Strong Sovereign Performance Provides Liquidity And Stability To Governments Through The Pandemic: Invesco Study

Invesco today released its ninth annual Global Sovereign Asset Management Study. The study detailed the views and opinions of 141 chief investment officers, heads of asset classes and senior portfolio strategists at 82 sovereign wealth funds and 59 central banks across the globe, who together manage $19 trillion USD in assets*.

With Covid-19 top of mind, impacting both operations and investment strategies, the impact of the ongoing pandemic is a major theme running throughout this year’s report.

Liquidity in focus as Covid-19 leads sovereigns to face drawdowns and double cash reserves

In response to Covid-19, governments rushed to implement policy measures designed to prop up their economies and public services such as health, as well as providing support for businesses and households at a time when tax revenues retreated with depressed economic activity.

The impact on public finances led some governments to tap their sovereign wealth funds for capital to fund spending and plug budget deficits asmore than a thirdof sovereigns, and 57% in the Middle East,sawdrawdowns during 2020 including 78% of liquidity sovereigns and 58% of investment sovereigns. Josette Rizk, Director Institutional Clients Middle East & Africa at Invesco, said: “The Covid-19 pandemic has prompted a focus on liquidity for Middle East sovereign funds, both to fund short term demands and to take advantage of future opportunities.  Given the commodity-based nature of regional sovereigns, it is not surprising that they were called on for support to fund necessary business relief as the result of the Covid-19 pandemicthrough drawdowns.”

Many sovereign funds had learned the importance of building large liquidity reserves, following the global financial crisis, and were successful in supporting local economies and large companies in need of stabilisation finance. But the scale and speed of withdrawals for those that hadn’t, meant a significant impact on allocations, and led sovereigns to reevaluate liquidity risk management. This has prompted a shift towards cash, with portfolio cash reserves more than doubling during 2020, as some sovereigns continued to focus on liquidity in anticipation of possible further withdrawals. 

However, sovereigns also noted that the pandemic had shone a spotlight on the importance of liquidity more generally, both as a buffer for future black swan events and to afford the flexibility to take advantage of market opportunities when they arise, such as the early run in equities at the start of 2020.

The study also revealed a shift in asset allocation as sovereigns were forced to look elsewhere in the face of falling fixed income yields, as the widespread easing of monetary policy pushed rates lower. Fixed income allocations fell from 34% to 30%globally as concerns about stimulus-driven inflation returned. The volatility present in markets through the first quarter of 2020 caused an uptick in equites, reversing a two-year trend of declining allocations.  Global sovereigns increased their allocations by 2% from 2020, rising to 28%. A further 30% of respondents, including 14% in the Middle East, expect to increase their allocation to equities over the next 12 months.Looking across asset allocations, Middle East sovereigns expect to significantly increase their allocations to real estate (57%), private equity (29%), infrastructure (43%) and direct strategic investments (29%). Josette Rizk said: “While the pandemic did cause initial drawdown requirements, the long-term investment horizon of Middle East sovereigns makes rising allocations to these more illiquid private markets more attractive.”

Rod Ringrow, Head of Official Institutions at Invesco said: “Governments, faced with fiscal challenges, have turned to sovereigns to help plug their spending deficits. While some funds were well prepared, others have had to make adjustments to generate liquidity. Sovereigns have also become aware of the importance of maintaining liquidity in order to take advantage of market opportunities as they arise. At the same time, generating sufficient returns in the face of an extremely low interest rate environment is having a substantial and potentially long-lasting impact on strategic asset allocations and perception of market risk.”

The pandemic increases ESG adoption

Invesco’sstudy has tracked a significant increase in the incorporation of environmental, social and governance (ESG) principles into sovereign and central banks portfolios since 2017.  In just four years the proportion of respondents adopting an ESG policy at the organisational level has increased dramatically, rising from 46% to 64% among sovereigns and from 11% to 38% among central banks.  In the Middle East, 56% of sovereigns and 43% of central banks have adopted an ESG policy, according to the 2021 survey.

