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Content

1. Benchmarks: Basics
2. Currencies (FOREX)
3. Inflation

Benchmarks: Basics

In most cases, investors choose a market index, or combination of indexes, to serve as the portfolio benchmark. An index tracks the performance of a broad asset class, such as all listed stocks, or a narrower slice of the market, such as technology company stocks. Because indexes track returns on a buy-and-hold basis and make no attempt to determine which securities are the most attractive, they represent a “passive” investment approach and can provide a good benchmark against which to compare the performance of a portfolio that is actively managed. Using an index, it is possible to see how much value an active manager adds and from where, or through what investments, that value comes.

These are among the most widely followed stock indexes, or benchmarks:

Fixed income securities do not trade on open exchanges, and bond prices are therefore less transparent. As a result, the most commonly used indexes are those created by large broker-dealers that buy and sell bonds, including Barclays Capital (which now also manages the indexes originally created by Lehman Brothers), Citigroup, J.P. Morgan, and BofA Merrill Lynch. Widely known indexes include the Barclays U.S. Aggregate Bond Index, tracking the largest bond issuers in the U.S., and the Barclays Global Aggregate Bond Index of the largest bond issuers globally.

Actually, bond firms have created dozens of indexes, providing a benchmark for virtually any bond market exposure an investor might want. Barclays Capital alone publishes more than 30 different bond indexes. New indexes are often created as investor interest grows in different types of portfolios. For example, as investor demand for emerging market debt grew, J.P. Morgan created its Emerging Markets Bond Index in 1992 to provide a benchmark for emerging market portfolios.

Indexes also exist for other asset classes, including real estate and commodities, and these may be of particular interest to investors concerned about inflation. A couple of examples are the Dow Jones U.S. Select Real Estate Investment Trust (REIT) Index and the Dow Jones-UBS Commodity Index.

Index Methodologies: Market Capitalization and Alternatives

The major index providers use specific, predetermined criteria, such as size and credit ratings, to determine which securities are included in a particular index. Index methodologies, returns and other statistics are usually available through the index publisher’s website or through news services such as Bloomberg or Reuters.

Instead of averaging stock or bond prices, indexes typically weight each component; the most common weighting is based on market capitalization. Companies with more equity or debt outstanding receive higher weightings and therefore have greater influence on index performance. Big price swings in the stocks or bonds of the largest companies can create big price movements in an index.

To reduce the volatility that may result with market cap weighting and potentially improve performance, alternative indexing methodologies have emerged in recent years. Among these, fundamental indexing, developed by PIMCO subadviser Rob Arnott and Research Affiliates, selects and weights components using fundamentals such as sales, cash flow, book value and dividends.

Bond indexes using market cap weighting can have a troubling twist: The most influential components may also have the biggest debt loads, which can be a sign of deteriorating finances. In part to avoid overexposure to highly indebted countries and companies, PIMCO introduced a bond index in 2009 based on gross domestic product, called the PIMCO Global Advantage Bond Index (GLADI)TM, which attempts to identify investment opportunities in fast-growing economies. GLADI also includes more instruments than a typical bond index, such as swaps and inflation-linked bonds. Markit LLC, an independent and unaffiliated leading financial information services company and global index provider, administers and calculates the GLADI index.

Currencies: Basics

The currency market is the largest and most liquid financial market in the world. Currencies like the U.S. dollar, the euro and the yen trade in the foreign exchange (FX) market 24 hours a day, fluctuating in value relative to each other almost constantly. However, the currency market is also one of the least understood, and this chapter aims to explain the basics of currencies, the FX markets and the role of currencies in investing.

Overview of the Global Currency Markets

Currency describes the money or official means of payment in a country or region. The best-known currencies include the U.S. dollar, euro, Japanese yen, British pound and Swiss franc. Currency symbols exist for most currencies, such as $, €, ¥ or £. The foreign exchange markets, however, use ISO (International Organization for Standardization) codes to identify currencies. Some of these ISO codes are included in the chart below:

Every day, trillions of dollars in currencies change hands in a highly professional interbank market, in which electronic trading platforms link currency traders from banks across the world. FX markets are effectively open 24 hours a day thanks to global cooperation among currency traders. At the end of each business day in Asia, traders pass their open currency positions to their colleagues in Europe, who – at the end of their business day – pass their open positions to U.S. traders, who then pass positions back to Asia at the end of their business day. And the cycle begins anew. This makes FX truly global and very liquid.

