Sovereign investors take advantage of ‘unique buying opportunity’, says Invesco

Invesco has released its eighth annual Global Sovereign Asset Management Study, an in-depth report which details the views of 139 chief investment officers, heads of asset classes and senior portfolio strategists at 83 sovereign funds and 56 central banks, who together manage USD19 trillion USD in assets*.

The Study reveals that many sovereigns were well prepared for the Covid-19 crisis, with a drop in valuations and plenty of dry powder making the crisis an unprecedented buying opportunity. As custodians of long-term capital, most also benefited from the lack of an imperative to sell to meet withdrawals. Sovereigns were also better prepared due to changes they implemented and lessons they learned from the Global Financial crisis (GFC). This included building large cash reserves and making organisational improvements for the management of liquidity.

 
Before Covid-19 affected markets, sovereigns’ average equity allocations at the end of 2019 were at their lowest level since 2013 both relative to fixed income and as an overall proportion of asset allocation: 26 per cent (equities) vs 34 per cent (fixed income). The  movement away from equities was motivated in part by end of cycle concerns that led to decreasing strategic allocations. Thirty seven per cent of sovereigns aim to decrease equity allocations, with half of these doing so by more than 5 per cent. Just 22 per cent of sovereign investors aim to increase their equity allocations over the next 12 months, and those that do will proceed cautiously.
  
Over the next 12 months sovereigns plan to continue allocating to fixed income; 43 per cent aim to increase their fixed income allocations, 43 per cent to private equity & infrastructure and 38 per cent to real estate.
 
“Traditionally fixed income is seen as a defensive anchor and this was tested by the crisis with even US government debt caught up in a broad sell off as investors rushed into cash. However government interventions including rate cuts and global quantitative easing forced down yields and had a positive impact on many fixed income portfolios,” says Rod Ringrow, Head of Official Institutions at Invesco.
 
Covid-19 also accelerated the existing trend towards infrastructure projects by creating potential distressed opportunities. Many investors have considered infrastructure investments expensive due to the abundance of capital chasing relatively few deals. But some see the current situation as an opportunity to take advantage of selling in sub-sectors, such as airports. Within the infrastructure asset class, sovereigns report the highest level of interest in electricity generation and transmission (54 per cent) and communications (52 per cent).
 
“Infrastructure projects, particularly electricity generation and transmission that help countries transition away from fossil fuels were seen as ways of fulfilling ESG objectives," says Mr Ringrow, however many pension funds also have this theme, so it can be a challenge for some of the medium sized sovereigns and those newer to the asset class  to source the right investments.”
  
This year’s study saw both central banks and a small but significant group of sovereigns increase their allocations to gold. On average, 4.8 per cent of total central bank reserve portfolios are now allocated to gold – up from 4.2 per cent in 2019 – with almost half (48 per cent) of those that increased their allocations having done so with a view to it replacing negative yielding debt. This was seen as the most important reason for moving into gold, more so than commonly-understood reasons such as diversification, return and its role as an inflation hedge. While central banks often approach gold with a pre-existing allocation, the starting position for sovereigns is rarely the same. For many sovereigns  gold is seen as a powerful inflation and tail hedge, with positive correlations in risk-on scenarios but barely correlated/negatively during a risk-off scenario.
 
Four-fifths of central banks choosing to increase allocations to gold are funding the move from existing USD assets – significantly more than from those in EUR and GBP. This highlights a major problem faced by central banks. How can they diversify away from USD without sacrificing liquidity and convertibility. This trend was particularly prominent among emerging market banks, where almost 90 per cent were drawing on USD allocations to boost gold reserves.
 
Sovereigns investing in gold have several options. While physical gold is still used by some, more flexible approaches are being considered. Futures are used by 40 per cent of sovereign gold investors with respondents pointing to the flexibility and returns that can be achieved through skilful trading. Meanwhile, 40 per cent of sovereigns investing in gold gain exposure through gold-backed ETFs. These vehicles have grown significantly in recent years – 80 per cent over the past year alone**.
 
ETFs are also an option for central banks. For banks looking to increase exposure without adding significantly to domestic holdings, or take on the credit risk of a bullion bank, ETFs are likely to be increasingly attractive. Furthermore, given the potential political challenges of trading gold, ETFs could offer a politically more acceptable means to trade the asset class.
 
“Last year's study found gold to be growing in popularity, but Covid-19 has revealed it as an asset class now staking a claim to a new role within sovereign portfolios. We also found that physical gold doesn’t answer all liquidity needs, prompting both central banks and sovereigns to look closely at gold backed ETFs added Mr Ringrow, and we think the development of these alternative modes of investment is likely to increase interest in gold in the coming years”.
  
The study revealed that 83 per cent of central banks and sovereigns believe immediate action is required to combat climate change, and this is increasingly being translated into investment strategies with an understanding that climate-related risk should be embedded into the wider investment process.
 
The single greatest concern globally is a rising number of natural disasters (Figure 6). Investors tend to be concerned by the risks that directly threaten them, so views differ significantly according to region. Western investors are the most conscious of the transition to a low-carbon economy, given the number that have considerable exposure to metals and mining, integrated oil & gas and oil exploration. 88 per cent of Asian and 75 per cent of emerging market investors consider themselves to be disproportionately affected by climate change, far more than the West 33 per cent (Figure 5). Their greatest worry is that climate change could cause trade issues, as those regions are more reliant on a healthy level of open trade to support their agriculture export sectors, which may be impacted by abnormal temperatures.
  
Respondents found that while regulation presents clear guidelines for companies, they often lack implementable guidelines for investors. Some central banks are addressing this but many argue that, to increase engagement, mandates and policies must be restructured to consider climate change risks as several banks are constitutionally prohibited from doing so.

Clearer guidelines are also needed for sovereigns. Respondents suggested that public officials need to clarify definitions, outline methods of adoption, and set parameters around carbon emissions targets for their portfolios.
 
Ringrow adds: “We’re pleased to see sovereigns and central banks continuing to build climate concerns into their investment decisions and developing capabilities to detect and mitigate climate risks. To take the next step, broader buy-in will be needed from policymakers and other investors. This, coupled with new, creative solutions, can compel other investors to look at climate risks more closely.”