Investing Daily

As was telegraphed in last Tuesday’s statement announcing another 25 basis point increase to its target overnight interest rate, the Bank of Canada’s (BoC) July 2010 Monetary Policy Report (MPR) included a downward revision to its economic growth forecast.

It seems rather incongruous that Governor Mark Carney and his colleagues at the BoC would hike rates at the same time they issue a gloomier growth forecast, but the BoC sees enough inflation pressure already in the pipeline to justify another modest increase right now. The global economic situation is apparently no longer so severe that extraordinary monetary ease is required of Canada. But it must be noted that at 0.75 percent the BoC’s target overnight rate is still historically accommodative.

The conclusion of July’s MPR is that “the economic recovery is proceeding but is not yet self-sustaining.” And a further drag on growth could come from efforts the world over to address out-of-control balance sheets, which would mean more savings and less spending by consumers as well as governments. These efforts will likely have negative impacts on short- and medium-term growth, but over the long term fiscal health will support sustainable expansion.

Although the BoC notes that Canada’s recovery continues, the central bank projects a more gradual unfolding, with growth of 3.5 percent in 2010 and 2.9 percent in 2011, down from April forecasts of 3.7 percent and 3.1 percent, respectively. By 2012 Canada’s economy should be growing by 2.2 percent, which represents a slight upgrade from the 1.9 percent estimate from the spring. The 2010 and 2011 revisions have more to do with less optimistic views about the situation beyond Canada, though domestic consumption will moderate a bit as well.

Regarding Canada and its increasing prominence in the global economy, following is an excerpt from the September 2010 FT Press volume The Rise of the State: Profitable Investing and Geopolitics in the 21st Century by Yiannis G. Mostrous, Elliott H. Gue and our very own David F. Dittman that discusses the country and its minor but important role in a drama that’s played out with increasing consequence over the last decade, the emergence of sovereign wealth funds (SWF) and other, similarly structured state-sponsored and state-owned entities that operate in the global economy. Canada has been both a source of talent for rising SWFs and a destination for their capital.

The Next New Order

Sovereign wealth funds have existed for more than half a century--in the Middle East, East Asia, and North America, too. The truth is government has and will always have a critical role in the economy. We are now in a period where the state’s prominence is on the rise.

The early response from US leadership to the proliferation of state-sponsored actors in the economy was more about establishing domestic political advantages than enlightening the public to the realities of globalization. Contrary to the worst fears catered to by elected officials, SWFs and their like have proven to be no more political than a typical pension or mutual fund.

But the Great Recession changed everything. SWFs played a key role in stabilizing the global financial system, providing significant capital to Western institutions at critical moments. Their legitimacy confirmed, SWFs have been among the most aggressive global investors in the early days of the recovery.

The rise of SWFs is just one sign of the changing balance of power in the world economy. Influence is shifting away from Western industrialized countries to emerging China and the GCC states.

SWFs attracted the attention of economists and fiscal and monetary bureaucrats for three reasons. There was a significant up-tick in the number of funds after 2003. Funds--new and old-- rapidly accumulated assets. Their sheer size and scope put several in company with some of the largest public-pension plans and central bank reserves in the world.

What politicians and the media initially emphasized is that SWFs are owned by the state. There are fascinating intellectual debates about the propriety of government involving itself in markets; there are vital practical debates about whether such entities will destabilize foreign markets and governments at the behest of their political bosses. But overwhelming evidence indicates that, since first appearing more than half a century ago, while making many equity investments abroad, including in iconic names such as Chrysler in 1973, SWFs have acted as responsible investors. One of ADIA’s key recent hires was actually recruited out of the Canadian Pension Plan Investment Board (CPPIB) to establish an in-house infrastructure investment operation. ADIA is perhaps the most secretive of SWFs; that it hired the person who started CPPIB’s infrastructure practice, one of the institutional management world’s first, is a sure sign ADIA is on the prowl for global assets and for knowledge to bring home for long-term domestic modernization. Equally important, this personnel move illustrates the similar nature of SWFs and traditional institutions such as pension funds. The record suggests that their long-term focus in fact improves market stability. And SWFs have largely accepted that, with regard to their cross-border investments in publicly traded companies, they must be seen as passive investors lest they be the subject of political controversies.

There’s nothing particularly remarkable about SWF managers’ sheer stock-picking ability. Available data reflect the fact that SWF returns don’t stand out relative to the broader market; in fact, part of SWFs’ collective notoriety can be traced to international--and domestic--reaction to significant losses related to high-profile investments in damaged Western financial institutions. Half of the investments included in the Monitor-FEEM database occur after June 2005, in line with the mid-decade surge in SWF activity. As such, performance numbers are skewed because to the historic correction that got underway in the fourth quarter 2007. As of Dec. 31, 2008, almost a third of the number and more than half of the dollar value of SWF investments were directed toward financial firms. Although the Gulf Cooperation Council (GCC) funds suffered losses on paper of between a fifth and a quarter of their value, as a group they performed better than funds based in the Asia-Pacific region as well as certain high-profile funds and endowments in North America and Europe. Older funds with large, diversified portfolios fared better than those which had pursued aggressive investment strategies and participated in significant leveraged transactions.

