Lazard Insights. Understanding the Effects of FX. Summary

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1 Lazard Insights Understanding the Effects of FX Yvette Klevan, Managing Director, Portfolio Manager/Analyst Robert A. Failla, CFA, Director, Client Portfolio Manager Summary The strength of the US dollar relative to other currencies over the past year has heightened investor awareness of currency effects. The main drivers of foreign-exchange rates include fundamental factors such as interest rate and economic growth differentials. At the same time, technical factors and flows are also important as they are effective at indicating exchange rate trends. While currency volatility is an important consideration in both fixed income and equity investments, because equities are inherently more volatile on their own, the additional volatility created by currencies typically has a more pronounced effect on fixed income investments. Currencies fluctuate just like any other financial asset and can have a significant effect on investors portfolios. However, decisions to hedge foreign exchange exposure are not straightforward as there are times when unhedged performance can be favorable. Lazard Insights is an ongoing series designed to share valueadded insights from Lazard s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the authors. The original recording can be accessed via The strength of the US dollar relative to other currencies over the past year has heightened investor awareness of currency effects. Currency fluctuations are an important consideration for global investors in both fixed income and equity investments and can have a profound effect on investors portfolios. In this paper, we present important factors about foreign exchange, the main drivers of currencies, and the effect of currency movements on both fixed income and equities. Global foreign exchange markets are deep, as daily turnover exceeds $5.3 trillion. These massive flows add complexity to currency markets and can often overwhelm fundamental conditions. Over the past five to ten years, changes have been occurring in currency market share, with the euro, Swiss franc, and Canadian dollar losing some significance while the Japanese yen, Australian dollar, and New Zealand dollar gained a more prominent role in the world s foreign exchange market. Importantly, the Mexican peso and Chinese renminbi are now on the list of top ten most actively traded currencies as China is vying for reserve currency status. Today, global foreign-exchange trading is more fragmented than in the past with a slowdown in top inter-bank dealing (due to increased regulation after the global financial crisis), as institutional investors, hedge funds, and high-frequency trading firms become the main drivers of growth. Exhibit 1 lists some additional important facts about the evolving currency market.

2 2 Exhibit 1 Important Facts about Foreign Exchange Daily turnover in the currency markets exceeds $5.3 trillion ($1.5 trillion in 1998). Cross border transactions represent 58% of foreign exchange activity. The United Kingdom, because of its location/time zone, is still the most active trading center in the world with 41% market share (United States is second with 19%). In terms of global reserves, approximately 63% are held in US dollars which is high but down from 71% in Japanese individual day traders account for 2% to 3% of Tokyo spot market turnover. Over 5% of global foreign-exchange activity is driven by algorithmic trading. As of 31 December 214 Sources: Bank for International Settlements (BIS), Euromoney, Financial Times, Bloomberg, Bank of England Drivers of Foreign-Exchange Rates The main drivers of exchange rates include fundamental factors, technical factors, and flows. Two of the most important fundamental drivers are interest rate and growth differentials which can influence currency direction and valuations. For instance, the Canadian dollar versus the US dollar is closely correlated to the short-term interest rate differential between Canada and the United States (Exhibit 2). In addition, other important fundamental factors include the balance of payments, inflation, and the mix of government policy tools a combination of fiscal, monetary, and foreign-exchange policies. Technical factors are another important driver of currency valuations, which may become self-fulfilling and often override fundamentals for extended periods. Exhibit 3 illustrates two typical technical factors, moving averages and the relative strength index, which provide different signals. The moving averages indicator may suggest a currency is changing direction, while the relative strength index may indicate a currency is oversold or overbought. Both of these metrics are closely watched by currency analysts. Furthermore, option activity and strike levels are often positioned around these technical levels. It is important to evaluate these technical signals in the context of other asset classes, such as commodities and equities. Flows are a key part of foreign-exchange analysis, especially for smaller markets including emerging and frontier markets. Equity market flows are an important consideration due to their magnitude and because there is generally less hedging involved in this asset class. Exhibit 4 shows the similarity between