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Sovereign wealth funds turn to private markets as inflation poses tough questions

Surging inflation has prompted sovereign investors to re-examine their asset allocation, with private markets the main beneficiary, according to the latest Invesco Global Sovereign Asset Management Study.

Now in its tenth year, the study details the views of 139 chief investment officers, heads of asset classes and senior portfolio strategists at 81 sovereign wealth funds and 58 central banks, who together manage $23 trillion USD in assets.
  
After 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. The majority (59%) have repositioned 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.
 
Sovereign wealth funds’ fixed income allocations have declined steadily in recent years, but they are no longer being redirected to listed equities. Instead, they are going to private market alternatives, notably real estate, private equity and infrastructure, which most (71%) respondents agree are effective inflation hedges. While there are some concerns about deal flow and supply driving rich valuations, private assets now constitute, on average, 22% of sovereign wealth funds’ portfolios, the highest proportion on record, with the figure rising to 27% for the larger (AUM > $100 billion) funds. In total, sovereign wealth fund investors now own $719 billion in private assets, up from $205 billion in 2011.
 
Interest in private assets looks set to continue. When asked which asset classes they intend to increase, maintain, or decrease exposure to over the next year, private equity (net +29%) was the most popular, followed by unlisted real estate (+23%). By contrast, respondents were most bearish on fixed income (-12%) and cash (-4%), while sentiment on equities is broadly unchanged (+1%).
 
In early 2022, many sovereign wealth fund investors saw good value in Europe, especially when compared to the US. However, this sentiment changed after Russia invaded Ukraine, which investors feared would make inflation harder to contain while also curbing growth, posing a risk of stagflation. Unsurprisingly, developed Europe (19%) and Emerging Europe (13%) are the geographies to which sovereign wealth fund investors are most likely to decrease exposure. Respondents are most likely to increase exposure to North America (33%) and Asia-Pacific (23%).
 
This study has previously noted sovereign wealth funds’ high levels of capital flows into China; however, views this year are mixed. The majority (52%) of sovereign wealth funds said that China was a more challenging place to invest than last year. However, others noted that its level of integration into global trade and markets – notably the interdependence of the American and Chinese economies – could mitigate the geopolitical risk posed by the Russian invasion of Ukraine.
  
The freezing of Russia’s foreign reserves in response to the invasion of Ukraine 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% to 58.8%.
 
While there was broad agreement that the Russia-Ukraine war would have a limited impact on the USD, central bank respondents recognise that the Renminbi (RMB) will continue to grow and could impact the status of USD in coming years. A sizeable majority (63%) of central banks now have RMB allocations, up from 40% in 2018, and most central bankers see their position as underweight, intending to increase it in the next five years. RMB remains just 2.8% of foreign exchange reserves, but as one European central banker put it, “the position of the US Dollar is strong today, but its position can change significantly, especially with the rise of China as an economic superpower in the coming decade.”
  
Despite the widespread anticipation that institutional investors will embrace digital assets, sovereign wealth funds do not yet see them as investable. Just 7% of sovereign wealth funds have any exposure to digital assets, and much of this is through investments in underlying blockchain companies. Volatility (68%) and regulatory pressure (55%) are the most common concerns, and just 15% think that digital assets can act as a credible inflation hedge. 
 
However, research into digital assets is increasing. In 2018, just 12% of sovereign wealth funds were conducting research into the area; now, the figure is 41%. Sovereign wealth funds generally feel comfortable about investing in the underlying technology via private equity and venture capital products, and 55% said they would consider investing in the industry if the right opportunity were to present itself.
  
In 2021, sovereign wealth funds grew their total assets under management to $10.5 trillion, up from around $8 trillion in 2018**. The increased scale, combined with greater exposure to competitive and esoteric areas of private markets, 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.
 
More than half of sovereign wealth funds have developed strategic partnerships with third-party asset managers, rising to more than nine in ten for investment sovereigns.

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