It’s great when posts just write themselves, and I can tell you, right now, in the first sentence, that this is going to be one of those posts.
Back in January, I wrote something here called “Norway: Future Shithole Country“. In case it wasn’t obvious (and it should have been because, you know, I explicitly stated it in the article), the allusion to “shithole” was a humorous jab at Donald Trump, not an expression of some deeply held prejudice I harbor against Norway, a place which is exceedingly unlikely to ever fit anyone’s description of a “shithole”.
The point of that post was simply to state the obvious, which is that if you’re a giant sovereign wealth fund tasked with preserving a country’s natural resources wealth for future generations, it’s generally a good idea to exercise some semblance of prudence when it comes to managing that wealth.
Good people can disagree about what counts as “prudence” and SWF allocation decisions will of course vary, but from where I’m sitting, the decision by Norway to ratchet up the equity allocation to more than 66% (on the way to 70%) is ill-advised because as it turns out, equities can be volatile, 2017’s anomalous calm notwithstanding.
I’m not going to delve too deeply into the specifics of how Norway came to the decision to push the envelope on the allocation as much as they have because you can read about it for yourself in the above-linked post, but suffice to say this idea was “informed” (and I use that term loosely) by a desire to juice returns. The push unfolded amid the downturn in crude prices that prompted the country to withdraw money from the fund for the first time ever in 2016 as part of an effort to plug a budget gap.
The problem with this is painfully obvious. Assuming withdrawals become more commonplace (and you’d be forgiven for assuming that Norway opened something of a Pandora’s box in 2016 when they started tapping the fund) this has the potential to make fiscal policy beholden to the vagaries of the global equity market. And look, don’t take it from me. Just ask Deputy Norges Bank governor Egil Matsen, who said the following last year:
Say you have a decline in the equity market, and these returns have been partly funding the government, do you want variations in international financial markets to have a direct impact on fiscal policy?
I can answer that: “no”.
And while we’re quoting Matsen, let’s do like Egil and let’s “say you have a decline in the equity market.”
Like for instance, “let’s say” you get a quarter like, oh, I don’t know, like Q1 2018, when equity volatility spikes. What happens to a portfolio that’s 66% in equities during a tumultuous quarter for global stocks?
I’ll tell you what happens. What happens is that you lose $21 billion in three months, which is what Norway’s SWF did in Q1. And guess which assets performed the worst? Well, stocks, naturally, as the fund’s equity portfolio fell 2.2% (the overall quarterly return for the fund was -1.5%, with gains in real estate offsetting loses in stocks and bonds).
Here’s Yngve Slyngstad, CEO of Norges Bank Investment Management stating the obvious:
The most important expression of the risk in the fund is that the strategic equity share is set to 70 percent. This means that fluctuations in the fund’s value are predominantly determined by the development in global stock markets.
Right. And that’s fine as long as you assume that stocks only go up (which has generally been a safe assumption for the better part of a decade), but once you take into account the fact that stocks can also fall, you run into a problem. That problem is exacerbated when the money you’re managing is not “investor money” in the traditional sense, but rather, “the people’s money”.
Just to be clear, a loss of $21 billion is nothing – Norway’s SWF is the largest on the planet with over $1 trillion in AUM. Additionally, if oil prices remain buoyant, it’s likely that Norway will be able to stop withdrawing money from the piggy bank.
But as the fund itself admitted recently, a severe market rout coupled with an appreciating currency could wipe 40% off the value of the rainy day stash. As FT wrote, “there has been significant debate in Norway about whether the government would be able to keep spending so much from the fund — it is due to use NKr231bn ($30bn) or about 3 per cent of the fund this year in its budget — if there is a market crash.”
Again, that gets right back to the issue of tying fiscal policy to the vagaries of the equity market. That’s a bad idea for reasons which are so obvious that it boggles the mind how anyone could think otherwise.
Finally, one thing that seems to be underappreciated in this whole debate is the extent to which the fund, by virtue of its size, could have a hard time exiting positions without exacerbating the rout. In other words, they could end up Plaxicoing themselves. Bloomberg reminds you that they own, on average, 1.4 percent of the world’s listed stocks. So if things are going south and they start selling, well then they could conceivably make things worse.
As with anything else, the worst case scenario here is extremely unlikely to pan out, but when I wrote the post linked here at the outset, I knew damn well there would eventually be a quarter where I got to say “I told you so”.
I just didn’t know it would be this quarter.