CCTrack White Paper: Why FX Overlay programs help the long-term savings risk problem

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1 CCTrack White Paper: Why FX Overlay programs help the long-term savings risk problem Reducing volatility in a portfolio is more than a smoothing exercise. People in the post-2008 world want security and sustainability. Big rallies in equities over the last 3 years have produced more doubt than satisfaction. The drivers of asset allocation, security selection, and market timing are usually the fundamental tools used in mitigating risk in an investment pool. FX Overlay is an offshoot of all three and has long been used to reduce volatility in international portfolios. This paper sets out to show how long-term demographics and growth, deflation, and savings issues have real links back to the foreign exchange markets and decisions made by money managers. As shown in the above chart, the FX contribution to bond portfolios can be significant up to 80% of the overall performance can be explained through FX risks. This makes hedging those moves important or more accurately understanding where the returns come from in a bond portfolio.

2 Likewise, the equity markets can also have a significant FX risk component. The chart above suggests FX can explain up to 50% of returns in some years. The need to understand this risk and return remains similar to bonds and requires some thought as to why FX markets move divergently. Long-term macroeconomic forces are the first place to find fundamental explanations for FX movements. The history of FX trading is short, but volatility from FX explains up to 50% of the returns in equities and 80% in bonds. The need to prepare for longer-term shifts driven by demographics makes FX a useful barometer. Using FX as a lens, investors can see early winners and losers in growth and innovation. Some of the present deflation and growth concerns flow out from demographic shifts. Treatment of education, productivity, and savings in current long-term policy drives much of future market dislocations.

3 The need to trade anything, let alone Foreign Exchange, has been challenged since portfolio theory began. Since currencies became unpegged from the US dollar at the 1971 collapse of Bretton Woods, FX has been treated as a dubious asset class. From March 17, 1973 to the present, trading currencies has been viewed more as a sideline for commodity types than the business of real money managers. There are logical reasons for this, as the trading of foreign exchange is more closely associated with long/short positioning, like spreads in bonds or equities. FX is sometimes considered a zero sum game. This makes the relative measure of holding a long position meaningless. There are no great benchmarks for FX managers and no single index. The US dollar index is decades old and irrelevant to present global trade flows, but it s the preferred market measure, as most of the others are untradeable. Over the last ten years the USD has essentially moved in one direction, down (see chart below). The ability to ignore the USD and invest abroad in growth stocks and converging bond yields has been the main support for pensions and their managers over the last ten years. The USD has turned in the last three years with the divergence of Federal Reserve policy from other G7 central banks, because of increasing energy independence, and because of a sharply improving fiscal situation. The role of the USD in funding foreign growth will change sharply, and other nations will need to send capital abroad and run current account deficits to keep the targets for 2035 (and beyond) intact. Emerging Markets have been the salve for the wounds of developed international markets from Japan and Europe. At the heart of the risk problem for portfolios today is this overdependence on intrinsic short USD positions and how to hedge those holdings over the longer term.

4 At the core of the portfolio, trading FX is about trading risk and fund inflows and outflows over time, with an eye to trend, carry, and correlation. These are generally not the methods academics attribute value to in an asset class and yet they become increasingly important as big trends unwind. The ways to outperform in a portfolio are well known and studied asset allocation, market timing and securities selection all three determine the performance of savings over time. Unfortunately for pensions and those concerned about their retirement, this approach is generally a zero-sum game if you find a manager that outperforms in picking stocks, it means some other set of stock-pickers are losers. Throw in the cost of trading and there is a negative bias to returns for those focused solely on security selection. Market timing is much the same problem as those that trade more efficiently and effectively than others are offset by losers on the other end of the spectrum. Again, there is a negative bias as intermediaries (trade-clearing agents, like banks) are making money on commissions and spreads. Asset allocation, on the other hand, is not a zero-sum game but it does require work to find uncorrelated assets and it requires a process to get the weighting shifts done efficiently. FX stands out for its unique correlation to equities globally and, more importantly, it has lower transaction costs and more liquidity than many other asset classes.

