Invesco has released its fifth Invesco Global Sovereign Asset Management Study, an annual in-depth report on the complex investment behavior of sovereign wealth funds and central banks, which this year shows that 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.
This year’s study, conducted face-to-face amongst 97 individual sovereign investors and central bank reserve managers across the globe representing $12 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% and +68% respectively), as the implications of political shifts on investment performance becomes clearer.
Trump on Top
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% 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% are planning to overweight further in 2017. This compares to only 4% who were underweight on new flows in 2016, and 4% who plan to do the same in 2017 – the rest (59% for 2016 and 56% 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.
Falling allocations to the UK linked to Sterling value; long-term outlook stable for now
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% of respondents reported being underweight on new flows to the UK (higher than any other region) compared to 13% who reported new overweight positions to the UK, while the rest (54%) cited no change. However, when the fall of Sterling is taken into account, UK allocations remain relatively stable, with stated allocation declines of 15% likely linked to the corresponding drop by 16% 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% of sovereigns expect to introduce new underweight positions in 2017, compared to just 5% who are planning new overweight positions to the UK. The majority (54%), however, don’t intend to make 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, commented: “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.”
Germany is core to Continental Europe
A fall in sovereign investor allocations was seen in Continental Europe, from 12.8% of AUM last year to 11.2% this year, as the risk of wider EU disbandment appeared to be growing. However, Germany stands out from its European neighbors as one of the most attractive investment destinations globally for sovereign investors, increasing from 7% 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. Please note, so called safe-haven assets do not imply risk-free investments.
Real estate offers income generation as new contributions slow
The return environment has, on the whole, remained challenging for sovereign investors who have on average underperformed their target returns by 2%. Over the past 3 years, governments have responded to poor economic performance by reducing new funding to sovereigns (on average down from 8% in 2015 to 5% in 2017) and cancelling investments (down from -1% in 2015 to -3% in 2017).
With deployment into real assets overall being challenged by reducing opportunities in infrastructure and private equity, as outlined in the 2016 Study, and 71% 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%) of sovereigns reported being overweight to global real estate in 2016, and 46% expect to be overweight this year. Figures were similarly positive for home market real estate, with 58% being overweight to this segment relative to their portfolio in 2016, and 38% expecting to be overweight this year. Sovereigns on average increased their home market real estate allocations at a greater rate (increasing by 1.2% of AUM) than they did their global real estate allocations (increasing by 0.3% 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 internalization 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 favored 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% of total respondent real estate portfolios in the next three years, while industrial and residential are expected to make up 16% and 28% of portfolios respectively.
Alex Millar commented: “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. While 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.“
Alex Millar concluded: “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.”