Market Sector Update
- Despite slowing to below 1.0% annualized in the first quarter, U.S. gross domestic product (GDP) growth rebounded to approximately 2.5% in the second quarter of 2016. Growth in underlying retail sales reached a two-year high in May, suggesting real consumption growth of around 3.5%.
- Headline consumer price index (CPI) inflation has changed little in the quarter and is around 1%, but much of that reflects earlier sharp declines in energy prices. The CPI measure of core inflation has been above 2% for some time. The Federal Reserve’s (Fed) preferred core personal consumption expenditures (PCE) measure remains markedly lower at 1.6%.
- The unexpected sharp slowdown in the pace of payroll gains in May is concerning to the data-dependent Fed. The expected interest rates implied by Fed Funds futures dropped significantly following the disappointing May payroll data and again after the surprise United Kingdom (U.K.) vote to leave the European Union.
- Some of the largest effects of the Brexit vote have been felt in the currency markets, with sterling falling by more than 10% against the dollar. Although the dollar has had a broad-based strengthening on the back of the safe haven flows, the trade-weighted appreciation has been small.
- Interest rates rallied in the global rate market, with international growth concerns and the flight-to-quality trade that occurred after the Brexit vote.
- Credit spreads tightened over the course of the quarter as the reflation trade improved, with oil and commodities rallying. The Brexit fears have pressured spreads but, as of now, it is only a political concern and not a growth concern
- The Fund underperformed the Barclays Multiverse TR USD Index, primarily due to the relatively shorter effective duration versus the index. Global demand for longterm duration led to a dramatic decline of the term structure of interest rates in countries such as Germany, Japan, and the U.K. The Fund’s lack of exposure to the Japanese yen also hurt its relative exposure, as the yen appreciated 9% versus the U.S. dollar.
- We continue to seek opportunities to reduce the volatility in the Fund.
- We are maintaining a low duration strategy for the Fund as it allows us a higher degree of certainty involving those companies in which we can invest.
- We continue to focus on maintaining proper diversification for the Fund.
- We look for opportunities to make longterm investments in foreign currencies in certain emerging markets should they weaken vs. the U.S. dollar.
- We continue to hold a higher level of liquidity (patient capital) because of structural changes in the capital markets. We will be opportunistic in allocating that capital when dislocations in market arise.
- Activity in the United States seems to have rebounded from weakness in 1Q and leading indicators suggest some further firming ahead. However, Brexit has sent shockwaves through the financial markets and the political establishment in many European countries. There is a renewed risk of an economic slowdown and financial volatility.
- Brexit could be seen as a watershed event that could reinforce trends towards protectionism, de-globalization, nationalism, and isolationism. All could be seen as inflationary in nature, long-term.
- Soft data coming out of China suggests that growth momentum may have moderated. As investment is still an important driver of growth, our expectation is that another round of stimulus may be coming. Monetary policy will remain accommodative with more reserve requirement ratio (RRR) cuts. If the flight-to-quality continues and the dollar appreciates, look for the People’s Bank of China (PBOC) to offset with depreciation of RMB.
- Longer Treasury rates will be more volatile regarding fiscal and monetary policies. The decline in Treasury yields is not following a conventional path. Long-term U.S. rates seem to be saying more about the fragility of Europe and Japan than about the U.S. The expectation is for the Federal Open Market Committee to continue the normalization of rates but at a slower trajectory than the Fed's guidance.
- The structural change in the financial market has led us to build up more liquidity (patient capital). Incentives to carry high inventory levels of corporate bonds have been reduced by higher capital requests, therefore making it more expensive to hold high levels of these bonds. As a result, market liquidity has been reduced and there are more opportunities for dislocations in the corporate bond going further.
The opinions expressed in this commentary are those of the Fund’s manager and are current through June 30, 2016. The manager’s views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.
Past performance is not a guarantee of future results.
Diversification is an investment strategy that attempts to manage risk within your portfolio but it does not guarantee profits or protect against loss in declining markets.
Risk factors. The value of the Fund's shares will change, and you could lose money by investing. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Investing in below-investment-grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. The Fund may include a significant portion of its investments that will pay interest that is taxable under the Alternative Minimum Tax (AMT). Exempt-interest dividends the Fund pays may be subject to state and local income taxes. The portion of the dividends the Fund pays that is attributable to interest earned on U.S. government securities generally is not subject to those taxes, although distributions by the Fund to its shareholders of net realized gains on the sale of those securities are fully subject to those taxes. The municipal securities market generally, or certain municipal securities in particular, may be significantly affected by adverse political, legislative or regulatory changes or litigation at the Federal or state level. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.
Waddell & Reed Investments refers to the investment management services offered by Waddell & Reed Investment Management Company, the investment manager of the Waddell & Reed Advisors Funds, distributed by Waddell & Reed, Inc.