5 The bigger problem facing anyone who saves for retirement today governments, pensions, corporations and individuals comes from the clash of longer-term forces like demographics, inflation and global growth. A nation can save more, but this depresses growth. One can have more children, but this raises inflation. One can spend more and grow faster, but this detracts from savings and sustainability. The best way to think through where to invest now may be in thinking through the longerterm. Many see 2035 and 2050 as milestones for savings and pensions. The thought experiment to consider is to extend the investment problem to Last July, the United Nations released population projections based on data until 2012 and a Bayesian probabilistic methodology. Analysis of these data reveals that, contrary to previous literature, world population is unlikely to stop growing this

6 century. There is an 80% probability that world population, now 7.2 billion, will increase to between 9.6 and 12.3 billion in Back in 2012 there was an 11 billion high end estimate. This uncertainty is much smaller than the range from the traditional UN high and low variants. Much of the increase is expected to happen in Africa, in part due to higher fertility and a recent slowdown in the pace of fertility decline. Also, the ratio of working age people to older people is likely to decline substantially in all countries, even those that currently have young populations, due to growing lifespans. By 2035, however, more than 1.1 billion people 13% of the population will be above the age of 65. This is a natural corollary of the lower birth rates that are slowing overall population growth; they mean there are proportionally fewer young people around. The old-age dependency ratio the ratio of old people to those of working age will grow even faster. In 2010, the world had 16 people aged 65 and over for every 100 adults between the ages of 25 and 64, almost the same ratio it had in By 2035, the UN expects that number will have risen to 26. Japan will have 69 old people for every 100 of working age by 2035 (up from 43 in 2010), Germany 66 (from 38). Even America, which has a relatively high fertility rate, will see its old-age dependency rate rise by more than 70%, to 44. Developing countries, where today s ratio is much lower, will not see absolute levels rise to those levels; but the proportional growth will be higher. Over the same time period the old-age dependency rate in China will more than double from 15 to 36. Latin America will see a shift from 14 to 27.

7 So what are the implications for investors and those interested in protecting wealth into 2015? Is it as simple as buying Africa and Asia funds to protect a portfolio with demographic-driven growth? The long-term outlook forces national savings programs to bet on innovation and emerging market growth. The problems of 2014 highlight the risks to this strategy with geopolitics playing a far more important role than in previous incidents. The risks from natural disasters Ebola, weather or earthquakes also play a role. The long-term trading for growth equities and bond convergence in frontier markets remains a theme, albeit one filled with real volatility. Finally, the cost of picking the right set of emerging markets and tracking their progress from frontier to developing to sustainable growth nations remains difficult and filled with monetary and fiscal policy traps. The role of FX trading in smoothing those returns seems underappreciated by those pursuing a less volatile yet still positive excess return. In short, demographics force a rethinking of long-term investment allocations and make FX overlay a logical program to allow better risk/return ratios.

8 1) The ratio of workers to retired people Does this means we need to save more, retire later or be even more productive? Perhaps the answer is a bit of all three. In China, the world s most-populous country, the number of working-age adults for each person 65 or older is projected to shrink from 7.9 in 2010 to 1.6 in The ratio in India, the world s second-most-populous country, is projected to decrease from 11.1 in 2010 to 2.0 in The United States ratio is seen as declining from 4.6 in 2010 to 1.8 by the end of the century. Other developed nations with low fertility rates show somewhat larger declines, including the Netherlands dropping from 4.0 to 1.6 and the United Kingdom dropping from 3.6 to 1.6 by century s end. One counterpoint to lower labor ratios is higher productivity. In the US, the growth in productivity from 1960 means its takes less workers to make the same output and sustain standards of living. According to the Bureau of Labor Statistics, productivity is more than three times as high today as it was in This means that for every hour worked, a worker in 2014 on average produces three times as much by way of goods and services as did a worker in This is the reason that both workers and retirees can enjoy higher living standards even though there are fewer workers to support each retiree. As nations face pension squeezes and move to shifting from pay-as-you-go schemes to other plans, productivity increases will solve some of the problems.

