That 'Other' Non-Investment Stock Bid

by: Jeffrey Snider

By Jeffrey P. Snider

On November 2, Hong Kong's Exchange Fund reported its worst-ever quarterly loss. For the quarter, the number was an astonishing -HK$63.8 billion, turning what was an already reduced YTD profit from Q2 into a -HK$36.8 billion loss so far for 2015. What caught most people's attention was not specifically the loss, but that it was derived more so from "other equities" (-HK$34.1 billion) rather than strictly those trading in Hong Kong (-HK$30.7 billion). In other words, some began to wonder why Hong Kong's primary sovereign wealth fund, tasked with a particular monetary effort, would be "investing" in China's stock bubble.

The category "other equities" isn't strictly Chinese stocks, of course. Sovereign wealth funds around the world invest in all kinds of assets around the world. What is notable about them in 2015 is that they are still concentrated mostly in the oil-producing areas, and had steadfastly maintained their affinity for stocks. Funded by oil revenues, mostly, it is estimated that sovereign wealth funds have amassed at least $7 trillion in assets, and quite likely significantly more than that. Hong Kong's fund is more the exception in terms of its funding.

Perhaps the prime example, and undoubtedly a fund that has earned its respectful reputation, is Norway's Government Pension Fund Global. Managed by an internal unit within the nation's central bank, the fund has upended what was conventional "big fund" logic. The Yale model of investment had, unchallenged for decades, pushed larger asset pools such as sovereign and pension funds toward the illiquid assets, such as private equity and bespoke arrangements (equity and otherwise). Norway's fund has instead been aimed exclusively and quite purposefully at publicly traded securities.

We focus a lot of attention and effort at defining the "non-investment" flows into global equities in terms of corporate share repurchases, and with good reason, but that should not be considered exhaustive. It isn't nearly as appreciated, but sovereign wealth funds have been a major stock market trend (and fixed income, even "reach for yield") in their own right. That sets up a sort of petro-stock flow, operating in an almost direct manner exactly as the wrongly characterized petro-dollar is thought to. Oil revenues are recycled back into the world's asset markets.

Norway's fund hasn't been perfect. In 2007, for example, the fund raised its upper equity allocation limit to 60% from 40% just in time for global monetary disorder - even the best funds have trouble seeing the top. And though they were heavily criticized for their 2008 results, by 2012 everyone had practically forgotten what the fuss was about, though there are definitive signs that Norway's managers have not (more on that below).

From March 2013:

Norway's sovereign wealth fund, one of the world's biggest investors, grew by around $100-billion (U.S.) in 2012, sealing one of its best years on record as it benefited from the striking upturn by stock markets.

Known as the "oil fund," it invests revenue from Norway's lucrative oil industry for the country's future. It is now worth around $710-billion, 40 per cent more than the value of the entire Norwegian economy.

It "earned" 13.4% in 2012, up sharply from the -2.6% returns booked in 2011.

"The fund's good performance is largely the factor of a good run on the stock markets," Yngve Slyngstad, its chief executive said.

Norway's "lucrative oil industry" is responsible for the basis of all that growth, as profits from the state's business channel into the fund. Unlike past experience with such processes in Europe and elsewhere, there are very specific rules governing the fiscal and monetary parameters so that there aren't temptations to politically "cheat." The government is committed to spending just 4% of the fund's profits, while prohibiting the fund from investing in domestic securities. The oil "overflow" gets pointed elsewhere so that graft or inflation do not, commendably, skew and alter Norway's economy.

But at its heart, the fund is that petro-stock "investor" recycling oil flows into the world's various asset centers; oil profits that are benefited by Bernanke's (now Yellen's) "inflation" signaling, comfort and almost outright demand for $100 and above oil. Again, from March 2013:

The oil fund is expected to grow to $1.1-trillion by 2020 and record investments into Norway's petroleum sector indicate plenty more income to invest beyond the end of the decade.

