“[T]he investment environment in 2015 will be even more complex and difficult than 2014. There is considerable uncertainty on global fund flows, exchange rates, interest rates and asset markets arising from the timing and pace of the US interest rate normalisation, which is then complicated by the implementation of QQE by Japan and the launch of a full scale QE by the ECB...”
Mr Norman Chan, Chief Executive of the HKMA, gave this “warning” in January this year as he announced the Exchange Fund performance in 2014.
With hindsight, the “warning” we made at the start of 2015 was quite prescient. The global financial markets have been abnormally turbulent so far this year, especially in the third quarter. There are two key drivers for this – market expectations on the US interest rate lift-off and worries over Mainland China’s economic slowdown and financial market turmoil.
After a long period of ultra-low interest rates, the US Federal Reserve is poised to raise rates for the first time in a decade, kicking off an interest rate up-cycle. Spurred by this general expectation, the US dollar began to strengthen in mid-2014. Up to the end of the first quarter, the US dollar has already appreciated by 9%, with the US dollar index surpassing the 100 level for the first time in 12 years. At the same time, other major currencies depreciated sharply. The euro in particular dropped 11.3% against the US dollar in the first quarter, posting the biggest single-quarter fall in the history of euro since 1999.
Meanwhile, the China factor triggered deep corrections in the global financial markets in the third quarter. A slew of economic data suggesting a slowdown in the Chinese economy sparked investors’ worries about the outlook for China as the key engine of global growth, and that for the global economy more generally. Compounded by the Mainland stock market turmoil and the knock-on effects of the RMB exchange rate reform in August, investors’ sentiment in the global financial markets worsened noticeably in the third quarter. Volatilities in equities, commodities, currencies and high-yield bonds in most markets spiked to levels rarely seen since the outbreak of the global financial crisis in 2008:
－ The US Dow Jones Industrial Average Index once lost over 1,000 points on 24 August.
－ The Hang Seng Index fell a cumulative 5,404 points, or 20.6%, in the third quarter, its worst quarterly fall in terms of points.
－ The Shanghai Shenzhen CSI 300 Index dropped by 1,270 points, or 28.4%, in the third quarter, its biggest fall in a single quarter since the first quarter of 2008.
Commodities and Options
－ Crude oil futures in New York at one stage plunged below US$39 a barrel to a new low since the 2008-09 global financial crisis.
－ The Chicago Board Options Exchange Market Volatility Index (VIX), dubbed the “fear gauge”, surpassed 50 for the first time since March 2009.
－ The currencies of some emerging market economies dropped to lows not seen since the 1997-98 Asian financial crisis, with the Brazilian real plunging over 30% earlier this year.
－ RMB depreciated by more than 2% in the third quarter, with the central parity rate against the US dollar registering its biggest single-week fall.
－ The Bank of America Merrill Lynch Global High Yield Index retreated 4.5% in the third quarter, resulting in a cumulative loss of 1.4% so far this year.
In such an adverse financial market environment, many investment managers, including the more conservative ones, have taken a hit to varying degrees in their investment performance. For example, even the conservative PIMCO Investment Grade Corporate Bond Index fell 2.7% in the first three quarters of the year. Another example is the Mandatory Provident Fund (MPF), which concerns most of us. According to preliminary data, the MPF lost a cumulative 5.42% since the beginning of this year and registered a negative return of 9.01% in the third quarter － my MPF account is no different. Similarly, the performance of the Exchange Fund in the first three quarters of 2015, which will be announced early next month, can hardly be encouraging.
When Facing the “El Nino Phenomenon”……
The dismal situation facing the global financial markets is not just related to economic fundamentals but also to the “El Nino Phenomenon” in the investment climate. Here, I would like to discuss three major challenges currently faced by asset managers, including the investment team of the Exchange Fund.
First, “low return and high volatility” are becoming the “new normal” for financial markets. The quantitative easing introduced in the US, Europe and Japan following the global financial crisis in 2008 has flooded the global economy with liquidity in search of higher yields. This has inflated asset prices in many places in the past few years, but this up-cycle is approaching an inflection point and the downside risk is apparent. Once the US interest rates start to rise, capital flows will reverse, and any negative news might easily unnerve investors and trigger chaos on financial markets.
Secondly, the effectiveness of bonds in diversifying risk in portfolio investments has weakened considerably. Conventionally, equities and bonds move inversely in turbulent times. This “equities down, bonds up” pattern means that gains in bonds can help offset losses in riskier assets. For example, in the face of the outbreak of the global financial crisis in 2008, the Exchange Fund suffered a full-year loss of HK$151 billion in equities. Fortunately, risk aversion led to safe haven flows into US Treasuries which, together with higher US interest rates at the time, resulted in an income of HK$88.4 billion from bond investments. This helped partly offset equity losses and substantially reduced the Fund’s full-year loss to 5.6%, compared with the hefty losses of 20-30% suffered by many major funds.