What Determines Exchange Rates?

The exchange rate gives the relative value of one currency against another currency. An exchange rate GBP/USD of two, for example, indicates that one pound will buy two U.S. dollars. The U.S. dollar is the most commonly used reference currency, which means other currencies are usually quoted against the U.S. dollar.

What determines the exchange rate between currencies? The most common theory to explain the relationship between two currencies that can change in value is the purchasing power parity theory, which can be illustrated with the “Big Mac index” created by The Economistmagazine. In a perfect world, a Big Mac should have the same value everywhere in the world, regardless of the local currency. In a simplified example, assuming the exchange rate between the British pound and the U.S. dollar is two and the price of a Big Mac is £2.50 in the U.K., a Big Mac should cost $5 in the U.S. If the purchasing power of the British pound increases relative to that of the U.S. dollar, the exchange rate has to adjust so that the pound buys more dollars than previously. Otherwise, consumers will start to buy goods in the cheaper country.

A similar principle applies when looking at money itself and considering interest as the price for money. If the real return (adjusted for inflation) on a financial asset differs between two countries, investors will flock to the country with the higher returns. Interest rates have to change to stop this movement. The theory behind this relationship is called the interest rate parity theory. (When looking at interest rates, it is important to distinguish between real rates and nominal rates, with the difference reflecting the rate of inflation. The higher the expected inflation in a country, the more compensation investors will demand when investing in a particular currency.)

Who Are the Players in the FX Market?

The influence of the players in the FX market has shifted over the years. Traditionally, the most important players in the FX markets were importers and exporters of goods, trading currencies through banks. International trade was thus the primary driver of supply and demand for currencies. Trade still influences FX markets directly through commerce and indirectly through market movements that follow official international trade and investment flow data. But over time, the importance of trade has waned as financial investors have become increasingly active in FX markets.

The driving force behind this transition to a market dominated by investors was the search for profitable investment opportunities across borders. For example, a British investor buying equities in the U.S. takes on currency risk by holding shares in U.S. dollars. He may want to hedge this risk in an attempt to insulate profits from the impact of any adverse movements in the exchange rate.

In recent years, investors discovered currencies as a distinct asset class and potentially an additional source of income. Lower returns on traditional asset classes, such as equities and bonds, and a mismatch between the assets and future liabilities of pension funds led investors to seek new, uncorrelated sources of return. Currencies can offer not only diversification but also the potential for additional returns due to inefficiencies in the FX market.

Financial institutions have become the biggest players in the FX market. Interbank business accounts for about half of FX turnover, according to the Bank for International Settlements, but the greatest growth in participation comes from other financial institutions; including insurance companies, pension funds, hedge funds, asset managers and, most of all, central banks.

Approaches to Investing in Currencies

Although currencies are considered an asset class, an investor cannot simply invest in a currency. An investment requires taking a view on the value of one currency relative to another, such as the U.S. dollar relative to the euro.

Many global companies and investment management firms use the FX markets to hedge their currency exposures. Investors seeking profits through the FX markets can use different approaches to investing in currencies. Among these, the “carry trade” has made the most headlines. Also known as forward rate bias, the carry approach seeks to take advantage of different interest rate levels in two countries. In its simplest form, an investor borrows money in a low-interest rate currency and invests in a higher yielding currency, profiting from the difference in interest rates. The carry trade exposes investors to the risk that exchange rates could move adversely and unexpectedly, reducing or even eliminating the potential for profits.

The so-called fundamental approach is one of the most common approaches in the FX market. Companies and investors often analyze fundamentals, such as economic growth, economic policy and national budget deficits and surpluses, to try to identify the fair value of a currency and anticipate how the exchange rate will move. By taking direct exposure to currencies this way, investors take the risk of losing part or all of their investment if their analysis is not correct.

Currencies, the world’s oldest financial instruments, are an integral part of modern trade and investment. Today, most major currencies have free-floating exchange rates, which help boost financial stability in the increasingly global economy. Globalization in trade and services laid the foundation for the modern currency markets, but profit-seeking investors have since become the dominant force in the FX market. There are several paths to potential profits in the FX market, including the carry trade and direct exposure to currency movements. Now regarded as a distinct asset class, currencies are among the world’s most liquid and high-volume markets.

