4 January 2016

The next shoe to drop

One of the principal features of the enduring commodity “super-cycle” that permeated the early parts of this decade was the rise of Sovereign Wealth Funds (SWFs).


These powerful institutions arose out of the globalisation which fuelled the rise of global commodity demand and global trade. SWFs were essentially funded by the revenues off commodities and the resultant trade surpluses that arose in Emerging Markets.

As these trends in commodity and capital flows are now all in reverse, SWFs themselves are under increasing pressure. Inflows into these funds are dwindling, even turning into net outflows as many countries have to deal with large capital outflows as well as commitments to higher social payments and other types of fiscal commitments. We have witnessed Saudi Arabia enter international capital markets with major bond issuance designed to fund social support domestically, protecting the ruling dynasty’s status quo.

One of the added complications is the tendency for SWFs to have invested heavily in Emerging Markets. Oil-based SWFs are commonly known to be the largest holders of Indonesian and other Emerging Market sovereign bonds. As the US Dollar enters a rate tightening cycle and shows increasing strength, there is a tricky combination arising here; underlying commodities weaken pro rata and Emerging Market currencies themselves end up under increasing pressure to devalue. This circularity between Emerging Markets and oil-based SWFs is there for all to see. This will put increased downwards pressure on holdings in such sovereign bonds, potentially creating further pressure to sell.

What may emerge as one of the leading problems for 2016 is for SWFs to try and redeem prior investment patterns in Emerging Markets. As management is often bureaucratic and driven by government policy, it is only natural that SWFs should be coming forward as the source of a later cycle in Emerging Market disinvestment patterns. Whilst Western fund management groups such as Blackrock and Aberdeen Asset Management have publically stated that they have seen SWF driven outflows, we may be entering a more illiquid cycle as asset purchases, often made on a long term basis in Emerging Markets, are redeemed. These might, for instance, be constituted in property or infrastructural projects, none of which are readily liquidated. Evidence that this phase has only just commenced is anecdotal, with many SWFs feeling that they are in for the long haul and will ride out volatility.

It is my belief that SWFs will be the last seller s of Emerging Market assets. I believe that the current pressures on the Gulf States, oil rich Nigeria and the rapidly devaluing territories oil-based economies such as Kazakhstan and Azerbaijan will see disinvestment pressures proliferate. It will become increasingly clear that not all Emerging Market economies are equally prudently run. I believe that any former attempts by SWFs to achieve an “index-based” strategy to investing across a wide spread of Emerging Market economies will begin to unwind. We have seen the initial pressures of more privileged capital flows under stress in our commentary on the London property market. I anticipate weakness spreading to other alternative areas that have flourished, namely contemporary art, fine wine, luxury goods and classic cars for instance. All these categories have boomed during this period of loose money. As oil and commodity deflation are compounded by a rising US Dollar rate cycle, I believe that difficulties in managing SWFs will see further Emerging Market weakness in 2016. I believe that efforts to reorganise, redeem and manage SWFs will be an important investment theme throughout 2016.

What may lessen the awkwardness of this situation is the electoral cycle in the US. The Federal Reserve is a Democratic enclave and commentators have pointed out that this may slow the degree to which rates are hiked into an election year. In addition, the Fed’s Stanley Fischer has been clear about the effects that any US rate cycle may instil on Emerging Market economies. The Fed is acutely aware of the pronounced borrowing binge that low US interest rates have created amongst SWFs and Emerging Market corporates. Any excessively steep US interest rate cycle would create US Dollar demand and strength as this large body of debt would be forced to source US Dollars through its debt servici ng requirements. It is a further natural influence that Emerging Market base currencies come under such increasing devaluation pressure, thereby exacerbating the US Dollar’s strength in the same process. The Fed seems keen to manage this scenario smoothly, aware of all the incipient risks. Despite the Fed’s forecasts on their dot matrix of estimates implying a moderately steep increase in interest rates over the coming year, market indicators are indeed assuming a shallower path to increases than the formal guidance implies. This in turn may stifle the US Dollar’s rise and provide some respite to struggling SWFs as they attempt to negotiate a difficult 2016.


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