Sovereign Wealth Funds: Where Will the Money Flow?
By Tony Allison, July 23, 2007
The rise of once-docile Sovereign Wealth Funds and their trillions of dollars of foreign currency reserves may emerge into dominant institutions within a few short years. Sovereign Wealth Funds have been around, but are just beginning to flex their muscles. As the name implies, they are investment funds representing sovereign nations that are now pouring a portion of their massive foreign currency reserves into funds that will invest in areas beyond the traditional treasury bonds. The funds will be investing in stocks, corporate bonds, commodities and private companies, looking for much faster growth and higher returns. The major players are China, Norway, Russia, Saudi Arabia, the UAE and a dozen other countries with hefty trade surpluses. They will no doubt be joined by Japan and India shortly. Don’t expect the US to join the club, as we sport an annual trade deficit of nearly $900 billion and must borrow $2.5 billion a day to keep the lights on.
The capital available to the Sovereign Wealth Funds (SWF’s) is staggering, but it’s only the beginning. According to analyst Stephen Jen of Morgan Stanley, SWF’s currently have approximately $2.5 trillion available to invest. Jen estimates, conservatively, that the total for all SWF’s will reach $5 trillion before 2010 and hit $12 trillion by 2015. That is some serious wealth. Jen expects the world’s reserves to grow at a much slower pace, and by 2011 he estimates the Sovereign Wealth Funds will surpass the world’s official foreign currency reserves at $6.5 trillion.
The implications are enormous. The massive shift of hundreds of billions and perhaps trillions of dollars from sovereign bond markets into other assets will have profound effects. Even if the SWF’s decide not to sell their Treasury bonds (and they might), but just cap new purchases, the effects will be harsh for the US treasury markets, and ultimately the US dollar. To feed our insatiable and endless appetite for borrowed foreign currency, the US will be forced to raise rates significantly to attract foreign capital. Or perhaps the Fed will just print the money and buy the bonds. Either path will lead to higher inflation.
Financial Protectionism a Looming Issue
Jen is concerned that financial protectionism will be a major problem once the Sovereign Wealth Funds shift into high gear. They will be targeting strategic assets and companies around the globe. Among the areas will be commodity producers, high tech firms and banking. Many believe the US, and other countries, will find this trend politically explosive and legislate against it. The Dubai Ports incident may be just the first salvo of many. The tidal wave of cash from the SWF’s will make a protectionist backlash all but inevitable.
For investors, the rise of Sovereign Wealth Funds will very likely push stocks higher, particularly in the commodity/natural resource area. The SWF’s, especially those of China, India and other developing nations, will most likely be purchasing energy products and base metals wherever and whenever they can. They will probably also be buying the stocks of companies that produce or mine these products. This makes much more sense than keeping trillions of dollars in depreciating US treasury bonds, which pay an interest rate that lags a real world rate of inflation.
Precious Metals May Benefit as Currency Hedge
The price of scarce commodities should continue to be bid higher. SWF capital will most likely flow to the fastest growing areas in the world. Conversely, money is likely to flow out of the bond markets of the slower-growing economies, such as the US. The over-printed currencies will be bid lower over time. The Sovereign Wealth Funds, as well as the wealthy, may hedge their currency holdings by diversifying into precious metals. Any incursion by the SWF’s into the relatively small precious metals markets will be a significant event, unless it is done very, very slowly. As an aside, Japan will open its first domestic gold ETF on August 10th, allowing Japanese institutions and citizens a way to diversify into gold through a Japanese company. The fund will be managed by Normura Asset Management and will trade on the Osaka exchange.
The key SWF will likely belong to China, which will begin to deploy its massive, and growing, $1.2 trillion in foreign currency reserves into higher-returning global assets. Its State Investment Company is roughly $250 billion, and growing. The Chinese have also announced their interest in building strategic reserves of energy and mineral holdings. China has been a net importer of oil since 1993. Even more significantly, China became a net importer of coal last year. According to BCA Research, coal accounts for 70% of China’s total energy consumption, crude oil 20% and natural gas only 3%.
China seeking Commodity Reserves
Many analysts believe that pressure is growing on the China’s government to put its currency reserves to more productive use. Building strategic commodity reserves that are likely to rise in price in future years seems to be a sensible use for a portion of their massive foreign currency reserves. BCA Research believes the key commodities will be crude oil, natural gas, coal, uranium, bauxite, manganese, iron ore, copper, chromium and sylvite.
China has already announced a strategic petroleum reserve plan, which will ultimately amount to 510 million barrels of stockpiled crude oil, the world’s third largest, after the US and Japan. As to nuclear power, it still only accounts for 1% of electricity generation, but the Chinese government has announced plans for 40 nuclear plants over the next 15 years. If this is to be accomplished, one can imagine an immense amount of uranium will need to be stockpiled in the next few years.
Lastly, it must be emphasized that China will continue growing rapidly for decades as it industrializes. Beyond China’s stockpiling of reserves, its ongoing yearly demand for commodities should continue to expand, unlike most developed countries. The Chinese have previously announced that by 2010, they will have spent $350 billion to expand generation and distribution of electricity, and $175 billion improving railroad infrastructure. The overall effect on commodity pricing globally is unknown, but could be dramatic if supply growth continues to be tight.
Taken as a group, the Sovereign Wealth Funds, while currently still under the radar, seem fated to become powerful, market-dominating entities within the next decade. There will be issues to overcome along the way, such as a lack of transparency. But as a growing world seeks to acquire increasingly precious natural resources, the dawn of the Sovereign Wealth Funds may see unimaginable wealth competing for any and all tangible assets. The probability of political turmoil seems assured. And the commodity boom looks far from over.
Stocks climbed moderately Monday, bouncing back from Friday's sharp decline, on above-forecast results from Schering-Plough Corp. and Merck & Co. and merger news in the financial, oil-drilling and equipment-rental sectors. Transocean Inc., the world's largest offshore drilling contractor, and rival GlobalSantaFe Corp. said they agreed to merge. The combined company will have a market value of about $53 billion. GlobalSantaFe (GSF) stock was 5.75% higher and Transocean (RIG) shares rose 6%.
The Dow Jones Industrial Average was up 92.34 to close at 13,943.42. The Nasdaq rose 2.98 points to 2,690.58. The S&P 500 Index was up 7.47 at 1,541.57.
Leading the gains among blue chips, shares of Merck jumped 7.8%. The pharmaceutical company lifted its annual earnings forecast and its quarterly results exceeded Wall Street's expectations.
Gold futures closed lower Monday as traders locked in recent gains, pressured by a retreat in oil prices to below $75 a barrel and fractional strength in the U.S. dollar against most other major currencies. Gold for August delivery fell $3.20 to close at $681.50 an ounce on the New York Mercantile Exchange.
Wishing you a good evening,
© 2007 Tony Allsion