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In equities, the fourth quarter of 2015 began with a strong market rally after suffering its worst quarter in four years in the third quarter. The October rally saw the S&P 500 rise over 9%, but market strength began to fade again in November and December; with negative returns for the last two months of the year. Overall the S&P 500 was up1.37% for the year and just over 7% for the fourth quarter. Several key themes from previous quarters returned as investors once again turned their attention towards U.S. economic data and its influence on the Federal Reserve’s (Fed’s) decision to hike rates as well as turmoil in the Chinese economy and volatile energy prices.
On the domestic front, the Fed stole headlines during the quarter as it had done throughout the year. The much-awaited tightening cycle finally began in mid-December as the Fed raised the target funds rate by 25 basis points despite concerns over energy, manufacturing and a weak global economy. Volatility going into the meeting was not enough to postpone liftoff yet again. Several strong jobs reports as well as excellent home and auto sales numbers were some of the signals the Fed used to justify the beginning of the tightening cycle. However, investors remained uneasy about the market as concerns over China and commodity prices, namely oil, lingered into the New Year.
Looking abroad, China was the main source of volatility for investors in the fourth quarter of 2015. As the fourth quarter began, fears of a slowing Chinese economy waned and equity markets flourished. These issues came back, though, and are likely to be a focal point for equity investors throughout 2016. Another source of concern in equity markets during the quarter was the continued drop in oil prices, an effect of ramped-up production from the U.S. and OPEC. OPEC opted not to cut prices at its November meeting, continuing the downward march of crude. The decline in oil prices put pressure on the Energy sector as well as high-yield fixed income throughout the quarter. Commitments from the European and Japanese central banks to continue quantitative easing in 2016, on the other hand, proved to be a positive catalyst for equities in a quarter that epitomized a year in which the battle between positive and negative macro-economic news left investors feeling uneasy.
As we look to 2016, we expect market volatility to continue and even become more pronounced. In the U.S. we expect the consumer to remain resilient with improving job, housing and lower gas prices helping roughly the 70% of the U.S. economy that is driven by this group. In addition, U.S. corporate balance sheets remain strong. However, the manufacturing economy, the energy/commodity complex, and the Fed’s interest-rate decisions and subsequent impact upon the U.S. dollar, along with global forces, will create the majority of the market and earnings volatility through the year.
Globally, we continue to believe China will not have a hard landing; however, the risk of policy mistakes has increased. As with any economic transition, the road will not always be smooth as China transitions to a consumer economy, but we expect the consumer to remain strong. The European economy as defined by Germany, which is roughly 50% of the Union’s growth engine, remains in positive territory with equity valuations that are more favorable than that of the U.S. Through all the troubled waters, we continue to focus on companies with strong balance sheets, free cash flow and shareholder-friendly management that exhibit growth, quality and valuation factors that we look for in our fundamental investment process.
From the fixed-income perspective, most major fixed-income asset classes reported negative total returns during the fourth quarter. The credit-sensitive fixed-income markets, such as, investment-grade corporates, high yield, and emerging markets outperformed the higher-quality U.S. Treasury market in October as investors’ fears of a global growth slowdown declined. However, a stronger U.S. dollar and declining commodity prices negatively impacted these credit-spread markets as the quarter progressed. During the fourth quarter, the Energy and Metals & Mining sectors were the worst total-return-performing sectors in the investment-grade corporate and high-yield markets. Despite the weakness in commodity prices and the increased volatility in the financial markets, the Fed at its December meeting increased the federal funds target rate by 25 basis points. This increase was anticipated by the financial markets. Therefore, interest rates did not increase materially immediately following the announcement. However, interest rates increased for all maturities across the U.S. Treasury curve during the quarter. The U.S. Treasury curve flattened with yields for maturities of two to seven years increasing by 35 to 40 basis points, while rates on the 10- and 30-year maturities were up 24 and 16 basis points, respectively. As a result of higher rates, the U.S. Treasury and Barclays U.S. Aggregate indices both reported negative total returns during the fourth quarter. The Barclays Emerging Market Index was one of the few major fixed-income markets to report positive total returns for the fourth quarter.
