Investing in the Currencies of STRONG Nations

Transcription

1 Whitepaper Investing in the Currencies of STRONG Nations We live in a period of historical transition, an age when global dominance by the historic great powers is giving way to something new. This transition of power not only impacts geopolitics and economics, but that ultimate indicator of the power of nations the strength of a nation s currency. There was a time when the strongest currencies in the world were uniformly acknowledged to be the US Dollar, the British Pound, and the Japanese Yen. Such a list would even have included the mighty German Deutsche Mark. After the birth of the Euro, the Mark, one of the most venerable names in currency history, was struck from the list. As for the Swiss Franc? The decision by the Swiss National Bank to intervene in currency markets last year, which drove down the value of the Swiss Franc by nearly 25% in a handful of trading sessions, reduced its usefulness as a tool for protecting investor capital. This decision to intervene may have helped s export economy, but it hurt investors seeking a haven from currency volatility. Safeguarding capital and currency purchasing power from the unknown consequences of experimental central bank policies is of paramount importance to today s investors, but what can be done? In the aftermath of the financial crisis, determining which currencies will hold their value for the longer term, and which will fall, is harder than ever. The traditional approaches to currency investing do not seem comprehensive enough to address today s challenges. For example, interest rate parity and purchasing power parity are useful constructs, but they do not offer the guidance needed today to help us more fully determine relative currency strength. What process can we use to separate winners from losers in the pursuit of currency diversification? First, we have to begin with an appropriate solution set. For us, nations that enjoy some level of affiliation with the Organization of Economic Cooperation and Development (OECD) are the best starting point. OECD nations account for 8% of world trade and investment. Most importantly, OECD nations must meet certain standards for the reporting of economic data, the cornerstone of fundamental analysis. Using this fundamental analysis, as well as other metrics that we believe reflect the strength of nations, can help us determine which currencies should be in a STRONG nations currency portfolio. The table on the following page (table 1) shows some of the OECD nations and how they are traditionally categorized as developed or emerging nations. Our goal is to break down the silos createdbythislanguageandinvestinthecurrenciesofstrong nations regardless of the column in which their names appear. Properly identifying currencies that may help investors during this period of historical transition will require an outlook that is longer-term and an investment process that rests securely on fundamental analysis. Our research indicates that those nations that will likely succeed in the years ahead share these common characteristics: S ustainable fiscal policies that reduce the probability of financial crisis T ransparent, reliable, readily accessible economic data R egulatory systems that support, rather than constrict or distort, economic growth O pen societies where free markets are becoming more dominant, and currency rates are set by market forces N ational fundamentals that reflect prudent fiscal management G overnment that is more democratic, where the rule of law and property rights are secured If we accept that the concepts above can help us identify currencies that will hold their value better than their peers, particularly during a time when fears of currency debasement by the major powers is a genuine concern, then we can design an investment process to help us navigate these times. First, let s place these fundamental ideas in the context of the most basic of investment concepts: the law of supply and demand and its impact on price.

