How Much Will Sovereign Wealth Funds Impact Stocks and Bonds?

A lot of ink has been spilled recently on the subject of so-called “sovereign wealth funds.” Traditionally, countries accumulating foreign exchange reserves invested them in low risk and very liquid government securities – e.g., U.S. Treasury and Agency bills, notes and bonds. However, as the size of some countries’ reserves have grown to levels well in excess of any conceivable precautionary needs, they have established new vehicles (Sovereign Wealth Funds) to invest in a wider variety of asset classes to earn higher long-term returns.

Norway was among the first nations to take this approach when its North Sea oil revenues rose; a number of Persian Gulf oil exporters have also gone this route, such as the Kuwait Investment Office.

However, it seems that the announcement that China would also take this approach (via the launch of the China Investment Corporation) set of a new wave of analyses of SWFs’ likely impact on the financial markets.

By far the best of these analyses was produced by Morgan Stanley. They estimate that, in future years, the shift of foreign exchange reserves out of government bonds and into other asset classes could push up average yields on the former by 30 to 40 basis points, while reducing the equity risk premium [ERP] by 80 to 110 basis points.

That's not an insignificant amount if you believe, as we do, that the best estimate of the ex-ante ERP (what investors expect to receive, as opposed to the ex-post return they actually realize) is between 3.5% and 4.0%.

Comments

[Kunst:]

Given the depreciation of the dollar, Treasuries are and have been an awful investment. SWFs are the beginning of a break from just propping up our national debt toward making some money on all the money they have accumulated from us. This is far more ominous for interest rates than people seem to realize. We need close to a billion dollars of new money every day to cover the federal deficit (which will be increasing as the economy droops). Right now, stocks aren't that attractive an investment, but when they have dropped enough, they are going to look really enticing to all that big money. Money that goes into equities isn't going into T-bills. Treasury interest rates will have to increase to compete. The Fed doesn't control the interest rate on Treasuries; that's a supply/demand auction situation. Of course higher interest rates also mean higher interest payments on the national debt, which adds to the problem. Higher interest rates also aren't good for US stocks, so there will be some kind of balance struck. The basic fact is that if Treasuries pay substantially less than other available investments, they are going to have to pay more in order to attract the funding they absolutely have to have.

2008 Jan 11 07:28 PM