Sovereign investors are adapting their portfolios to the new macroeconomic environment. They are characterised by sticky inflation and rising geopolitical and climate risk, according to Invesco, the investment management firm.
The rise in interest rates and correction in listed asset prices led most sovereign wealth funds to report negative returns for 2022. According to the eleventh annual Invesco Global Sovereign Asset Management Study, 86 per cent anticipate inflation to be higher in the coming decade than in the last. This includes 88 per cent of sovereign investors based in the Middle East. In response, many are fundamentally rethinking the way they invest in fixed-income and private assets, alongside a renewed interest in emerging markets.
Invesco’s study is based on the views of 142 chief investment officers, heads of asset classes and senior portfolio strategists at 85 sovereign wealth funds and 57 central banks. Together, they manage $21trillion in assets.
Middle Eastern SWFs and Central Banks drive green investment surge amidst widespread adoption of ESG policies
From 2017 to 2023, the adoption of environmental, social, and governance (ESG) policies by SWFs witnessed a substantial rise. They increased from 46 per cent to 79 per cent. For central banks, this growth was even more significant. It jumped from a mere 11 per cent to a robust 59 per cent. In the Middle East, 90 per cent of SWFs and 22 per cent of central banks have now embraced ESG policies.
“Geopolitical fluctuations and the urgent issue of climate change have underscored the necessity for secure and sustainable energy supply chains, thus amplifying the importance of renewables in investment strategies,” commented Josette Rizk, head of Middle East and Africa at Invesco.
Two-thirds (67 per cent) of SWFs and central banks affirm that sovereign investors can substantially contribute to financing the energy transition. Fifty six per cent of their Middle Eastern counterparts also share this belief.
To align with their objectives, SWFs and central banks are increasingly focusing on direct green infrastructure investments and green bond allocations. Nearly 69 per cent of central banks and 44 per cent of SWFs globally are putting their resources into green bonds. In the Middle East, this trend involves 57 per cent of central banks and 25 per cent of SWFs.
However, greenwashing poses a significant challenge to ESG investing. Eighty-nine per cent of sovereign investors (including both SWFs and central banks) identify it as a concern.
“This sentiment is even more pronounced in the Middle East, where 94 per cent of investors see greenwashing as a hindrance. To combat this issue, SWFs are taking a proactive approach: they are welcoming development risks and issuing green bonds themselves to ensure authentic alignment with ESG principles,” further added Rizk.
Increased MEA sovereign allocation towards fixed-income assets over the next 12 months
Fixed income is the asset class sovereigns are most likely to increase in their strategic asset allocation over the next 12 months, with a 28 per cent net allocation intention surpassing infrastructure (25 per cent), private equity (21 per cent), listed equities (15 per cent), and real estate (nine per cent).
In response to evolving macroeconomic conditions, SWFs are strategically reassessing their portfolios to better align with the current financial landscape. A notable 39 per cent of SWFs globally, and 14 per cent in the Middle East specifically, are proactively planning to augment their allocations towards fixed income in the forthcoming 12 months.
However, fixed income’s failure to shelter portfolios from the 2022 asset price correction has changed the way sovereign investors perceive the asset class.
Rather than a ‘set and forget’ position for diversification purposes, they now favour a more active and tactical approach, creating value by actively rebalancing across different fixed income segments and utilising a wide range of strategies, similar to listed equities. Alternative fixed-income segments can therefore play a greater role, with private credit, high yield and infrastructure debt seen as the most attractive options.
“SWFs are taking a proactive approach: they are welcoming development risks and issuing green bonds themselves to ensure authentic alignment with ESG principles” – Josette Rizk
Changing trends
Historically categorised as private equity by many sovereign investors, private credit has now matured into a distinct asset class, often supported by dedicated investment teams. Investors have been attracted by the funds’ favourable risk-return profiles and high liquidity levels, as well as the transparency of the holdings and good levels of diversification within funds, as most are large-scale and invest in a wide range of issuers.
