ETF Securities Currency Research:

Martin Arnold Director – FX & Macro Strategist Josh Tiwana Associate - Product Specialist [email protected]

12th February 2016

ETF Securities Currency Research: Investors need to know about currency volatility Summary 

Investing internationally requires more careful analysis, with currency risks adding to potential investment pitfalls.



Currency returns have recently demonstrated that they can overwhelm movements in foreign assets both on the upside and downside.

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Current macro trends should see FX volatility persist in 2016 keeping currency hedging high on the agenda for international investors.

volatility of currency returns on a month to month basis. This volatility and the resulting magnitude of movements in the currency markets have made the topic of currency hedging a key investment theme of 2015. Currency outweighs asset returns 10% 8%

MSCI US Local Returns (USD) Currency returns

6% 4% 2%

Investing should be a conscious decision by individuals. However, there is a critical part of the investment decision that many investors in foreign assets are not taking into account: currency movements. Most investors trade currencies, but often it is not an active decision. Regardless of the asset class, if an investor is purchasing offshore assets, a currency transaction is being entered into and if this is not taken into account, risk is being understated. Any offshore investment involves a currency position, unless it is offset by hedging. Whether it is US or emerging market equities, commodities or bonds, any investment that is a denominated in a foreign currency for the investor will involve a currency exposure. It is important for investors to be fully aware of the currency exposures within their portfolio, as it can have a significant impact on investment returns. As seen in the following chart, the currency component of US equity returns has been significant and varied. The example highlights the returns from a US equity portfolio in 2015, from the perspective of a UK investor. An investment in the MSCI US index would have returned nearly 5% over the course of 2015, largely due to favourable currency movements. The US Dollar strengthened nearly 6% against the British Pound in 2015, offsetting the -0.75% decline in the underlying US equity benchmark. Although overall the currency movements in GBP/USD and EUR/USD have been favourable, because of the broad based strength in the US Dollar in 2015, there has been significant

0% -2% -4% -6%

-8% Jan 2015

Mar 2015

May 2015

Jul 2015

Sep 2015

Nov 2015

Source: ETF Securities, Bloomberg

Peak US Dollar and hedging The Fed’s rhetoric indicates that the central bank is likely to continue its gradual rate hike path in 2016. The market continues to discount the appetite for the Fed to raise rates, expecting just one rate hike by year-end. In turn, near-term strength could turn into longer-term weakness for the dollar. Fed vs. the Market Monthly data in %, from 12/31/2003 to 12/31/2016 8

Fed Funds Rate Fed Projected Fed Funds Rate

6

Rate in %

Currencies impact investors

Market Expectations

4

2

0 2003

2005

2006

2008

2009

2011 Dates

2012

2014

2015

2017

Source: ETF Securities, Bloomberg

Indeed, if, as we believe, the USD peaks by end-Q1 2016, investors will need to be closely attuned to the level of currency

Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.

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ETF Securities Research 2016

volatility and the potential for a falling USD to have an adverse impact on portfolio returns. Our expectation for a USD peak in coming months suggests investors in foreign assets should look to hedge foreign currency (particularly USD exposures).

Volatility to continue to impact returns While currency volatility has softened in early 2016, it remains elevated from a historical perspective. During the remainder of 2016 a number of factors look set to keep FX markets unsettled. Thus, international asset managers need to remain conscious of inherent currency risks they may assume through offshore assets, because currency movements are rarely neutral.

Currency volatility softens

publicised slump in commodity prices has been a contributing factor to the current elevated level of currency volatility and looks set to remain a catalyst for further currency gyrations in the year ahead. Commodity prices can impact currencies through inflation dynamics. In particular, the current low price of energy is depressing inflation expectations and is making the future path of global monetary policy less predictable. Central bank activism has been a key driver of currency market movements and the prospect of increasingly uncertain monetary policy is likely to keep currency volatility raised. Energy depresses global inflation metrics 6

US CPI, YoY % (LHS) Euro Area Inflation, YoY % (LHS)

5

80

UK CPI, YoY % (LHS) US Crude Oil, YoY % (RHS)

66 52

4

17

38

EUR Volatility

24

3

GBP Volatility

14

10

JPY Volatility

2

USD Volatility

11

-18

1

8

-32 0

5

-46

-1 Mar-10

Jan-2016

Oct-2015

Jul-2015

Apr-2015

Jan-2015

Oct-2014

Jul-2014

Apr-2014

Jan-2014

2

Source: Bloomberg, ETF Securities

Commodity feedback loop for FX volatility As an asset class, commodities are unique for non-US investors: the investable universe is denominated in US Dollars and therefore should be considered by any non-USD denominated investors as a foreign asset with inherent currency risk. The majority of commodity investors situated outside of the US are therefore directly exposed to currency fluctuations. Unless a commodity investment is hedged, movements in the exchange rate between the US Dollar and the investor’s own domestic currency, directly impact the returns from commodity investments. For example, in 2015 the price of gold fell by 10.5%, but for European investors this loss was limited to 0.3%, due to the 10.2% appreciation of the US Dollar against the Euro over the same period.

115 110 105 100

90 85

Apr 15

Source: Bloom berg, ETF Securities

Mar-12

Nov-12

Jul-13

Mar-14

Nov-14

Jul-15

Source: Bloomberg, ETF Securities

In addition, falling commodity prices have damaged the terms of trade for commodity exporters globally and the impact is unlikely to be short-lived. Reduced investment and job losses in resource sectors worldwide will continue to filter through to economic performance throughout 2016 and create instability for currencies underpinning exporting nations.

EM and the demand for safe-havens Return during S&P 500 worst 20%

3%

Monthly Data, From November 30, 2005 to December 31, 2015

2%

1% 0% -1%

considered a safe haven, such as the CHF and JPY. Investors with exposure to safe haven currencies or EM currencies directly should be aware of the effects that a short term crisis of confidence can have on these currency markets.

95

Gold, US$/Oz

Jul-11

-2%

120

80 Dec 14

-60 Nov-10

14/12/2015 15/12/2015 16/12/2015 17/12/2015 -3% 18/12/2015 NOK SEK GBP CHF JPY 21/12/2015 Source: Bloomberg, ETF Securities. All currencies against the USD. 22/12/2015 23/12/2015 24/12/2015 Uncertainty surrounding China and lapses in confidence can 25/12/2015 28/12/2015 cause sharp appreciation of currencies that are traditionally 29/12/2015

Commodities provide currency exposure

Perform ance, %

-4

Gold, €/Oz Aug 15

Dec 15

While currency movements can impact commodity returns, the two asset classes also have other linkages. The highly

These factors have potential to maintain currency volatility at elevated levels throughout 2016 and should give investors pause for thought regarding the source of investment returns for foreign assets in the year to come.

Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.

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ETF Securities Research 2016

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