Notes From Underground: Sovereign Wealth Funds and Their Potential Impact

Today brings a further confirmation of the negative divergence that we have been writing about for the past month. The equities have found continued strength even as the DOLLAR has had a 5% rally. The theme of U.S. growth emerging before other developed countries has helped to buoy the S&Ps and also brought an end to the DOLLAR as the main funding vehicle. We continue to hammer on the idea that if the U.S. has begun to stabilize, then the sovereign wealth funds will be searching to spend their dollars in the arena where they will have the greatest value. That is the U.S. domestic economy.

It was interesting to read overnight that the Chinese Investment Corporation (CIC) may get a $200+ billion infusion of capital from the country’s foreign exchange reserves. CIC has performed fairly well outside of a couple badly timed  infusions of capital into Morgan Stanley and Blackstone. The Chinese government appears to want to change their investment profile as we head into the New Year. Keep your eyes focused on Chinese strategic needs and an industries that yield high returns and have some inflation protection built into them.

In the Lex column of the Financial Times, there is a piece titled “Extend and Pretend.” It is another piece on the continuing stress in the commercial real estate market. Lex cites that there is $3.4 trillion of debt on commercial properties, $1.4 trillion that matures by 2012. Couple this with the cascading rental prices and falling asset values and the banks are in an “extend and pretend” mode. We believe that this is why the FED is in need of a “little” inflation to alleviate the coming stress to the debt markets from the property overhang. This is only in the commercial property market. Add to this stress the ARMS coming due in the residential market and we begin to understand why banks are parking money in treasuries rather then taking on new loans. The Obama administration can cajole all they want, but until the credit stress dissipates we believe this will continue to be a drag on the economy. If the FDIC and FED would force a liquidation the sovereign wealth funds would be there to find value for there money. This inflow of foreign funds would be the next boost to the equity markets as foreign buyers have been missing from the U.S. market, which is why volumes have not been there in the recent rally. Longer term this does not cure the ills of the DOLLAR but it does provide a short term respite from decline.

The news out of Europe has not improved as there is no clear understanding of how to do a bailout for a potential defaulting country.For all the rhetoric about a potential aid program for Greece the German/Greek 10-year spread widened out further to 276 basis points. Interestingly, the other European sovereigns have held up very well as investors believe that Greece is a one-off event. We will continue to watch the Italian bond futures to see if the stress begins to contaminate others. The debt stress continues to pressure the EURO as many investors begin to see profits erode as some central banks reconsider the role of the EURO in their reserves.As we noted last week, the YEN is the tell in the game as the Japanese currency is deemed to be the major funder.

When the equities were under pressure Friday, the YEN struggled to rally signaling us that the funding shift is underway. The Japanese are worried about a strong Yen in a period of deflation as was emphasized by BOJ Chairman Shirakawa: “We will supply ample liquidity … we are prepared to act swiftly and decisively.” The Japanese are evidently concerned and we will be also.

The AUSSIE dollar, which has been the most beloved major currency this year, is under selling pressure as year end profit taking has seen a 5% move down in the currency. We continue to believe that the Aussies are still ahead of the curve and with the Asian growth story still intact support levels need to be examined. The copper market is still holding even with Gold and Silver being sold–this should aid the Aussie but if technical support gives way then we will be alerted that other factors are at work to undermine the highly valued Aussie. Also watch the Aussie crosses to give credence to this position.

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