CYCLICAL DIVERGENCES

In 2014, cyclical divergences in the global economy became more pronounced, in both the developed and emerging markets.

Throughout the year, the market’s narrative shifted quickly. For the first three quarters, the focus was on a combination of accelerating US growth and inflation and greater easing by foreign central banks, as the Fed concluded its quantitative easing. At the beginning of October, global markets focused on weak European growth, as well as geopolitical risks ranging from the spread of ebola to the continuing upheavals in Syria, Iraq, and Ukraine. This confluence of events raised fears of a downgrade in global growth and increasing disinflationary pressure. Equities declined, volatility spiked, cyclical sectors underperformed, and treasuries rallied as inflation expectations fell.

In the fourth quarter, it became evident that among the developed economies growth was holding up best in the United States. In Japan, growth had slowed since the increase in the value-added tax in April, but it is likely to reaccelerate with the expanded monetary stimulus from the Bank of Japan. In the euro area, the slow recovery in the first half of the year stalled. Fighting the risk of deflation, the European Central Bank finally declared in the beginning of 2015 plans to purchase assets totaling 60 billion euros per month.

Emerging markets showed signs of weakness, with China being the chief concern. At the end of 2014 the People’s Bank of China joined other central banks in announcing measures to stimulate the economy.

All of these monetary policies support the belief that global central banks are committed to backing economic growth. Therefore, in November the Federal Reserve completed its quantitative easing (QE3) program after US$1.6 trillion in bond purchases.

A growing US economy and the possibility of an increase in rates, combined with the relative weakness evident in the rest of the world, supported a strong US dollar. The average emerging-market currency is now back to a level last seen in 2002, down more than 15% against the US dollar. The issue is that emerging markets are now 50% of world GDP, and they too have become overleveraged. Therefore the potential for central banks to engage in a new currency war exist: a race to the bottom of the exchange rate in an attempt to weaken one’s own currency and undercut competitor nations.

We finished 2014 with a shock in oil prices, down 50% from their June peak. A mix of concerns over a global growth slowdown, a stronger US dollar, and a deterioration of the global balance of supply and demand created the perfect environment for such decline.

The path of normalization of the global economy, after the financial crisis, continues to present divergences, as a multispeed world finds its balance in terms of monetary policy and currency.

In this macro context, the KF portfolio was up 4.5%, close to our targeted investment return of 5%, with an expense ratio of 0.19% and a turnover of 13%. At the end of 2014, the total portfolio was approximately $12.8 million.

FIXED INCOME

At the beginning of 2014, the consensus was that interest rates were going to edge higher throughout the year. Even though the US economy has grown and the first Fed rate hike is expected around mid 2015, by the end of 2014 the 10-year treasury yield had broken out of the “range bound” behavior of 2013 and declined to 2.17% (from 3% at the start of the year). The decline of interest rates can be attributed to several factors, including concerns about global growth, lower inflation, easing by central banks, and a stronger US dollar.

The result of this scenario was a return of 4.4% in KF’s fixed income portfolio, with part of the gains taken away by losses with a weaker Canadian dollar, yielding a final 2%.

Since the US dollar is expected to continue to strengthen due to the upcoming increase in interest rates around mid 2015, we reduced the position and hedged the balance.

EQUITIES

The overall equity portfolio returned 7.1%, a good performance when compared to the MSCI World Index (Developed Markets), up 2.6%, and the MSCI Emerging Markets Index, down 4.2%.

On the back of strong growth, US equities returned 11%, with emphasis in the biotech, technology, and consumer sectors. Investments in Apple, Gilead, FedEx, and Berkshire Hathaway — very solid and established names — paid off. Japan, aided by the most recent stimulus and tax reform, was up 9%, while investments in China returned a very solid 16%, with focus on A-shares and technology-related companies.

The laggards were Europe (-12%) and Canada (-9%). We invested too early in Europe, at a time when they were still struggling with growth, and for part of the year the position was unhedged, therefore suffering from the strengthening of the US dollar against the euro. In Canada we were also affected by the weaker Canadian dollar, combined with depressed commodity prices, especially oil and gold. The exposure to emerging markets was small, only 2%; therefore the negative return of 9% did not have much effect on the total return.

We traded options, covered calls and puts only, and the result was 2.5% positive return, using about 10% of the portfolio.

We treasure your confidence in us and will strive to return it with good results and lower risk, in order to continue to serve Rinpoche and his vision for Buddhism in the world.

— Khyentse Foundation Investment Committee