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Inflation shock pushing sovereigns to private markets: report

With an eye on private assets amid growing inflation and uncertainty, sovereign wealth funds pivot to US and Asia Pacific and away from Europe as the war in Ukraine rages, according to the latest Invesco report.
Inflation shock pushing sovereigns to private markets: report

Inflation is the biggest threat – alongside geopolitical instability – to sovereign wealth funds (SWF), with many of them increasing their allocation to private markets at the expense of fixed income to hedge against value erosion, according to an Invesco report on Monday (July 18).

More sovereign wealth funds are expected to focus on private market alternatives such as private equity, real estate, and infrastructure in the year ahead, according to a key finding in the Global Sovereign Asset Management Study 2022 conducted by Invesco in the first quarter of this year.

The US and Asia Pacific are the favoured destinations for these investors, but Europe has declined in popularity due to the ongoing Russian-Ukraine conflict,  the report said.

The report surveyed 139 chief investment officers, heads of asset classes and senior portfolio strategists at 81 sovereign wealth funds and 58 central banks worldwide managing a combined $23 trillion in assets as of March 2022.

INFLATION DRIVING PRIVATE MARKET

About 40% of the respondents surveyed expect inflation – now at a 40-year high of 9.1% in the US - in developed markets to remain high over the next two years, while another 40% expect it to steadily decline. Just under a fifth anticipate stagflation.

Over half of respondents (59%) expect US inflation to average 3-4% over the next 5 years.

Given this mixed inflation outlook, uncertainty is the main driver behind the shift of sovereign funds to private markets, said the report. Sovereign investors surveyed now have an average of 26% of their portfolio allocated to alternative investments, with private equity and real estate the largest sub-sectors, and infrastructure growing steadily year on year.

When asked which asset classes they intend to increase, maintain, or decrease exposure to over the next year, private equity was the most popular (net +29%), followed by unlisted real estate at +23%. By contrast, respondents were most bearish on fixed income (-12%) and cash (-4%), while sentiment on equities was largely unchanged (+1%).

Terry Pan, Invesco

“When we look at real estate and infrastructure from an investment point of view, the rental income and income generated by different types of infrastructure programmes are the things that attract sovereign asset owners,” said Terry Pan, Invesco’s chief executive for Greater China, Southeast Asia and Korea to AsianInvestor.

“From an inflation hedge standpoint, prices of real assets have generally been quite positive. There’s a positive correlation between prices and inflation,” he said, adding that private equity has generally delivered decent long-term returns while also acting as an inflation buffer.

Diego Lopez, managing director at Global SWF said real and unlisted assets are compatible with sovereign wealth funds, which by nature are long-term, and patient investors seeking to generate cash flows over a timeframe of 10 to 20 years.

Diego Lopez, Global SWF

“I would say infrastructure and private debt are the most popular choices by SWFs right now, as well as some pockets of real estate (logistics, senior housing) and private equity (tech-related sectors),” he told AsianInvestor.

Globally, cumulative allocations by sovereign wealth funds to private equity, real estate, and infrastructure have risen 251% over the past decade, from $205 billion in 2011 to $719 billion at the end of 2020, according to the Invesco report, citing data from a Preqin study in May 2021.

This trend is unlikely to change even with the increase in bond yields as real assets offer several other benefits including protection from inflation and diversification, said the report.

Source: Invesco

CHINA CANNOT BE IGNORED

Sentiments around European investments took a hit because of the conflict in Ukraine, with respondents expected to reduce their exposure to developed Europe (19%) and emerging Europe (13%) and raise their stakes in North America (33%) and Asia-Pacific (23%), according to the report.

About a third of the sovereign funds polled remain optimistic about China because of its deeper integration into the global trading system than Russia and the higher interdependence with the US, even as more than half (52%) of the respondents say China has become a more challenging place to invest in.

There is also increased reserve allocation to the renminbi among central banks although few view it as a threat to the US dollar’s position as the world reserve currency, at least not for the next five years, said the report.

“I don’t think the situation in Russia influences our view of China. China is a large and growing market that you can’t ignore. The relevant risk is perhaps in relation to Taiwan, but if in anything that risk might have gone down,” said the report, quoting a Middle East-based sovereign investor.

Lopez said every SWF should have significant exposure to China as it is a long-term play despite the current geopolitical tensions and risks, adding that Southeast Asia and India – both highly urbanised with large growing populations - also held opportunities in consumer lifestyle, technology, and transportation sectors.

Source: Invesco

ESG ON THE RISE

There is growing interest in environmental, social and governance (ESG) investments among sovereign funds, with 75% of the respondents having an ESG policy in place compared with 46% in a similar survey in 2017, according to the Invesco report.  Some 30% of sovereigns have now implemented a carbon target, up from 23% a year ago, it said.

Javier Capapé
IE University

Javier Capapé, director of sovereign wealth research at the IE University’s Center for the Governance of Change said many SWFs – including those saddled with legacy assets - are collaborating with traditional energy companies on decarbonisation projects and net-zero plans.

“It is a great time for oil and gas-based SWFs to ignite the transition toward alternative sources of income while enjoying the important inflows coming from high prices,” he told AsianInvestor.

In terms of delivering positive ESG outcomes, the report found that sovereign funds perceived active voting and engagement to be more effective than negative screening even though the latter is more widely used (60%) than the former (55%) among those polled, reinforcing the view that passive investing may not be a suitable strategy for ESG investments.  

“Active ownership is gaining traction among institutional investors and relevant SWFs have already announced that they will focus on that path,” said Capapé, adding that such a strategy entailed more cost and resources.

 

 

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