Inflation and Its Impact on Investments

Understanding inflation is crucial to investing because inflation can reduce the value of investment returns. Inflation affects all aspects of the economy, from consumer spending, business investment and employment rates to government programs, tax policies, and interest rates.

What is inflation?

Inflation is a sustained rise in overall price levels. Moderate inflation is associated with economic growth, while high inflation can signal an overheated economy.

As an economy grows, businesses and consumers spend more money on goods and services. In the growth stage of an economic cycle, demand typically outstrips the supply of goods, and producers can raise their prices. As a result, the rate of inflation increases. If economic growth accelerates very rapidly, demand grows even faster and producers raise prices continually. An upward price spiral, sometimes called “runaway inflation” or “hyperinflation,” can result.

In the U.S., the inflation syndrome is often described as “too many dollars chasing too few goods;” in other words, as spending outpaces the production of goods and services, the supply of dollars in an economy exceeds the amount needed for financial transactions. The result is that the purchasing power of a dollar declines.

In general, when economic growth begins to slow, demand eases and the supply of goods increases relative to demand. At this point, the rate of inflation usually drops. Such a period of falling inflation is known as disinflation. Disinflation can also result from a concerted effort by government and policymakers to control inflation; for example, for much of the 1990s, the U.S. enjoyed a long period of disinflation even as economic growth remained resilient. The chart below shows that inflation in the U.S. has fallen significantly since the 1980s.

When prices actually fall, deflation has taken root. Often the result of prolonged weak demand, deflation can lead to recession and even depression. The chart shows that the longest and most severe period of deflation over the past century occurred in the 1920s and in the 1930s during the Great Depression.

How is inflation measured?

When economists try to discern the rate of inflation, they generally focus on “core inflation.” Unlike the “headline,” or reported inflation, core inflation excludes food and energy prices, which are subject to sharp, short-term price swings. There are several regularly reported measures of inflation that investors can use to track inflation. In the U.S., the two most widely monitored indicators are the Producer Price Index (PPI) and the Consumer Price Index (CPI).

The PPI, previously called the wholesale price index, measures prices paid to producers, usually by retailers. Reported monthly, some three-quarters of the index measures prices of consumer goods, while capital goods prices account for the rest. The PPI picks up price trends relatively early in the inflation cycle.

The more widely followed CPI reflects retail prices of goods and services, including housing costs, transportation, and healthcare. Many private and government contracts, such as social security payments or labor contracts, are explicitly linked to changes in the CPI. The value of Treasury Inflation-Protected Securities (TIPS), a type of bond, is also contractually linked to the CPI, as discussed below.

The Gross Domestic Product Deflator (GDP Deflator) is a broad measure of inflation reflecting price changes for goods and services produced by the overall economy; it is reported quarterly in conjunction with the Gross Domestic Product.

What causes inflation?

Economists do not always agree on what spurs inflation at any given time. However, certain forces clearly contribute to inflation.

Rising commodity prices are perhaps the most visible inflationary force because when commodities rise in price, the costs of basic goods and services generally increase. Higher oil prices, in particular, can have the most pervasive impact on an economy. First, gasoline prices will rise. This, in turn, means that the prices of all goods and services that are transported to their markets by truck, rail or ship will also rise. At the same time, jet fuel prices go up, raising the prices of airline tickets and air transport; heating oil prices also rise, hurting both consumers and businesses.

By causing price increases throughout an economy, rising oil prices take money out of the pockets of consumers and businesses. Economists therefore view oil price hikes as a “tax,” in effect, that can depress an already weak economy. Surges in oil prices were followed by recessions or stagflation – a period of inflation combined with low growth and high unemployment – in the 1970s, 1980s and the early 1990s.

In addition to oil price hikes, exchange rate movements can presage inflation. As a country’s currency depreciates, it becomes more expensive to purchase imported goods, which puts upward pressure on prices overall. When the dollar weakened to a then-record low against the euro in the first half of 2003, for example, the cost of European imports in the U.S. rose, suggesting that inflation could increase in the U.S.

Over the long term, currencies of countries with higher inflation rates tend to depreciate relative to those with lower rates. Because inflation erodes the value of investment returns over time, investors may shift their money to markets with lower inflation rates.

How does inflation affect investment returns?

