Today we announced the investment results of the Exchange Fund for the first half of 2013. Overseas equities and other investments recorded gains while debt securities, foreign exchange and Hong Kong stocks saw losses. On the whole, a small loss of HK$ 6.1 billion, or a return of -0.3%, was recorded.
When the 2012 Exchange Fund performance was announced early this year, we highlighted that global financial markets would continue to be clouded by many uncertainties in 2013. It turned out that following US’s narrow escape from “fiscal cliff” towards end-2012, market conditions fluctuated as Cyprus financial crisis intensified in mid-March and the Bank of Japan introduced a fresh round of economic stimulus measures in early April. Major market fluctuations happened in May and June upon the US Fed Chairman’s remarks about the possible scaling down of Fed’s bond purchase programme. Market expectations of the Fed’s exit from monetary easing shifted significantly, leading to a surge in volatilities across equities, bond and foreign exchange markets in late June. Ten-year US Treasury bond yields rose by nearly 100 basis points from a low of 1.63% on 2 May to the high of 2.61% on 25 June. US stock markets also fell, by almost 5% during the week after the Fed Chairman’s remarks on 19 June.
Affected by the significant rise in the US government bond yields and falling bond prices during May and June, investors with substantial bond holdings (including the Exchange Fund) invariably suffered from investment loss in the first half of 2013. We noted that the high-low range of the 10-year US Treasury yield had been a mere 39 basis points during January to April. Yet it surged almost 100 basis points in May and June. Some major bond funds were faced with heavy investor redemptions. Only funds that focused on overseas equities might have managed to avoid losses. According to statistical data from Morningstar Asia, global bond funds fell by an average of around 4% year-to-date up to early July; US dollar government bond funds around 3%; euro government bond funds around 1%; and GBP government bond funds around 9%. The Mandatory Provident Fund in Hong Kong also recorded an overall loss of 0.56% during the first half of this year and its global bond funds lost 3.8%.
When evaluating the performance of the Exchange Fund, we should have regard to its nature, objectives and portfolio structure. Distinct from commercial investment funds, the Exchange Fund’s investment objectives are (i) capital preservation, (ii) ensuring full backing of the entire Monetary Base by US dollar assets, and (iii) ensuring adequate liquidity for the maintenance of monetary and financial stability of Hong Kong. To meet these objectives, the Fund has to adopt a prudent asset allocation and investment strategy that aims at stable medium- and long-term returns. It is therefore more appropriate to assess the Fund’s performance based on its medium- and long-term investment results rather than short-term gains or losses.
The Exchange Fund’s total asset size is about HK$2,850 billion, comprising two portfolios which are of similar size: the Backing Portfolio and the Investment Portfolio. Under the Currency Board arrangements, the Backing Portfolio must hold highly liquid and quality US dollar assets including cash and short-term US Treasuries to provide full US dollar backing to the Monetary Base. By contrast, the Investment Portfolio comprises a greater variety of liquid asset classes, including bonds, equities and cash to seek for stable long-term return for the Fund. To ensure adequate liquidity, the Investment Portfolio holds a relatively large portion of bonds, the majority of which are US Treasuries as it is the world’s most liquid asset. Average maturity of the bonds is higher than that in the Backing Portfolio. As a result, when the long-term bond yields rise while short-term interest rates remain relatively stable, the mark-to-market valuation of the Investment Portfolio takes a bigger hit than that of the Backing Portfolio.
The Fed will eventually have to exit from its quantitative easing programme, putting an end to the exceptionally low interest rate era. US interest rate movement and trend therefore has been a key factor in formulating our investment strategy. Notwithstanding the uncertainties about the timing of the US interest rate hikes, we remain vigilant of the interest rate risks and have, in the past few years, implemented proactive measures in our asset allocation strategy to mitigate the impact of a sharp interest rate reversal on our bond holdings. These measures include:
(i) doubling the share of cash and cash equivalents such as short-term papers in the Investment Portfolio in the past three years;
(ii) diversifying away from US dollar bonds and euro bonds in the Investment Portfolio by increasing the share of bonds denominated in other major foreign currencies (such as Australian dollars, Canadian dollars and Nordic currencies) with sufficient market liquidity and market depth;
(iii) adjusting the investment strategy as and when appropriate to reduce long-term bonds, thereby minimising the interest rate risk caused by rising long-term bond yields; and
(iv) embarking on investment diversification in a prudent and gradual manner since 2008 to expand into asset classes such as emerging market bonds and equities, private equity, overseas investment properties, and Mainland bonds and equities. Despite their lower liquidity and greater return variability, these assets can help generate higher long-term returns and further diversify risks.
When taking these precautionary measures to mitigate interest rate risks, we have carefully assessed the pace and magnitude of our moves. We have also considered alternative strategies such as increasing our equities holdings relative to bond holdings, and replacing more long-term bonds with short-term papers or even cash sooner. In the process, we have given due deliberation to the potential downsides of these options:
(i) Equity markets can be more volatile and riskier than bond markets. An example was the drastic fall of the US stock market by 39% in 2008, followed by a sharp rise by 24% in 2009. As the Exchange Fund is a long-term investor focusing on liquidity and relatively stable returns, it might not be appropriate to allocate an aggressively large proportion to equities.
(ii) Holding short-term bonds or cash has its opportunity cost. If we reduced the duration of our bond portfolio too soon or by too much because of concerns about interest rate hikes in the US, and interest rates turned out to be rather stable, then our interest income from bonds would drop substantially. The current yield of one-year US Treasuries is 0.11% while that of 10-year US Treasuries is 2.57%. If interest rates remained stable, the difference in the annual rate of return (or cost of carry) would be over 200 basis points. Given the sheer size of the Exchange Fund, we will forego rather substantial interest income by significantly reducing the duration of our bond holdings. For example, between the second half of 2009 and early 2010, there were already market views that interest rates in the US would surge and US bond prices would fall. But in reality, bond yields kept heading to lower levels. If the Fund had started to trim the duration of its bond holdings at that point, the foregone interest income for the past three years would have been enormous.
In the aftermath of the global financial crisis, advanced economies have pursued unprecedented accommodative monetary policy (zero interest rate and quantitative easing) to support economic growth, creating imbalances in the global financial markets. One of these was the massive capital inflows into emerging markets. For example, Hong Kong recorded total fund inflow of around US$100 billion since 2008. Moreover, the availability of ample liquidity also fuelled asset prices. Upon the eventual exit of the Fed from its monetary easing programme, the investment environment will inevitably be adversely affected. The longer the quantitative easing lasts, the bigger the imbalances will accumulate, and greater impact will be inflicted on asset prices should the policy reverse. The surge in market volatility in recent months clearly demonstrates the risk associated with the Fed’s exit.
Looking forward, the Fed’s exit from quantitative easing and interest rate normalisation will be the inevitable course for global financial markets, bringing immense shocks to the financial markets. As market expectations of the Fed’s exit from quantitative easing continue to heighten, the financial markets would remain highly volatile for a prolonged period. The HKMA will maintain its prudent and conservative investment approach and take proactive steps to enhance the Exchange Fund’s resilience against market fluctuations. However, we need to be cautious and avoid making inappropriate adjustments to our medium- and long-term investment strategy by responding to temporary swings in investment sentiment or market movements.
Deputy Chief Executive
26 July 2013