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This year’s study was conducted face-to-face amongst 139 individual sovereign investors
and central bank reserve managers across the globe representing $20.3trillion[[Sourced by NMG Consulting: total assets of those sampled stands at $17 trillion as at year end 2017.]] of assets, of which 71 are central banks (62 in 2018), reflecting their growing status as
sovereign investors.
Fixed income displaces equities as largest asset class for sovereigns
2018 was a challenging year for sovereigns as weak and volatile equity markets led to a
decline in overall investment returns. On average, sovereign investors achieved returns
of 4% in 2018 compared to 9% in 2017. Despite the decrease in returns, sovereigns
performed well given negative returns from global equities, which fell 8.7% in US dollar
terms during the year, according to MSCI World Index***.
The majority of sovereigns (89%) anticipate the end of the economic cycle within the
next two years. This combined with volatility concerns and the prospect of negative
returns from equities has led to increased fixed income allocations and more
diversification in allocations to infrastructure, real estate and private equity markets.
Fixed income allocations increased to 33% in 2019 from 30% in 2018, becoming
sovereigns’ largest asset class. Meanwhile, allocations to equities fell from 33% to 30%,
marking the end of a five-year trend between 2013 and 2018 during which fixed income
fell from 35% to 30% as equities posted strong gains.
Challenging equity markets in 2018 highlighted the limitations of market-cap weighted
passive strategies, as well as some more basic factor strategies. Some of the most
popular factor strategies, e.g. value and momentum, performed below sovereign
expectations during 2018, and some of those adopting a simple ‘set and forget’ approach
to their factor allocations reported negative returns. This is encouraging a move away
from a single-factor approach towards multi-factor positions that can better adapt to
changing market conditions.
Sovereigns optimistic on China
China’s attractiveness rating for sovereign investors has improved more than any other
major region since 2017. Some 82% of sovereigns cited trade tensions as having had an
influence on asset allocation decisions, yet China’s attractiveness as an investment
destination over the next three years scored an average rating of 6.1 out of 10 among
sovereign investors, a marked increase on 2017’s 5.2 rating.
Despite the fact that the study was carried out during a period of ongoing rhetoric on a
trade war, those surveyed saw China’s pledge to improve safeguarding of intellectual
property as grounds for optimism that some resolution of tensions would be reached.
The unique competitive dynamics of China are appealing for sovereigns seeking more
diversification, the survey found, with equities continuing to be the asset class most
favoured. Approximately 90% of sovereigns with China exposure held Chinese equities,
showing that the government’s measures to open the market to foreign investors are
bearing fruit. Fixed income allocations are also likely to increase with Chinas inclusion in
major bond indices and initiatives, such as Bond Connect, giving foreign investors access
to the local bond market. Transparency remains a significant obstacle to higher
allocations in China for sovereigns, while for those sovereigns with no existing allocation
to China, investment restrictions and currency risk are seen as the main impediments.
Investors don’t see economic attractiveness in Europe
A combination of slowing economic growth and perceptions of rising political risk have
led to a decline in the perceived attractiveness of major European economies. Brexit is
now influencing asset allocation decisions for 64% of sovereigns.
While
continental Eurozone internal politics, seen as increasingly uncertain with the
ascendance of populist movements in major European economies such as Germany and
Italy, is impacting asset allocation decisions for 46%. This has resulted in Europe falling
out of favour, with nearly one third of sovereign investors decreasing allocations to
Europe in 2018 and a similar number planning further decreases in 2019. Only 13% of
sovereigns plan on increasing allocations to Europe this year, compared to a 40%
allocation to Asia and 36% to Emerging Markets.
Renminbi finds a bigger place in Central Banks reserve portfolios
As a group, Central Banks believe the end of the economic cycle will be characterised by
a gradual slowdown, rather than an economic crisis. However, the uncertain market
environment, combined with an increasingly hawkish Federal Reserve, led many of them
to find perceived safety in increased allocations to deposits, and, in some cases, gold.
Central banks bought 651.5 tonnes of gold in 2018, the second highest annual total on
record and up 74% from the year earlier12
. Over a third (35%) of central banks increased
allocations over the last three years, with 32% expecting further increases over the next three years, but overall gold holdings remain steady at around 4% of overall reserve
portfolios. Respondents to the study reported additional challenges associated with gold
as a reserve asset, including volatility, storage costs and the political implications of
selling. 75% of Central Banks agreed or strongly agreed that selling gold holdings would
attract negative domestic media coverage in their country.
Central Banks continue to diversify away from the negative yields of government bonds
(especially in Europe) into bank deposits; and away from the US dollar. The main
beneficiary has been the Renminbi and between 2017-18, allocations to China’s currency
overtook the Australian and Canadian dollar, with 43% of central banks now holding it in
their portfolios, compared to 40% in 2018. Over a quarter (27%) of central banks expect
to continue to increase Renminbi reserves in 2019, making it the most favoured currency
for the year ahead, with increased allocations expected to be taken from the USD, EUR
and GBP. Though USD remains the dominant reserve currency, allocations reached a 5-
year low, falling from 62.7% of global currency reserves to 61.7%.
Environmental considerations move ESG firmly into the spotlight
ESG is an increasingly important issue for sovereigns and Central Banks. Since 2017, the
percentage of sovereigns with a specific ESG policy rose from 46% to 60%.
20% of Central Banks now have an ESG policy, compared to 11% in 2017. Approaches
to ESG are increasingly sophisticated, having moved beyond screening to incorporate
more advanced forms of integration.
There has also been a shift in focus of the nature of ESG activity. While asset owners
have, in the past, focused on issues of governance due to clearer risk and return
benefits, these factors are now often assumed by ESG adopters. For sovereigns,
environmental concerns are increasingly becoming the lead focus, with carbon emissions
and climate change the single most important ESG issue.
Alex Millar, Head of EMEA Institutional Distribution Sales, Invesco, commented:
“Our wide-ranging study reveals that sovereigns and Central Banks are adopting defend
and diversify investment strategies. The combination of a likely end-of-cycle within two
years and an uncertain global environment has led to allocations to fixed income, private
markets, and emerging markets growing in portfolios. Political uncertainty and lack of
economic attractiveness has seen a shift of allocations away from Europe, pivoting
towards China, despite some concerns at continuing trade wars. While central banks
have maintained their commitment to alternative assets, there have been significant
changes in their lower risk assets, moving from government bonds towards deposits and
in some cases gold, and from the US dollar to Renminbi.”
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