Strategic Impact of Currency Risk on US Institutional Investors
William G. Clark Director of Investment State of New Jersey May 13, 2008 GIC Abroad in Paris
About the New Jersey Division of Investment • Total Assets Under Management: $97.4 billion – Pension Fund $82.5 billion • Invests on behalf of 780,000 public employees throughout the State
– Other (primarily Short-Term investment pool): $14.9 billion – 10th largest pension fund in the US – 50th largest money manager in US
(As of 6/30/07)
The Changing Face of New Jersey’s Pension Fund June 05
Dec 07
Medium-Term Goal
US Equities
50.0%
35.6%
25.0%
Int’l Equity
16.2%
18.9%
19.7%
0
0.3%
2.5%
26.2%
26.3%
23.8%
0
0.3%
4.0%
1.8%
0.0%
Asset Class
Emerging Mkts Equities US Fixed Income US High Yield Int’l Fixed Income
2.2%
Commodities/Real Assets
0
1.1%
4.0%
TIPs
0
2.8%
3.0%
Private Equity
0
2.8%
5.0%
Real Estate
0
1.8%
4.0%
Absolute Return
0
3.7%
6.0%
4.6%
3.0%
Cash
5.4%
Changes in New Jersey are Similar to Other US Institutions Asset Mix of US Pension Funds Assets
2005
2007
US Equity
46.7%
41.7%
Fixed Income
22.8%
22.6%
International Equity
13.9%
17.9%
Guaranteed Investment contracts/stable value investments
3.6%
3.2%
Equity Real Estate
3.9%
3.8%
Private Equity
3.6%
3.7%
Hedge Funds
1.9%
2.6%
Source: Greenwich Associates, April 2008
Reasons for Shifts in Pension Fund Asset Allocation •
Changes in financial reporting raises importance of minimizing “plan surplus” volatility
•
Plans seeking assets that are more appropriate for fixed, longdated pensions liabilities (duration = 12.5 years)
•
Attempt to protect the portfolio from potential increases in inflation
•
Looking for uncorrelated returns (i.e, alpha) in different asset classes as a means to improve risk/return profile of the portfolio
How Currency Impacts Views of US Institutional Investors •
Role of currency in Public Equity Portfolios: micro & macro considerations
•
Concern about inflationary aspects of a falling dollar
•
Potential impact on infrastructure investments
•
Currency as an asset class
Role of Currency in Public Equity Portfolios US Corporations increasingly rely on profits generated outside of the US 28.0% 26.0% 24.0% 22.0% 20.0% 18.0% 16.0% 14.0% 12.0%
20 01 -I 20 01 -II I 20 02 -I 20 02 -II I 20 03 -I 20 03 -I I I 20 04 -I 20 04 -II I 20 05 -I 20 05 -II I 20 06 -I 20 06 -II I 20 07 -I 20 07 -II I
10.0%
Source: BEA
Role of Currency in Public Equity Portfolios In Many Cases, Currency Exposure Can Be a Major Driver of Share Performance
•35% of sales from North America; N.A. profit share even higher due to luxury/hybrid/SUV sales •Downward pressure on dollar-denominated energy and steel costs • Benefit from translation of dollar-denominated debt •US-based competitors may be hurt by rising US interest rates (to defend dollar) •Mismatch between cost base (largely in Japan) and export sales to the United States •Toyota’s own internal currency hedging program
Source: MFS
Toyota Price History 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 M ay -0 Ju 5 l-0 Se 5 p0 N 5 ov -0 Ja 5 nM 06 ar -0 M 6 ay -0 Ju 6 lSe 06 p0 N 6 ov Ja 06 nM 07 ar -0 M 7 ay -0 Ju 7 lSe 07 p0 N 7 ov -0 Ja 7 nM 08 ar -0 8
Toyota: Currency risk considerations for weak US Dollar
Price
Role of Currency in Public Equity Portfolios Macro Consideration: Currency was formerly viewed as a source of risk to be hedged. Now it is viewed as a source of diversification to be embraced. Correlation Coefficient 1993 - 2008 US Dollars
Local Currency
S&P 500 vs.
MSCI EAFE
81.02%
91.68%
S&P 500 vs.
