As investors fret over the growing possibility of a US recession in 2008 and potential earnings downgrades, they should not forget many experts believe that the allocations of Sovereign Wealth Funds (SWFs) are likely to support equity valuations in the medium term. Many of these funds are in the early phases of their investment programs. They currently control roughly $3 trillion in assets and are projected to invest roughly $5 trillion in the next five years.

Given that the net supply of global stock has been negative in recent years and that indicators suggest that this trend is unlikely to reverse soon, as SWFs diversify into publicly-traded equities, there is scope for the global equity risk premium to fall. Possible other financial implications of the rise of SWFs include: a rise in US real yields; sustained interest in emerging market equities and debt; accelerated development of new asset classes; and continued strong flows into private equity, real estate and alternatives, including hedge funds and commodities. The acquisition by SWFs of 5-10% strategic stakes in global companies also has the potential to accelerate corporate restructuring.

A primary goal of SWFs is to earn a return greater than returns on foreign exchange reserves, which are typically invested in deposits, US Treasury notes and other sovereign instruments. As a pure conjecture, analogizing from the asset allocation of a typical pension plan, I speculate that over time the approximate collective allocation of SWFs will be 60% equities, 30% bonds and 10% alternatives.

Capital market theory holds that the world market portfolio is the most efficient. A working hypothesis is that SWFs will, over time, sell US Treasuries and reallocate to global equities and bonds in proportion to their world market weights.

Estimates of the size of the world’s capital market vary; the average of figures compiled by the McKinsey Global Institute, Goldman Sachs, and Merrill Lynch place the total stock of global equities at roughly $33 trillion; global government bonds - $21 trillion; private sector bonds - $24 trillion.

If all SWFs were today to index 60% of their assets to the FTSE® Global All Cap Index (the “index”), they would collectively own roughly 4.6% of each of the 7,805 companies in the index. Given prospective flows and supply/demand dynamics, there is scope for global p/e ratios (currently at 14 times 12 month forward earnings) to expand.

Foreign official institutions currently hold 32% of the roughly $4.5 trillion in marketable US debt held by the public; eighty-five percent of these holdings are in Treasury notes and bonds. In a recent study of the US Treasury market, University of Virginia scholar Frank Warnock found that foreign buying of US Treasuries has kept long-term US interest rates about one to one and a half percentage points lower than otherwise. Others place the impact at roughly 50 basis points. To the extent foreign central banks reduce their purchases of US securities and that SWFs sell Treasury notes and bonds to diversify, US real yields potentially could rise.

Since 2001, the US dollar’s share of allocated currency reserves has fallen from 71% to 65%. The dollar constitutes a smaller portion of the developing countries’ reserves (60.5%) than developed countries’. At the margin, increasing diversification over time by SWFs may further pressure the dollar. But many believe that the overall impact is likely to be small, given that global FX markets trade approximately $3 trillion a day.

Many SWFs originate in developing countries. Middle East funds may promote regional markets and new instruments like Islamic bonds. And China’s voracious demand for commodities may lead to a strategic focus on emerging markets (particularly resource rich markets and Asia) and the infrastructure required to get materials to market.

Investors should be cautious in their overall assessment of the impact of SWFs on global asset prices. A “partial equilibrium” analysis can be misleading. For example, a shift by US baby boomers out of stocks into US bonds could offset some of the effects of reduced US Treasury purchases by foreign governments. But neither can investors ignore the emergence of a major new class of investors, and the policy response to their activities.

This article first appeared in the Financial Times December 13, 2007.

The FTSE® Global All Cap Index is a trademark jointly owned by the London Stock Exchange Plc and The Financial Times Limited, and is used by FTSE International Limited under licence. “All-World”, “All-Share” and “All-Small” are trademarks of FTSE International Limited.

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The views expressed are the views of George Hoguet only through the period ended December 3, 2007 and are subject to change based on market and other conditions. The opinions expressed may differ from those with different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results.

Posted On: January 04, 2008