Institutional investors have their work cut out for them. Between the bout of inflation in most major economies, tightening financial conditions and slow global growth, concerns for financial stability are mounting. To discuss public investment in a volatile climate, State Street Global Advisers and OMFIF hosted a roundtable series. They convened panels of experts to speak on strategic issues impacting the institutional investment community.
Representatives from central banks, sovereign funds and public pensions funds from across Europe, the Middle East and Africa spoke on the global macroeconomic outlook, central bank reserve management as well as sovereign and public pension funds’ investment strategies. There was a unanimous acknowledgement of the difficult environment facing investors. One speaker noted that, ‘After 15 years of lower-for-longer, 0% interest rates, there is a lack of risk management knowledge and how to deal with this environment – it is unprecedented.’
Central banks seen to be reaching end of tightening cycle
After 10 consecutive rate hikes by the US Federal Reserve, with the Bank of England and European Central Bank not far behind, roundtable participants seemed to agree that not much more monetary tightening is needed. Though prices will fall back down to the target rate, this will take time: ‘The bottom line is that monetary policy takes two years to unfold,’ said one participant, with another noting that credit provision and money supply statistics suggest we are already in a period of ‘marked disinflation’.
For the panellists, this tightening cycle is unlike those before it. When asked whether central banks should engineer a recession to bring down inflation, one participant reflected: ‘As long as expectations are anchored, we don’t need to crash the economy or the banking sector’ to get inflation back to target.
Regarding financial stability concerns, Europe is seen to be better positioned than the US. Because governance within the European Union is trickier, the pre-emptive arm of banking regulation – which includes liquidity and capital adequacy provisions – is stronger than in the US. One participant stated that the European banking sector would be ‘well prepared to weather a mild and shallow recession if it happens,’ while the US banking sector may face more difficulties.
Geopolitical fragmentation anticipated to worsen
Industrial policy and nearshoring were two key topics of discussion in the context of geopolitical tensions. In addition to China continuing its pursuit of a strong state-led growth model, the US is pursuing a ‘green’ industrial policy with the 2022 Inflation Reduction Act. The climate spending bill ruffled feathers in Europe, bringing accusations of protectionism for US industry. There was a sense among panellists that Europe would need to focus on activating Next Generation EU funds earmarked for digital and green projects before developing another subsidy programme in response to the IRA.
On nearshoring or ‘friendshoring’, the rate of decoupling between China and the West so far has varied by sector. While some diversion away from China has been seen in high level and strategically important areas of the supply chain, most manufacturing is still being conducted in China. The highest risks are around technology, with potential for further tit-for-tat regulatory moves between the US and China. Some emerging markets, namely Mexico, may stand to benefit from the competition between the two economic superpowers.
Diversification back on the table
Due to geopolitical risk and higher, more volatile rates, ‘diversification is back in this cycle’, said one participant. On currencies, though de-dollarisation of central bank reserves has been predicted for years, there seems to be a lack of viable alternatives: ‘It’s hard to find good diversifiers from the dollar,’ noted one panellist. Another agreed, expressing scepticism of de-dollarisation in the short term due to the wide range of dollar instruments available to investors. Where, then, are reserve managers looking to diversify?
For some, losses are prompting a higher risk tolerance, as they seek to boost returns. Here, equities are a good alternative to traditionally low-yielding government bonds. On equities, exchange-traded funds may be preferable to central banks wishing to maintain neutrality, as they provide access to equities without shareholder voting or other corporate governance responsibilities. Others are retreating to gold as a safe-haven asset.
Finally, it also looks like a sensible return on safe assets may emerge, making risk-off fixed income a better bet than it has been as yields rise (although not yet, since negative real rates persist). While there is some optimism on fixed income in the medium term, alternative investments look wobbly. Multiple participants from the investment community voiced concerns over commercial real estate and unlisted property, which they fear are ‘highly leveraged’ and ‘yet to have a price correction’.
Demographic change expected to drag on global growth
Amid vast uncertainty for investors, one thing is definite: demographic changes will impact economic growth over the long run. Apart from the African continent, all regions in the world are forecasted to undergo demographic decline in the coming decades, as birth rates slow and populations age. This is likely to drive down growth and drag on public finances – ageing is already affecting sovereign credit ratings. As fiscal costs increase from healthcare and pension spending, this will have a perverse effect on debt sustainability. And, as government financing becomes more difficult, ageing will lead to high bond yields and, potentially, default.
Taylor Pearce is Senior Economist at OMFIF.
For more on central bank reserve management, the 10th edition of OMFIF’s 2023 Global Public Investor report – our flagship study of central bank behaviour and decision-making – is launching soon. Read more here.