CURRENCY MARKETS CHANGING THE INVESTMENT MODEL

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1 FOR PROFESSIONAL CLIENTS ONLY. NOT TO BE DISTRIBUTED TO RETAIL CLIENTS. THIS STRATEGY IS OFFERED BY INSIGHT NORTH AMERICA LLC (INA) IN THE UNITED STATES. INA IS PART OF INSIGHT INVESTMENT. PERFORMANCE PRESENTED IS THAT OF INSIGHT INVESTMENT AND SHOULD NOT SPECIFICALLY BE VIEWED AS THE PERFORMANCE OF INA. PLEASE REFER TO THE IMPORTANT DISCLOSURES AT THE BACK OF THIS DOCUMENT. MARCH 218 CURRENCY MARKETS CHANGING THE INVESTMENT MODEL IT HAS BEEN A CHALLENGING PERIOD FOR CURRENCY MANAGERS. A PRIMARY FACTOR THAT USED TO DRIVE CURRENCY MARKETS RELATIVE INTEREST RATES INDICATING A CHANGE IN RELATIVE ECONOMIC STRENGTH FAILED AS A PREDICTOR OF US DOLLAR PERFORMANCE IN 217. AN ASSESSMENT OF MARKET DRIVERS SUGGESTS THE DOLLAR IS SET TO UNDERPERFORM. TESTING TIMES Figure 1: Currency managers struggled in 217 It has been a challenging period in the currency markets. The Citi 135 Parker Global Currency Manager Index, which is based on the 13 performance of a range of currency investment strategies, generated a negative return of c.5% in 217. It is now down over % from its 215 and down 15% from its all-time peak in 21. The performance of the Index reflects that poor returns have been 115 generated by currency managers with many different styles: macro, systematic trend-following, short-term trading and quantmacro strategies have all suffered, as has our discretionary macro approach. The usually reliable correlations and signals that we have relied on have become false prophets. BACK TO BASICS: CURRENCY MARKETS DRIVEN BY RELATIVE RATES Citi Parker Global Currency Manager Index Source: Bloomberg. Citi Parker Global Currency Manager Index. As of February 1, 218. The price of a currency, like anything else, is determined by supply and demand. The flows that constitute this supply and demand move across a country s balance of payments, but they are hard to measure accurately in real time and even if you do consider and revise estimates, large balancing items are typically required to account for errors. We believe that instead of focusing on the flows themselves, it is usually more instructive to focus on the drivers of the flows and how they correlate with the currency rate. We have observed that currencies usually follow cyclical patterns, rising when an economy is surprisingly strong and falling when it is surprisingly weak. This link between economic strength and currency performance is a result of the link between economic activity and return on investment, based on the general observation that faster-growing economies can support higher interest rates, while higher profits will be generated by companies operating in this stronger growth environment. These higher returns attract international capital, which might be expected to push up the currency rate. However, the increased supply of international capital can be expected to be balanced by a deterioration of the current account, as the trade balance is undermined by rising imports. Exports might also fall as local producers divert production to meet buoyant domestic demand. It is important to note that the capital account and current account respond at different rates to a shift in demand. Capital flows tend to move in anticipation of, or in line with, changes in the relative attractiveness of investment opportunities. In contrast, current accounts typically change after some time, as agents get used to their altered financial status and take time to alter their consumption pattern. This time gap the difference in the rate of response of capital and current accounts to changes in demand is plugged by the exchange rate, which adjusts to maintain equilibrium. We would note that this characterization of different lags in different parts of the economy, resulting in exchange rate volatility, is consistent with Rüdiger Dornbusch s exchange rate overshooting model. What is set out above provides a framework for thinking about exchange rates. It suggests that as an economy strengthens, and its interest rates go up relative to other jurisdictions, its exchange rate will usually appreciate. Historically, the US dollar has typically appreciated when US rates are higher relative to other major economies the principal exception was the period from 25 to 26 (see Figure 2).

