JPM Explains How Crude Carnage Creates $75 Billion SWF "Contagion" For Equities

Back in August, we explained why the great petrodollar unwind could be $2.5 trillion larger than anyone thinks.

China’s effort to “control” the glidepath for the yuan devaluation led to a dramatic decline of Beijing’s FX reserves and pushed reserve liquidation to the front of the market’s collective consciousness.

But “the great accumulation” (as Deutsche Bank calls it) of USTs ended long before the RMB deval forced the market to start talking about FX reserves. In short, the inexorable decline in crude prices (and commodities in general) forced producers to sell USD assets in an effort to offset pressure on their currencies and plug yawning budget gaps.

And while the world is now fully awake to the fact that these asset sales amount to QE in reverse (global central banks are selling the same assets the Fed once bought), what isn’t as well understood is that looking strictly at official FX reserves paints an incomplete picture. “Crucially, for oil exporting nations, central bank official reserves likely underestimate the full scale of the reversal of oil exporters’ ‘petrodollar’ accumulation,” Credit Suisse wrote last year. “This is because a substantial part of their oil proceeds has previously been placed in sovereign wealth funds (SWFs), which are not reported as FX reserves (with the notable exception of Russia, where they are counted as FX reserves).”

The difference between total SWF assets and official reserves for oil exporting nations is vast. "Currently, oil exporting countries hold about $1.7trn of official reserves but as much as $4.3trn in SWF assets," Credit Suisse went on to point out, adding that. "In the 2009-2014 period, oil exporters accumulated about $0.5trn in official reserves but as much as $1.8trn of SWF assets." Or, visually:

As you can see from the above, oil exporters' accumulation of SWF assets comes to a dramatic halt when crude prices fall. Critically, it's exceedingly possible that the accumulation of SWF assets turns negative now that the return of Iranian supply means oil prices are set to stay lower for longer. Or, as Credit Suisse put it, "now that the tide has turned, it is likely that not only official reserves drop but that SWF asset accumulation slows to nil or even reverses."

Perhaps the best example of this is Norway's SWF which, at $830 billion, is the largest in the world. 

Falling crude has put enormous pressure on Norway's economy, and with oil revenue plunging along with prices, the country is now set to drawdown its SWF rainy day fund for the first time in history in order to plug budget holes and pay for fiscal stimulus designed to offset some of the jobs lost to the industry downturn. The fund will still grow as long as return assumptions hold up, but as we saw in the first two weeks of this year, any "assumptions" about returns are dubious in an increasingly uncertain environment. Here, for reference, it a handy table lists SWFs by country and AUM:

It's important to understand that SWFs hold more than just bonds. That means that if SWFs become sellers, there are implications for other asset classes. 

Like stocks. 

Here are some findings on SWF equity investments from "Sovereign Wealth Fund Investments: From Firm-level Preferences to Natural Endowments," by Paris School of Economics' Rolando Avendano:

There is significant variance in the allocation of SWF equity investments, depending on underlying factors associated with the fund (source of proceeds, OECD “effect”, home/foreign bias). Whereas most SWFs are attracted to large firms, with proven profitability and international activities, differences among groups remain:

  • Non-commodity funds favour firms with more foreign activity and higher turnover, in contrast to commodity-funds.

  • OECD-based funds prefer firms with lower leverage levels, whereas non-OECD funds have a preference for profitable and international firms.

  • SWF foreign investments are oriented towards large and highly leveraged firms, in contrast with their domestic (small and low leveraged) investments. Foreign investments are attracted to R&D sectors.

  • In line with the previous literature, I find that SWF ownership has a positive effect on firm value. However, this effect is only significant for commodity and OECD-based funds.

The study was from 2006-2009 and one imagines some of these preferences might have changed in the post-crisis world, but the paper (found here) is still worth a read.

All of the above begs the following question: will the SWFs of oil producing countries be net sellers of stocks if crude prices remain subdued and if so, how much will they sell?

JP Morgan's Nikolaos Panigirtzoglou and team have ventured a guess. "In our mind financial contagion from lower oil prices to equity markets is created via sovereign wealth funds," JPM begins. Here's more:

The lower the oil price the higher the potential depletion of SWF assets as oil producing countries struggle to prevent their spending from declining too much. And the equities owned by oil producing countries SWFs encompass all regions and all sectors.


To assess SWF flows and their potential impact on equity market flows, we update our analysis on FX reserves and Sovereign Wealth Fund (SWF) assets for 2016 in light of the recent steep decline in oil prices. Using our average Brent oil forecast of $31 for 2016, how would oil-related financial flows look like in 2016?


In 2015, oil exporters (Middle East, Norway, Russia, Africa and Latam countries) received $740tr from their oil exports and will see their oil revenue decline further to $440bn should Brent oil price average at $31 this year. Oil exporters’ revenues are recycled via two channels: via imports of goods and services from the rest of the world and via accumulation of financial assets, mostly through SWFs. In 2015, oil exporters consumed $70bn more than their oil revenues to prevent their spending from declining too much. On our estimates, this excessive spending was met via around $50bn of FX reserve depletion and $20bn of SWF depletion.


Assuming a $22 decline in the average oil price in 2016 relative to 2015 (i.e. from $53 to $31), the oil exporters’ aggregate current account balance will likely decline to around -$260bn vs. -$70bn in 2015 (based on last year’s sensitivities of current account balance change to oil price change). This year’s dis-saving of $260bn should be mostly met via depletion of official assets, i.e. FX reserve and SWF assets ($240bn) rather than issuance of government debt ($20bn). For 2016 we look for FX reserve depletion of $100bn and a decline in SWF assets of $140bn.


Assuming selling in accordance to the average allocation of FX Reserve Managers and SWF across asset classes, we estimate that the sales of bonds by oil producing countries will increase from -$45bn in 2015 to -$110bn in 2016 and that the sales of public equities will increase from -$10bn in 2015 to -$75bn in 2016. There is little offset to this -$75bn of equity sales from accumulation of SWF assets by oil consuming countries, as we expect these countries to spend most of this year’s oil income windfall.  

In short, SWF's will liquidate some $75 billion in equities this year assuming oil at $31 per barrel. Needless to say, the lower oil goes, the more selling they'll be. 

"This prospective $75bn of equity selling by SWFs in 2016 is not huge but becomes significant after taking into account the potential swing in equity fund flows," JPM continues, in an attempt to discuss the impact this will have on markets. "Last year retail investors bought $375bn of equity funds globally. This year we expect an amount between 0 and $200bn. Subtracting $75bn of selling from SWFs would leave the overall equity flow from Retail+SWF investors barely positive for 2016."

Well, not really. It's "barely positive" if retail buys $76 billion or more. But if retail investors buy anywhere from zero to $74 billion, SWF + retail goes negative.

Needless to say, the first two weeks of the year haven't done anything to either shore up the SWFs of oil producers or put retail in a bullish mood. That being the case, the market better home the "smart" money is buying or you can forget about equities catching a bid this year.

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An infographic look