Trade surpluses driving asset bubbles - How to prepare

June 20, 2007

The massive U.S. current account deficit of $862 billion is creating a trade surplus for many countries, most notably China, Japan, and the oil-producing countries. This generates extra cash, known as foreign reserves, most of which has been invested in U.S. Treasury bonds. The resultant low interest rates have allowed cheap credit for U.S. consumers to keep buying imported products, creating further trade surpluses. (For a ranking of foreign reserves by country, see CIA Factbook)

However, many of these countries have set up special funds, known as sovereign wealth funds, that could be driving a global asset bubble. Although U.S. Treasury bonds are safe, they have been returning less than 5%. So, sovereign wealth fund managers have been looking for better returns by investing in companies, real estate, and other assets.

Morgan Stanley estimates that the total amount held by sovereign wealth funds is $2.5 trillion, more than the $1-2 trillion estimated hedge fund holdings. Sovereign wealth fund holdings could grow by $500 billion per year at the current rate. However, like hedge funds, no one really knows where this money is invested or even how much there really is. (Source: Financial Times, “Sovereign wealth funds and the $2.5 trillion question,” 5/25/07; CIA Factbook, Current Account Balances, 2006)

What the trade surplus asset bubble means:
The recent increase in bond yields is thought to be, in part, a reaction to the lack of interest in the most recent Treasury bond auction. If, in fact, sovereign wealth funds are starting to move away from Treasuries, then bond yields will continue to increase. This will drive up mortgage interest rates, and make all kinds of loans more expensive. This will, in turn, further slow U.S. economic growth.

The good news is that this money should increase the value of other investments, including stocks, private equity investments, and commodities such as real estate. In addition, some of this money will be reinvested back into the originating country, which will boost emerging markets funds.

However, the sheer size of the money being invested could be creating an asset bubble. As sovereign wealth fund managers look for return, their demand will drive the prices of these assets higher, regardless of the underlying value of the asset. This could create a bubble which could self-destruct, similar to bubbles created by hedge fund and private equity firm investments. (See Hedge fund impact -- Protect yourself from volatility, 6/6/07; Private equity firms -- blowing next stock market bubble?, 5/30/07)

Action steps:
Make sure any money you need for the next ten years is in money market funds, which is relatively safe. Make sure the rest of your investments are well-diversified, which is the best way to maximize return and minimize risk. Read the World Money Watch Special Report, "Profit from China's Growth."

Sovereign wealth fund related articles:
China invests $3 billion in U.S. company , 5/23/07
Paulson to visit China, 3/7/07

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