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In the third quarter of 2015, global equities wrapped up their worst three-month period since 2011 as volatility and investor uneasiness weighed heavily on the market. Central points of focus for investors during the quarter were a Chinese slowdown, the anticipation of a rate hike from the Federal Reserve (Fed) that still has not come, and stronger-than-expected U.S. economic data.
On the domestic front, all eyes once again were on the Fed as investors anticipated a decision at its September meeting on whether or not to raise short-term interest rates, and once again the central bank put off liftoff. Policymakers cited uneasiness about weak overseas economies and the potential effect they could have on the U.S., as well domestic inflation that remains stubbornly low—both reflecting in part the collapse in metals, minerals and other global commodity prices led by crude oil, which established a new low during the third quarter. The Fed’s decision came on the heels of a very volatile August that saw the S&P 500 tumble 11% in five days, one of the sharpest 5-day drops on record. Despite the global slowdown, the U.S. enjoyed solid economic data throughout the quarter. Auto sales, retail and housing data all showed continued positive momentum, consumer sentiment and confidence surprised to the upside, and second quarter GDP was upwardly revised to 3.9% from an initial estimate of 2.3%.
Looking abroad, the quarter started on a volatile note with the Greek crisis, but that was ultimately resolved after a soft deadline passed, giving way to worries about a rapidly slowing Chinese economy. An unexpected devaluation of China’s currency in August shocked the equity markets, causing the VIX to spike to 2009 recession levels and stocks to post their worst day in four years. During the sell-off, major U.S. equity markets dropped more than 10% from peaks reached in the spring, leading many to declare it a “correction.” In China, the yuan’s devaluation coupled with poor Chinese economic data led to a major correction of Chinese stocks, with the Shanghai Composite surrendering more than 25% of its value in the quarter. This led to the implementation of extreme measures by the Chinese government, including the purchase of securities and the halting of trading of numerous firms in an attempt to boost equity markets. The Fed’s inaction in the face of positive U.S. economic data only added to investor fears about weakness in global economies, especially emerging markets where the low commodities prices represent a major drag.
As the final quarter of 2015 gets underway, we expect volatility to continue. We remain upbeat about the U.S. economy amid indications the U.S. consumer is doing well. We anticipate a positive fourth quarter for equities, traditionally a strong seasonal period, as U.S. data continues to be strong and the data from China potentially gets “less worse.” Job creation continues to be a bright spot in the U.S. economy, with the unemployment rate currently at its lowest level since April 2008 and the economy, many believe, nearing full employment. We expect GDP to remain about average with some headwinds from a stronger U.S. dollar. While its strengthening stalled in the third quarter, the dollar remained strong. We expect the Fed to continue to dominate the headlines as it goes into its final two meetings of the year, with a much-anticipated rate hike still on the table, though we believe the more important variable will be the pace of those hikes once they come. We expect further mergers and acquisitions, dividend increases and share buyback announcements due to strong balance sheets and free cash flows from our companies and persistently low interest rates. Globally, we are watching China closely for signs of a controlled versus hard landing. We remain vigilant for opportunities globally and adhere to our true and tested investment process to guide us through the volatile waters of 2015.
On the fixed-income front, the volatile third quarter fueled a risk-off trade, abetted by the Fed’s decision not so much to hold off on raising rates but for the first time to inject in its policy statement “recent global economic and financial developments” as a potential factor for its actions; its prior communications emphasized only the U.S. labor market and inflation as key determinants for its rate decision. Despite the dovish tone of the September policy statement and subsequent press conference with Chair Janet Yellen, 13 of the 17 policy-setting Federal Open Market Committee members still expect a rate increase by the end of the year. The risk-off mood in the credit- sensitive financial markets saw U.S. Treasuries outperform U.S. mortgage-backed securities (MBS), U.S. commercial MBS, investment-grade corporates, U. S. high yield and emerging markets (EM) in the third quarter. The U.S. Treasury curve flattened in the reporting period, as rates declined for all maturities greater than two years, with the largest declines for maturities of five years and longer.
For the third quarter of 2015, the Barclays Treasury Index returned 1.76%, the Barclays Mortgage Index returned 1.30%, the Barclays Commercial Mortgage Index returned 1.54%, the Barclays Credit Index returned 0.53%, the Barclays High Yield Index returned -4.83%, and the Barclays Emerging Markets Index returned -2.39%. In addition, the S&P 500 Index returned -6.44%, the Dow Jones Select Dividend Index returned -2.26% and the Barclays Aggregate Index returned 1.23%.
The fund met its primary goal of current income and long-term growth of income during 2015’s third quarter. The fund’s 12-month distribution yield for Class A Shares at net asset value (NAV) at quarter-end was 5.48%, with a 30-day SEC yield of 4.72%. The fund’s distribution yield is well above the S&P 500 yield at 2.25%; Dow Jones Select Dividend Index at 4.02%; 10 year Treasury yield at 2.04% and Morningstar Conservative Allocation at approximately 2.15%. The fund received 10 dividend increases during the third quarter including Microsoft, Lockheed Martin, and Altria Group.
For the third quarter, Federated Capital Income Fund Class A Shares at NAV returned -6.01%, underperforming the -2.09% return of the fund’s benchmark comprising 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 third quarter performance within its class was impacted primarily by two factors 1) Treasuries significantly outperformed our credit-sensitive bonds and 2) an underweight in Utilities relative to the fund’s equity benchmark.
During the quarter, within the equity markets, dividend stocks outperformed growth stocks. For the quarter, the Russell 1000 Growth Index returned -5.29% while the Dow Jones Select Dividend Index returned -2.26%. In terms of asset allocation, Dow Jones Select Dividend Index underperformed 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 neutral 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 Energy and Consumer Discretionary. The two sectors that most negatively contributed to fund performance were Utilities and Health Care.
On an absolute basis the five securities contributing most fund performance were Reynolds American, Dominion Resources, Conv. Pfd., Altria Group, Lockheed Martin, and Motorola Solutions. The five positions detracting most from performance were US Steel (ELN), Arcelormittal, Superior Energy (ELN), Dynergy and Hospitality Properties Trust.
Click on the Portfolio Characteristics tab for the fund’s top ten holdings.
The fixed-income portfolio under-performed its blended benchmark in the third quarter and also underperformed higher quality bond benchmarks such as the Barclays U.S. Treasury and U.S. Aggregate indices. The negative contribution to performance from being underweight the index duration during the quarter was partially offset by a yield-curve flattening bias. Sector selection was the largest negative contributor to performance due primarily to an overweight to the underperforming high yield market and a corresponding underweight to the outperforming mortgage market. Security selection had the largest positive contribution to performance due to strong security selection in the high yield portfolio, which was underweight energy and metals and mining credits. However, the positive security selection in the high yield portfolio was partially offset by negative security selection in the EM portfolio due to increased sovereign credit exposure in September and an underweight position to Ukrainian debt.
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.
Given some of the macro issues discussed above, 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 sheet 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 Health Care, Information Technology, and Financials. The fund’s largest underweight positions include Utilities, Consumer Staples and Energy.
The fixed-income portfolio remains overweight high yield and under-weight the higher quality corporate and mortgage markets, while adding some EM exposure to a slight overweight relative to the fixed-income portfolio’s blended benchmark. The portfolio had an average effective duration of 4.3 years versus the benchmark at 4.5 years. The fixed-income portfolio’s yield-curve positioning is currently neutral.