CIO WEEKLY

September 29, 2015

Falcon Private Bank Ltd. | Pelikanstrasse 37 | P.O. Box 1376 | 8021 Zurich, Switzerland Phone +41 44 227 55 55 | Fax +41 44 211 55 11 | www.falconprivatebank.com

CIO WEEKLY

SEPTEMBER 29, 2015

TOPIC OF THE WEEK SAFETY: WHERE AND HOW?

As our regular readers will know, we have taken a defensive position with respect to risk assets (equities) first in mid August and then another risk dial down last week. In this kind of environment capital preservation is the dominant objective and accordingly this week’s focus is on how one should think about capital protection strategies. Since all safe havens (cash, gold and bonds) are denominated and traded in a government issued currency, and since these currencies fluctuate in value relative to one another, the most important risk factor affecting ‘cash’ and its global purchasing power, is the exchange rate structure. This issue is of paramount importance to many of our clients who have lifestyles, and

therefore liabilities, in emerging markets (EM). For last 12 months and even more recently, EM currencies have lost significant value and purchasing power relative to the USD, the EUR and the CHF. Those clients that stored value in USD, EUR or CHF as local currency depreciation insurance, have had a big windfall source of value/purchasing power increase. In effect the insurance paid off. This begs the question of what our outlook is for the major insurance currencies and how the current global monetary system with flexible exchange rates is related to global capital market issues, countries competing for declining global real growth and increasing military tensions and geopolitical risk factors.

USD VS. EMERGING MARKET CURRENCIES MSCI EM CURRENCY INDEX

USD INDEX

(Index 2000=100)

250 200 150

100 50 0 2000

2005

2010

2015

Source: Bloomberg. Illustration: CIO Office.

Falcon Private Bank Ltd. | Pelikanstrasse 37 | P.O. Box 1376 | 8021 Zurich, Switzerland Phone +41 44 227 55 55 | Fax +41 44 211 55 11 | www.falconprivatebank.com

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CIO WEEKLY

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MSCI EM CURRENCY INDEX

USD INDEX

(Index 2010=100)

130 120 110 100 90 80 2010

2011

2012

2013

2014

2015

Source: Bloomberg. Illustration: CIO Office.

Bonds, cash or gold? As noted above, traditional safety instruments are still exposed to risks but these are predominantly related to currency denomination. This is only too apparent to those who sought some degree of safety in a higher yielding ruble denominated bonds or local bank deposits (cash) only to later suffer massive global purchasing power destruction because of the decline in the value of the ruble relative to other major currencies. So in short, currency denomination is the single most important factor in wealth preservation strategies. What drives currency appreciation and deprecation? The currency markets are the largest in terms of daily trading volumes. This is because currencies underpin everything from bonds, stocks, commodities, derivatives and almost every transaction in the ‘real’ economies. Currencies generally follow certain economic principals and appreciate due to strong underlying economies, stable political risk environments and rising real interest rates. In contrast, weak underlying economic conditions and slow growth relative to the world, leads to currency devaluation. Many EM (e.g. India, Mexico and Brazil) run current account deficits and suffer from capital flight which puts pressure on local currency. Currencies decline due to rising inflation and social instability. They also are heavily influenced by geopolitical issues, speculative trading activity and central bank policies and interventions. In a nutshell determining currency movements is one of the most challenging aspects of wealth management. Reserve currencies We look at currencies really in two categories, those that are considered dominating reserve currencies and those that are not. A reserve currency is one that central banks/governments hold as part of their foreign reserves for international transactions. At the moment there are eight official reserve currencies, but the USD and

the EUR comprise 85% of these reserves with the JPY, GBP and CHF comprising in total less than 9%. These reserve currencies are considered relative safe havens against EM currency devaluation risk. There are some attempts to replace or reduce the dominance of the USD as the global reserve currency of choice. Those countries not in the ‘reserve club’ recognize that the USD enjoys an inordinate amount of global demand as a result and this keeps the USD strong and increases the purchasing power of the USD and gives the US economy an economic edge. The selection of the reserve currencies is based in part by the size of the underlying economies. ‘Reserve club’ members enjoy economic privileges, chiefly lower costs of capital, and this is in part one of many reasons why the Chinese, longer term, wish to join this ‘reserve currency club’. The basis of the USD as a major reserve currency is one of the hidden powers of the US banking system as it allows the US to enforce economic and banking sanctions against anyone using its currency. USD focus Our preferred currency protection instruments are therefore USD, EUR, GBP and CHF. These are the major anchors of stability for any wealth originating in an EM. The EUR is an alternative, but it is subject to potential QE printing risk (read devaluation risk) relative to the others at the moment. The USD has been in ascendency as there has been a global flight to quality and this still in our opinion is a currency that has longer term appeal in light of the diversification and relative strength of the US economy. That said it is also prudent to consider the CHF and GBP as safe haven diversifiers as they have shown relative strength compared to other alternatives to the USD. Conclusion EM currency devaluation is a significant risk factor in seeking to protect wealth originated in these markets. All EM wealth holders should consider, as many central banks do, holding reserves (safety)

Falcon Private Bank Ltd. | Pelikanstrasse 37 | P.O. Box 1376 | 8021 Zurich, Switzerland Phone +41 44 227 55 55 | Fax +41 44 211 55 11 | www.falconprivatebank.com

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CIO WEEKLY

SEPTEMBER 29, 2015

in one or several of these reserve currencies. EM currencies showed enormous appreciation in the period when these economies were re-entering the global economic stage from 1992-2008 (see top chart above), but at the moment there is a pause and bear market in these currencies due to the ongoing crisis and bear market for commodities. This has more acutely and adversely affected EM currencies.

At some point, when there is an end or a capitulation to the commodity bear market, it will be time to go long this group of currencies, but for now we still subscribe to the notion of holding safety in reserve dominant currencies as we consider this storm to not yet have run full cycle.

CURRENCY PERFORMANCE YTD (VS. USD) 5

2.2

0

0.0

0.0 -2.5

-5

-2.5

-4.6 -7.1

-10

-9.3 -11.7

(%)

-15

-18.0

-20

-25

-23.6

-30 -35

-34.3

-40 SWISS FRANC *

JAPANESE YEN

HONG KONG DOLLAR

BRITISH CHINA INDIAN POUND RENMINBI RUPEE

EURO

THAI BAHT RUSSIAN RUBLE

SOUTH AFRICAN RAND

TURKISH LIRA

BRAZIL REAL

In USD terms. | Source: Bloomberg, as per September 28, 2015.

Despite the recent bounce, the RUB is still down on a year-to-date perspective. The ruble remains under pressure because of low oil prices and sanctions against Russia.

The CHF is one of the few currencies which is up versus the USD. The CHF is considered as safe haven diversifier as it has shown relative strength compared to other alternatives to the USD.

Falcon Private Bank Ltd. | Pelikanstrasse 37 | P.O. Box 1376 | 8021 Zurich, Switzerland Phone +41 44 227 55 55 | Fax +41 44 211 55 11 | www.falconprivatebank.com

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CIO WEEKLY

SEPTEMBER 29, 2015

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