Geo-political uncertainty and limited options to increase risk asset allocations are causing sovereign investors globally to make fewer allocation changes than at any point in the last five years, despite target return gaps increasingly widening.
That’s according to the fifth Invesco Global Sovereign Asset Management Study, an annual in-depth report on the complex investment behaviour of sovereign wealth funds and central banks.
This year’s study, conducted face-to-face amongst 97 individual sovereign investors and central bank reserve managers across the globe representing USD12 trillion of assets, asked sovereign investors to rate the importance of various economic and geopolitical factors on their investment strategies.
Sovereign investors see low interest rates as the greatest tactical asset allocation factor, driving increasing allocations to real estate as sovereigns look for alternative sources of income generation. However, the longer term implications are less certain with expectations of a gradual return from quantitative easing to quantitative tightening. Instead Brexit and the US election results are expected to grow in importance for future allocations (set to increase in importance by +82 per cent and +68 per cent respectively), as the implications of political shifts on investment performance becomes clearer.
Sovereign investors have ranked the US as the number one market in terms of attractiveness for the past three years, and this year the country retains its top spot with a score of 8.0 (out of ten). The US is also the winner in terms of actual allocations, with 37 per cent of respondents reporting overweight new flows to North America in 2016 relative to their total portfolio – higher than any other region – and a net 40 per cent are planning to overweight further in 2017. This compares to only 4 per cent who were underweight on new flows in 2016, and 4 per cent who plan to do the same in 2017 – the rest (59 per cent for 2016 and 56 per cent for 2017) did not change or plan to change the weighting.
This attractiveness is driven largely by interest rate rises as well as market confidence of a “pro-business” corporate tax regime following Trump taking office in January 2017. However, long term confidence is still restricted by uncertainty around whether Trump will deliver on policy promises, and positive views on potential infrastructure investments in the US are hampered by concerns about growing protectionism limiting access for foreign sovereigns.
The UK saw the biggest drop in attractiveness to sovereign investors, down to 5.5 from 7.5 last year. Brexit is seen as a significant negative for UK investment, and investment sovereigns with European interests questioned the future of the UK as an “investment hub” for Europe, given uncertainty over taxes on imports and market access.
Sovereign investor allocations to the UK were down in 2016; 33 per cent of respondents reported being underweight on new flows to the UK (higher than any other region) compared to 13 per cent who reported new overweight positions to the UK, while the rest (54 per cent) cited no change. However, when the fall of Sterling is taken into account, UK allocations remain relatively stable, with stated allocation declines of -15 per cent likely linked to the corresponding drop by 16 per cent in the value of the GBP relative to the USD, rather than withdrawals. Furthermore, the fall in the value of the pound has led to a rally in UK stocks.
Moving forward, 41 per cent of sovereigns expect to introduce new underweight positions in 2017, compared to just 5 per cent who are planning new overweight positions to the UK. The majority (54 per cent), however, don’t intend to making any changes to their allocation weightings as they wait to assess the likely longer-term impact of Brexit.
Alex Millar, Head of EMEA Sovereigns, Middle East and Africa institutional sales at Invesco, says: “Despite the apparent negative sentiment around the UK, many sovereigns confirmed their long-term commitment to existing UK investments post-Brexit – especially real estate and several high-profile UK infrastructure investments, including Thames Water and Heathrow Airport. These are unlikely to move until the outlook for the UK as a preferred investment destination becomes clearer.”
A fall in sovereign investor allocations was seen in Continental Europe, from 12.8 per cent of AUM last year to 11.2 per cent this year as the risk of wider EU disbandment appeared to be growing. However, Germany stands out from its European neighbours as one of the most attractive investment destinations globally for sovereign investors, increasing from 7.0 last year to 7.8 this year. Germany’s popularity is attributed to its perceived “safe haven” status and positivity towards Germany has increased based on its economic strength.
The return environment has, on the whole, remained challenging for sovereign investors who have on average underperformed their target returns by 2 per cent (Figure 4). Over the past 3 years, governments have responded to poor economic performance by reducing new funding to sovereigns (on average down from 8 per cent in 2015 to 5 per cent in 2017) and cancelling investments (down from -1 per cent in 2015 to -3 per cent in 2017) (Figure 5).
With deployment into real assets overall being challenged by reducing opportunities in infrastructure and private equity, as outlined in the 2016 Study, and 71 per cent of sovereign investors reporting being underweight to infrastructure due to execution challenges this year, investors are continuing to instead seek similarly attractive investment outcomes through real estate investment.
Over two thirds (67 per cent) of sovereigns reported being overweight to global real estate in 2016, and 46 per cent expect to be overweight this year. Figures were similarly positive for home market real estate, with 58 per cent being overweight to this segment relative to their portfolio in 2016, and 38 per cent expecting to be overweight this year. Sovereigns on average increased their home market real estate allocations at a greater rate (increasing by 1.2 per cent of AUM) than they did their global real estate allocations (increasing by 0.3 per cent of AUM) year on year.
Sovereigns cited a range of reasons for increasing target real estate allocations, including the scope to capture liquidity alpha, the potential to generate income matching mid to long-term liabilities, and the potential for internalisation and control. Home market real estate was particularly attractive for liability and investment sovereigns given there is no need to hedge currency exposure. The increase in home market allocations generally is mirrored in sovereign appetite for income-generating real estate assets, matching home currency-denominated liabilities at higher yields than domestic fixed income. Consequently, the tilt to real estate in home markets is substantially funded from lower allocations to fixed income.
Growth in international real estate allocations was mostly linked to tactical factors such as restrictions in domestic markets or challenges achieving target allocations in infrastructure or private equity. Sovereigns favoured high grade office and commercial real estate, since long-term tenancies make these good income generators, over industrial or residential categories, which offer asset growth and development potential. They expect office and commercial to each comprise 40 per cent of total respondent real estate portfolios in the next three years, whilst industrial and residential are expected to make up 16 per cent and 28 per cent of portfolios respectively.
Millar says: “2016 was a challenging year for sovereign investors with concerns surrounding funding levels and return expectations remaining front of mind amidst added macro-economic and political uncertainty. Demand for alternatives like infrastructure has been a consistent theme in past years, but this year the challenge of increasingly scarce supply is compounded. Whilst investors have fewer asset allocation levers with which to respond, they are delving deeper into more supply-rich real estate markets, and looking to the US and Germany for opportunity and economic strength.
“Sovereign investors are a diverse group and challenges affect sovereigns differently according to their liabilities, risk appetite, funding dynamics and other factors. Our study has once again illuminated how these diverse investors are responding to global trends as they become ever more sophisticated, yet limited by both external and internal constraints.”