- USD remains key world reserve currency for now, but RMB allocations are increasing
- Central banks counteract inflation by moving into non-traditional asset classes and government bonds
- More sovereigns are researching digital assets but prefer direct investment in the wider ecosystem to gain exposure
- Scale and private market exposure drive manager outsourcing and increased use of data science
Dubai – Surging inflation has prompted sovereign investors to re-examine their asset allocation, with private markets the main beneficiary, according to the latest Invesco Global Sovereign Asset Management Study. Now in its tenth year, the study details the views of 139 chief investment officers, heads of asset classes and senior portfolio strategists at 81 sovereign wealth funds and 58 central banks around the globe, who together manage $23 trillion USD in assets.
Inflation shock presents hard choices
After a long period of low interest rates and low inflation, sovereign investors have been forced to reconsider their macroeconomic assumptions and adjust their investments accordingly. The majority of sovereigns in the Middle East (55%) have repositioned their portfolios in anticipation of further rate rises, though the sharp correction in equities and failure of bonds to shelter portfolios have presented difficult choices.
Zainab Faisal Kufaishi, Head of the Middle East and Africa, and Senior Executive at Invesco said, "While most markets ended 2021 with a cautiously optimistic outlook for 2022, the start of the year presented a perfect storm of challenges for investors. Inflation is surging, global growth is slowing, and geopolitical tensions are rising. Where the macro environment had once been relatively predictable, it is now more uncertain, sending sovereigns to rethink how to position their portfolios as they look ahead.”
Invesco’s study affirms that while global sovereigns’ fixed income allocations have declined steadily in recent years (Fig.1), they are no longer being redirected to listed equities. Instead, they are going to private market alternatives, notably real estate, private equity and infrastructure. In the Middle East, most (82%) respondents agree that real assets are effective hedges against inflation and higher yields. Zainab Kufaishi commented, “While there are some concerns about deal flow and supply driving valuations higher, private markets remain attractive to long-term investors in the region because they provide a long-duration play and shelter from volatility.” Interest in private assets looks set to continue, with 50% of sovereign wealth funds in the Middle East citing an intention to increase allocations to private equity, 20% to real estate and 20% to infrastructure over the next 12 months. Globally, private assets now constitute, on average, 22% of sovereigns’ portfolios, the highest proportion on record. In total, sovereign investors now own $719 billion in private assets, up from $205 billion in 2011*.
Although the increased interest in private markets has come at the expense of reduced allocations in fixed income for sovereign funds globally, some respondents, including those in the Middle East, are looking to take advantage of opportunities arising from the equity market correction, as well as right entry-points for fixed income as rates begin to rise.
Rod Ringrow, Head of Official Institutions at Invesco, commented: “‘Uncertainty’ has been the word dominating investors’ conversations so far this year. After a relatively predictable few years, consensus over the direction of the global economy has broken down. This, paired with the potential end of a multi-decade bull run in fixed income markets, is creating a new backdrop for sovereigns.
“While many are looking to private markets for solutions, we should not overstate the pace of this shift. As long-term investors, sovereigns are treading very carefully, and many are making only incremental changes to their portfolios, adopting a ‘wait and see’ approach.”
Ukraine invasion derails enthusiasm for Europe
In early 2022, many sovereign investors saw good value in Europe, especially when compared to the US. However, this sentiment changed after Russia invaded Ukraine, which investors feared would make inflation harder to contain while also curbing growth, posing a risk of stagflation. Unsurprisingly, developed Europe and Emerging Europe are the geographies to which sovereign investors are most likely to decrease exposure. Invesco’s study reveals that 40% of Middle East sovereigns plan to reduce allocations to developed Europe and 30% to Emerging Europe over the next 12 months. Regional respondents are most likely to increase exposure to North America (70%), the Middle East (40%), and Emerging Asia-Pacific (40%).
This study has previously noted sovereigns’ high levels of capital flows into China; however, views this year are mixed. The majority (52%) of sovereigns said that China was a more challenging place to invest than last year, with regulatory risk and government interventions in certain sectors such as technology viewed as having an impact on asset prices. However, others noted that China’s level of integration into global trade and markets notably the interdependence of the American and Chinese economies – could mitigate the geopolitical risk posed by the Russian invasion of Ukraine.