2 Figure 2: USD trade-weighted index and periods when US short-term interest rates are above average 17 USD performance in high US interest rate periods USD trade-weighted index level US is high yielder (top half of G1 yields) US$ trade weighted Index Source: Bloomberg. As of June 3, 217. This is apparent when considering different currency pairs and the corresponding movements in relative government bond spreads. For example, if one considers how the US dollar has performed against the euro and Japanese yen, against the relative spreads between treasuries and bunds or Japanese government bonds respectively, it appears that currency performance generally tracks changes in relative interest rates (see Figures 3 and 4). When forecasting currency performance this relationship is a key consideration as we focus on assessing which economies will surprise on the upside or downside. Figure 3: EUR/USD alongside 2-year vs 1-year government bond spreads (US and Germany) Government bond spreads (bp) EUR/USD performance US-Germany 2yr spreads US-Germany 1yr spreads EUR/USD Source: Bloomberg. As of February 2, 218. The EUR currency value prior to January 1, 1999 is the European Currency Unit (ECU), which is an artificial basket currency used by the member states of the European Union. The EUR replaced ECUs on a one-to-one basis. Figure 4: USD/JPY alongside 2-year vs 1-year government bond spreads (US and Japan) USD/JPY performance Government bond spreads (bp) Source: Bloomberg. As of February 2, 218. A NEW REGIME IN 217 USD/JPY US-Japanese 2yr spread US-Japanese 1yr spread It is worth considering these points to understand what was different in 217. If historical evidence suggests that interest rate spreads drive currency performance as a result of it indicating changes in the relative strength of an economy and the associated return on capital a key question is why this relationship appeared to break down last year. One reason is that for regions where the central bank is purchasing assets, like Japan and the eurozone, bond yields may not reflect the growth outlook or investment returns from markets outside the bond market.

3 This appears to have been the case in Germany, where the correlation between bond yields and the business cycle in place until the global financial crisis has not been present since (see Figure 5). This lends weight to the argument that, for Germany at least, interest rates do not currently reflect the business cycle and are therefore not a good signal of the investment environment. By contrast, the equity market has responded consistently to the improvement in the cyclical picture in Germany, and higher investment returns have been delivered (see Figure 6). The same picture emerges if we look at Japanese measures of business activity, yields and the stock market. Figure 5: versus 1-year German bund yield Yield (%) 1yr Geman bund yield Source: Bloomberg. As of February 2, 218. Figure 6: versus the German equity market DAX Index performance Source: Bloomberg. As of February 2, 218. DAX Index This leads to a further question: why the correlation between yield spreads and the behavior of the US dollar has broken down only now, if yields have been a poor indicator of investment returns since the financial crisis. One explanation may be that until 217, the US economy was generally outperforming and the Federal Reserve was ahead of other central banks in normalizing policy. In this environment, the outperformance of the US economy was accompanied by the usual combination of relatively higher yields, US stock market outperformance and a rising dollar. In 217 the Federal Reserve was still ahead of the pack in terms of policy normalization and so yield spreads were still moving in favor of the dollar, but now the bigger growth surprises occurred elsewhere. Moreover, valuations have moved: it appears that the dollar is now operating from the strong side of fair value on a real effective exchange rate (REER) basis the dollar appears to be c.1% overvalued. Table 1 shows a number of different measures of long-term currency valuations. Each measure has advantages and disadvantages, so we tend to look for consistency across the measures or to focus on the average. On top of this, US stock market outperformance over recent years has led to US companies being more highly valued than their peers overseas (see Figure 7). Based on these measures, it appears that the dollar and US assets have already re-rated to reflect better economic conditions, perhaps leaving European and Japanese assets more room to reflect their more recent improvement. In 217, there were positive inflows into European equities and an inflow of foreign direct investment. For a currency area with a large trade surplus, these inflows put a large burden on fixed income flows to balance the demand for euros. Indeed, in 217, the basic balances of the eurozone and Japan improved, while that of the US deteriorated. This combination of richly valued assets and a deteriorating basic balance seems to confirm that the US dollar did not benefit from relatively higher yields because its assets were expensive and there were better investment opportunities elsewhere.

4 Table 1: US dollar valuation relative to various measures Over/Undervaluation vs Valuation Measures Grouping Currency GSDEER vs USD PPP(PPI) vs USD REER TWI Average Majors AUD -1% -1% 11% 3% CAD -3% -5% -3% -4% CHF 3% -6% 6% 1% EUR -7% -2% 2% -2% GBP -8% -22% -12% -14% JPY -17% -34% -18% -23% NOK -24% 5% -8% 6% NZD 3% 26% 9% 13% SEK -2% -23% -9% -17% Latam BRL 5% 3% 4% CLP -5% -2% -3% MXN -21% -22% -21% CEEMA CZK % 14% 7% HUF -7% % -3% ILS 4% 9% 7% PLN -11% -2% -6% RUB 7% 3% 5% TRY -31% -17% -24% ZAR -2% -16% -18% Asia CNY -13% 2% 4% HKD -3% 1% -1% IDR 5% 8% 7% INR 5% 11% 8% KRW 17% 5% 11% MYR 63% -8% 27% PHP -4% 11% 3% SGD 9% 7% 8% THB 1% 12% 6% TWD -1% -4% -2% USD TWI 8% 1% 1% 1% Source: Bloomberg. As of January 31, 218. Figure 7: The P/E ratio for the S&P 5 Index has moved above ratios for the Eurostoxx 5 Index and Nikkei 225 Index 3 Price to earnings (P/E) ratio S&P 5 Index EuroStoxx 5 Index Nikkei 225 Index Source: Bloomberg. As of December 31, 217

