EXECUTIVE SUMMARY. Contents. The Dollar s Rise: What Does This Mean for Investors? Summer Author: Catherine Hickey Title: Vice President

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1 The Dollar s Rise: What Does This Mean for Investors? Summer 2015 Currency moves are very difficult to predict, particularly in the short run where practice and theory don t always align. Both equity and fixed income investors would do well to be aware of the effects of currency on their portfolios. Author: Catherine Hickey Title: Vice President Author: Melissa Binder, CFA Title: Director Author: Don Sheridan Title: Director Company: Segal Marco Advisors Website: EXECUTIVE SUMMARY The dollar s recent rise has major implications for the US economy and for investors. A number of global economic factors have converged to support the dollar recently. While a strong dollar may be beneficial to US consumers, it may be a detriment to US corporate profits. Equity investors need to be mindful of the costs of hedging currency exposure. Fixed income investors in particular should be aware of the implications of currency risk to their portfolios. The recent rise of the US dollar has many investors wondering how it will affect their portfolios and how to take advantage of its strength. However, currency movements are unpredictable, and investors should know that all investments are not impacted by currency movements in the same way. Contents Executive Summary 1 What is Behind the Dollar s Strength? 2 What Does It Mean? The Positive News 3 What Does It Mean? The Negative News 3 The Dollar and Its Impact on Equity Investments 4 The Dollar and Its Impact on Fixed Income Investments 5 Conclusion: Remember the Benefits of Currency Exposure 7 Author Biographies 8 This report was prepared by The Marco Consulting Group prior to its acquisition by Segal Rogerscasey. The combined firm is called Segal Marco Advisors.

2 2 A Bull Market For The US Dollar The US dollar has risen steadily higher lately, and has particularly taken off in the past 12 months. Since mid-2014, the US dollar s value has risen more than 20% against the euro and well ahead of the yen and several other major currencies. Figure 1: Currency Values By weakening their currencies, these central banks are hoping to make exports cheaper and spur economic growth. Meanwhile, the US has recently completed its own quantitative easing program and the central bank, the Federal Reserve has indicated its plans to hike interest rates in the near future. Currency values are a zero-sum game. Their values are shown when compared against another currency, so if the value of one currency goes down, the other goes up. Thus, as the euro and the yen weakened, the dollar has strengthened on a relative basis. Source: Bloomberg Currencies are always volatile, and it is difficult to pinpoint the reasons why a currency has appreciated or depreciated at any given time. However, a number of factors have contributed to the dollar s recent rise. What is Behind the US Dollar s Strength? First, global central bank divergence is a major contributor. Global monetary policy rate divergence and increased quantitative easing efforts out of Europe and Japan are supporting a strong US dollar. Central banks worldwide, and especially in Europe and Japan, are undertaking quantitative easing programs, meaning that they are buying up government debt in a bid to weaken their countries currencies. In August 2015, China devalued its currency in a bid to stimulate its economy. A stronger US economy has pushed the dollar higher as well. A steady drumbeat of positive economic news has emerged for the US in the last couple of years. While GDP growth was relatively weak in the first quarter of 2015, the second quarter s economic news was more robust. Other factors like unemployment have improved recently as well. This economic momentum is certainly stronger than the conditions overall in Europe and Japan. Figure 2: 5yrs Government Bond Yields Source: Bloomberg

3 3 In addition, as the QE program in the US has ended and the economy has strengthened, the Federal Reserve has indicated it is planning to raise interest rates soon. All other things being equal, investors will want to keep their cash in the currency that pays the highest short-term rates. Meanwhile, several European central banks have eased monetary policy to an extent that short-term rates went negative, depositors will have to pay the bank for the privilege of holding their money. Despite recently ticking up amid inflation fears, European yields are still quite low. If investors think the Fed is ready to hike at a time when other central banks are keeping rates low or even negative, they will flock to US dollardenominated assets which will likely appreciate in value. The strength in the dollar is impacted by the recent drop in oil prices. Individual commodities are homogeneous assets, and as such, should be priced equally across the globe. However, commodities are often priced in one currency, and currencies are anything but homogeneous. Oil is priced in USD per barrel, which means it must be purchased in USD regardless of the countries involved in the transaction. With a strong dollar, foreign countries are paying more per barrel of oil than they would if the contracts were priced using local currencies. Figure 3: Performance vs. Volatility What Does It Mean for Investors? The Positive News On one hand, a stronger dollar can be beneficial, especially to consumers. A stronger dollar means more purchasing power for consumers, meaning that consumers are able to buy more goods with fewer dollars. In turn, consumers with more purchasing power who can boost the US economy further by having more to spend on US goods. The plunge in oil prices has also helped keep money in consumers pockets. A continued consumer-led boom could power the US economy further. A stronger dollar is also a welcome development for the global economy. As the dollar has strengthened, and US exports have become that much more expensive, demand then shifts from the US economy to economies around the world. As exports are boosted in Europe and Asia, the global economy should benefit. Source: Bloomberg What Does It Mean for Investors? The Negative News The counterpoint to these benefits of a strong dollar is that US exports have struggled of late. As the dollar becomes stronger, US exports get pricier, and demand for them slows. The overly strong dollar has actually worked against the strengthening US economy lately because of exports stall. Meanwhile, countries with weaker currencies will likely find more demand for their goods, which in turn will benefit their economies. In fact, the US economy s weak Q GDP number was at-

