Financial markets are off roughly 17% in the last couple of weeks. S&P has downgraded US debt for the first time (ever). There’s talk of a new recession and a permanent change in the global economy’s prospects. Some think we’re heading into GFC2, while others I’ve been talking to think GFC1 never really got resolved. In other words, folks, it’s bad out there. And this raises an interesting question: What are sovereign funds doing? I’ve got some thoughts on the topic.
Investment Strategies: Obviously, SWFs are special purpose investment vehicles, so it is natural to wonder what, if anything, the current tumult is doing to their strategy and tactics:
- Equities: You might be saying to yourself (as I was earlier this morning) that the long-term nature of sovereign funds makes today’s rapidly declining market a long-term buying opportunity, right? Cue bucket of ice water: Not so say two C-level SWF execs I spoke with this morning (…the ‘nerdy finance’ kind, not the ‘government bureaucrat’ kind…). Both of these individuals had some rather pessimistic (and, as per usual, not for attribution) thoughts about long-term prospects for global equity markets. For example, one of these individuals was genuinely worried what markets would do if we were in fact heading into a new recession with high unemployment, considerable de-leveraging still required (consumer, housing, public, etc.), and little or no “ammo” left at the level of the government to do anything about it. This individual’s take: Risk is definitely in the “off” position.
- US Treasuries: Here’s a trick question that’s been going around: Does the US downgrade mean SWFs will be looking to hold fewer US Treasuries? Technically, asking if a SWF will be looking to hold fewer Treasuries is a bit like asking whether they have the Internet on computers now. (Huh?) Sovereign funds exist, generally, to help governments diversify their reserves away from low-yielding US Treasury holdings. (This is particularly true for Asia’s reserve investment corporations, such as the CIC and KIC). Recall that countries with large stockpiles of foreign reserves were finding it increasingly costly to hold these reserves due to the over-bought Treasury market (Dani Rodrik calculated this cost to be in the neighborhood of 1% per year for reserve hoarders). As such, governments sought new mechanisms to invest their assets so as to achieve higher returns. Indeed, SWFs were seen to be the “natural institutional blueprint for more active management of excess reserves.” So, I don’t expect the downgrade to push SWFs any further away from US Treasuries than they were already headed. If anything, a higher yield on T Bills could end up bringing some of the sponsors back towards these assets.
- Illiquids: If you’re overweight in illiquid assets and don’t have to sell to meet liabilities…big smiles. Otherwise…
Withdrawals: The investment strategy is interesting, but I personally think the more interesting question is what the current crisis means for SWFs AUM. Will governments start tapping their SWFs for reserves? Permit me to drop some science on you for a second: SWFs exist, at the most basic level, to insulate domestic economies from the external forces that would seek to disrupt domestic plans or discount domestic institutions. As such, while most SWF sponsors will tell you that the main impetus for setting up a sovereign fund is to manage foreign exchange reserves, diversify commodity rents or invest pension wealth; that’s really a second-order objective. SWFs’ sponsors’ first order of business is to buffer their domestic economies from the risks to autonomy and sovereignty in a global economy. These sponsors wield SWFs to protect against a commodity price collapse, a mortality improvement, a diminishing tax base, a currency crisis or even a financial crisis (among many other things). SWFs are a form of self-insurance; they are coping mechanisms for dealing with external uncertainties that inevitably come with global economic integration. Think of it this way: SWFs offer policymakers a chance to make reliable and consistent plans in an environment that is increasingly subject to volatility and market-based short-termism. (Confused? See this. More questions? Try this. Still struggling? Sorry, you’ll have to go here.) So, if the global economic environment continues to deteriorate, there is no doubt in my mind that we’ll see some SWF sponsors looking to their funds to help minimize the global volatility at the domestic level; to ‘stabilize’ the unpredictable market forces. In the past few years, we’ve seen this in Chile, Ireland, Kuwait, Russia, Singapore, and others. Who’s next?
Governance: Yes, I write about good governance all the time so I’ll keep this short. But I have some questions: As I write this post markets are off 6%, does your pension or sovereign fund board know where its portfolio is? Is it prepared to meet (and I mean right now) to evaluate the situation or is it sitting tight and waiting for its quarterly get together? Does your pension or sovereign have a savvy Chairman and CIO that can guide you through these difficult waters? Is your pension or sovereign staffed by a bunch of hardened, icy veined finance professionals or do you have green portfolio managers because that’s all you could recruit into your constrained HR environment? Tough questions for touch times.
Anyway, that’s all I have time for today. Hopefully tomorrow things turn around!
PS: Markets just closed: As it stands, if you invested a dollar in the S&P 500 in late 1998, you’d have less than a dollar today. That’s awful news for retirees. Awful. Imagine you’re 65 years old and ready to retire and all you have is a 401k filled with equities. Brutal.
This post originally appeared on the Oxford SWF Project