As of 09-30-2017

Market Overview

In the third quarter of 2017, U.S. equity markets reached all-time highs in the face of geopolitical uncertainty, severe natural disasters, continuing noise out of Washington, D.C., and the Federal Reserve’s unveiling of plans to normalize its balance sheet.

On the domestic front, stories out of Washington dominated the headlines. Failed efforts to repeal and replace the Affordable Care Act and a government shutdown that nearly came to fruition were among the primary domestic issues that investors looked past as equity markets continued to advance. Equity markets also shook off Hurricanes Harvey and Irma, some of the most devastating storms in more than a decade, as the S&P 500 finished higher for the eighth consecutive quarter while volatility continued to remain quite low. Despite all of the distractions, investors remained focused on the increasing potential for corporate tax cuts, which would provide a boost to the economy and potentially build on the strong year-to-date corporate earnings.

Looking abroad, geopolitical tensions between the U.S. and North Korea represented the main source of news throughout the quarter, creating a few short-lived episodes of weakness in equity markets that served as buying opportunities. Stronger economic data in Europe and Japan were additional tailwinds for equity investors throughout the three-month period, aided by a U.S. dollar that began to reverse its 2017 slide.

The fourth quarter of 2017 begins optimistically with a renewed hope that one of the main pillars of President Trump’s agenda—and arguably the most important for investors, tax reform—will move through Congress. The initial proposal of a 20% corporate tax rate and move to a territorial tax system would be bullish for equities. No doubt there will be tough negotiations ahead in Washington, creating volatility in the markets, but we believe a tax package ultimately will pass, helping propel stocks higher. A key item to watch will be whether Congress can pass a 2018 budget resolution.

Moving to the Fed, the balance sheet unwind is set to begin in October with a monthly $10 billion reduction ($6 billion in Treasuries and $4 billion in mortgage-backed securities, or MBS) that will increase quarterly until it reaches a $50 billion-per-month threshold. This plan had been well telegraphed by the Fed and we do not expect it to create any major market disruptions. We also continue to expect one more rate hike in December. With the economy continuing to grow steadily, we expect another solid earning season and, coupled with strong seasonality, a continued march higher in equity prices. Given relative market valuations, which are no longer cheap, we believe a balanced portfolio of cyclical and defensive companies that have strong cash flow, balance-sheet strength and improving fundamentals will help navigate the current investment landscape.

On the municipal side, Treasury yields rose modestly during the quarter amid indications of improving U.S. and global growth, heightened prospects for stimulative U.S. tax policy and, as previously mentioned, the beginning of the Fed’s gradual balance sheet reduction. Continued low inflation and bouts of risk aversion related to potential conflict between the U.S. and North Korea offered countervailing downward pressure on market yields during the quarter. Two-year Treasury yields increased by 10 basis points while 10-year and 30-year Treasury yields each increased 3 basis points. Municipal bond yields followed a similar pattern, with steady inflows into municipal bond funds and modest new issuance supporting some outperformance for short-and intermediate-term municipal bonds relative to Treasuries. Municipal Market Data (MMD) 2-year AAA tax-exempt yields decreased 6 basis points over the period, while the 10- and 30-year AAA tax-exempt yields increased by 1 and 5 basis points, respectively.

During the quarter, the S&P 500 Index returned 4.48% and the Russell 1000 Value Index returned 3.11%. The S&P Municipal Bond Index posted a return of 0.99%, the Bloomberg Barclays Treasury Index returned 0.38%, and the Bloomberg Barclays Aggregate Bond Index returned 0.85%.

Fund Performance

For the third quarter, Federated Municipal Stock Advantage Fund A Shares returned 3.10% at net asset value (NAV), outperforming the 1.85% return of the fund’s benchmark comprising of 60% S&P Municipal Bond Index and 40% Russell 1000 Value 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 on the Performance tab for standard fund performance.

Within the equity markets, growth stocks outperformed value stocks during the quarter, with the Russell 1000 Growth Index returning 5.90% and the Russell 1000 Value Index returning 3.11%. In terms of asset allocation, the Russell 1000 Value Index outperformed the S&P Municipal Bond Index, the broader Barclays Aggregate Index and the Barclays Treasury Index. The fund is overweight equities at 49% of its asset allocation, relative to its neutral 40% equity index exposure. The equity relative overweight, which has helped performance since 2010, was a positive contributor during the quarter.

Within the fund’s equity holdings, stock selection and sector allocation both added to the overall fund performance. Relative to the benchmark, the fund’s top contributing sectors were Information Technology, Industrials and Materials. The sectors that most negatively contributed to fund performance were Consumer Staples and Telecom Services.

On an absolute basis, the five securities contributing most to performance were Lam Research, Texas Instruments, Applied Materials, AbbVie, and Harris Corporation. The five positions detracting most from performance were Quest Diagnostics, Allergan PLC, Delta Air Lines, Teva Pharmaceutical and J.M. Smucker.

The S&P Municipal Bond Index posted a return of 0.99%. The 3-year component of the index returned 0.61%, the 10-year component returned 1.18% and the portion of the index maturing in 22 years and longer returned 0.86%. The AAA/Aaa component of the index returned 0.72%, the A-rated component returned 1.46% and the BBB-rated component returned 2.08%. The S&P Intermediate Municipal Bond Index posted a return of 1.07%. The S&P High Yield Municipal Bond Index returned -0.08% but rose 2.26% when excluding sharply underperforming Puerto Rico bonds.

The fund’s bond portfolio outperformed the S&P Municipal Bond index. The portfolio’s overweight exposure to outperforming A-rated, BBB-rated and below-investment-grade securities accounted for much of the favorable relative performance. Favorable positioning along the municipal yield curve and security selection also contributed positively to relative performance.

Click on the Portfolio Characteristics tab for information on quality ratings and the fund’s top 10 holdings.

Positioning and Strategy

The fund’s equity holdings are positioned within a diversified portfolio of qualified dividend-paying stocks with favorable valuations, strong balance sheets and improving business fundamentals. The portfolio continues to aim for a balanced yield, dividend growth and total return strategy. Over the reporting period, the average sector overweight positions relative to the fund’s benchmark include Information Technology, Industrials and Consumer Discretionary. The fund’s largest underweight positions include the Real Estate, Financials and Energy sectors.

Bond strategy integrates views on both interest rate and credit cycles. The bond portfolio manager attempts to add incremental return through active management of duration and credit risk, allocation among credit sectors, positioning on the yield curve and bond selection.

The bond portfolio manager strives to balance the fund’s primary objective of tax-advantaged income and secondary objective of total return. The fund remains focused on intermediate and long-term securities and the tactical use of mid-to-lower credit quality bonds to enhance income and total return.