MSCI EM
38.38%
67.76%
Inflationary Aspects of a Falling Dollar Major Net Exporters and Importers of Capital in 2007 Countries That Export Capital O t he r C o unt rie s 21%
Countries That Import Capital O t he r C o unt rie s 20 .2%
C hina 2 1%
T urk e y 2 .5 %
T a iwa n 2 % Unit e d S t a t e s 4 9 .4 %
S wede n 2% S inga po re 2%
G ree c e 2 .9 % It a ly 3 .2 %
J apa n 13 %
UA E 3 % A ust ra lia 3.4 %
N e t he rla nds 3 % Kuwa it 3 % N o rway 4 % S wit ze rla nd 4% R us s ia 5 %
Source: IMF
Unit e d Kingdo m 9 .1%
G erm a ny 11% S a udi A rabia 6 %
S pa in 9 .3 %
Inflationary Aspects of a Falling Dollar Is the US Dollar Still the World’s “Reserve Currency”? We’re Starting to See Cracks % of Foreign Exchange Reserves Held in US$ 80% 75% 70% 65% 60% 55% 50% 45% 40%
Industrial Countries
Source: IMF COFER Database
07 M ar -
06 M ar -
05 M ar -
M ar -
04
03 M ar -
02 M ar -
01 M ar -
00 M ar -
M ar -
99
35% 30%
Developing Countries
Inflationary Aspects of a Falling Dollar Can the US$ Be Diluted In It’s Role as the World’s Reserve Currency? 2007
2015 (P)
2020 (P)
3250.8
8735.0
15325.5
US
13843.8
19693.5
25134.5
EMU
12158.4
19081.8
24939.1
Japan
4383.8
6099.2
7139.6
If follows US
4.8
31.5
48.2
If follows EMU
4.8
25.3
38.2
If follows Japan
4.8
29.7
45.3
US if constant
43.5
61.9
79.0
EMU if constant
30.3
47.5
62.1
Japan if constant
13.0
18.0
21.1
GDP (Bln.USD) China
Bond & Stock Mkt. Total (Tin.USD) China
Source: BIS, Datastream, Haver, IMP, Morgan Stanley Research
Inflationary Aspects of a Falling Dollar Why the US Dollar is Particularly Vulnerable – In Our Opinion •
The scale and depth of any US recession is dependent on what credit lines the rest of the world extends to the US
•
US has received a revolving credit line of $750 billion a year
•
Foreign private investors appear to be no longer willing to extend that
•
US faces an external credit constraint unless official investors are willing and able to play a bigger role We are becoming increasingly concerned about the backlash against sovereign wealth funds and sovereign pension funds in the US
Inflationary Aspects of a Falling Dollar The Bottom Line: Currency Risk = Inflation Risk (Ultimately?) 0% -10% -20% -30% -40% -50% -60% Since Jan 2006
Since July 1990
m et al s us
Pr ec io
X
m et al s
M IL C
us tr ia l In d
l oi e C ru d
En er gy
as ol in e
G
O il g
H ea t in
m
od iti es
oc k So f
tc om
Li ve st
G
ra in s
-70%
We’ve already seen the correlation between the dollar and commodities spike. An increase in inflation expectations has not been confirmed by a widening in TIPs breakeven spreads, but that may be misleading. Source: Merrill Lynch
Inflationary Aspects of a Falling Dollar •
NJ Pension Plan: A 1% increase in assumed inflation adds $2 billion in present value terms to NJ pension liabilities – Benefits tied to final average salaries – Retiree benefits have COLAs
•
US Financial Markets – Higher real rates to attract capital – Higher equity risk premiums to attract capital
Infrastructure Estimated Average Annual World Infrastructure Expenditures OECD + BRICs Estimated Average Annual World Infrastructure Expenditures For Selected Sectors 2000-2030 Type of Infrastructure
2000 to 2010
Approximate % of World GDP
2010 to 2020
Approximate % of World GDP
2020 to 2030
Approximate % of World GDP
Road
220
0.38
245
0.32
292
0.29
Rail
49
0.09
54
0.07
58
0.06
Telecoms
654
1.14
646
0.85
171
0.17
Electricity
127
0.22
180
0.24
241
0.24
Water
576
1.01
772
1.01
1037
1.03
Total
1,626
1,897
1,799
Given the attributes of infrastructure investments (long-dated, stable cash flows), a stable currency and/or low expected inflation are critical factors to attract capital for such projects
Infrastructure Many Global Pension Funds Have Made Significant Investments in Infrastructure
Domicile
Total Portfolio Assets (USD mm)
Target Allocation
Infrastructure Allocation
Ontario Teachers
Canada
$71,677
8%
$5,734
Ontario Municipal (OMERS)
Canada
$29,941
15%
$4,491
Canada Pension Plan (CPP)
Canada
$86,194
10%
$8,619
OPSEU Trust
Canada
$9,073
10%
$907
State Super NSW
Australia
$19,829
3%
$595
UniSuper
Australia
$8,262
7%
$537
Telstra Super
Australia
$5,783
3%
$145
MTAA
Australia
$1,652
25%
$413
Illinois State Board of Investments
US
$11,000
5%
$550
BT Pension Scheme/Hermes
UK
$69,857
1%
$699
Institutional Investor
Source: Macquarie
Infrastructure Reasons for Investing in Infrastructure •
Stable and predictable cash flows: privatization allows assets to be leveraged
•
Natural monopoly characteristics: pricing power, lower return volatility
•
Low correlation to other asset classes: diversification benefits
•
Long-lived assets with high tangible value: match for long-term liabilities
•
Capital structure arbitrage: can increase value in addition to revenue growth
•
Risk transfer: some financial risks transferred to end users & subcontractors
•
Recession resistant: returns not highly sensitive to short-term GDP growth
•
Nascent asset class: investor interest growing
Infrastructure Issues Created by Currency (for Foreign Projects) and/or Inflation (for Domestic Projects) For Pension Funds •
Risks diminish attractiveness of infrastructure as a new asset class
For Global Economy •
Given the scope of global infrastructure needs, attracting “private” capital needed to fund projects key to economic growth
Currency as an Asset Class The One Silver Lining: Currency Volatility Creates Potential For Another Source of Diversification and Alpha Currencies Have Low Correlation With Other Asset Classes (1995 -2005)
S&P 500 MSCI ex-US Unhedged in USD Lehman Global Aggregate Currency Composite (Global)
S&P 500
MSCI ex-US Unhedged In USD
Lehman Global Aggregate
Currency Composite (Global)
1.00
0.81
-0.03
0.09
1.00
0.13
0.04
1.00
0.05 1.00
Recent NBER study by Pojarliev and Levich supports that a quarter of all active currency managers add statistically significant alpha (104 bp per month)