5 US TAX REFORM: IMPACT UNCERTAIN Looking forward, the rich relative valuation of US assets remains a hurdle to dollar strength. Moreover, the US tax package agreed at the end of 217 has both positive and negative aspects for the currency. Fiscal easing that boosts growth should be positive for a currency, especially if it shifts the balance of policy towards tighter monetary policy. For example, in the Reagan/Volcker period, the dollar surged as Volcker raised interest rates dramatically and then fell again as interest rates were pared back. However, while expectations for monetary tightening in the US have been brought forward, the expected terminal rate for interest rates has remained largely unchanged, unlike in the Reagan/Volcker period. This suggests that the market believes fiscal easing will change the timing of growth, but in the end the trend will not rise and the cycle will end or moderate again. Another aspect of the tax reform is that this fiscal easing has come unusually late in the cycle. This might lead us to expect a bigger deterioration in the external accounts and in the budget deficit: the external accounts might be worse than usual because there is less spare domestic capacity to supply the positive demand shock, and there might be a bigger deterioration in the budget position because the cycle has less time to run at a higher level to generate a boost to tax receipts. This combination of a static expected terminal rate for interest rates, and fears regarding a deterioration of the fiscal and current account deficits, seems to have undermined rather than boosted the dollar overall. The dollar rallied in the third quarter of 217 as the market initially priced the prospect of a fiscal package being delivered, but so far it appears the rally was temporary, rather than a restoration of the previously rising-dollar trend. Markets make mistakes. It is unclear whether the fiscal package will have a more positive long-term effect on productivity growth in the tradeable sector of the economy that would likely be supportive for the dollar. Moreover, the effect of the tax package on cross-border capital flows deserves greater scrutiny. It is expected that profits that have been held off-shore by US corporate entities will be repatriated. There is a lively debate as to whether these profits are already hedged or held in dollars. Judging by price action, the market seems to have decided there will be little new dollar demand as a result of this repatriation. Time will tell if that assessment is correct. OUTLOOK: LONG-TERM DRIVERS SUGGEST A WEAK DOLLAR For now, it appears that yield spreads are poor indicators of the direction of currencies, including the dollar. Instead, the focus appears to be on other drivers of long-term capital flows, such as valuation and the potential demand for capital that might be generated by the deterioration of the US budget and current account deficits. As long as the focus remains on these factors it seems likely that the dollar will be under downward pressure, at least until valuations have corrected or the market has altered its view on the potential for the tax package to boost productivity in the US. Other risks to the weak dollar view derive from the possibility that supportive aspects of the US tax package have been underestimated or that the US cycle may surprise significantly to the upside either in terms of its pace or duration. At this point, our judgement is that the tide favors dollar weakness, but we are alive to the risks to this view. FIND OUT MORE Insight Investment 2 Park Avenue, 7th Floor New York, NY Call charges may vary by provider. Institutional Business Development Institutionalna@insightinvestment.com Client Service Management clientservicena@insightinvestment.com Consultant Relationship Management consultantsna@insightinvestment.com IMPORTANT DISCLOSURES This document has been prepared by Insight North America LLC (INA), a registered investment adviser under the Investment Advisers Act of 194 and regulated by the US Securities and Exchange Commission. INA is part of Insight or Insight Investment, the corporate brand for certain asset management companies operated by Insight Investment Management Limited including, among others, Insight Investment Management (Global) Limited, Insight Investment International Limited, Cutwater Asset Management Corp., and Cutwater Investor Services Corp. Opinions expressed herein are current opinions of Insight, and are subject to change without notice. Insight assumes no responsibility to update such information or to notify a client of any changes. Any outlooks, forecasts or portfolio weightings presented herein are as of the

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