“Although average returns in 2022 were negative, there was significant variation within these results”, said Rod Ringrow, head of official institutions at Invesco. “The better performers were those that recognised the risks posed by inflated asset prices and were willing to make substantial portfolio changes. The key lesson from 2022 was that sovereigns need to be prepared to demonstrate greater flexibility and responsiveness to market conditions.”
Middle East SWFs capitalise on India’s rising star in emerging market debt investments
The higher interest rate environment has prompted a renewed appetite for emerging markets.
In recent years, as developed markets’ asset prices soared amid negative real rates, many funds found little need to pursue the extra research and risk associated with large emerging market allocations. However, the normalisation of higher rates looks set to change this, and many sovereign investors commented on increased resilience, institutional strength, and stability in key emerging markets.
Seventy-one per cent of sovereigns expect emerging markets to either match or better the performance of developed markets over the next three years.
Almost a third (29 per cent) of investors intend to increase their allocations to Emerging APAC in 2023. This makes it the joint most popular region alongside North America, and well ahead of Developed APAC (15 per cent), Developed Europe (14 per cent), and the Middle East (eight per cent). At 22 per cent, Latin America was the second most popular region overall.
Investors continue to perceive India as a leading market, with 76 per cent considering it an attractive opportunity for emerging market debt in 2023. This is well ahead of its closest competitor, South Korea, at 56 percent. Mexico (51 per cent), Brazil (49 per cent), Indonesia (44 per cent) and South Africa (41 per cent) have all seen significant year-on-year increases in their perceived attractiveness.
“The magnetism of the Indian market is even more pronounced among Middle Eastern SWFs, with a unanimous 100 per cent recognising its appeal. These figures underscore the growing confidence in India’s economic prospects and affirm its standing as a prime destination for debt investment among emerging markets,” added Josette Rizk, head of Middle East and Africa at Invesco.
Middle Eastern SWFs prioritise private equity, infrastructure investments
Globally, sovereign investors remain interested in private assets, with infrastructure seen as the overall most attractive asset class over the next five years, ahead of fixed income, private equity, and listed equity.
Within infrastructure, there is considerable interest in renewable energy generation: 81 per cent of sovereigns see it as an attractive area. This is followed in second by energy transmission and supply (65 per cent). This was in part caused by the war in Europe and energy crisis that followed. It consequently triggered a global surge in renewable infrastructure demand.
The valuation correction in 2022 revealed performance disparities across private assets, which has brought about a more selective approach. Investors are now more cautious about highly leveraged deals, with almost half of sovereign wealth funds reporting being dissuaded from recent real estate (48 per cent), private equity (49 per cent, 86 per cent of those in the Middle East) and infrastructure (43 per cent) deals due to unappealing debt structures.
Showing specific interest in industrial real estate and renewable energy
For Middle Eastern SWFs, the preference is towards private equity and infrastructure, with real estate ranking lower, due to challenges in the office and retail sectors. When dissecting the real estate sector, SWFs in the Middle East demonstrate a clear preference for specific segments: industrial spaces, hotels/resorts, and data centres, each chosen by 83 per cent of respondents from the region.
In the infrastructure realm, a similar pattern emerges. The study indicates renewable energy generation and energy transmission/supply as the primary focus for Middle Eastern SWFs, with both segments chosen by 71 per cent of participants.
Real estate is currently perceived to be the least attractive private asset segment, mainly due to challenges in the office and retail sectors. Many sovereign wealth funds heavily exposed to these sectors have sought diversification in areas such as industrials, healthcare and data centres, which have risen in popularity due to the growth of digital technologies and remote work.
A new generation of sovereign wealth funds
In the last decade, 27 new sovereign wealth funds have emerged, with Africa (11) and APAC (seven) accounting for the majority.
Most are development funds, set up to drive economic growth and diversification. For many funds, the energy transition has become the leading development objective, emphasising their focus on this area. In total, 65 per cent of funds with development objectives aim to facilitate the energy transition, making it the most commonly held objective, ahead of employment (59 per cent), GDP growth (57 per cent) and social objectives, such as health and education (57 per cent).
The challenge for new funds is building credibility alongside their more established peers. Demonstrating strong levels of governance will be key, alongside fact-finding partnerships with other funds and experienced asset managers to help build on their skills and knowledge.
