Back in August, we noted that, for the first time since it's creation in 1996, the Norwegian government had started raiding its sovereign wealth fund in 2016 to cover government deficits. Then in October the Nordic country revealed plans to massively increase withdrawals by over 25% in 2017, to $15 billion, to cover a budget hole that was expected to be roughly 8% of GDP.
That said, Norway's ultimate GDP potential, and therefore budget deficits, are heavily dependent on oil prices so any further weakening of crude could result in even more withdrawals. Moreover, given the substantial YoY increase, it's important to recall that there are fiscal limits imposed on fund withdrawals equal to 4% of assets, or roughly $36 billion, which could come into play at some point in the future if oil prices remain "lower for longer."
Of course the withdrawals accelerated just as the heavily oil-dependent economy of Norway started to absorb the impact of lower oil prices.
And what do you do when you depend on portfolio returns to fund everyday living expenses but are faced with extremely low returns courtesy of artificially depressed international bond yields? Well, you just buy more equities, of course. Which, as we noted back in December, was exactly the motivation behind a decision to increase the fund's equity allocation from 60%, to a staggering 75%, all while funneling another $130 billion to the global equity bubble.
The central bank’s board, which oversees the fund, on Thursday recommended an increase in the equity share to 75 percent from 60 percent. That will raise the expected average annual real return to 2.5 percent over 10 years and to 3.5 percent over 30 years, compared with 2.1 percent and 2.6 percent, respectively, under the current setup.
The world’s largest sovereign wealth fund said that it expects an annual return of only 0.25 percent on bonds over the next decade and that the expected “equity risk premium,” or return on stocks over government bonds, will be just 3 percentage points in a cautious estimate.
“In our analyses, this is clearly evident in global data: internationally, growth in firms’ cash flows and equity returns are correlated with growth in the global economy,” Deputy Governor Egil Matsen said in a speech Thursday in Oslo. “Global economic growth in the coming years is expected to be below its historical level. This ‘pessimism’ is partly related to the driving forces behind the low level of the real interest rate.”
But despite their best efforts to protect the principle balance of Norway's sovereign wealth fund through statutory spending caps and buying more and more equities, Norway’s central bank governor Oystein Olsen warned earlier today that increasing reliance on the fund to cover budget deficits could result in a "sharp reduction" in the fund's capital over the next 10 years. Per Bloomberg:
Governor Oystein Olsen said that the continued rise in oil cash spending, which now accounts for about 20 percent of the budget and 8 percent of gross domestic product, must now be halted to protect the $900 billion fund, the world’s largest sovereign pool of cash.
“With a high level of oil revenue spending, there’s a risk of a sharp reduction in the fund’s capital,” Olsen said in the traditional Annual Address in Oslo Thursday. “This could, for example, happen if a global recession triggers both a decline in oil revenue and low or negative returns on the fund’s capital.”
In fact, in some of the more dire scenarios, Olsen warned that 50% of the fund's $900 billion in assets could be wiped out over the next 10 years in the event of a global recession that kept oil prices low while also driving equity valuations down.
While the fund, which is overseen by the central bank, so far has said it’s more than able to handle outflows without selling assets, Olsen’s speech did lift the lid to reveal some of the worst case scenarios being calculated by the investor.
For example, it sees a 1 percent chance of a 50 percent decline over 10 years if spending is kept at the current level of about 3 percent of the fund. If spending is raised to 4 percent that probability rises to about 5 percent. If the fund’s allocation to stocks is boosted to 75 percent from 60 percent, which is currently being discussed, the probabilities rise even further to about 2 percent and 6 percent, respectively.
“This shows what you may risk if you increase oil spending from today’s level,” Olsen said in a separate interview. “This helps us to strengthen the message.”
“It must be recognized, however, that the longer-term challenges facing the the Norwegian economy can’t be resolved by spending more oil revenue and keeping interest rates low,” he said in the speech, arguing the Norwegian economy needs more legs to stand on.
That said, we wouldn't be too worried because equity prices never go down, right? Silly Central Banker...