility was unfolding in a vacuum. The euro suffered a 2% loss in the episode, but overall still secured a 1.28% gain during the quarter.
From an economic perspective, European GDP figures were in tune with consensus, but also revealed a slight acceleration from the prior quarter. French economic activity continued to recover; GDP growth was mainly driven by strength in domestic demand and export growth. Meanwhile, Spanish growth continued at a healthy pace of 0.7% quarter-over-quarter. In contrast, Greek growth, once again, turned negative and Italian GDP decelerated. Lastly, after a series of higher readings, sentiment indicators in Germany began to turn downward. Most worrisome perhaps, German CPI slowed from 2.2% to 1.6% as the reporting period drew to a close.
During the reporting period, Federated Prudent DollarBear Fund had a total return of 1.58% (I Shares at NAV). The return for the inverse of the U.S. Dollar Index (DXY) was 1.82% for the same period. The fund’s absolute return was largely the effect of U.S. dollar weakness against the majority of the G10 economies. The fund’s total return also reflected actual cash flows, transaction costs and other expenses that were not reflected in the index’s total return
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.
Click the Performance tab for standard fund performance.
Relative to the inverse of fund’s index (DXY), an overweight allocation to the Japanese yen and Mexican peso bettered performance. Meanwhile, an underweight allocation to the South African rand detracted from return relative to the inverse of the DXY.
The more that things changed in the first quarter of 2017, the more they are likely to remain the same in the second quarter. In other words, many of the drivers and themes that defined global markets in the year’s first quarter will likely port over to the second quarter of 2017. The two standouts to this observation are the European election outcomes and U.S. fiscal policy. Fund management is keenly aware of the macro implications from these topics and has implemented active controls to manage their outcomes.
Despite Brexit, U.K. data remains hardy. Accelerating inflation and a strong household sector suggest that the Bank of England could remain on hold for the foreseeable future. Consequently, U.K. yields could reclaim their pre-referendum highs. With this in mind, the British pound appears undervalued and short positioning in the currency seems excessive. However, headline news regarding the exit negotiation process is likely to infuse more volatility to the British pound exchange. To address this backdrop, fund management is likely to remain neutral the U.K., but potentially look for opportunities to instate overweight allocations to the British pound.
The recent move lower in the U.S. dollar is something we believe to be partly technical and partly qualitative in composition. The dollar had an unprecedented surge after the Trump presidential victory, and mean revision is a natural and routine force in all markets. Secondly, currency investors appear to be in the process of risk adjusting the three doctrines that ignited this whole dollar rally to begin with. Fiscal expansion, corporate tax reforms and repatriation incentives are all powerful arguments for a higher dollar. However, fund management will require evidence over promises before implementing broad overweight allocations to the U.S. dollar.
There is one space, however, where currency valuations appear particularly distorted. Recent appreciation in the commodity center appears to be getting ahead of itself and pricing in fundamental perfection. On this basis, we remain underweight some selective commodity-sensitive currencies on a strategic basis.