Following is an excerpt from the third chapter of the September 2010 FT Press volume The Rise of the State: Profitable Investing and Geopolitics in the 21st Century, a book I co-authored with my colleagues Yiannis Mostrous and Elliott Gue. In the excerpt we discuss the rise of sovereign wealth funds and what their new prominence means for the shape of the global economy.

One of the more gratifying experiences of my investment newsletter career was receiving word from our fantastic Subscriber Services folks that a KCI Wealth Society Member had written a thank note upon receiving The Rise of the State as a complementary gift as part of his membership. Of course we’re thrilled that readers are enjoying the book, but I was also struck by the context this gracious gentleman described: He intended to pass the book along to his grand-nephew, in the hope that The Rise of the State might serve as something of a primer as the younger generation adapts to a rapidly changing world.

Our hopes are certainly more modest than to provide a generational-scale statement on the global economy; we hope to provide an explanation for what’s taking place and useful advice on how to profit.

We’re grateful as well to our publisher for deciding to make The Rise of the State and the ideas we discuss therein a focal point of discussion at the second annual KCI Wealth Summit, an exclusive gathering of high net worth, self-directed investors taking place Apr. 1-2 at The Mandarin Oriental Hotel in Las Vegas. We’re excited for the opportunity to talk face-to-face with real investors about how to process what’s happening in the world today and how to make capital-deployment decisions.

We look forward to meeting you there, too.

The Road to Pan-Asia

During the last decade sovereign wealth funds (SWF) evolved into critical strategic tools in the Middle East and East Asia. The rising price of crude and insatiable Western demand for cheap imports lifted what had been low-key but significant global financial players into topics for front-page stories. Their rapid proliferation and their potential for long-term growth suggest that SWFs are here to stay.

SWF activity is directly linked to economic diversification in both emerging regions, and this role will only become more important during the next decade. What’s of greatest long-term significance is the potential for GCC and East Asian SWFs to lead the establishment of a third market to stand alongside the US and the EU.

China and the GCC are aggressively developing what’s now known as the “MENA” region–the Middle East and North Africa, where two thirds of the population is under 30 years of age, almost the mirror image of Europe and North America. Understanding the behavior of SWFs will help the long-sighted investor profit in the coming decade.

Although several rank among the world’s top institutional investors, as a group SWFs still represent a relatively small slice of total invested assets. Their recent proliferation is a function of the rapid accumulation of foreign reserves among emerging market countries, notably in petroleum-exporting countries in the Middle East, driven by the historic strength of oil prices in the mid-2000s, and in East Asia, a response to reforms implemented after the 1997-98 regional crisis as well as to US demand for exports. According to International Monetary Fund (IMF) data, reserves increased from about USD1 trillion in 1990 to an estimated USD7 trillion by June 2008, the result of insatiable demand stoked by easy credit in the US for oil and cheap manufactured products.

SWFs and their related cousin state-owned enterprises (SOE) are key instruments as East Asia and the Middle East mature into critical financial centers and the engines of growth for the global economy. Their activities–the types of investments they make and why–are broadly focused on generating long-term returns; research supports the conclusion that SWFs are no more political in their investment decisions than mutual funds. This does not mean, however, that their choices are not strategic. Only the most naïve observer would deny that positive long-term performance for the CIC and/or the ADIA will enhance China’s and the UAE’s economies, which, in turn, will boost their respective standing on the global stage. Insofar as SWFs represent a threat, the actual strategic exposure is the US consumer funding a massive accumulation of currency reserves by East Asian and Middle Eastern exporters. SWFs are an outgrowth of this phenomenon.

Early signs suggest officials in both sub-regions appreciate the long-term potential of a robust financial and development nexus between the Far and Middle East. Such a union could co-occupy the global economic leadership role with the United States. Discussions about potential investments between Chinese officials–representatives of both the government and the CIC–and the UAE intensified in early 2010, extending the cooperative relationship that led to a favorable outcome for the International Working Group of Sovereign Wealth Funds and its Generally Accepted Principles and Practices (GAPP).

