Sovereign funds fear inflation, looking to property & commodities

By Kevin Lim and Saeed Azhar, Reuters

SINGAPORE (Reuters) - Sovereign wealth funds are concerned about inflation caused by massive stimulus packages in the west and investing more in property and commodities to hedge against that risk, Franklin Templeton said on Friday.

"There is quite a lot of interest in real estate and other long-term hedges against inflation," David Smart, London-based global head of sovereign and supranational funds at Franklin Templeton told Reuters in an interview on Friday.

"When you have this degree of stimulus, if it is not unwound at the right time, the risk on the margins is that inflation will be higher rather than lower," said Smart, whose team advises or manages around $40 billion from sovereign funds and international organisations.

He said Franklin Templeton was not concerned about hyperinflation, but added the risk is that core inflation could hit 3-5 percent levels in developed countries from the 2 percent levels seen prior to the financial crisis.

Western governments and central banks have spent trillions of dollars to shore up banks and stimulate their economies over the past two years. While the measures have helped alleviate the worst recession in over 60 years, the surge in money supply has stoked fears that inflation could spike as the global economy recovers.

Smart, a former bond fund manager, said Franklin Templeton's sovereign clients are keen on real estate, in particular UK commercial property, which are offering net rental returns of 7.5 to 8 percent.

"From a currency perspective, the fact that sterling has declined quite a lot means in dollar terms you are getting something that would have cost you 50-60 percent more 18 months ago."

Sovereign funds are, however, wary about U.S. commercial property due to concerns prices could fall further.

The Federal Reserve said earlier this month that U.S. banks are at risk of sizeable new loan losses, particularly on commercial property.

"The price adjustments (in the U.S.) have not been nearly as savage as they have been in the other markets. There are a lot of issues on debt financing which have not really been addressed," Smart said.

Other investments favoured by sovereign wealth fund clients include inflation-linked bonds and commodities.

Sovereign funds, which together manage around $3 trillion (1.8 trillion pounds) in assets, have become more active in recent months, pouring billions into energy and commodities after a quiet first half of the year.

State investors led by Chinese and Abu Dhabi funds ploughed 61 percent of their total investment into natural resources and only 15 percent in financials, according to Barclays' estimates.

Smart said sovereign funds were concerned about the dollar's weakness and diversifying into other currencies, which partly explained the strength of the euro. Within Asia, the most popular currency was the won due to the depth of the Korean bond market.

Sovereign investors would, however, continue to buy U.S. Treasuries as there were few other alternatives.

"I would say some the U.S. dollar is still going to be a very substantial part of their portfolio in terms of the asset opportunities that are available in the U.S. and the liquidity that the bond market offers," he said.

Templeton's Smart said sovereign funds are also buying over private equity investments made by pension and university endowment funds.

Smart said some endowment funds had overcommitted to private equity, assuming their actual cash outlays would be smaller since the private equity fund would have paid out proceeds from the divestment of earlier investments.

"If you commit $100 million to private equity, you (assume) you are actually committing to a maximum of $75 million at one time because you get cash flows from earlier investments," he said.