2 Table 1: Developed or Emerging Nations Developed Australia Canada Denmark Eurozone** Hungary Iceland Israel Japan New Zealand Norway Singapore South Korea Sweden United Kingdom United States Emerging Brazil EE Chile China EE Czech Republic India EE Indonesia EE Mexico Poland Russian Federation D South Africa EE Taiwan O Turkey Source: OECD *Affiliation can include members, those engaged in discussions to become members (D), those with enhanced engagement (EE), or nations with observer status (O). **Eurozone nations are evaluated as a unit, with qualitative and quantitative balance sheet statistics aggregated. If our process directs us to a Euro allocation, the individual nation of the Eurozone with the strongest balance sheet would be selected; which has historically been Germany. Chart 2: Total Value of Central Bank Reserves by Currency 6 5 $Trillions USD GBP JPY EUR Other Allocated Reserves %USD Source: COFER Chart 3: Share of Reserves vs. Global GDP (US, GBP, JPY, EU) % 8% 6% 4% 2% % % Of Total Allocated Reserves % Global GDP Source: COFER 76% 73% 7% 67% 64% 61% 58% USD% of Total Reserves The chart above right (chart 2) shows the total value of central bank reserves broken down by currency. As can readily be seen, the amount allocated to the US Dollar, the Euro, the British Pound, and the Japanese Yen is far in excess of these nations share of world gross domestic product. While there is no iron clad law that demands central banks hold reserves in such an economically reasonable fashion, this comparison illustrates that material distortions exist in central bank currency reserve portfolios and these will likely need to be corrected over time. In fact, we have already seen central banks begin to diversify their reserves away from the major currencies. Chart 3 above right shows how the percentage of reserves allocated to the major currencies has already begun to fall. It seems reasonable that central bank reserve diversification away from certain major currencies will put longer-term downward pressure on their values and upward pressure on other currencies. But, which currencies will benefit from these flows? Furthermore, is this a short term investment theme or a long-term one? The Bank for International Settlements, also known as the central banker to the central banks, tracks trading in global currencies. Table 4 to the right shows the share of foreign currency market turnover held by the G3 currencies (U.S. dollar, Japanese yen, Euro). Table 4: Foreign Currency Market Trading: % Total Turnover Currency US dollar 45.5% 44.5% 43.4% 42.9% Euro 19.2% 18.9% 18.7% 19.8% Japanese yen 11.9% 1.5% 8.7% 9.6% 76.6% 73.9% 7.8% 72.3% Pound sterling 6.6% 8.3% 7.5% 6.5% Australian dollar 2.2% 3.% 3.3% 3.8% Swiss franc 3.% 3.% 3.4% 3.2% Canadian dollar 2.3% 2.1% 2.2% 2.7% Hong Kong dollar 1.1%.9% 1.4% 1.2% Swedish krona 1.3% 1.1% 1.4% 1.1% New Zealand dollar.3%.6% 1.%.8% Korean won.4%.6%.6%.8% Singapore dollar.6%.5%.6%.7% Norwegian krone.8%.7% 1.1%.7% Mexican peso.4%.6%.7%.7% Indian rupee.1%.2%.4%.5% Russian rouble.2%.3%.4%.5% Polish zloty.3%.2%.4%.4% Turkish new lira.%.1%.1%.4% Brazilian real.3%.2%.2%.4% New Taiwan dollar.2%.2%.2%.3% Chinese renminbi.%.1%.3%.2% Other currencies 3.5% 3.6% 4.2% 3.1% 23.3% 26.1% 29.2% 27.7% Source: COFER 2