4 4 tributed by many economists to the strong dollar s effect on exports. US companies that derive much of their revenue overseas have also been hit hard by the dollar s surge. This is especially important because a significant driver of US companies growth over the past 10 years has been expanding into international markets. In 2014, S&P 500 companies reported that almost 50% of revenues came from abroad. As international sales become a larger part of US companies profits, these companies are negatively impacted when revenues in foreign currencies are translated back into USD. This has been illustrated so far in 2014, as some US based multinationals have either reported or are expecting to report reduced revenues and profits on the stronger dollar. At the onset of earnings season, in April 2015, returns of the S&P 500 and MSCI EAFE (USD) were 1.0% and 4.2% respectively, which illustrates how US investors have been impacted by the rise of the USD at the company level. What s more, the interest rate hike that US dollar investors are anticipating may be delayed somewhat ironically by the dollar s continued strength. That s because the strong dollar is likely holding off inflation, something that Janet Yellen and the Fed governors have said they are looking to increase before they raise rates. When the US imports goods from other countries it pays for them with foreign currencies. These goods are cheaper to pay for when a stronger dollar drags those currencies down, which pushes inflation lower. A drop in inflation has coincided with the stronger dollar in the last 12 months. The impact of a strong US dollar may be a temporary phenomenon. However, it is important for investors to understand how these currency dynamics affect your portfolios. Below are ways that the rising dollar affects stock and bond portfolios. Figure 4: Consumer Price Index (y/y change) Source: Bloomberg The Dollar and Its Impact on Equity Investments Equity portfolios are impacted two ways. The first is the currency translation that occurs when a US investor exchanges its foreign investment returns into US dollar returns. The second is the impact currency movements have on US and international companies, which is often reflected in stock prices. The majority of international investment portfolios are unhedged, which means these portfolios will be directly impacted by currency translations because investors portfolio returns are calculated in US dollars. Specifically, there are 477 products in evestment Alliance s Non-US Diversified Equity universe that report their philosophy towards currency hedging. Of the 477 products, 339 do not engage in currency hedging, which means over 70% of the universe has been negatively impacted by the recent currency shifts. Here is an example of the currency impact on an equity portfolio. The Euro Stoxx 50 is an index comprised of 50 blue chip stocks from 12 Eurozone countries. Over the year ending June 30, 2015, the index returned 6.07% in euros, but a

5 5 US investor would have lost % over the same time period, which means the currency impact detracted almost 20% from performance. Details regarding the analysis are below: Figure 5: 1yr Investment in Euro Stoxx 50 Index Ending Figure 7: 1yr Investment in Euro Stoxx 50 Index Ending Source: Source: Given the example above, an investor would question why more equity managers don t hedge currency exposures. But, looking over the past 10 years the answer is clear. Currency shifts are volatile and only up until recently would a US investor benefit from hedging their international equity exposure. Figure 6: U.S./Euro Foreign Exchange Rate It is also worth noting that on the equity side, fund managers say they are often unaware of exactly what kinds of currency hedges CFOs are making at any given time at the company level. Therefore, there are often more hedges in the portfolio than they are aware of. Given the lack of transparency on corporate hedging, and given the lack of general utility in hedging equity portfolios, investors are not advised to actively hedge their portfolio s equity stake. The Dollar and Its Impact on Fixed Income Investments Because currency has a far more noticeable impact to the volatility of a global bond portfolio than it does to a global equity portfolio, it is crucial for investors to develop a well-considered ;fixed income currency strategy. Figure 8: Barclays Global Aggregate Returns Source: An example of a timeframe when currency shifts contributed positively to performance was in During 2007, the Euro Stoxx 50 index return 5.20% in euros, but as a US investor, the return was 15.49%, which means the currency impact contributed over 10% to performance. Details reading the analysis are below:

