Moving into 2022, investors were treading on thin ice when managing their assets amid multiple uncertainties, ranging from the evolving pandemic situation and rising inflation, to policy shifts by major central banks. The geopolitical crisis in Russia and Ukraine since February was perhaps the “last straw” that triggered huge swings in asset prices in equity, bond and currency markets, posing significant challenges to investors all over the world, including the Exchange Fund.
In the early days of the COVID-19 outbreak, major central banks and governments in various jurisdictions responded with unprecedented accommodative monetary policies and fiscal measures. With an abundance of capital seizing investment opportunities, global equity markets have risen over the past two years with many markets reaching record highs in 2021. The Exchange Fund also recorded investment gains of over HK$170 billion last year. However, lofty valuations have made equity markets more vulnerable to significant sell-offs at the slightest hint of trouble.
The equity markets have become particularly volatile. In mid-March of this year, the Hang Seng Index experienced huge fluctuations of several thousand points within a week (note 1). Such turbulent market conditions adversely affected the short-term performance of investors, and the Exchange Fund was of no exception.
In the past, when equity markets fell, bonds could usually provide investors with a good hedge against equity market risks such that the phenomenon of “equities down, bonds up” was often observed. This complementary relationship brings diversification benefits which help reduce losses for an equity-bond portfolio during turbulent market conditions. Yet in the first quarter of this year, we observed the rare situation of “equities down, bonds down”. In anticipation of inflationary pressure and tightening monetary policies by central banks, major sovereign bonds were under strong selling pressure, causing the bond prices to plummet. Return on US Treasuries as represented by the Bloomberg US Treasury Index fell by 5.6% overall in the quarter, the worst quarterly performance since 1973. In fact, quantitative easing policies over recent years have kept interest rates low for a long time, and investments in bonds have only generated meagre returns from interest income which could not offset the losses from falling bond prices. As such, most global equity and bond funds, and even conservative funds in the Hong Kong Mandatory Provident Fund scheme that have low equity exposures, suffered losses in the first quarter.
Regarding currency markets, the strengthening of US dollar since the beginning of this year has caused non-US dollar-denominated assets to suffer exchange losses on the book. If the US accelerates the pace of monetary policy tightening relative to other economies, the US dollar could continue to strengthen against other major currencies. In that case, the Exchange Fund would face a “triple-whammy” situation with equities, bonds and foreign exchange valuation all falling at the same time.
Notwithstanding a tough and volatile market environment, the Exchange Fund will stick to its investment principle of “capital preservation first while maintaining long-term growth” without being swayed by fluctuations in short-term returns. Unlike individual investors, we can hardly make frequent changes in positions or large scale adjustment to our investment portfolios, given the sheer size of the Exchange Fund. Rather, we should adhere to our established investment principle, and adjust our medium and long-term asset allocation as appropriate to achieve better long-term return for the Exchange Fund.
Indeed, when faced with higher levels of uncertainty in global markets, we have been managing the Exchange Fund flexibly in response to changes in market conditions. This includes adjusting asset allocation in a timely manner and taking appropriate defensive measures. Specifically, we have made four adjustments as follows:
First, in anticipation of US interest rate hikes, the Exchange Fund has increased its holdings of cash and floating-rate bonds. Floating-rate bonds allow us to more effectively offset the negative impact of rising interest rates and falling bond prices as mentioned above;
Second, the Exchange Fund has appropriately adjusted its foreign exchange exposures arising from non-US dollar assets to reduce potential losses from a further strengthening of the US dollar;
These two adjustments are intended to maintain sufficient liquidity in the Exchange Fund while minimising the impact of fluctuations in the US interest rate on its overall investment income.
Third, over the past few years, we have diversified our investments and more effectively managed our risk by holding inflation-linked investment products and more alternative assets (such as real estate and infrastructure investments) under the Long-Term Growth Portfolio (LTGP). The LTGP has performed well, recording an annualised internal rate of return of 15.3% since its inception to end-September 2021.
Fourth, we shall continue to enhance the liquidity of the investment portfolios to ensure that we can readily provide funds when needed to maintain Hong Kong's monetary and financial stability, and to support the government's need to draw on fiscal reserves to cope with the pandemic.
Our colleagues in the Exchange Fund Investment Office will continue to respond swiftly to the latest changes in the investment environment, to alleviate the potential impact on the Exchange Fund should all three major asset classes (equities, bonds and foreign currencies) suffer a simultaneous setback, to provide a strong backing for Hong Kong’s monetary and financial stability, and to enhance the medium- and long-term value of the Exchange Fund.
Hong Kong Monetary Authority
25 April 2022