3 It should be clear that currency trading volume drops sharply beyond the G3, and even a cursory review of the remaining members of a possible solution set suggests that it could take many years for central banks to effectively diversify their currency reserves more broadly without causing sharp distortions in the pricing of currencies. Another conclusion that can be drawn from this data is that there are likely to be longterm, sustained flows out of the G3. The currencies that are the beneficiaries of this reserve reallocation will have a long-term bid that will likely help sustain their value over the longer-term. Surely central banks, like investors, will prefer currencies whose governments practice sound policies over those that do not. The key question is: how can we identify them? Fundamental analysis is a cornerstone of our framework and we believe that currencies associated with countries that practice prudent fiscal management are more likely to appreciate against the dollar during periods of dollar weakness. For example, we believe that countries with stable to falling debt to Gross Domestic Product (GDP) ratios tend to correlate with positive currency performance vs. the dollar. To highlight this thesis, the chart to the right (chart 5) shows the cumulative return of various currencies for the period 2-21 and the change in each nation s Debt to GDP ratio over the period. Perhaps not surprising, nations with stable to falling Debt to GDP ratios achieved healthy currency returns vs. the dollar. While it is true that all historical analysis by definition is backward looking, we believe it is informative none the less. When we consider that a significant portion of this period was dominated by financial crisis, it is particularly notable that certain countries were actually able to improve their fiscal position and currency markets rewarded this. Debt-to-GDP is just one ratio that we consider, but it is a telling one. Though fiscal position matters, it is not the only indicator that helps determine the strength of nations. Economic freedom is among the most important as well. It is our thesis that countries with more economic freedom have proclivity for stronger currency performance vs. the dollar. In this context, freedom has a specific set of meanings: freedom from over-taxation and over regulation, micro-economic Chart 5: Currency Return (21-211) vs. Debt to GDP Cumulative Currency Return (%) % Canada, 46.7% Sweden, 36.8% Chile, 1.5% Australia, 82.7% New Zealand, 75.2% Korea, 9.% Norway, 47.4% Germany, 37.5% United Kingdom, 4.1% U.S. Mexico, -31.% Brazil, 4.6% Singapore, Change in Debt to GDP Chart 6: Currency Return (21-211) vs. Index of Economic Freedom by the Heritage Foundation Cumulative Currency Return (%) Lower Debt to GDP (better) Source: IMF as of 12/31/11 New Zealand, 75.2% Japan, 48.7% Australia, 82.7% 33.8% Germany, Sweden, 37.5% 36.8% United Kingdom, 4.1% U.S. South Africa, -6.3% Korea, 9.% Norway, 47.4% Chile, 1.5% Indonesia, 6.3% 71.5% India, -12.1% Canada, 46.7% Mexico, -31.% Less Freedom (worse) Change in Index of Economic Freedom Source: Heritage Foundation as of 12/31/11 Past performance is not a guarantee of future results. Higher Debt to GDP (worse) More Freedom (better) 3

4 dynamics where free market forces dominate, and national leaders who allow those forces to influence policy. Of course, markets do not care about absolutes, they care about change. In the matter of economic freedom, this is particularly true. The chart on the previous page (chart 6) examines this issue by contrasting the cumulative returns of some of the currencies in our solution set, with the change over the study period that occurred in each nation s Index of Economic Freedom as measured by the Heritage Foundation. As the chart shows, generally speaking, those nations that performed particularly well also experienced increased freedom during the study period. Regulatory quality is an important cornerstone of our STRONG currency thesis. For us, a well regulated economy is ruled by law, its regulators promote growth and efficiency and not red tape. Countries with stronger regulatory systems have tended towards better currency returns vs. the dollar. The World Bank has invested considerable intellectual resources in developing an index series that directly measures Chart 7: Currency Return (21-211) vs. World Bank WGI Cumulative Currency Return (%) Brazil, 4.6% 71.5% Singapore, 33.8% United Kingdom, 4.1% Japan, 48.7% India, -12.1% U.S. Indonesia, 6.3% Australia, 82.7% New Zealand, 75.2% Canada, 46.7% Germany, 37.5% Chile, 1.5% South Africa, -6.3% Norway, 47.4% Sweden, 36.8% Korea, 9.% Mexico, -31.% Change in World Bank WGI Less Regulation (worse) More Regulation (better) Source: World Bank as of 12/31/11 Past performance is not a guarantee of future results. these ideas and it is called appropriately, the World Bank World Governance Indicators. To explore this issue, we contrast the cumulative currency returns of nations in our solution set, with the change in their score on the World Bank Governance Indicators over the period (chart 7). Generally, a nation s currency was likely to perform better if it experienced an improvement in its index score. In short, a country that enjoyed an improved regulatory and governance regime was more likely to have better currency returns during a period of dollar weakness. The investment process we have outlined above is intermediate to long-term by nature and so we believe the appropriate portfolio management style should reflect those qualities. While many investors in currency markets are hedge funds or dealer desks with short-term trading cycles, our goal is to stay focused on long-term metrics and longterm objectives, changing the currencies in our portfolio only Table 8: Gold Reserves (Million Troy Oz) when material events cause a reappraisal. Just as one would Jun-2 Jun-7 Jun-12 not expect the strength of nations to change on a day to day World 1, ,8. basis, so our portfolio structure will evolve gradually over United States Venezuela time, rather than experiencing sharp readjustments. In our Eurozone Germany France view, this outlook towards investing allows us to look beyond many of the vagaries that can cause investors to overreact to short-term events. Italy Netherlands Britain Japan China Gold Spot $ $ $1, Source: Bloomberg Using this long-term process and portfolio management style, we believe our approach provides investors with a conservative tool to gain exposure to currency markets. While some investors may select gold as their exclusive tool to protect their portfolios from currency debasement, gold can be extremely volatile and generate significant losses as measured by drawdown. Yet, investors choose gold for 4

