Middle East sovereigns are looking at private markets in the face of rising inflation, reveals Invesco study

Following a long period of low interest rates and low inflation, sovereign investors have been forced to reconsider their macroeconomic assumptions and adjust their investments accordingly. This was one of the key findings of the recently published 10th Invesco Global Sovereign Asset Management Study.

According to the annual study, the majority of sovereigns in the Middle East (55 per cent of the respondents interviewed) have re-positioned their portfolios in anticipation of further rate rises, though the sharp correction in equities and failure of bonds to shelter portfolios have presented difficult choices.

Zainab Faisal Kufaishi, head of the Middle East and Africa, and senior executive at Invesco said, “While most markets ended 2021 with a cautiously optimistic outlook for 2022, the start of the year presented a perfect storm of challenges for investors.

“Inflation is surging, global growth is slowing, and geopolitical tensions are rising. Where the macro environment had once been relatively predictable, it is now more uncertain, sending sovereigns to rethink how to position their portfolios as they look ahead.”

Invesco’s study affirms that while global sovereigns’ fixed income allocations have declined steadily in recent years, they are no longer being redirected to listed equities. Instead, they are going to private market alternatives, notably real estate, private equity and infrastructure. In the Middle East, most (82 per cent) respondents agree that real assets are effective hedges against inflation and higher yields.

Zainab Kufaishi commented, “While there are some concerns about deal flow and supply driving valuations higher, private markets remain attractive to long-term investors in the region because they provide a long-duration play and shelter from volatility.”

Impact of the geopolitical crisis
In the early part of the year, many sovereign investors saw good value in Europe, especially when compared to the US.  However, this sentiment changed after the Russia-Ukraine crisis, which investors feared would make inflation harder to contain while also curbing growth, posing a risk of stagflation.  Unsurprisingly, developed Europe and Emerging Europe are the geographies to which sovereign investors are most likely to decrease exposure.

The majority (52 per cent) of sovereigns said that China was a more challenging place to invest than last year, with regulatory risk and government interventions in certain sectors such as technology viewed as having an impact on asset prices.

The dollar remains a key reserve currency even as Renminbi allocations rise
The freezing of Russia’s foreign reserves in response to the Ukraine crisis triggered a debate about the role of the US dollar (USD), as the world’s dominant reserve currency, especially as its allocation as a share of global central bank reserves had been steadily reducing for years: between 2016-2021, it declined from 65.4 per cent to 58.8 per cent, according to IMF year-end data.

While there was broad agreement that the Russia-Ukraine crisis would have a limited impact on the USD, the study stated that respondents recognised that the Renminbi (RMB) will continue to grow and could impact the status of USD in coming years.

Inflationary trends push central banks away from deposits
Invesco’s study showed that as central banks navigate within a rising global inflationary environment, cash deposits are being reallocated into government bonds.  Central banks are looking to diversity into new asset classes, including equities and real assets, valuing their diversification benefits and potential for higher returns.

Sovereigns cautious on digital assets
Despite the widespread anticipation that institutional investors will embrace digital assets, Invesco’s study revealed that sovereign funds do not yet see them as investable. For many Middle East sovereigns (70 per cent), there is more interest in investing in companies involved in the infrastructure behind digital assets as the largest growth opportunity than the digital assets themselves.

However, research into digital assets is increasing. In 2018, just 12 per cent of global sovereigns were conducting research into the area; now, the figure is 41 per cent, including 40 per cent of those in the Middle East.

Most central banks around the world are still deep in the research and development stage of their digital currency journeys: 71 per cent of central banks in the Middle East are either conducting research into Central Bank Digital Currencies or considering launching one themselves.

Scale and private market exposure drive outsourcing push
In 2021, the world’s sovereign wealth funds grew their total assets under management to $10.5tn, up from around $8tn in 2018. The expanded scale has increased operational complexity and prompted funds to seek external managers to help deliver on their objectives.

Some funds noted that they had struggled to manage private market assets outside of their domestic market and were backtracking on previous moves to internalise investing.  As a result, sovereign funds are increasingly rely on external asset managers to deliver on their private market objectives. The study cited that 9 out of 10 investment sovereigns have developed such strategic partnerships.  In the Middle East, more than half (56 per cent) of sovereigns expect relationships with third-party asset managers to increase over the next five years.

Technology is also seen as a solution to scale challenges, with most sovereigns citing a role for data science in developing the sophistication of their data analysis and research.  According to the study, data science is also playing a role in risk optimisation and asset allocation.

For more investment insights, download the study.