Sovereign investors are adapting their portfolios to the new macroeconomic environment, characterized by sticky inflation and rising geopolitical and climate risk, according to the eleventh annual Invesco Global Sovereign Asset Management Study.
The swift rise in interest rates and sharp correction in listed asset prices led most sovereign wealth funds to report negative returns for 2022, and the vast majority (86%) anticipate inflation to be higher in the coming decade than in the last. In response, many are fundamentally rethinking the way they invest in fixed-income and private assets, alongside a renewed interest in emerging markets.
Invesco’s study, which has become the leading bellwether for sovereign investor activity, is based on the views of 142 chief investment officers, heads of asset classes, and senior portfolio strategists at 85 sovereign wealth funds and 57 central banks, who together manage $21 trillion in assets.
Rethinking fixed income
Fixed income is the asset class sovereigns are most likely to increase in their strategic asset allocation over the next 12 months, with a 28% net allocation intention surpassing infrastructure (25%), private equity (21%), listed equities (15%), and real estate (9%).
However, fixed income’s failure to shelter portfolios from the 2022 asset price correction has changed the way sovereign investors perceive the asset class.
Rather than a ‘set and forget’ position for diversification purposes, they now favor a more active and tactical approach, creating value by actively rebalancing across different fixed income segments and utilizing a wide range of strategies, similar to listed equities. Alternative fixed-income segments can therefore play a greater role, with private credit, high yield, and infrastructure debt seen as the most attractive options.
Historically categorized as private equity by many sovereign investors, private credit has now matured into a distinct asset class, often supported by dedicated investment teams. Investors have been attracted by the funds’ favorable risk-return profiles and high liquidity levels, as well as the transparency of the holdings and good levels of diversification within funds, as most are large-scale and invest in a wide range of issuers.
“Although average returns in 2022 were negative, there was significant variation within these results. The better performers were those that recognized the risks posed by inflated asset prices and were willing to make substantial portfolio changes. The key lesson from 2022 was that sovereigns need to be prepared to demonstrate greater flexibility and responsiveness to market conditions.”
Rod Ringrow, Head of Official Institutions at Invesco.
Increased appetite for emerging markets
The higher interest rate environment has prompted a renewed appetite for emerging markets.
In recent years, as developed markets’ asset prices soared amid negative real rates, many funds found little need to pursue the extra research and risk associated with large emerging market allocations. However, the normalization of higher rates looks set to change this, and many sovereign investors commented on increased resilience, institutional strength, and stability in key emerging markets. 71% of sovereigns expect emerging markets to either match or better the performance of developed markets over the next three years.
Almost a third (29%) of investors intend to increase their allocations to Emerging APAC in 2023, making it the joint most popular region alongside North America, and well ahead of Developed APAC (15%), Developed Europe (14%), and the Middle East (8%). At 22%, Latin America was the second most popular region overall.
India continues to be seen as a leading market: 76% of investors see it as an attractive opportunity for emerging market debt in 2023, well ahead of its closest competitor, South Korea, at 56%. Mexico (51%), Brazil (49%), Indonesia (44%), and South Africa (41%) have all seen significant year-on-year increases in their perceived attractiveness.
A new generation of sovereign wealth funds
The last decade has seen a surge in new sovereign wealth funds: since 2012, 27 new funds have been created, with Africa (11) and APAC (7) accounting for the majority.
Most are development funds, set up to drive economic growth and diversification. Many funds are also focused on the energy transition and, for some, this has become the leading development objective. In total, 65% of funds with development objectives aim to facilitate the energy transition, making it the most commonly held objective, ahead of employment (59%), GDP growth (57%) and social objectives, such as health and education (57%).
The challenge for new funds is building credibility alongside their more-established peers. Demonstrating strong levels of governance will be key, alongside fact-finding partnerships with other funds and experienced asset managers to help build on their skills and knowledge.
