Sovereign wealth funds

01 Jan 2008

10 years of Vision: Sovereign Wealth Funds (SWFs) remain significant investors, with the assets of the top 10 now amounting to c.$5.5trn. They have been less prominent actors in mergers and acquisitions in recent years but still have significant influence as demonstrated by the news that Norway’s central bank has advised the country’s SWF is to divest its holdings in the major oil companies which account for c.$43bn of the c.$1trn fund; shares in Royal Dutch Shell fell 2% in response.

With evolving emerging markets, Vision 2008 examined how the West can still profit despite economic power shifting to the East.

Despite our short-term concerns, the Asian story remains compelling. With 200 to 300 million rural dwellers expected to migrate to cities over the next 10 to15 years, both domestic demand and output are likely to remain strong. As the region prospers, the thirst for resources and eventually western consumer goods will intensify.
 
Currently China accounts for 50% of global copper demand and a large proportion of demand for most other basic materials. We do not envisage this coming to a halt, regardless of events in the west. There is no denying that economic power is shifting from west to east, and as emerging markets continue to evolve that this is going to have a huge effect on the global economy. So how can we profit?
 
Asian equities have not been shy to price in this impressive growth. The MSCI Asia ex Japan Index is up 280% over the past five years,contrasted with the 98% returned by the FTSE 100. The Chinese A share market rose substantially through 2007 and has traded on a P/E of over 60 times. The float of PetroChina saw the stock triple on the first day’s trading, giving the company a market capitalisation of $1.1trn.
50%
Proportion of global copper demand accounted for by China
 
We see little value in Asian equities, believing all of the good news and more is already priced in. However, western equities that derive a large proportion of assets from the region provide an alternative route to gaining exposure to the Asian theme. Despite a four year bull market, most western valuations remain sensible with the FTSE 100 trading on 14 times and the S&P 500 on 16 times historic earnings.
 
Since this summer’s credit crunch the market has been led by larger companies deriving significant revenues from emerging markets. Conversely, those heavily reliant on domestic revenues and other western economies have lagged.
 

Top UK stocks with Asian exposure*

FTSE 100 Asian sales

FTSE 250

Asian sales
Rio Tinto 34% CSR 81%
Xstrata 30% Premier Oil 42%
Lonmin 28% PZ Cussons 40%
ICI 27% Aveva 35%
Unilever 27% Intertek 34%
* Excludes Japan
Source: Bloomberg
Sterling continues to look overvalued against most currencies and despite its weakness against the runaway euro, should be expected to fall through 2008 on a trade weighted basis. The move should be particularly pronounced against the strong Asian economies, where interest rates are likely to move upwards to fend off the inflation which threatens to flare up in certain areas.
 
In summary, the Asian story remains intact and we predict the strong growth rates continuing for years to come. Conversely, the west will struggle to escape the claws of stagflation as the housing market continues to stutter and the indebted consumer stops spending, whilst energy and food prices continue to soar.
 
But Asian equity markets themselves look to offer precious few attractively priced opportunities and we much prefer to look for more modestly rated western equities that derive significant percentages of their revenues and profits from this part of the world.
 

Recycling the Commodity Boom

The trade surpluses of the oil producers and the booming Asian exporters have given rise to a new investment phenomenon, the Sovereign Wealth Fund. These vast pools of money are recycling petro- and commodity- dollars back into markets at a speed and in a manner that is changing investment dynamics globally.
 
From Dubai’s acquisition of P&O, to Qatar’s failed bid for Sainsbury and Abu Dhabi’s investment in Citigroup, the tentacles of these funds are far reaching and key to the performance of global equity markets.
 
Sovereign Wealth Funds (SWFs) are investment vehicles backed by governments from commodity rich countries, which as a result have built large current account surpluses. The main players in this arena have been Middle Eastern countries, along with Russia, China and Singapore. According to The Sunday Times, the Gulf States are accumulating cash at an extra $1bn a day.
 
The newspaper estimated that SWFs grew by $1,200bn in 2006 compared to the $461bn sold in government debt last year by America, the European Union and Britain combined. Although estimates vary, it is now said that assets held in SWFs amount to more than $2,500bn; if we compare this to the $2,000bn held in hedge funds worldwide we can see the significance.
 
SWFs are by no means a new phenomenon. The International Monetary Fund paved the way by encouraging countries to build up such funds in preparation for a rainy day. The Kuwait Investment Authority was established in 1953 in order to benefit future generations of Kuwaitis when the oil reserves ran dry, while the Abu Dhabi Investment Authority, the world’s largest SWF, was set up in 1977. Perhaps surprisingly, the second largest SWF is The Norwegian Pension Grant which has assets of $322bn. 
 