9 2) The level of savings to retired people Does this mean we need to spend more on education and health for children or cut more from government pension payouts? Will individuals need to shoulder more of the burden for retirement? The other way countries can mitigate the cost of retirement is to force more savings, cut the payout of present retirement or extend the working age to 70 (or higher). Most of these solutions lead to less growth and more deflationary pressures on the global economy. Some of this has been forced from 2008 due to fiscal constraints; some of it has been done by individuals as they chose to work longer either because of weaker savings or because of their ability, and some of it has been done with improvements in health care. Education also plays a significant role in the extension of retirement age as a practical tool. Education also seems to be highly correlated to savings as those with more school are paid better and save more. The choice of pushing up savings and cutting investments has longer term implications for growth in all nations as they grapple with the problem of savings and retirement. The factors measuring out a global retirement success matrix are well described in the Natixis annual global retirement index. Health, finances, material well-being and quality of life all drive the index and show that most of the developed world remains in a strong position while most of the developing world is weak. This makes clear that demographics in the

10 shorter term from 2020 to 2030, for instance are important for emerging market allocations. Perversely, countries with higher savings and lower fertility have lower price indices. The correlation of demographics to deflation has been the work of interfluidity blog the role of FX in this story isn t small as currency movements will show up as deflation or inflation in any global index. This is the unspoken risk in the present demographic mix for much of the developed world. Deflation is not a problem for the retired, as they have less need to spend immediately. For investors, this paradox has left difficult choices for bonds and stocks at home vs. abroad. Central banks have moved rates to negative real levels throughout most of the developed world. This is unlikely to shift quickly even if the US lifts off in 2015.

11 3) Level of Fertility. Do higherearning nations grow populations more slowly? Does child healthcare and level of education matter to the overall sustainable growth of a nation? The arguments in 2014 about income stagnation for the average worker against the wealth inequality for most of the world drive much of the fears for further geopolitical volatility. Voters in 2014 have already shown some of the push for change as have the sharp increases in protests across the world. Many are looking for some magical solution to demographic problems either through immigration or by bribing the affluent to have more children. Both have significant implications for investment as healthcare is put on longer-term hold along with education while policy battles over border control and immigration rises to the top as a political issue. The role of fertility and wealth is well-documented and much of the push for sustainable development in frontier markets focuses on lower fertility, improving healthcare and education to make the squeeze for food and energy less problematic. In the US, the level of education and the ability to work longer and more successfully has become part of the worry about structural stagnation in the workforce post The longer-term role of immigration to growth is another obvious factor for investors to consider in their factor analysis for sorting through emerging markets and sustainability. The role of the US to LATAM or UAE to South Asia are well understood and have become part of the economic fabric, but new routes of migration happen and merit attention as the poorest people are not the most likely to move. The open economic connections between regions have a connection to innovation and growth as well. The analysis from the Wittgenstein Centre on Demography in Vienna is worth studying for those hungry for more information.

12 Conclusions: What does this all mean for investors and FX markets? Forecasting long-term trends isn t easy. The ability for a world with 12 billion people to live well and peacefully, with food, energy and health intact seems incredible if not impossible and yet that is the goal and best case scenario for the year The only way to get there will be through smart planning and investments. The last century has made clear that war doesn t solve these problems, nor does a breakdown of globalization. Innovation and growth follow from governments that open up their domestic markets to flows of people, capital and ideas.

13 The role of foreign exchange in the process remains important as currencies are the shock absorber for larger economic imbalances between nations and regions. The ability for the world to get to the finish line of sustainable food and energy with 12 billion people will require rethinking much of the food supply chain and energy supply networks in the present. The role of climate change and global growth will be in dynamic tension as well. Dividing the world into nations with excess energy and those with excess food production forces global coordination, as few nations have both. Brazil, Russia, US, Canada and Australia stand out as winners for now but their ability to sustain their position and extend their legacy will require much work between the private and public sectors. The important role of Asia and Africa in the next 50 years seems obvious from a demographic point of view but increasingly also to geopolitical ones as well as we shift from a world focused on North-South trade routes to one more balanced with South-South trade rising along with the flow of people, money and ideas. The currency markets are a good barometer for these shifts and will be lightning rods for understanding how the world adjusts with new winners and losers.