But our advice is not to chase stocks in which SWFs invest. Rather, the value of SWFs to the individual investor is primarily what their emergence says about the changing nature of the global economy. That’s not to say, however, that SWFs don’t emit important signals to investors. The Middle East and East Asia will be key centers of growth in the coming decade. Because in many cases SWF investments reflect, for example, the resource needs of the domestic economy, their choices broadly lead us to markets such as Australia and Canada because of their coal and precious metals reserves. A partnership with a leading technology manufacturer suggests CIC would like to both expedite and profit from the spread of computers and the use of the Internet in its home country. On one hand changes in the global consumption profile still leave oil producers and the SWFs their governments sponsor in good position to realize steady foreign currency flows. Fossil fuels remain the key input for economic growth. The export-modeled powerhouses of Asia, on the other hand, will have a more difficult path to future funding as the US undergoes its now-mandatory deleveraging. Although the Chinese, because of their sheer number, have the potential to replace some of the consumption slack left by the American consumer’s behavior change, higher savings rate for the world’s No. 1 consumer.

Criticism of sovereign wealth funds often centers on the concern that they’ll pursue politicized investment objectives and that they’re non-transparent, particularly those headquartered in Asia and the Persian Gulf. However, it’s the larger threat, to an order that has only taken shape during the last three decades, driving the backlash in the US. The US is ostensibly committed to the principle that private actors allocate capital better than public actors. The rise of SOEs and SWFs by some accounts is a direct challenge to this orthodoxy. Politicians have invoked emotion to stir opposition, and their actions suggest that, no matter what principles and standards of practice, for investing SWFs as well as recipient countries, international institutions establish, governments will defend themselves as they see fit. This emotional approach provides a stark contrast with SWFs’ behavior. The notable thing about SWFs during the financial crisis and the recession it exacerbated is not that they made particularly savvy investment deals; rather, they didn’t panic. They proved to be steady, reliable sources of capital. Many withstood withering criticism for decisions made in 2007 and 2008, not only from recipient countries but from domestic officials and citizens.

Some observers in the US, critical of the political response to the DP World-P&O deal and the suspicions expressed following the massive infusions of capital made by SWFs into crippled financial institutions, worried that these sources of capital would simply avoid the US in favor of more hospitable jurisdictions, places where their activities wouldn’t be subject to the kind scrutiny hyper-partisan domestic political theatrics and a 24-hour news cycle hungry to be fed by same naturally subjects them to. Paradoxically, however, the record suggests SWFs avoid such considerations altogether. They are focused on long-term returns, wherever they can find them.

In testimony before the House Committee on Foreign Affairs on May 21, 2008, Dr. Gal Luft, Executive Director of the Institute for the Analysis of Global Security, noted:

The rise of sovereign wealth funds (SWF) as new power brokers in the world economy should not be looked at as a singular phenomenon but rather as part of what can be defined a new economic world order. This new order has been enabled by several mega-trends which operate in a self-reinforcing manner, among them the meteoric rise of developing Asia, accelerated globalization, the rapid flow of information and the sharp increase in the price of oil…[1]

Sovereign wealth funds, on the whole, made it through The Great Recession and are now fixtures in the global financial system. The most substantial funds are stronger now than they were before the crisis began. SWF leaders--namely ADIA--won the 2006-2008 transparency struggle with Western financial elites. The Santiago Principles for the most part reflect their influence.

In a Dec. 6, 2009, New York Times article describing the impact of the rally that commenced almost exactly nine months earlier, sovereign wealth funds were described as “white knights” now collecting ample profits from their once-distressed investments.[2]

Their second act has gotten off to a better start than the first. But there remain serious questions about how--and whether--governments should act in the economy, much less as shareholders, both in the near term and over the longer term. These questions are important with regard not only to China, Singapore, Russia, Abu Dhabi and the other GCC States. They are also important in light of the extraordinary efforts by policymakers in the US and the United Kingdom to prop up their respective economies. How the US government handles its exit from financial institution- and the auto sector-ownership and the manner in which the Fed rolls back extraordinary liquidity measures will have at least as much impact on the global economy in the short term as any move CIC or the ADIA makes. These tasks are much more fraught with risk: The government has to keep these businesses alive while simultaneously overseeing their fundamental transformation. SWFs, by contrast, are simply seeking long-term returns.

Along with the proliferation of state-run companies and pools of capital in the middle part of the last decade came rising suspicion about the motives of such actors; were they investing based on pure financial and economic considerations, or were they advancing the interests of their sponsoring regimes? Recent events have exposed SWFs as generally responsible, long-term-oriented investors that provide liquidity and stability during times of duress. Broader motivations for investment decisions include diversifying economies; setting aside funds for future generations; establishing a fund to cover general government expenditure during times of low commodity prices; and investing in foreign companies to gain access to particular expertise that will enhance domestic development. At the end of the day decisions are made based on logical, rational considerations made by professionals.

The recent rise of SWFs and their relative health in the aftermath of one of the most severe market downturns in decades is strong evidence of a changing global financial and economic architecture. Their behavior is worthy of understanding by the individual investor because of what it says about changing consumption patterns around the world and where the growth is. Those who pay attention will profit.

The preceding is an excerpt from The Rise of the State: Profitable Investing and Geopolitics in the 21st Century, to be published by FT Press in August 2010. The Rise of the State is available now for pre-order at Amazon.com.

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[1] Luft, Dr. Gal, “Sovereign Wealth Funds, Oil and the New World Economic Order,” (Testimony, House Committee on Foreign Affairs, May 21, 2008). Available at http://foreignaffairs.house.gov/110/luf052108.htm. Accessed 07/12/09.

[2] Dash, Eric, “Big Paydays for Rescuers in the Crisis,” (New York Times, December 6, 2009). Available at http://www.nytimes.com/2009/12/07/business/global/07bank.html. Accessed 12/7/2009.