W. Clark May 1108

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)