spot currency movements of the Mexican peso versus the positioning of the Mexican peso on the futures market. As currencies weaken, the number of net long minus short future contracts (a proxy for flows) typically decline. For instance, during late 213 through the beginning of 215 the Mexican peso was sharply weakening at the same time the flows were decreasing in the Mexican peso futures exchange. Exhibit 2 Interest Rate and Foreign Exchange Differentials Move in Similar Patterns CAD/USD [RHS, inverted scale] Canada-US, 2-Year Government Bond Yield Differential [LHS] CAD per USD Exhibit 3 Technical Factors Often Override Fundamentals for Extended Periods Moving Averages (MA) USD per EUR USD/EUR MA (55) MA (1) MA (2) Relative Strength Index (RSI) RSI (3) 1 Overbought Oversold Numbers in parenthesis for moving averages and RSI indicate number of days

3 3 Exhibit 4 Flows Can Substantially Influence Exchange Rates (contracts, thousands) 2 1 MXN/USD [RHS, inverted] Weaker Mexican Peso MXN per USD Exhibit 5 The Effect of Currency on Global Fixed Income Performance Is Volatile, and Cancels Out over Time Rolling One-Year Performance, Unhedged minus Hedged 12 6 Global Fixed Income, Unhedged minus Hedged MXN Futures Net Longs Decline in net minus Shorts [LHS] long minus short futures contracts As of 1 May 215 Views on the US Dollar For the past few years, the US dollar has been supported by better growth prospects and monetary policy differentials relative to other countries. However, we believe the potential for a US Federal Reserve interest rate hike this year is largely priced in. The euro zone and even Japan are now catching up to the United States, in terms of their growth and inflation outlook, and have been helped by the tailwinds of lower energy prices, extensive monetary and fiscal stimulus, and weaker currencies. These factors are starting to weigh on US dollar strength. The landscape for currency valuation and volatility is diverse in this current environment. From a fundamental standpoint, certain regions are improving, but there are still some countries, such as Turkey, South Africa, and Brazil, that are under pressure. Currency markets are famous for overshooting in both directions, but it appears that, based on current fundamentals, technical positioning, and flows, many currencies have reached an inflection point. For the remainder of 215, while there will definitely be more currency volatility, we are also likely to see a reversion to the mean. Select commodity-linked currencies, such as the Norwegian krone, Australian dollar, and Canadian dollar are trading stronger, in concert with the bounce off the low of oil, energy, and other commodity prices. We are also monitoring certain countries, such as the United Kingdom, New Zealand, Chile, and Mexico, whose central banks may be very close behind the Fed in terms of raising rates over the coming year. Generally, such an increase in rates will support their currencies. The Effect of Currencies on Bonds It is important to understand currencies effect on bond returns. Exhibit 5 shows the difference between unhedged and hedged returns for the Barclays Capital Global Aggregate Bond Index. The main point is that currency cycles change and strong US dollar cycles are not permanent. Hence, the recent US dollar strength may be a Average good opportunity for select currency exposure in the future. Over two decades, performance leadership has frequently shifted from unhedged to hedged based on one-year rolling returns. 1 Although currency exposure may be volatile relative to bonds, we believe it should be considered an additional tool to diversify a portfolio and potentially enhance returns through positioning, either opportunistically or defensively. How to Think About Currencies in Equities Data are based on the Barclays Capital Global Aggregate Bond Index, unhedged and USD hedged versions. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The indices above are unmanaged and have no fees. It is not possible to invest directly in an index. Not intended to represent any product or strategy managed by Lazard. Source: Barclays, Bloomberg Since the summer of 214, US dollar strength has significantly impacted equity investing. Over long periods of time, currency movements have tended to wash, but for nearly a year, dollar strength has been an important theme for equity investors. We have seen very significant shifts in the euro and yen relative to the US dollar as well as changes in the US dollar relative to most emerging markets currencies. Investors are concerned about how these currency moves may affect their portfolios. We will frame our discussion in terms of two principal effects of currency moves in non-us equity portfolios. One involves the effect of foreign operations in the income statement of individual companies and the other is related to how currency affects the returns of a portfolio composed of foreign currency stocks. While investors are ultimately interested in the return in their home currency, it is also important to understand that the underlying stocks within a portfolio are affected by currency movements in specific ways. Cross-border operations are prevalent in global companies and management teams may or may not engage in currency hedging, depending on the geographic source of revenues and costs.