6 6 One way to illustrate the currency impact on the bond markets is to study the hedged vs. unhedged performance of the investment grade global bond universe. Today, currency exposure in the Barclays Global Aggregate Index is around 40% US dollar, 35% euro, and 20% yen (the other 5% is in other index-eligible developed and developing regions of the world). Since 2004, the unhedged index has significantly underperformed during times when the euro and yen were depreciating relative to the dollar. Heightened short-term bouts of currency volatility have created a less compelling annualized long-term performance track record for the unhedged index over the last decade. Two meaningful relative performance periods came in and 2013-present. The primary catalyst for the former was a correction from an overexuberant euro versus the dollar, while the latter was a confluence of global growth and monetary policy factors. Figure 9: Barclays Global Aggregate Returns Annual Difference Secular US dollar bull markets are far more relevant to global and international portfolios than to domestic-oriented ones. Risk and performance for the Barclays US Aggregate Index is primarily a result of duration, bond price appreciation/depreciation, convexity, and yield. Currency doesn t factor into a domestic bond portfolio allocation decision for US investors with Dollar-denominated liabilities. However, currency strength can contribute to a temporary technical impact from international flows that are either seeking safe harbor in US bonds or trying to capitalize on a carry trade (for example, using their own less attractive currency to fund an appreciating US Dollar). Figure 11: 10yr Returns Correlation Matrix Figure 12: Global Aggregate - Sharpe Ratio vs. 10 Standard Deviation Figure 10: Barclays Global Aggregate Returns Annual Examples of long-term dollar bull markets are (when the dollar was up 61% versus the majors) and (when the dollar was up 43% versus the majors). With yield levels where they were and the birth of a 30-year bull market for bonds, the US Aggregate performed quite well from (+14.09%). The Global Aggregate Indices did not exist during that peri-

7 7 od, but were around for the second meaningful dollar rally ten years later. Figure 13: Global Aggregate Returns MCG encourages clients to carefully consider the role that currency plays in their fixed income portfolios. Currency can be a risk mitigator and potential source of alpha in fixed income, but its contribution to volatility in bond portfolios cannot be overstated. Due to high currency volatility, emerging markets will display an even more pronounced dispersion between US dollar hedged and unhedged fixed income indices than investment grade developed market indices. This can be seen in the return differential during the one-year period ending April 30, 2015 between the the unhedged JPMorgan Government Bond Index-EM Global Diversified (-9.35%) and the hedged JPMorgan EM Bond Index Plus (+6.30%). When thinking about currency strategy in a fixed income portfolio, it s necessary to first define what fixed income means to the overall plan. Often, it is meant to provide a lower volatility counterweight to the equity, leveraged, and less liquid components in a portfolio. If this is the case, the income and correlation benefits unique to traditional investment grade fixed income should always be desirable attributes for a core strategy. Currency has a place at the margin of such a portfolio if risk tolerance permits. Exposure to currency instruments in fixed income should be with managers that analyze the currency separately from the bond portion. A manager with the resources and skill to effectively manage the risk, as well as rigorous manager due diligence, are paramount in order to maintain a portfolio s desired fixed income risk profile when incorporating currency. Conclusion: Remember the Benefits of Currency Exposure The US dollar s strength in recent months has been a boon to some investments but has been a negative for others. There is considerable economic data to support the thesis that the US economy will continue to strengthen as other parts of the world slow down. This means that the already strong dollar might still have room to run. Again, currency moves are very difficult to predict, particularly in the short run where practice and theory don t always align. Both equity and fixed income investors would do well to be aware of the effects of currency on their portfolios. Hedging currency risk for ex-us allocations can be one solution for those that are wary of currency volatility, but it s important to be aware of the costs involved. On the other hand, long term investors can derive diversification and total return benefits from exposure to currencies. Investors and plans should assess their own risk tolerance to best determine if and how to gain currency exposure.

8 8 Catherine Hickey, Vice President Catherine joined The Marco Consulting Group in 2013 as Director of Capital Markets Research. She has more than 12 years of experience in capital markets research and consulting. Prior to joining MCG, Catherine was responsible for developing macroeconomic and capital market research at Marquette Associates. Before joining Marquette she worked at the World Bank Group, where she specialized in capital markets and corporate governance research. She also previously served as the lead mutual fund analyst for several high-profile fund families at Morningstar, Inc. Catherine holds a B.S. in Journalism from Northwestern University and an M.B.A. from the Wharton School at the University of Pennsylvania. Melissa Binder, Director Melissa joined The Marco Consulting Group in 2006 and currently serves as Portfolio Manager for MCG s Equity Group Trust. She is responsible for manager selection and asset allocation for the multi-investment manager equity portfolio, which is part of MCG s Fiduciary Services platform. Prior to her role as Portfolio Manager, Melissa served as Senior Investment Analyst and was responsible for the recommendation and monitoring of investment strategies for institutional investment clients. In this role she conducted ongoing analysis of individual managers and asset classes, and coordinated all aspects of the investment due-diligence process, including liaising with current and prospective fund managers. Melissa received an M.B.A. from the University of Chicago Booth School of Business, a B.S. in Finance from the University of Illinois at Chicago and holds the Chartered Financial Analyst designation. Don Sheridan, Director Don Sheridan began his career in finance and investing in 2001 at the Chicago Mercantile Exchange where he was an S&P 500 Futures trader and order management lead for Eurodollar Futures. He joined Mercer in 2006 where he began his career as a fixed income researcher. In the fall of 2010 Don joined The Marco Consulting Group as Portfolio Manager for the Fixed Income Group Trust. Don received his M.B.A. in finance from DePaul University and a B.S. in economics from the University of Illinois Business School (Champaign-Urbana). The views contained in this report are those of The Marco Consulting Group (MCG) and are based on information obtained by MCG from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations, or projected returns for any particular investment product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from The Marco Consulting Group.