State Street Corporation recently released a ‘ Vision Report’ on sovereign wealth funds (SWFs). The latest report assesses the impact of SWFs on the global economy. With nearly US$3 trillion in aggregate financial resources and a rapid growth trajectory, SWFs are increasingly important cross-border investors. Here, GEORGE HOGUET, a senior portfolio manager and global investment strategist specialising in emerging markets at State Street Global Advisors (SSgA), writes about the impact of sovereign wealth funds on world equity, fixed income and currency markets.
Given the diverse requirements and profiles of SWFs, their investment objectives, risk tolerance and time horizons vary over a considerable range. Some of this variation reflects differences in fund liabilities. The exception is those funds that have open-ended liabilities – whether these are contingent, fixed or mixed. For most funds, however, return enhancement is a high priority. SWFs generally seek to earn returns greater than they would achieve on foreign exchange reserves which are primarily invested in short term deposits, US Treasury bonds and other sovereign instruments. Diversification is another leading priority.
According to a recent article in Central Banking , fully 80 per cent of the sovereign investors surveyed had diversified their portfolios in the past two years by adding a new asset class, including corporate bonds, equities, gold and other real assets. What will be the impact of SWFs on global asset prices? To begin with, we should be cautious of partial equilibrium models. Many factors shape incremental asset supply and demand and, hence, prices. However, it is clear that SWFs may represent an important source of additional demand for financial assets. As pure conjecture based on the asset allocation of a typical pension plan, we can speculate that over time the collective asset allocation of SWFs will be approximately 60 per cent equities, 30 per cent bonds and 10 per cent alternatives.
Capital market theory holds that the world market portfolio is the most efficient. The international capital asset pricing model is not perfectly robust, but it provides a good starting point for analysis. As part of our thought experiment, we formulate a working hypothesis that SWFs will, over time, reduce their incremental purchases of US Treasuries, sell a portion of their existing US Treasuries, and reallocate to global equities and global bonds in proportion to world market weights.
Estimates of the size of the world’s capital markets vary. The average of figures compiled by the McKinsey Global Institute, Goldman Sachs and Merrill Lynch placed the total stock of investable global equities at about US$33 million, global government bonds at US$21 trillion, and private sector bonds at US$24 trillion.
IMPACT ON EQUITY VALUES
SWFs currently control nearly US$3 trillion in assets and are projected to invest about US$5 trillion in the next five years. If, today, they were to collectively allocate 60 percent of this capital to the FTSE Global All Cap Index, they would own about 5.2 percent of each of the 8,009 companies in the index.
By the same token, if they were to allocate 60 percent of their assets to the MSCI All Country World Index, they would collectively own about 5.5 percent of each company in that index as of March 31, 2008. If SWFs do, indeed, allocate some 60 percent of their assets to equities, there is scope for the global equity risk premium to fall and for real bond yields to rise. In the medium term, SWF allocations to stocks are likely to be supportive of equity valuations.
IMPACT ON FIXED INCOME
As of December 2007, foreign official institutions held 32 percent of the roughly US$4.5 trillion in marketable US debt held by the public, with 85 per cent of these holdings in Treasury notes and bonds. In a recent study of the US Treasury market, University of Virginia scholar Frank Warnock states, “Foreign buying has kept long-term US interest rates about one to one-and-a-half percentage points lower than otherwise.” To the extent that foreign central banks reduce their purchases of US Treasuries and SWFs sell a portion of their existing US Treasury notes and bonds to diversify, US real yields could rise.
IMPACT ON CURRENCIES
Since 2001, the US dollar’s share of allocated currency reserves has fallen from 71 per cent to 65 percent. Many factors affect the value of the dollar, but at the margin, as SWFs increasingly diversify into global portfolios, their activities may place further pressure on the dollar.
However, many believe the impact could be small, given that global foreign exchange markets trade about US$3 billion a day. There are several factors that impact the value of the dollar, including the attractiveness of the US as an investment destination, and we should be cautious in attributing movements in the dollar to any one factor.
Given their countries of origin, SWFs could produce sustained interest in emerging market equities and debt and at the same time facilitate the development of new asset classes, such as infrastructure, local currency emerging debt and frontier emerging markets. SWFs may also continue to provide strong flows into private equity, real estate and alternative investments, including hedge funds and commodities. Aggregate SWF investments in hedge funds and private equity funds had already reached $350 billion by the close of 2007.
SWFs may also accelerate corporate restructuring by taking 5 percent to 10 percent strategic stakes in global companies – financial services companies in particular. From the start of 2007 through April 2008, SWFs invested some US$80 billion in new capital to the banking sector.
This number is influenced greatly by the additional investment SWFs made in US and European banks that have experienced serious losses on sub-prime mortgages. As patient, long-term investors, SWFs are in a position to influence key corporate decisions, such as selection of chief executives or of major acquisition targets. So far, most SWFs have limited their stakes in public companies to less than 10 percent.
However, as their resources grow as recipient countries and corporate boards gain greater familiarity with SWF investors, there is scope for SWFs to exert great influence in their target companies. SWFs are among the most rapidly growing segment of the institutional investor base. Their uniqueness arises in part from their ownership and governance, their provenance and liability structures, and their rapid growth.
They reflect the changing structure of world output and the commodities boom brought about in part by the partial integration of more than 2 billion people in former command economies into the world economy. As SWFs assets grow and their asset allocation shifts, they have the potential to place upward pressure on global equity prices. However, we should be cautious of partial equilibrium analyses, particularly in today’s rapidly changing and technology-driven global economy.
Many factors, including potential asset allocation shifts by retiring baby boomers, will impact global equity prices in the years ahead.