4 4 Exhibit 6 Cross-Border Operations and Company Results Hypothetical European Company with Activity in the United States Assumptions (thousands)* Year 1 Year 2 US revenue $1, $1, European Revenue 1, 1, Exchange Rate USD/EUR Total Revenue 1,741 1,99 Interest 5 5 Tax Rate 3 3 Shares Outstanding 5 5 Scenarios Scenario A Scenario B (thousands)* Year 1 Year 2 Year 1 Year 2 US Operating Costs $75 $75 European Operating Costs 1,5 1, Total Operating Costs 1,5 1,5 1,36 1,432 Net Income EPS EPS Growth *Except exchange rates, EPS, or where indicated otherwise. This information is for illustrative purposes only. First let s look at what could be the effect of a change in currency on corporate profits and the income statement of a company. It is important to keep in mind that this example is very basic and most multinational companies could have multiple hedging programs in place and often attempt to match their regional sources of revenue with a more local cost structure. Exhibit 6 analyzes two scenarios for a corporate income statement and the impact a change in currency has to its earnings. Our assumptions examine a European company reporting earnings in euros over two years. This is a hypothetical multinational company that generates $1 million in revenue from the United States and 1 million in revenue from Europe. The revenue is the same in both years. During year 1, the exchange rate is 1.35 dollars per euro and in year 2, that exchange rate is 1.1 dollars per euro. In scenario A, all costs are in euros; that is, the company s physical plants and labor are in euros. In scenario B, those same costs and revenues are split evenly between the United States and Europe. In scenario A, the company experienced a significant benefit to its earnings growth, as there were no currency effects on costs. By contrast, in scenario B the stronger dollar offset the benefits of US-dollar revenue, as there was a cost component in US dollars in this instance. Without knowing how a company hedges or whether or not costs are matched with revenues around the globe, the currency move we have seen over the past nine months appears to have improved earnings for European companies. This effect is illustrated in Exhibit 7. The left-hand axis shows the ratio (upgrades to downgrades) of euro zone earnings estimates to those in the United States. As the line moves up, European consensus estimates are improving faster than those in the United States. The right-hand axis is inverted and represents the euro/dollar exchange rate. As this line moves up, the US dollar is appreciating relative to the euro. Over the last nine months, there has been a pronounced improvement in European companies earnings revisions. Importantly, while investors may or may not judge these currency moves as impactful to the valuation they are willing to pay for a company, the fact remains that, if everything else remains static (and we understand that nothing is ever static in investing), a stronger US dollar should benefit European corporate profits. Exhibit 7 Foreign Exchange Can Influence Earnings Revisions Ratio of EPS Revisions and Exchange Rate Euro Zone vs US EPS Revisions, 3-Month Moving Average (Ex-Energy and Financials) [LHS] USD per EUR 1.5 USD/EUR, 3-Month Moving Average [RHS, inverted scale] As of 22 April 215 Data are based on MSCI country/region indices. EPS revision ratio is defined as the number of EPS upgrades to downgrades based on IBES data. Source: MSCI, J.P. Morgan Exhibit 8 Currency Fluctuations Can Have a Significant Effect on Foreign Holdings Hypothetical European Stock Investment Local Stock Currency: EUR; Investor Home Currency: USD Year 1 Year 2 Amount Invested $1, Stock Price 5 6 Local Return 2% Exchange Rate USD/EUR Shares Owned Ending Investment $1, $9,778 Actual Return -2% This information is for illustrative purposes only.