For the fourth quarter of 2015, the Barclays Treasury Index returned -0.94%; the Barclays Mortgage Index returned -0.10%; the Barclays Commercial Mortgage Index returned -1.24%; the Barclays Credit Index returned -0.52%; the Barclays High Yield Index returned -2.06% and the Barclays Emerging Markets USD Aggregate Index returned 0.98%. In addition, the S&P 500 Index returned 7.03%, the Dow Jones Select Dividend Index returned 4.36% and the Barclays Aggregate Index returned -0.57%.
Federated Capital Income Fund met its primary goal of current income and long-term growth of income during fourth quarter of 2015. The fund’s 12-month distribution yield for Class A Shares at NAV, at the end of quarter was 5.54% net, with an SEC yield of 4.43%. The fund’s yield was well above the S&P 500’s yield of 2.15%, the Dow Jones Select Dividend Index yield of 3.93%, the 10-year Treasury yield of 2.27% and the Morningstar Conservative Allocation yield of approximately 2.19%. The fund received eight dividend increases during the quarter, including Boeing, Pfizer, and Merck.
For the fourth quarter of 2015, Federated Capital Income Fund (Class A Shares at NAV) returned 0.59%, underperforming the 1.51% return of the fund’s benchmark comprised of 40% Dow Jones Select Dividend Index, 20% BHY2%ICI, 20% BMB and 20% BEMB Index.
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 Performance tab. Performance does not reflect the maximum 5.5% sales charge for Class A Shares. If included, it would reduce the performance quoted.
Click the Performance tab for standard fund performance
The fund’s fourth quarter performance within its class was impacted primarily by dividend stocks underperforming growth stocks.
During the quarter, within the equity markets, growth stocks outperformed dividend stocks. For the quarter, the Russell 1000 Growth Index returned 7.32% while the Dow Jones Select Dividend Index returned 4.36%. In terms of asset allocation, the Dow Jones Select Dividend Index outperformed the broader Barclays Aggregate Index and the Barclays Treasury Index. The fund is overweight equities at 50% of its asset allocation, relative to its neutral 40% equity index exposure and class. The equity relative overweight, which has helped performance since 2010, was a positive contributor during the quarter.
In the equity portfolio, both stock selection and sector weight detracted from the fund’s overall performance. Relative to the fund’s Dow Jones Select Dividend Index, the two best-performing sectors were Information Technology and Financials. The two sectors that most detracted from fund performance were Consumer Discretionary and Utilities.
On an absolute basis the five securities contributing most fund performance were Old Republic, Microsoft, GlaxoSmithKline, Six Flags and Computer Sciences. The five positions detracting most from performance were Dynegy (Conv. Pfd.), Corus Entertainment, Kinder Morgan (Conv. Pfd.), ArcelorMittal (Conv. Pfd.) and Baker Hughes.
Click on the Portfolio Characteristics tab for the fund’s top ten holdings.
The fixed-income portfolio outperformed its blended benchmark by six basis points in the fourth quarter, and also out-performed higher-quality bond benchmarks such as the Barclays U.S. Treasury and U.S. Aggregate indices. Security selection made the largest positive contribution to performance due to strong security selection in the high-yield and emerging-market portfolios. An underweight to Energy and Metals & Mining credits in the high-yield portfolio was the primary driver of positive security selection. However, this positive security selection was partially offset by negative security selection in the Mortgage portfolio and longer duration investment-grade corporate credits. Sector selection was the largest negative contributor to performance due primarily to an overweight to the under-performing high-yield market. The impact of interest rates on the portfolio was slightly positive due the fund’s yield curve flattening bias during the quarter.
The fund continues to strive to achieve its primary goal of current income and long-term growth of income with capital appreciation as a secondary objective.
We remain broadly diversified within equity market sectors, with a prudent approach to balancing income, risk and long-term total return. The fund’s equity holdings are positioned within a diversified portfolio of income-producing securities and dividend-growing stocks with favorable valuations, strong balance sheets and improving business fundamentals. The portfolio continues to aim for high yield and consistent dividend growth.
Sector overweight positions relative to the fund’s Dow Jones Select Dividend Index benchmark include Information Technology, Health Care and Financials. The fund’s largest underweight positions include Utilities, Consumer Staples and Consumer Discretionary.
The fixed-income portfolio remains overweight the high-yield and emerging-market sectors and underweight the higher-quality corporate and mortgage markets relative to the fixed-income portfolio’s blended benchmark. The portfolio had an average effective duration of 4.2 years versus the benchmark at 4.4 years. The fixed-income portfolio is positioned for a flattening of the yield curve.