The coming of a perfect storm
Hong Kong was hit by the first typhoon of the year in early July, but fortunately no significant damage was done. However, a more prolonged and destructive storm swept across the global financial markets in the first half of this year, with all asset classes being affected, presenting a daunting challenge for the Exchange Fund.
As mentioned in my inSight article on 25 April (see Staying Calm in Stormy Markets), unprecedented accommodative monetary policies and fiscal measures introduced by various jurisdictions in the early days of the COVID-19 outbreak had caused bond yields to fall to ultra-low levels and equity valuations to remain very high. In the first quarter this year, we encountered the rare occurrence of “equities down, bonds down” amid substantial financial market volatilities on the back of the anticipation of inflationary pressures and tightening monetary policies by central banks, as well as the intensifying geopolitical risks arising from the Russia-Ukraine situation and the ensuing financial sanctions on Russia.
As we entered the second quarter, the already battered markets were further hit by a “perfect storm”, which was a culmination of several factors including: (i) lingering geopolitical tensions which disrupted the supply of energy and food; (ii) heightened concern about inflation as prices in several major economies were rising at the fastest rate in 40 years; (iii) central banks taking a firm stance on tightening monetary policies1, (iv) concerns over recession dampening investor sentiment, and (v) lockdown measures to contain the outbreak of pandemic on the Mainland. With uncertainties rising sharply in markets, investors rushed to sell off their assets, leading to a concurrent fall in equity and bond prices as well as currency exchange rates against the US Dollar in the second quarter. The asset price declines were even more severe than those in the first quarter. For example, the S&P 500 Index fell by 4.9% in the first quarter, and by a further 16.4% in the second quarter.
In summary, multiple asset classes recorded a double-digit price fall in the first half of the year, which was quite rare in many decades.
How did the Exchange Fund perform? Could the investment losses be avoided?
The Exchange Fund, as a long-term investor, has been allocating investments to different assets and currencies to diversify risks. Moreover, it has substantial bond holdings in order to achieve the primary investment objectives of preserving capital while maintaining liquidity. Our diversification strategy had withstood the 2008 global financial crisis when stock markets plunged, as safe haven flows into bond markets shored up bond prices which partly offset the losses from equities. As a result, the overall investment loss of the Exchange Fund was much reduced. However, in the first half of this year, prices nosedived across almost all types of assets, leaving investors with no real options for taking shelter.
Caught in this perfect storm, the Exchange Fund, as with other investors, could not stay totally unscathed. We expect quite a significant loss in the first half of the year. However, with the Exchange Fund’s diversified long-term asset allocation and defensive measures responding to market developments as well as the strategic adjustments set out in my April 25 inSight article (including increased holdings of cash and floating-rate bonds, adjusted proportion of non-US dollar assets, and the holding of inflation-linked investment products), the destructive impact of the perfect storm has been somewhat mitigated.
Since 2008, the HKMA has diversified part of the Exchange Fund investments in an incremental manner into new asset classes, including renminbi assets and alternative investments under the Long-Term Growth Portfolio. The better performance of these investments relative to other assets in the first half of the year reflected that investment diversification is key to achieving stable medium to long-term investment returns.
It is important that we do not focus only on the short-term performance of the Exchange Fund. Rather, we should assess the Exchange Fund’s performance from a medium and long-term perspective based on its investment objectives.
Has the storm come to an end?
It is too early to tell whether the storm has ended. But one thing that is more certain is that higher interest rates can increase the bond portfolio’s interest income which could partly offset the losses caused by falling bond prices. However, the investment environment in the second half of the year is still fraught with challenges, with factors including high inflation, tightening policies of various central banks, geopolitical tensions and recession worries continuing to weigh on financial markets. Market uncertainties have led to wide-ranging market projections of asset prices by investment firms and analysts, which would complicate investment decision making. Hence the investment climate will remain difficult in the second half of the year.
Regardless of the volatilities that we may face and the challenges that we may encounter in our investments, the Exchange Fund will remain committed to the principle of “capital preservation first while maintaining long-term growth”. It should not be driven by short-term fluctuations in investment gains or losses and enticed into short-term speculation or market-chasing. Such actions will heighten risk and increase trading cost, distracting us from the long-term investment objectives of the Exchange Fund. The HKMA will continue to diversify investments so as to stabilise the Exchange Fund’s long-term investment returns.
Hong Kong Monetary Authority
26 July 2022
1 Many central banks have become more aggressive in raising interest rates to curb inflation. For example, following a 50-basis-point hike in May, the US Federal Reserve raised the fed funds rate by 75 basis points in June, the biggest rate hike since 1994, in addition to shrinking its balance sheet.