Private credit, high yield and infrastructure debt have been earmarked by sovereign investors as the most attractive asset classes to combat inflation and rising geopolitical and climate-change risk, according to the latest annual Invesco Global Sovereign Asset Management Study.

The swift rise in interest rates and sharp correction in listed asset prices led most sovereign wealth funds to report negative returns for 2022, and the majority (86%) anticipate inflation to be higher in the coming decade than in the last. In response, many are fundamentally rethinking the way they invest in fixed income and private assets, alongside a renewed interest in emerging markets.

Rod Ringrow, head of official institutions at Invesco, said: “Although average returns in 2022 were negative, there was significant variation within these results. 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.”

Rethinking fixed income

While fixed income remains the asset class that sovereign investors are most likely to increase in their strategic asset allocation over the next 12 months, fixed income’s failure to shelter portfolios from the 2022 asset price correction has changed the way sovereign investors perceive the asset class, the study found.

Invesco’s research revealed that sovereign wealth and pension funds are moving away from a ‘set and forget’ position in favour of 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.

Additionally, sovereign investors now recognise private credit as a distinct asset class, “with favourable risk-return profiles and high liquidity levels”.

India Tajmahal

India is seen as a leading market in emerging marekts for SWFs

Increased appetite for emerging markets

The higher interest rate environment has prompted a renewed appetite for emerging markets, the study found.

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, with India seen as a leading market.

A more selective approach to private assets

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, according to Invesco.

The report found that within infrastructure, there is considerable interest in renewable-energy generation: 81% of sovereigns see it as an attractive area, followed by energy transmission and supply (65%). This was in part caused by the war in Europe and the energy crisis that followed, which triggered a global surge in renewable-infrastructure demand.

Respondents said 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 put off recent real estate, private equity and infrastructure deals due to unappealing debt structures.

Real estate is currently perceived as 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.

The price correction has had little impact on the attractiveness of private equity, with just 13% of sovereign investors seeing private equity as less attractive than before. More than a third (34%) see it as more attractive, and the majority (53%) observe no impact.

Ringrow added: “Challenges notwithstanding, for many sovereigns the global economy remains fundamentally resilient and expected returns across asset classes are higher than in recent years.

“This year’s data, however, reveals a misalignment between sovereign wealth funds and central banks on interest rate expectations over the next two years. Sovereign wealth funds are far more likely to expect real interest rates to trend downward, albeit remaining higher than in the last decade, while central banks are more likely to expect them to trend upward. This further underscores the importance of a watchful and flexible approach.”

Leading the energy transition

Invesco’s study found that sovereign investors are now more resolute than ever in their ambitions to fund the energy transition. Respondents asserted that the ramifications of climate change (66% of citations) and the financial cost of the energy transition (53% of citations) are two of the three most significant risks to global growth over the next decade, behind only rising geopolitical risk.

Between 2017 and 2023, according to the research, the number of sovereign wealth funds with ESG policies grew from 46% to 79%. The increasing significance of ESG initially stemmed from climate-driven long-term risks to returns.

Invesco found that “improving returns” and “reducing risk” were primary motivations for adopting ESG policies. The Russian invasion of Ukraine, however, underscored the importance of energy security and prompted even greater urgency, with this year seeing the fastest rate of ESG adoption among both sovereign wealth funds and central banks.

Ringrow said: “With the energy transition taking precedence, we see sovereign investors concentrating more on green infrastructure and green bonds.

”Those sovereigns with extended investment horizons are increasingly considering direct investments in green infrastructure as a means of maximising impact. In particular, investment, liability, and development sovereign wealth funds all deem ‘direct investment in green infrastructure’ as the most crucial method for financing the energy transition.”

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