Last year’s study found the focus among sovereigns and central banks had zeroed in on climate change, in particular climate-proofing their portfolio.ESG then had taken hold and, while some had still to adopt formal policies, many moved to action and impact.This year’s study revealed that climate change risks remain high on the agenda in the Middle East, with 75% of respondents indicating that climate change influences their asset allocation decision, compared with 62% globally. For Middle East sovereigns, climate change is seen as one of the most significant risks to real estate portfolios, with 88%increasing their consideration of climate risk when making property investments. The Covid-19 pandemic broadly acted as a catalyst for sovereigns and central banks to prioritise ESG, with 32% of respondents overall, and 50% of those in the Middle East increasing their focus on ESG as a result of the pandemic.

Sovereigns’ ESG commitment is in stark contrast to the attitudes observed in the 2017 survey, which pointed to persistent reluctance by some to pursue ESG considerations at all, let alone during a crisis that exacerbates competing priorities.  Yet there are idiosyncrasies arising from differences in the purpose of sovereign wealth funds which influence ESG adoption.

The study finds that globally, liquidity sovereigns are more focused on maintaining liquidity to assist funding budget shortfalls and only 12% of liquidity sovereigns have a formal ESG policy. In contrast 79% of liability sovereigns have an ESG policy, reflecting their longer investment horizons and need to take into account long-term risks such as climate change, as well as a need to reflect the views and priorities of their beneficiaries.

Sovereigns have also accelerated their research for sustainable investment opportunities. A growing appreciation of the opportunities in climate-related investments has contributed to a shift in their motivations for ESG integration towards improved investment returns, with 53% of sovereigns in the Middle East and 57% globally believing the market has not priced in the long-term implications of climate change, offering opportunities for alpha.

Central bank sentiment has shifted significantly over the past year.  In 2021, 65% saw climate change as falling within their remit, up from 46% in 2020.67% of Middle East central banks believe that green bonds are a desirable foreign reserve asset.

Sovereigns return to China as Covid-19 threat abates, though geopolitical risks remain

China’s appeal has steadily increased over the past four years, driven by attractive local returns and opportunities for diversification. In the first few months of 2020 when the implications of the Covid-19 pandemic were still unclear, sovereigns were among those investors making tactical shifts away from markets perceived as vulnerable, including China, to less risky investments, notably the relative quality and safety of North America, and US bonds in particular.

The rapid response to the Covid-19 pandemic enabled emerging APAC nations and economies to bounce back, and, as a result 40% of investment sovereigns and 56% of liquidity sovereigns globally see China as more attractive than pre-pandemic level.  Increased allocations to the region though came at the expense of investing in Europe, and other emerging markets such as Latin America and Africa.

Despite China’s growing appeal there are some notable obstacles to investing. 86% of global sovereigns point to the rising political tensions with the US as a significant barrier indicating that the tensions are influencing their asset allocation decisions. As well as being the most significant barrier to investment, political risk was the obstacle most commonly cited as having changed for the worse in the past two years.

Other obstacles investors noted include the inability to convert RMB (cited by 50% of sovereigns), a lack of alignment of investments with ESG considerations (45%) and the comparative lack of investor rights (41%).

Looking ahead the study found that in 2021 sovereigns expect to finance increased allocations to China both with new capital and by drawing on North America and Developed Europe allocations. The rise of China as an economic and political powerhouse with favorable consumer themes - including an emerging middle class and a highly digitalized economy - all contribute to the prospect of attractive local returns for sovereign allocations. The survey found that 75% of sovereign’s were attracted to invest in China due to the prospect of attractive local returns, a further 57% saw China as an important portfolio diversifier.  In the Middle East, sovereigns also cited desire to better reflect China’s position as a trading partner and changes to global fixed income benchmarks as driving allocations.

Many investors remain bullish on China and are looking to build on existing allocations. 75% of Middle East sovereigns currently invest in China, and 60% expect the size of their allocation to increase over the next 5 years. Josette Rizk said: “As a major part of the global economy and a significant contributor to global GDP, sovereigns in the Middle East look to China as a long-term play. The rising interest in China is reflected in the growing universe of attractive investment opportunities.”

Rod Ringrow commented “China’s increasing appeal comes from improved access and growing opportunities for attractive returns. This is being buoyed by innovations in areas such as technology and increased openness to foreign investment in sectors such as infrastructure. Chinese companies are making improvements in addressing environmental issues. However, transparency around corporate governance continues to be an area of concern and a rise in operational obstacles demonstrates the unique nature of the Chinese market.”