As of 03-31-2018

Market Overview

Volatility returned to the markets in the first quarter of 2018 as the S&P 500 finished in negative territory for the first time in 10 quarters. Drivers for equity underperformance during the quarter include heightened fears about inflation, threat of an impending trade war and Technology sector volatility.

Inflation fears sparked the initial market sell-off in late January and early February, fueled by accelerating wages and exacerbated by high-volume, algorithm-based trading that worsened volatility. Inflation and interest-rate worries were fed further in March, when citing a healthy economy, the Federal Reserve (Fed) under new Chair Jerome Powell again raised the federal funds target rate and signaled at least two more 25 basis-point hikes are likely this year. Layered over all this was increasing talk of tariffs and potential trade wars with Europe, China and U.S. Nafta partners Canada and Mexico. While those fears eased in regards to Nafta and Europe, both U.S. and international equity markets struggled toward the end of March as trade tensions ratcheted up with China. In the Information Technology sector, news of widespread data sharing of Facebook users’ information sent waves throughout the highflying sector, adding to overall volatility. Despite higher volatility and the equity sell-off, economic data for the most part was relatively strong, with nonfarm payroll growth, consumer confidence and the final reading on fourth quarter GDP surpassing expectations.

As the calendar turns to the second quarter of 2018, we expect heightened volatility to stick around. Trade and tariff rhetoric is likely to continue in fits and starts, with a possible conclusion to the Nafta renegotiation on the horizon and a wide swath of possibilities on U.S.-China trade relations. Additionally on the international stage, a potentially high-stakes meeting between the U.S. and North Korea is tentatively scheduled for later in the second quarter. There no doubt will be headlines out of that meeting if it in fact happens. On the domestic political front, midterm elections are moving closer and we expect that to begin to make headlines near the end of the quarter. We view all these geopolitical events as both sources of volatility as well as opportunities as we get back to the fundamentals. We expect another strong earnings season as companies report first quarter 2018 results and tax reform begins to work its way into the real economy. In the medium term, we anticipate companies to step up capital expenditures as they take advantage of full deprecation provisions of the new tax law, creating potentially positive second and third order effects that will show up over the coming quarters. Given relative market valuations, which are cheaper now after the correction following a strong January, 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.

Yields on intermediate and short-term Treasury securities increased during the quarter, while yields on long-term municipal and Treasury bonds climbed higher on the Fed rate hike and projected moves. Concerns that the Fed may excessively tighten monetary policy and the prospect of escalating trade conflicts as the Trump administration rolled out a series of proposed tariffs caused Treasury and municipal yields to retrace somewhat from their highs during the quarter as the risk markets sold off. New issuance of muni bonds fell by about 30% during the quarter compared to the same period last year as the acceleration of deals into 2017’s final quarter to beat the tax legislation left a diminished calendar of financings. Demand for muni bonds was somewhat muted as banks and insurance companies reacted to the large corporate tax cut by selling a portion of their municipal holdings, while individual investor demand for bonds and municipal mutual funds was muted as total returns turned modestly negative. Yields on AAA-rated 2-, 10- and 30-year municipal securities increased 9, 44 and 41 basis points, respectively. Yields on 2-, 10- and 30-year Treasury securities increased a respective 38, 33 and 23 basis points.

During the quarter, the S&P 500 Index returned -0.76% and the Russell 1000 Value Index returned -2.83%. The S&P Municipal Bond Index posted a return of -0.92%, the Bloomberg Barclays Treasury Index returned -1.18%, and the Bloomberg Barclays Aggregate Bond Index returned -1.46%.

Fund Performance

For the first quarter, Federated Municipal Stock Advantage Fund (Class A Shares at NAV) returned -0.78%, outperforming the -1.64% 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 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 1.42% and the Russell 1000 Value Index returning -2.83%. In terms of asset allocation, the Russell 1000 Value Index underperformed the S&P Municipal Bond Index, the broader Bloomberg Barclays Aggregate Index and the Bloomberg Barclays Treasury Index. The fund is overweight equities at 47% of its asset allocation relative to its neutral 40% equity index exposure. The equity relative overweight, which has helped performance since 2010, was a negative 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 Consumer Staples. The sectors that most negatively contributed to fund performance were Consumer Discretionary, Telecom and Utilities.

On an absolute basis, the five securities contributing most to performance were Lam Research, Texas Instruments, Intel, Motorola, and Raytheon. The five positions detracting most from performance were CVS, Johnson & Johnson, Cimarex Energy, General Motors, and Citigroup.

The S&P Municipal Bond Index posted a loss of 0.92%. The 3-year component of the index posted a return of 0.15%, while the 10-year component returned -1.58% and the portion of the index maturing in 22 years and longer returned -1.27%. The AAA/Aaa component of the index returned -1.14%, the A-rated component returned -1.08% and the BBB-rated component returned -0.65%. The S&P High Yield Municipal Bond Index returned 1.29%, but rose 0.43% when excluding sharply outperforming Puerto Rico bonds.

The fund’s bond portfolio slightly outperformed the S&P Municipal Bond index. The portfolio’s overweight exposure to outperforming BBB-rated and below-investment-grade securities accounted for the favorable relative performance somewhat offset by unfavorable positioning along the yield curve.

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, Consumer Discretionary and Industrials. The fund’s largest underweight positions include the Financials, Real Estate 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 capital appreciation. 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.