While that seems more to indicate the great problem with orthodox economic thinking - that even where actual flows have gained in areas monetary policy wished to directly influence don't always go where they "should" (orthodox theory would prefer that oil prices redistribute to the real economy rather than the stock market economy, but complexity isn't a consideration in orthodox theory) - it raises a more fundamental question about the state of affairs in 2015. What might happen, then, if oil prices didn't just sail along into the 2020s on Bernanke's QE debasement, instead suddenly collapsing by more than 60%? It's actually a trick question, since the world's economists and central bankers would quickly reassure the fund's managers such a momentous decline would be "transitory." Should the investment considerations be proven more hearty than economists can appreciate, that leaves, however, relatively simple math.

The fund's updated numbers through the end of Q3 leave no room for Janet Yellen's commodity ignorance. In Q3 and Q4 last year, the fund gained "inflows of new capital" - oil profits of KR36 billion and KR25 billion, respectively. In the first three quarters of this year (in order): KR5 billion, KR12 billion, and KR12 billion. Three calendar quarters of new "capital" to be deployed this year have been less than that of just Q3 2014 alone.

That is added to the fund's returns, which have also suddenly and sharply declined. In Q4 2014, the fund saw +KR259 billion, and then +KR401 billion the next quarter, Q1 2015, in paper asset profits; but the next two quarters, it has been -KR73 billion and -KR273 billion.

Stung by these results, particularly the back-to-back quarterly losses and the prospects for more - at least in terms of volatility - viewed risks and uncertainty, the fund is thinking elsewhere:

The world's largest sovereign wealth fund says the optimal level of property investments might mean putting another $86 billion into real estate, singling out Asia as a hot spot for growth.

Norway's $860 billion Government Pension Fund Global, Oslo, whose mandate is set by the government, was in 2010 allowed to invest 5% in the property market and is now studying whether it should add more to its portfolio. It has snapped up properties in New York, Paris, London and Berlin, among other cities, and is targeting Tokyo and Singapore.

My issue with adding this speculation to the mix is not to decry the Deutsche Bank level of chasing EMs at the worst possible time, but rather, what even making that consideration might suggest about these large asset pools evolving in terms of their allocations more generally. As it is, the petro-stock "flow" is in great danger to begin with, so any determined shift in allocations might visit a double blow upon the world's non-investment stock "bid."

Again, the biggest sovereign wealth funds are concentrated in oil states, which makes this much, much more than a trivial concern:

The signs are worrying: For the first time ever, Norway announced plans to tap its fund to make up for lost oil revenues earlier this month.

While this is not a massive slice of the pie, analysts are worried that the behemoth fund's days of stellar growth may be numbered especially with oil prices predicted to stay low for longer and the $100 per barrel price tag something of a distant memory.

Sovereign wealth funds control around $7 trillion of assets, largely created through investing natural resource revenues. After Norway, oil rich Abu Dhabi and Saudi Arabia manage in the region of $770 billion and $670 billion respectively, according to data from Sovereign Wealth Fund Institute.

Less oil revenues in a great deal of that $7 trillion plus gains heightened scrutiny about fund performance derived from stocks, and then may add up to knock out one of the largest supporting "pillars" that keeps global stock prices from joining the spreading reset in fixed income. As it is, even the Hong Kong fund reported losses YTD of HK$35.9 billion from forex alone, meaning that redeployment and redirection is likely systemic.

With public companies under great strain in terms of cash flow to fund share repurchases, the turn in oil marking a potential turn now in sovereign wealth funds might explain at least the stock market's failure to reaffirm new highs - dating back to the middle of last year, when all this "dollar" volatility first overwhelmed the determined complacency in the first place. If bond prices are the primary economic setting in terms of recycled financial considerations - and they historically have been - then we don't really have to wonder either why stocks have diverged from bonds so much in the past or how they might, in one channel at least, eventually converge.