‘Sovereign Wealth Funds are looking for higher-yielding and riskier investments.’
It has been the fresh surge in the activities of these funds that has generated increased interest from both the media and politicians alike. SWFs have until recently, been invested in government bonds but are now looking for higher-yielding and riskier investments in order to diversify and enhance their returns.
 
Parallels can be drawn between the power of SWFs and that of corporate Japan in the late 1980s. Like China, Japan became a leader in the international economic scene through the huge success of its exports. As a result of its large trade surpluses, the yen appreciated at formula one speed against foreign currencies.
 
This surplus capital was used to make acquisitions predominantly in the US, in a similar way to today’s SWFs. In Japan’s case an asset bubble was created. It was estimated that at the height of the boom in Japan, the land beneath the Imperial Palace in Tokyo was worth more than the entire state of California.
 
Rising price of oil

SWFs - Estimated Assets*

Country Fund

Assets ($bn)

Inception year
UAE Abu Dhabi Investment Authority 875 1976
Singapore Government of Singapore Investment Corp. 330 1981
Norway Government Pension Fund - Global 300 n/a
Saudi Aabia Saudi Arabian funds of various types 300 1996
China State Foreign Exchange Investment Corp. + Central Huijin 300 2007
Singapore Temasek Holdings 100 1974
Kuwait Kuwait Investment Authority 70 1953
Australia Australian Future Fund 40 2004
US (Alaska) Permanent Fund Corporation 35 1976
Russia Stabilisation Fund 32 2003
Brunei Brunei Investment Agency 30 1983
South Korea Korea Investment Corporation 20 2006
* As at March 2007
Source: Morgan Stanley
 
As a result of the force of its economy in the late 1980s Japan riled many of its trade partners, particularly the US. SWFs are alarming many of the Western economies in a similar way today.
 
SWFs have been heightening protectionist tensions since the United States refused to allow Dubai Ports to take control of several US ports as part of its acquisition of P&O. There is increasing pressure on the EU Commission to set a common line, to prevent EU countries from taking measures of their own, which may create restrictions on the free movement of capital. However, the chance of obtaining unanimous agreement from the 27 member states in the near term is most unlikely. The main problem is that these funds lack transparency.
 
It has been suggested that the EU could address this by restricting the actions of funds that fail to meet a set criteria, for example, to only buying non-voting shares in European companies. While underlying visibility is to be preferred, the current drift towards protectionism should concern all investors. An overly protectionist attitude could result in political tension and perhaps more disastrously, a severe and abrupt downturn in foreign investments.
 
It is predicted that SWFs will move from their current worldwide valuation of $2trn-$3trn to $10trn-$12trn by 2012. As this happens the phenomenon is likely to attract even greater attention. The question therefore is how to profit from the involvement of SWFs in the western economy, especially at a time when our confidence in equity markets is dwindling. The most obvious approach is to buy holdings in potential SWF targets. However, due to the lack of transparency in SWFs, picking their next big investment is a difficult game to play.
 
In order to do so we need to identify the types of companies attractive to SWFs. The funds tend to adopt a traditional long only, buy and hold strategy, looking for strong brand names or unique assets. Examples would include Coca Cola which has a very strong position in the drinks industry, ports, utilities and most recently supermarket chains. Another important factor is the need to diversify the funds’ existing US dollar exposure.
 
Falling dollar
 
The failed Delta Two bid for J Sainsbury is a fine example of a SWF doing exactly this, trying to gain control of one of the largest UK supermarkets. Delta Two was also at the heart of a failed bid for Thames Water earlier this year. Other recent deals include the Singapore fund, Temasek, buying the property group that owns the Merrill Lynch Financial Centre in London for $960m and 50% of West Quay shopping centre in Southampton for $600m.
 
Dubai and Qatar have also brought nearly 50% of the London Stock Exchange. Some of the SWFs also hold investments in some highly sensitive areas. For example, Dubai and Russia own stakes in EADS, the company that produced the Eurofighter. While SWFs are commonly regarded as price insensitive investors and thus frequently a buyer of last resort, the failed Delta Two bid has perhaps highlighted an encouraging concern for valuation.
 
Regardless of recent failures, SWFs will be a feature of the investment landscape for the foreseeable future. It could even be argued that they have become an essential part of the global economy. But with 2008 being US election year, we can be sure that protectionist rhetoric against the SWFs will be used as a potential vote winner. Despite this, the funds represent an unprecedented pool of funds for investment and provide possibly the single most important prop to global equities during the economic problems that will evolve during 2008.

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