5 5 Exhibit 9 The Effect of Currency on Non-US Equity Performance Is Volatile, and Cancels Out over Time Rolling One-Year Performance, USD minus Local Exhibit 1 Currencies Have Periods of Strength and Weakness Relative to the US Dollar Calendar Year Spot Currency Returns Relative to USD 2 1 MSCI EAFE Index, USD minus Local Average April 215 CAD GBP CAD JPY AUD JPY JPY GBP EUR GBP CHF AUD EUR AUD CHF CAD AUD AUD CAD CHF AUD JPY GBP CHF EUR EUR GBP CHF CHF CHF GBP CAD GBP MSCI indices are total return, gross. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The indices listed above are unmanaged and have no fees. It is not possible to invest directly in an index. Not intended to represent any product or strategy managed by Lazard. Source: MSCI, FactSet, Lazard The second effect of currencies on equity investing is dependent upon an investor s base currency. We illustrate this in Exhibit 8 with a simple example of a US investor who owns European stocks directly movements in the euro/dollar exchange rate will affect returns, both positively and negatively. The conclusion from Exhibit 8 is that despite a healthy return in local currency terms for the stock (+2%), the exchange rate effect turned this into unfavorable results in the investor s home currency (-2%). This dynamic is effectively what happened last year. In 214, the strength of the US dollar took over 1% from the MSCI EAFE Index local currency returns, which were positive in local terms (Exhibit 9). An important takeaway from this exhibit is that US dollar strength has ebbed and flowed dramatically over the past two decades and while the move we have seen over the past year has been more severe than those experienced over the past twenty years, recent economic news has been favorable for Europe relative to consensus, which has helped the euro improve from its March low. EUR AUD CHF CAD CHF CAD GBP AUD CAD CHF AUD JPY CAD JPY AUD EUR GBP CAD EUR AUD EUR CAD CHF JPY GBP GBP JPY EUR EUR JPY JPY JPY EUR AUD CAD CHF EUR GBP JPY The performance quoted represents past performance. Past performance is not a reliable indicator of future results. Not intended to represent any product or strategy managed by Lazard. Conclusion The drivers of currencies include fundamental factors, technical factors, and flows. The strength of the US dollar relative to other currencies over the past year has heightened investor awareness of currency effects, and it is important to consider the sustainability of this trend in light of the underlying drivers. While currency volatility is an important consideration in both fixed income and equity investments, because equities are inherently more volatile on their own, the additional volatility created by currencies typically has a larger effect on fixed income investments. The effect on equity investments can be seen through the lens of a company s income statements as well as the return of a currency in the home country where the investment was made. Clearly, there are many different ways currencies can affect the returns of both fixed income and equity investments and a decision to hedge or not to hedge these investments should take into account multiple factors. Finally, it is important to note that non-us equity investing typically involves more currencies than just the US dollar and euro. We examined a basket of developed markets currencies over the past ten years, and found that there have been no calendar years when the US dollar has appreciated relative to all other major currencies, except in 214 (Exhibit 1). Clearly, currencies fluctuate just like other asset classes. Each currency has periods of strength and weakness relative to the US dollar. Last year, 214, was different, which is frankly why there has been so much attention on the topic. However, for those investors who were unhedged in 214 it does not appear, in our view, that now would be a favorable time to start implementing currency hedges.

6 6 Notes 1 In the presentation accompanying this paper, we evaluated three-year rolling returns since That analysis smoothed some the performance fluctuation between unhedged and hedged, and showed that the unhedged version outperformed in 58% of the monthly observations. In this paper, we shortened the data series to conform to a two decade period and used a shorter rolling window (one year). Important Information Published on 4 June 215. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of 27 May 215 and are subject to change. The securities and/or information referenced should not be considered a recommendation or solicitation to purchase or sell these securities. It should not be assumed that any of the referenced securities were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond s maturity, the greater the impact a change in interest rates can have on its price. 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Forward currency contracts, and other derivatives investments are subject to the risk of default by the counterparty, can be illiquid and are subject to many of the risks of, and can be highly sensitive to changes in the value of, the related currency or other reference asset. As such, a small investment could have a potentially large impact on performance. Use of derivatives transactions, even if entered into for hedging purposes, may cause losses greater than if an account had not engaged in such transactions. Investments in global currencies are subject to the general risks associated with fixed income investing, such as interest rate risk, as well as the risks associated with non-domestic investments, which include, but are not limited to, currency fluctuation, devaluation, and confiscatory taxation. 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