Reports of the dollar’s demise are overstated – for now
The freezing of Russia’s foreign reserves in response to the invasion of Ukraine triggered a debate about the role of the US Dollar (USD) as the world’s dominant reserve currency, especially as its allocation as a share of global central bank reserves had been steadily reducing for years: between 2016-2021, it declined from 65.4% to 58.8%, according to IMF year-end data.
While there was broad agreement that the Russia-Ukraine war would have a limited impact on the USD, respondents recognize that the Renminbi (RMB) will continue to grow and could impact the status of USD in coming years. A sizeable majority (63%) of the world’s central banks now have RMB allocations, up from 40% in 2018, and most central bankers see their position as underweight, intending to increase it in the next five years.
Inflationary trends push central banks away from deposits
Many central banks sought liquidity following the outbreak of Covid-19 leading to an increase in cash deposits. Invesco’s study shows that this trend has now reversed, as demand for greater liquidity of reserves had dried up post-Covid. As central banks navigate within a rising global inflationary environment, cash deposits are being reallocated into government bonds.
Central banks are looking to diversity into new asset classes, including equities and real assets, valuing their diversification benefits and potential for higher returns.
Sovereigns cautious on digital assets
Despite the widespread anticipation that institutional investors will embrace digital assets, Invesco’s study unveils that sovereign funds do not yet see them as investable. Just 7% of global sovereign investors have any exposure to digital assets, and much of this is through investments in underlying blockchain companies. Volatility (78%), regulatory pressure (78%) and transparency (67%) are the most common concerns among Middle East sovereigns, with just 20% thinking that digital assets have a role in asset allocation as a diversifier. For many Middle East sovereigns (70%), there is more interest in investing in companies involved in the infrastructure behind digital assets as the largest growth opportunity than the digital assets themselves.
However, research into digital assets is increasing. In 2018, just 12% of global sovereigns were conducting research into the area; now, the figure is 41%, including 40% of those in the Middle East. Sovereigns generally feel comfortable about investing in the underlying technology via private equity and venture capital products, and 55% said they would consider investing in the industry if the right opportunity were to present itself. Most central banks around the world are still deep in the research and development stage of their digital currency journeys: 71% of central banks in the Middle East are either conducting research into Central Bank Digital Currencies or considering launching one themselves.
Scale and private market exposure drive outsourcing push
In 2021, the world’s sovereign wealth funds grew their total assets under management to $10.5 trillion, up from around $8 trillion in 2018**. The expanded scale, combined with greater exposure to competitive and esoteric areas of private markets, has increased operational complexity and prompted funds to seek external managers to help deliver on their objectives.
Some funds noted that they had struggled to manage private market assets outside of their domestic market and were backtracking on previous moves to internalize investing. As a result, sovereign funds increasingly rely on external asset managers to deliver on their private market objectives. In the Middle East, 71% of sovereigns say that harnessing external expertise and knowledge is the most important driver of this trend.
There is recognition among sovereigns that developing strategic relationships with a small number of global asset managers can play an important role in helping them to meet long-term objectives. The study cites that 9 out of 10 investment sovereigns have developed such strategic partnerships. In the Middle East, more than half (56%) of sovereigns expect relationships with third-party asset managers to increase over the next 5 years.
“Sovereigns are aware that increased scale and broader operations can, in fact, be a hindrance to strong performance,” continued Ringrow. “However, partnerships and outsourcing are not just about lowering operational costs; in fact, harnessing others’ expertise is by far the most popular driver of externalization.
“Delivering alpha at scale is difficult, especially in markets that require in-depth knowledge and hands-on management, so it’s unsurprising to see sovereigns embrace solutions to navigate ‘uncharted territory’ and overcome these challenges.”
Technology is also seen as a solution to scale challenges, with most sovereigns citing a role for data science in developing the sophistication of their data analysis and research. Data science is also playing a role in risk optimization and asset allocation. 44% of sovereigns in the Middle East have invested in data science teams in the last 5 years.