SWFs sponsored by Asian exporters are sending out important signals about the direction of the global economy. Suspicion about state-owned companies gave way to obsequiousness as the last decade’s pendulum swung from credit-driven excess to credit-driven privation and crippled banks sought new sources of capital. This–not their absolute or relative size (although their rate of growth is impressive and suggests they’ll be moving up the financial chain)–is the overarching lesson about SWFs: Their “arrival” is still more evidence of a shift of global economic influence eastward. Understanding why and where their capital flows will help individual investors profit.

East Is East

The term “Seidenstrasse” literally translated means “Silk Road.” It was coined by German geographer Ferdinand von Richthofen in 1877 to describe the lucrative Chinese silk trade, which began during the Han Dynasty (206 BCE to 220 CE). The Chinese silk trade was the driving force behind the connection of trade routes into an extensive trans-Asian network.

Today these routes are in wide and increasing use. But the dynamic has changed. Now that the Middle Kingdom is rapidly growing, the vast petroleum reserves found on the Arab peninsula are of profound strategic value to it. As China’s thirst for oil has grown, energy security has become a major consideration of its Middle East policy.

Beijing once thought the Middle East too distant for significant direct investment; it limited its engagement to pushing Arab leaders to cut ties with Taiwan in favor of the People’s Republic, instead limiting its efforts to convincing Arab capitals to sever their ties to Taiwan and establish diplomatic relations with the People’s Republic. But this view has changed dramatically in the last decade. In recent years commerce between East Asia and the Middle has intensified. In addition, Chinese officials are becoming more actively engaged with counterparts in the Arab world. Energy is the critical factor in the economic relationship, but this, too, is a two-way street. Beijing values the Middle East as a source of oil and as a huge potential market for China’s oil services firms. In fact, Chinese labor services companies started working in the GCC in 1979. By 2001 China had signed almost 3,000 contracts in all six GCC states for labor services worth USD2.7 billion. China National Petroleum Corporation’s construction unit entered Kuwait in 1983 and grew substantially when it won major oil storage reconstruction projects in the wake of the first Gulf War. Chinese services firms now operate in Egypt, Qatar, Oman and other parts of the MENA region.

Trade between the GCC and China increased 40 percent between 1999 and 2004, spurring talks between the two parties about a comprehensive free-trade agreement June 2004. China and the UAE in April 2007 signed a memorandum of understanding in April 2007 for the purpose of deepening economic relations. In 2008 Dubai International Capital (DIC), a subsidiary of SOE Dubai Holding, and Chinese investment bank First Eastern Investment Group, formed a USD1 billion joint venture to invest in infrastructure, resource, and health care projects in China, with the long-term aim of listing these China-based companies on the Dubai Financial Market. This deal was an early effort in DIC’s push to invest more than USD5 billion in Asia, the Middle East and North Africa by 2011. Oil-based sovereign wealth is as interested in boosting its exposure to the Far East’s economic boom as the Far East exporters are in exploring development opportunities in the increasingly relevant MENA region.

By September 2009 the Gulf Cooperation Council and China had concluded the first round of negotiations to establish a free-trade zone between the GCC and the Middle Kingdom. In early 2010 a delegation of high-level Chinese officials met in Dubai with management of debt-burdened SOE Dubai World, the holding company whose assets include DP World. Discussions included potential Chinese investment in Dubai’s transportation and logistics operations. DP World already has a presence in China, operating marine terminals in Shanghai, China’s largest city, Shenzhen, location of the first and most successful Special Economic Zone, Tianjin, one of four municipalities with provincial-level status, and Qingdao, a major city in eastern Shandong province.

Chinese and GCC leaders played important roles in crafting the IWG’s Santiago Principles. Their work not only preserved the long-term interests of their respective SWFs. It demonstrated that Asian leaders could cooperate in a supranational context and produce a result acceptable to the West. Their ability to exert economic influence is unquestioned; this initial endeavor suggests East Asia and the Middle East are capable of participating with the US in the establishment of a 21st century global economic and financial architecture.

To learn more about sovereign wealth funds and their role in a changing global economy, read The Rise of the State: Profitable Investing and Geopolitics in the 21st Century by Yiannis G. Mostrous, Elliott H. Gue and David F. Dittman. And be sure to register for the KCI Wealth Summit, Apr. 1 and 2 at The Mandarin Oriental Hotel in Las Vegas.