Inflation poses a “stealth” threat to investors because it chips away at real savings and investment returns. Most investors aim to increase their long-term purchasing power. Inflation puts this goal at risk because investment returns must first keep up with the rate of inflation in order to increase real purchasing power. For example, an investment that returns 2% before inflation in an environment of 3% inflation will actually produce a negative return (−1%) when adjusted for inflation.

If investors do not protect their portfolios, inflation can be harmful to fixed income returns, in particular. Many investors buy fixed income securities because they want a stable income stream, which comes in the form of interest, or coupon, payments. However, because the rate of interest, or coupon, on most fixed income securities remains the same until maturity, the purchasing power of the interest payments declines as inflation rises.

In much the same way, rising inflation erodes the value of the principal on fixed income securities. Suppose an investor buys a five-year bond with a principal value of $100. If the rate of inflation is 3% annually, the value of the principal adjusted for inflation will sink to about $86 over the five-year term of the bond.

Because of inflation’s impact, the interest rate on a fixed income security can be expressed in two ways:

• The nominal, or stated, interest rate is the rate of interest on a bond without any adjustment for inflation. The nominal interest rate reflects two factors: the rate of interest that would prevail if inflation were zero (the real rate of interest, below), and the expected rate of inflation, which shows that investors demand to be compensated for the loss of return due to inflation. Most economists believe that nominal interest rates reflect the market’s expectations for inflation: Rising nominal interest rates indicate that inflation is expected to climb, while falling rates indicate that inflation is expected to drop.
• The real interest rate on an asset is the nominal rate minus the rate of inflation. Because it takes inflation into account, the real interest rate is more indicative of the growth in the investor’s purchasing power. If a bond has a nominal interest rate of 5% and inflation is 2%, the real interest rate is 3%.

Inflation can adversely affect fixed income investments in another way. When inflation rises, interest rates also tend to rise either due to market expectations of higher inflation or because the Federal Reserve has raised interest rates in an attempt to fight inflation. (See below for more information on how the Federal Reserve combats inflation.) When interest rates rise, bond prices fall. Thus, inflation may lead to a fall in bond prices, potentially reducing total returns on bonds.

Unlike bonds, some assets rise in price as inflation rises. Price rises can sometimes offset the negative impact of inflation:

Common stocks have often been a good investment relative to inflation over the very long term, because companies can raise prices for their products when their costs increase in an inflationary environment. Higher prices may translate into higher earnings. However, over shorter time periods, stocks have often shown a negative correlation to inflation and can be especially hurt by unexpected inflation. When inflation rises suddenly or unexpectedly, it can heighten uncertainty about the economy, leading to lower earnings forecasts for companies and lower equity prices.

Prices for commodities generally rise with inflation. Commodity futures, which reflect expected prices in the future, might therefore react positively to an upward change in expected inflation.

How can inflation be controlled?

Central banks, including the U.S. Federal Reserve (the Fed), attempt to control inflation by regulating the pace of economic activity. They usually try to affect economic activity by raising and lowering short-term interest rates.

Lowering short-term rates encourages banks to borrow from the Fed and from each other, effectively increasing the money supply within the economy. Banks, in turn, make more loans to businesses and consumers, which stimulates spending and overall economic activity. As economic growth picks up, inflation generally increases. Raising short-term rates has the opposite effect: it discourages borrowing, decreases the money supply, dampens economic activity and subdues inflation.

Management of the money supply by the Fed, and by other central banks in their home regions, is known as monetary policy. Raising and lowering interest rates is the most common way of implementing monetary policy. However, the Fed can also tighten or relax banks’ reserve requirements. Banks must hold a percentage of their deposits with the Fed or as cash on hand. Raising the reserve requirements restricts banks’ lending capacity, thus slowing economic activity, while easing reserve requirements generally stimulates economic activity.

The Fed is often credited with engineering, through monetary policy, the long period of disinflation in the U.S. that helped lead to the stock market gains of the 1990s. Starting in 1979, then-Fed Chairman Paul Volcker allowed short-term interest rates to rise continuously to break an inflationary spiral that had driven the CPI to almost 15%. In the following years, the Fed responded to economic conditions with great care, causing rates to rise and fall as needed, and brought inflation down to less than 2% by mid-2002.

The federal government at times will attempt to fight inflation through fiscal policy. Although not all economists agree on the efficacy of fiscal policy, the government can attempt to fight inflation by raising taxes or reducing spending, thereby putting a damper on economic activity; conversely, it can combat deflation with tax cuts and increased spending designed to stimulate economic activity.

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