5 reasons that are rooted in history and indeed have validity in the context of currency discussions. Gold, of course, has played a historic role as a currency itself, and there have been notable periods when currencies have been linked to gold. To the extent one needed convincing on this subject, the table on the previous page (table 8) shows the gold holdings of some of the major central banks of the world. Central banks hold significant reserves in gold. Indeed, gold has its purpose as a store of value, but by itself its level of risk as measured by volatility is considerable. Although gold could be considered a STRONG currency from a certain perspective, our intention is to use gold sparingly as a portfolio diversifier, and as an insurance policy against extreme currency debasement policies. When we look at the graphs below (tables 9 and chart 1) showing the returns, volatility, and drawdown of select currencies in our solution set, compared with gold, it becomes clear that it is possible to construct a balanced currency portfolio that provides some of the protective value of gold, but with better risk characteristics a better gold bar for conservative investors. Table 9: Monthly Statistics (1/31/2 1/31/12) Chart 1: Growth of $ (1/31/2 1/31/12) Ann. Ann. Std Min Mo. Max 6 Return Deviation Return Drawdown 55 CAD CHF SEK NOK AUD NZD SGD TWD KRW GOLD Eq Wtd Avg Source: Bloomberg Past performance is not a guarantee of future results. Oct-2 Apr-3 Oct-3 Apr-4 Oct-4 Apr-5 Oct-5 Apr-6 Oct-6 Apr-7 Oct-7 Apr-8 Oct-8 Apr-9 Oct-9 Apr-1 Oct-1 Apr-11 Oct-11 Apr-12 CAD EUR CHF SEK NOK AUD NZD SGD TWD KRW GOLD There is little doubt that the years ahead will likely witness a protracted transformation in the world s balance of economic power, and that currency relationships will realign accordingly. The Samson STRONG Nations Currency Fund, and the investment ideas outlined in this paper, will seek to navigate those long-term trends with an appropriately longer term investment process. Through this effort, we will seek to provide investors with a currency strategy that helps them to achieve currency diversification with an emphasis on nations that are conservatively managed from a fiscal view, well managed from a regulatory perspective, and experiencing greater freedom and respect for liberty from the perspective of their citizens. Fund Portfolio Managers Jonathan Lewis Managing Principal Chief Investment Officer Iraj Kani, PhD Principal Quantitative Strategist 5

6 The fund's investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus contains this and other important information about the investment company and it may be obtained at or by calling SCA-FNDS. Read it carefully before investing. Past performance is not a guarantee of future results. One cannot invest directly in an index. Index performance is not indicative of fund performance. The fund is new. To obtain performance when available, please visit or call SCA-FNDS. Mutual fund investing involves risk. Principal loss is possible. The Fund invests in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks are greater for investments in emerging markets. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. The Fund is non-diversified, meaning it may concentrate its assets in fewer individual holdings or geographical areas than a diversified fund. Therefore, the Fund is more exposed to individual stock volatility than a diversified fund. The fund may also invest in gold, which involves additional risks, such as the possibility for substantial price fluctuations over a short period of time. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management, and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. The fund may make short sales of securities, which involves the risk that losses may exceed the original amount invested. Diversification does not assure a profit or protect against a loss in a declining market. The is distributed by QuasarDistributors, LLC. Samson Capital Advisors LLC is the advisor to the. 6