However, the benefit of bonds as a tool for risk diversification has vastly diminished during the past six years of monetary easing in the US. With interest rates at rock bottom thanks to quantitative easing, interest income has declined substantially. Yields on 1-year US Treasuries have been persistently close to zero, much lower than the pre-crisis yield level of generally over 2%. On the longer end, 10-year US Treasury yields in 2008 were about 4%, but have since dropped to a meagre 2%. As the Exchange Fund must remain highly liquid to safeguard monetary and financial stability, our investments mainly comprise short-term US Treasuries and cash. The two percentage point difference in yields has huge implications for the investment income of the Exchange Fund. At the end of 2014, the bond portfolio of the Exchange Fund totalled HK$2.5 trillion. A rough back-of-the-envelope calculation suggests that a two percent drop in yields would mean a reduction of tens of billions of Hong Kong dollars in income.
In addition to meagre interest income, low interest rates have limited the room for a rise in bond prices. The conventional wisdom of “equities down, bonds up” in a volatile market has become less pronounced. For example, in the fourth quarter of 2008 when the global equity markets crashed, 10-year US Treasury yields also fell by more than 160 basis points in the same period, boosting bond prices considerably for the Exchange Fund’s bond investments. However, when the global equity markets experienced a sharp fall in the third quarter of this year, 10-year US Treasury yields only dropped 30 basis points. As a result, the rise in bond prices was constrained, significantly reducing the resilience of an ordinary equity/bond portfolio.
The third challenge is that when the US dollar strengthens, non-US dollar assets will inevitably incur book exchange losses when translated into the US dollar. And, the Exchange Fund is no exception. Indeed, I gave a detailed analysis of this in my inSight article in January. Any readers interested in this can view the article on the HKMA website.1
Are we seeing light at the end of the tunnel? Let’s hope so, but we need to prepare for the worst. At present, the prices of US Treasuries remain stable. However, once the US Fed begins to normalise its monetary conditions and raise its interest rates, the prices of US Treasuries will invariably fall. The normalisation process is unlikely to be short. Should there be any hiccups in the process like a larger-than-expected increase in interest rates, bond prices could slump while equities and currencies could see turbulence again. This phenomenon of seeing all three major asset classes (namely, equities, bonds and foreign currencies) plummeting in tandem, or the investment managers’ so-called “triple whammy”, which is the result of prolonged excess global liquidity, is very rare but cannot be ruled out altogether.
Rising up to the Challenges
In order to enhance the resilience of the Exchange Fund, we have taken a more defensive and diversified investment strategy and introduced a three-pronged approach to the changing market conditions:
The first measure is a short-term tactical asset allocation in which timely and appropriate adjustments will be made in the allocation of assets in response to market developments and trends. The adjustments will be modest to avoid excessive risk-taking. After all, we are not engaging in short-term speculation.
The second measure involves a long-term strategic asset allocation. Although the timetable for the US interest rate hikes remains uncertain, our asset allocation has undergone a gradual shift over the past few years with a reduction in long-term bonds and an increase in cash to lessen the impact of interest rate hikes on our bond holdings.
The third measure is the gradual build-up of the Long-Term Growth Portfolio (LTGP), which invests in medium- to long-term assets with lower liquidity. With a low correlation between its return and the return on conventional asset classes, coupled with relatively stable cash flow income from some investments like real estates, the LTGP can help reduce the overall volatility of the Exchange Fund’s investment income while enhancing its income. We have consistently achieved more than 10% annualised internal rate of return on the LTGP since its inception in 2009.
Capital Preservation First, Long-Term Growth Next
The Exchange Fund has always adopted the principle of “capital preservation first, long-term growth next”, allocating its investments to different asset classes, markets and currencies. It strives to achieve relatively stable medium- to long-term investment returns through diversification. The Exchange Fund is not a sovereign wealth fund or an ordinary investment fund nor is it a hedge fund. It will not engage in short-term speculation, short-selling or “market-chasing”. Therefore, we should focus on the medium- and long-term overall performance of the Exchange Fund instead of eyeing on the short-term performance of individual asset classes.
As the global financial markets are entering the post-quantitative easing era of “low return and high volatility”, market changes and responses will be even more unpredictable. Indeed, low yields are a trend which individual investors have to live with. In the face of high volatility, we must hold our nerve and not be blinded by short-term returns or take excessive risks. As long as we continue to carefully and prudently manage our investments by adhering to the objective of “capital preservation first, long-term growth next”, we are confident of adding value to the Exchange Fund over the long term.
Deputy Chief Executive
Hong Kong Monetary Authority
25 October 2015