The Roundup

Just a couple weeks after completing a conversion it probably wanted to avoid, peat moss producer Sun Gro Horticulture Inc (TSX: GRO, OTC: SGRFF) has agreed to be taken over for CAD6.60 per share by privately held IKO Enterprises Inc. Shareholders are happy with the culmination of Sun Gro’s long strategic review; though the company incurred the relatively big cost of converting, the deal price is a 28.9 premium over last Friday’s closing price of CAD5.12. Sun Gru put itself up for sale in September 2010 because the board didn’t believe the market properly valued the business. The good news is now shareholders can get out a little closer to the original CAD10 offer price.

Earnings season is underway, as Google (NSDQ: GOOG) and General Electric (NYSE: GE) each reported fourth-quarter results that gave a boost to the broader market on Friday morning.

Here’s the rundown of estimated (except where indicated) earnings announcement dates for Canadian Edge Portfolio Holdings.

Aggressive Holdings

• Ag Growth International (TSX: AFN, OTC: AGGZF)–Mar. 11
• ARC Resources Ltd (TSX: ARX, OTC: AETUF)–Feb. 9
• Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF)–Feb. 24
• Daylight Energy Ltd (TSX: DAY, OTC: DAYYF)–Mar. 2
• EnerCare Inc (TSX: CWI-U, OTC: CSUWF)–Mar. 1
• Enerplus Corp (TSX: ERF, NYSE: ERF)–Feb. 25
• Newalta Corp (TSX: NAL, OTC: NWLTF)–Mar. 2
• Parkland Fuel Corp (TSX: PKI, OTC: PKIUF)–Mar. 2
• Penn West Petroleum Ltd (TSX: PWT-U, NYSE: PWE)–Feb. 18
• Perpetual Energy (TSX: PMT, OTC: PMGYF)–Mar. 9
• Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF)–Mar. 9 (confirmed)
• PHX Energy Services Corp (TSX: PHX-U, OTC: PHXHF)–Mar. 3
• Provident Energy Ltd (TSX: PVE-U, NYSE: PVX)–Mar. 11
• Vermillion Energy Inc (TSX: VET, OTC: VEMTF)–Mar. 3
• Yellow Media Inc (TSX: YLO, OTC: YLWPF)–Feb. 11

Conservative Holdings

• AltaGas Ltd (TSX: ALA, OTC: ATGFF)–Feb. 23, 2011
• Artis REIT (TSX: AX-U, OTC: ARESF)–Mar. 2, 2011 (confirmed)
• Atlantic Power Corp (TSX: ATP, NYSE: AT)–Mar. 29, 2011
• Bird Construction Inc (TSX: BDT, OTC: BIRDF)–Mar. 11, 2011
• Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF)–Feb. 16 (confirmed)
• Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF)–Feb. 24
• Cineplex Inc (TSX: CGX, OTC: CPXGF)–Feb. 11
• CML Healthcare Inc (TSX: CLC, OTC: CMHIF)–Mar. 4
• Colabor Group (TSX: GCL, OTC: COLFF)–Feb. 24
• Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF)–Mar. 2
• IBI Group Inc (TSX: IBG, OTC: IBIBF)–Mar. 17
• Innergex Renewable Energy (TSX: INE, OTC: INGXF)–Mar. 22, 2011
• Just Energy Group Inc (TSX: JE, OTC: JSTEF)–Feb. 11, 2011
• Keyera Corp (TSX: KEY-U, OTC: KEYUF)–Feb. 18, 2011
• Macquarie Power & Infrastructure Corp (TSX: MPT-U, OTC: MCQPF)–Mar. 2
• Northern Property REIT (TSX: NPR-U, OTC: NPRUF)–Mar. 17, 2011
• Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF)–Mar. 3, 2011
• RioCan REIT (TSX: REI-U, OTC: RIOCF)–Feb. 9, 2011
• TransForce (TSX: TFI, OTC: TFIFF)–Mar. 2, 2011 (confirmed)