Why are sovereign funds and central banks in defensive mode?

Report shows increase caution and diversity among world’s biggest investors

Why are sovereign funds and central banks in defensive mode?

No-one is certain when the next downturn will come but canny investors are positioning their portfolios in readiness.

Among them are sovereign wealth funds and central banks with a combined U$20.3 trillion of assets who have been surveyed on their 2018 activity by Invesco for its Global Sovereign Asset Manager Study.

“Our authoritative annual study of the global sovereign segment shows sovereigns and central banks preparing for an end to the current economic cycle seen within two years, leading them to be more defensive and diversified in their portfolios,” said Alex Millar, head of EMEA institutional.

He added that sovereigns have reduced equity exposure in favour of fixed income but also have rising long term commitments to private markets.

For larger sovereigns those private market assets now include direct investments in China and the technology sector.

Fixed income allocations increased to 33% in 2019 from 30%, 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.

Why China?
The increased exposure to China comes even as trade tensions with the US continue unresolved. But John Galateria, Invesco’s head of North America Institutional says this is because the fund managers are looking beyond the short-term geopolitical challenges and focusing on the core dynamics.

Although 82% of sovereigns cited trade tensions as having had an influence on asset allocation decisions, 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.

Approximately 90% of sovereigns with China exposure held Chinese equities but they are likely to increase fixed income assets, especially as China focuses on foreign investment options such as its Bond Connect initiative.

For those funds without exposure to China, currency and investment restrictions are among the main barriers along with concerns over transparency.

Europe is a risk
The report shows that many sovereigns are pulling back from investment in Europe.

This is down to a mix of weakening economic growth and political issues with Brexit influencing asset allocation decisions for 64% of sovereigns and Continental Europe’s internal politics – including a rise in populism - influencing decisions for 46%.

Just 13% of respondents plan to increase allocations to Europe compared to two thirds who are decreasing; 40% are increasing Asia allocations and 36% are increasing exposure to EMs.

ESG is key
The rising importance of ESG for investors is reflected in the survey of sovereigns.

The percentage of sovereigns with a specific ESG policy rose from 46% to 60% in 2018 with 20% of central banks now having an ESG policy, compared to 11% in 2017.

For sovereigns, environmental concerns are increasingly becoming the lead focus, with carbon emissions and climate change the single most important ESG issue.

Buying gold but no crisis
Although the next slowdown is expected to be gradual rather than a crisis according to the central banks polled, they are still increasing their holdings of gold and deposits.

Central banks bought 651.5 tons of gold in 2018, the second highest annual total on record and up 74% from the year earlier.

However, gold holdings are not without risk with respondents citing volatility, storage costs and the political implications of selling. Three quarters of central banks agreed or strongly agreed that selling gold holdings would attract negative domestic media coverage in their country.

Moving away from the US dollar, central banks have increased their holdings of China’s Renminbi and this is expected to become the currency of choice in 2019.

Meanwhile, 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.