May 30, 2007
John N. Mayberry

Sovereign Wealth Funds: Tomorrow’s Investors

The US dollar has fallen against most foreign currencies this year, especially the euro and the pound sterling. Strength in foreign currencies increases the value of Core’s foreign stock and bond investments.

A remarkable world-wide rally in stocks and commodities has produced very strong returns in Core’s portfolios. Since the sharp bout of selling in late February and early March, equity markets have posted steady gains. Since March 5, the low point of the brief sell off, the S&P 500 has gained more than 11 percent; since the end of 2006, the S&P is ahead by 7 percent. In the aggregate, Core’s portfolios have gained more than 7 percent so far this year. Foreign stock markets and commodities have been particularly strong; the US dollar has been weak.

The persistence of strong investment markets flows from the accumulation of investment assets, especially by foreign investors, and the continued strength in global economies. (It is interesting to note that the US economy is the weakest of the world’s big economies.) The confluence of global growth and capital accumulation raises prices of investment assets around the world. This letter takes a look at an important set of huge and rapidly growing pools of capitals and considers their effect on investments and politics in the future.

Two groups of countries have generated--and continue to generate--huge surpluses: the oil-exporting countries and the (mostly) Asian exporters, including China, Japan, India and others. With persistently high oil prices and growing demand for oil, the oil exporters have accumulated enormous reserves. Similarly, the non-oil export powerhouses earn vast sums; China’s foreign currency reserves exceed $1.2 trillion and grow daily by more than $1 billion. Because the reserves held by these countries now far exceed amounts needed to finance their trade and defend their currencies, more countries have created investment funds with their excess capital. These funds, sometimes referred to as Sovereign Wealth Funds (‘SWFs’), are being deployed in the world’s investment markets in ever larger amounts. Their influence grows steadily.

The growth of Sovereign Wealth Funds provides a good measure of the increased wealth, power and influence of oil exporting countries and the developing countries in Asia.

According to Morgan Stanley, these funds may hold $2.5 trillion today; by 2015, their totals may exceed $12 trillion. The nature of investments by SWFs is likely to be very different from the investments of the official reserves of the same countries. Typically, a country’s official reserves are held in treasury bonds of the United State, the euro countries, and the United Kingdom. These investments have supported bond markets and kept interest rates low. SWF investments are more likely to be in equity markets, real estate, and natural resources. A striking deal was announced recently: China agreed to invest $3 billion in the stock of the Blackstone Group, the large, New York-based private equity firm, which plans to sell shares to the public in coming months. This suggests that China plans to be a significant private equity investor. China is not the first country to invest in private equity: Korea has been an investor in private equity funds organized by Blackstone and others for some time. Private equity is only one investment activity for China, which has also been very active in recent years in attempts to secure supplies of oil in Africa, Latin America and Central Asia.

Sovereign Wealth Funds are significant for two reasons, the scale of their assets and the scope of their investments. As they grow in size, their influence in the world’s investment markets grows. Broadly speaking, it seems likely that SWFs will avoid bond markets in favor of equity and natural resource markets. Political strife may loom larger in investment markets as sovereign funds seek strategic investments in sensitive industries and difficult places: recall the squabbles in recent years when China sought to buy Unocal (the old Union Oil of California) and a Dubai sovereign investment fund sought to buy a company that operates several United States ports.

For us as private investors, the growth of these funds creates opportunities. Ever larger SWFs will be buyers of investment assets in America and Europe, pushing up prices of our investments in these stock markets. It is also likely that SWFs will be significant investors in emerging markets, contributing to the broadening and deepening of these markets. Core has been investing more capital into emerging markets and we have held significant investments in commodities and natural resources companies for several years. These investments will benefit from the attention SWFs direct to them.

Foreign stock markets, of emerging and developed countries, have been strong since 2003.Investment by Sovereign Wealth Funds will lift these markets further.

As mentioned, these sovereign investment funds will deploy their capital differently than has been typical with a country’s foreign currency reserves. To the extent that a given country’s reserves are now ample, it is likely more of its surpluses will be directed to its SWF and thence into equities, real estate and natural resources. Although the investments will not be in US dollar bonds, the proportion allocated to US dollar assets will not necessarily fall. However, SWFs may find that their need for productive investment assets cannot be filled with US assets and the US share of investment by SWFs may well be lower in coming years than it is now. This may weaken the value of the dollar and diminish the attraction of US dollar investments. This is a further reason why it is useful for us to invest large portions of our capital in foreign markets and in non-dollar securities.