This year’s study was conducted face-to-face amongst 139 individual sovereign investors and central bank reserve managers across the globe representing $20.3trillion [2] of assets, of which 71 are central banks (62 in 2018), reflecting their growing status as sovereign investors.

Fixed income displaces equities as largest asset class for sovereigns

2018 was a challenging year for sovereigns as weak and volatile equity markets led to a decline in overall investment returns. On average, sovereign investors achieved returns of 4% in 2018 compared to 9% in 2017. Despite the decrease in returns, sovereigns performed well given negative returns from global equities, which fell 8.7% in US dollar terms during the year, according to MSCI World Index***.

The majority of sovereigns (89%) anticipate the end of the economic cycle within the next two years. This combined with volatility concerns and the prospect of negative returns from equities has led to increased fixed income allocations and more diversification in allocations to infrastructure, real estate and private equity markets.

Fixed income allocations increased to 33% in 2019 from 30% in 2018, becoming sovereigns’ largest asset class. Meanwhile, allocations to equities fell from 33% to 30%, marking the end of a five-year trend between 2013 and 2018 during which fixed income fell from 35% to 30% as equities posted strong gains.

Challenging equity markets in 2018 highlighted the limitations of market-cap weighted passive strategies, as well as some more basic factor strategies. Some of the most popular factor strategies, e.g. value and momentum, performed below sovereign expectations during 2018, and some of those adopting a simple ‘set and forget’ approach to their factor allocations reported negative returns. This is encouraging a move away from a single-factor approach towards multi-factor positions that can better adapt to changing market conditions.

Sovereigns optimistic on China

China’s attractiveness rating for sovereign investors has improved more than any other major region since 2017. Some 82% of sovereigns cited trade tensions as having had an influence on asset allocation decisions, yet China’s attractiveness as an investment destination over the next three years scored an average rating of 6.1 out of 10 among sovereign investors, a marked increase on 2017’s 5.2 rating.

Despite the fact that the study was carried out during a period of ongoing rhetoric on a trade war, those surveyed saw China’s pledge to improve safeguarding of intellectual property as grounds for optimism that some resolution of tensions would be reached.

The unique competitive dynamics of China are appealing for sovereigns seeking more diversification, the survey found, with equities continuing to be the asset class most favoured. Approximately 90% of sovereigns with China exposure held Chinese equities, showing that the government’s measures to open the market to foreign investors are bearing fruit. Fixed income allocations are also likely to increase with Chinas inclusion in major bond indices and initiatives, such as Bond Connect, giving foreign investors access to the local bond market. Transparency remains a significant obstacle to higher allocations in China for sovereigns, while for those sovereigns with no existing allocation to China, investment restrictions and currency risk are seen as the main impediments.

Investors don’t see economic attractiveness in Europe

A combination of slowing economic growth and perceptions of rising political risk have led to a decline in the perceived attractiveness of major European economies. Brexit is now influencing asset allocation decisions for 64% of sovereigns.

While continental Eurozone internal politics, seen as increasingly uncertain with the ascendance of populist movements in major European economies such as Germany and Italy, is impacting asset allocation decisions for 46%. This has resulted in Europe falling out of favour, with nearly one third of sovereign investors decreasing allocations to Europe in 2018 and a similar number planning further decreases in 2019. Only 13% of sovereigns plan on increasing allocations to Europe this year, compared to a 40% allocation to Asia and 36% to Emerging Markets.

Renminbi finds a bigger place in Central Banks reserve portfolios

As a group, Central Banks believe the end of the economic cycle will be characterised by a gradual slowdown, rather than an economic crisis. However, the uncertain market environment, combined with an increasingly hawkish Federal Reserve, led many of them to find perceived safety in increased allocations to deposits, and, in some cases, gold.

Central banks bought 651.5 tonnes of gold in 2018, the second highest annual total on record and up 74% from the year earlier12 . Over a third (35%) of central banks increased allocations over the last three years, with 32% expecting further increases over the next three years, but overall gold holdings remain steady at around 4% of overall reserve portfolios. Respondents to the study reported additional challenges associated with gold as a reserve asset, including volatility, storage costs and the political implications of selling. 75% of Central Banks agreed or strongly agreed that selling gold holdings would attract negative domestic media coverage in their country.

Central Banks continue to diversify away from the negative yields of government bonds (especially in Europe) into bank deposits; and away from the US dollar. The main beneficiary has been the Renminbi and between 2017-18, allocations to China’s currency overtook the Australian and Canadian dollar, with 43% of central banks now holding it in their portfolios, compared to 40% in 2018. Over a quarter (27%) of central banks expect to continue to increase Renminbi reserves in 2019, making it the most favoured currency for the year ahead, with increased allocations expected to be taken from the USD, EUR and GBP. Though USD remains the dominant reserve currency, allocations reached a 5- year low, falling from 62.7% of global currency reserves to 61.7%.

Environmental considerations move ESG firmly into the spotlight

ESG is an increasingly important issue for sovereigns and Central Banks. Since 2017, the percentage of sovereigns with a specific ESG policy rose from 46% to 60%. 20% of Central Banks now have an ESG policy, compared to 11% in 2017. Approaches to ESG are increasingly sophisticated, having moved beyond screening to incorporate more advanced forms of integration.

There has also been a shift in focus of the nature of ESG activity. While asset owners have, in the past, focused on issues of governance due to clearer risk and return benefits, these factors are now often assumed by ESG adopters. For sovereigns, environmental concerns are increasingly becoming the lead focus, with carbon emissions and climate change the single most important ESG issue.

Alex Millar, Head of EMEA Institutional Distribution Sales, Invesco, commented: “Our wide-ranging study reveals that sovereigns and Central Banks are adopting defend and diversify investment strategies. The combination of a likely end-of-cycle within two years and an uncertain global environment has led to allocations to fixed income, private markets, and emerging markets growing in portfolios. Political uncertainty and lack of economic attractiveness has seen a shift of allocations away from Europe, pivoting towards China, despite some concerns at continuing trade wars. While central banks have maintained their commitment to alternative assets, there have been significant changes in their lower risk assets, moving from government bonds towards deposits and in some cases gold, and from the US dollar to Renminbi.”