Sovereign funds prefer Germany during Brexit deal

Invesco released its fifth Invesco Global Sovereign Asset Management Study on 5th June, an annual in-depth report on the complex investment behaviour of global sovereign wealth funds and central banks. This year's study shows that geopolitical uncertainty and limited options to increase risk asset allocations are causing sovereign investors to make fewer allocation changes than at any point in the past five years, despite target-return gaps increasingly widening.

The survey, conducted face-to-face among 97 individual sovereigns and central bank reserve managers across the globe, including Canada, representing $12 trillion of assets, asked sovereigns to rate the importance of various economic and geopolitical factors on their investment strategies.

It found that investors were starting to question the future of Britain as an “investment hub” in Europe. This comes after Prime Minister Theresa May pledged that she would seek a good deal for London’s financial-services industry when she negotiates the country’s withdrawal from the EU. She first has to win this week’s general election.

"Sovereign investors are a diverse group and challenges affect sovereigns differently according to their liabilities, risk appetite, funding dynamics and other factors," says Alex Millar, Head of EMEA Sovereigns & Middle East and Africa, Institutional Sales at Invesco. "Our study has once again illuminated how these diverse investors are responding to global trends as they become ever more sophisticated, yet limited by both external and internal constraints."

Sovereigns see low interest rates as the greatest tactical asset allocation factor, driving increasing allocations to real estate as they seek alternative sources of income generation. However, the longer-term implications are less certain with expectations of a gradual return from quantitative easing to quantitative tightening.

Brexit and the election of Donald Trump in the U.S. are expected to grow in importance for future allocations (set to increase in importance by 82% and 68%, respectively) as the implications of political shifts on investment performance becomes clearer.

The U.K. saw the biggest drop in attractiveness to sovereigns, down to 5.5 from 7.5 last year. Brexit is seen as a significant negative for U.K. investment, and investment sovereigns with European interests questioned the future of the U.K. as an "investment hub" for Europe, given uncertainty over taxes on imports and market access.

Trump on topSovereigns have ranked the U.S. as the number one market in terms of attractiveness for the past three years, and this year the country retains its top spot with a score of 8.0 (out of ten). The U.S. is also the winner in terms of actual allocations, with 37% of respondents reporting overweight new flows to North America in 2016 relative to their total portfolio – higher than any other region – and a net 40% are planning to overweight further in 2017. 

The sovereign investors, which also includes state pension funds and government ministries, instead rated Germany as the most attractive European market to invest in with 7.8, the survey showed. That was followed by Italy and France which both scored 6.1 out of 10. Globally, the U.S. had the highest rating with a score of 8 while India was the most preferred in the emerging markets. Germany's popularity is attributed to its perceived "safe haven" status and positivity towards Germany has increased based on its economic strength.

The return environment has, on the whole, remained challenging for sovereigns who have, on average, underperformed their target returns by 2%. Over the past three years, governments have responded to poor economic performance by reducing new funding to sovereigns (on average, down from 8% in 2015 to 5% in 2017) and cancelling investments (down from -1% in 2015 to -3% in 2017).

"Last year was challenging for sovereign investors with concerns surrounding funding levels and return expectations remaining front of mind amidst added macro-economic and political uncertainty," says Millar. "Demand for alternatives like infrastructure has been a consistent theme in past years, but this year the challenge of increasingly scarce supply is compounded. While investors have fewer asset allocation levers with which to respond, they are delving deeper into more supply-rich real estate markets, and looking to the U.S. and Germany for opportunity and economic strength."