Some of the biggest challenges facing markets will recede and be overtaken by overlooked risks, according to this year’s Invesco Global Sovereign Asset Management Study.
The report found that sovereign investors considered inflation to be the biggest danger facing global growth over the next year, but this will lower considerably over the long term.
It poses an 83% risk to global growth in the near term, but that is likely to pull back to 47% over the next decade.
Instead, climate issues will become a greater threat to the global economy over time. Economic risks from climate change and natural disasters could rise from 41% to 66%, while the cost of energy transition could leap from 32% to 53%.
Risks to global growth
Source: Invesco
While inflation will pull back over the coming 12 months, there are still more than 27 years and billions of pounds worth of investment needed before countries around the globe meet their net-zero commitments.
Although markets seem to be captured by inflation for the time being, most sovereign investors agreed that climate risk is worthy of the most attention over the long term.
The report found that 44% of sovereign funds hold green bonds, up from 38% the year before as they are motivated by “improving returns and reducing risk”.
Central banks went even further to mitigate against climate risk, with the number of them buying green bonds rising from 42% to 69% over the past year.
Investors holding green bonds
Source: Invesco
The Invesco study said: “As the energy transition takes precedence, investors almost unanimously concentrate on green infrastructure and green bonds.
“Direct investment frequently offers a more dependable means of tracking progress toward sustainable objectives, along with more influence and leverage to achieve those objectives.”
However, it also noted that greenwashing remains “the most significant challenge of environmental, social and governance (ESG) investing”. There are ways around this, with the report saying that investors should “seek established names to minimise reputational risks and guard against greenwashing”
Although sovereign investors expect inflation risk to fall back on the agenda, they said levels are likely to stay higher than markets are used to, largely due to global supply chain issues.
Supply chains were backed-up when Covid halted global movement, which was exacerbated when the war in Ukraine.
Whilst this normalises, the vast number of baby boomers retiring – creating a tighter labour market –is also likely push inflation over the coming decade.
The cost of replacing carbon-generated power for clean energy is also likely to be one of the driving forces of this above-average inflation.
The report said: “High inflation was a novel phenomenon, with uncertainty about its persistence. However, as the situation clarifies our respondents largely agree that, despite falling, inflation is likely to remain elevated compared to the previous decade.”
Expectations for inflation in Developed Markets over the next two years
Source: Invesco
However, a tighter monetary environment comes with its own opportunities, with the Invesco report finding that fixed income could play a much bigger role in portfolios.
Over half (53%) of the respondents said interest rates will be higher or unchanged for the next two years, leading to some high yields on fixed income assets.
This is lower than the wider consensus, with 71% of central banks expecting rates to stay the same, if not rise over the coming years.
Expectations for real interest rates in next 2 years
Source: Invesco
The study said: “This has led sovereigns to reassess long-term macro assumptions, as many believe the cheap money era has ended, and ultra-low and negative rates are history.
“Some investors reported buying as much fixed income as possible within existing asset allocation limits and were considering revising their framework to accommodate the new interest rate environment.”
A decade of higher inflation and interest rates is likely to play well for emerging markets, where central banks were quick to tackle economic challenges, according to the report.
Sovereign funds have typically held an underweight position in emerging markets, but they became more popular over the course of the year.
The report said: “As developed markets’ asset prices soared due to cheap money and negative real interest rates, many funds found little need to pursue the extra effort or risk associated with significant emerging market allocations.
“The normalisation of interest rates looks poised to disrupt the status quo, as this year’s study revealed a broadened appetite for emerging markets among sovereign investors.”