A new concept for reserve management
The period of economic stability, known as the 'great moderation,' came to an end in 2022 when central banks had no choice but to begin aggressively increasing interest rates in order to control the rapidly rising inflation. At the same time, tensions between nations intensified as Russia launched its invasion of Ukraine, leading to further strain in the relationship between China and the United States. Additionally, reserve managers have faced difficulties due to the impact of rising interest rates on both fixed-income and equity markets.
Nevertheless, the year 2023 began on a hopeful tone, mainly due to the mounting proof that we had surpassed the highest point of inflation. Unfortunately, this optimistic outlook took a hit in March as a sudden banking crisis emerged in the United States, bringing back volatility. This unexpected turn of events raised concerns about the possibility of a rapid decline in (core) inflation and whether the US would be able to avoid a severe economic downturn.
This served as the economic setting for the 29th UBS reserve management seminar and the accompanying survey of reserve managers. With the participation of over 60 central bank officials from various countries, the survey and conference provided a glimpse into the effects of this constantly changing economic environment on the forthcoming asset allocation landscape.
In regards to the overall economic situation that reserve managers anticipate in the next few years, there were different outcomes. The majority of participants (64%) foresee a scenario where the economy stabilizes with moderate growth and inflation of 2-3% in the next five years. However, 72% of those surveyed also believe that the era of steady economic conditions may be coming to an end, and future business cycles could be more unpredictable. Additionally, 69% think that we have entered a period of increased inflation that will last for a significant amount of time. Furthermore, 61% of participants expect the US headline consumer price index to fall within the range of 3-4% within a year. It is important to note that none of the participants anticipate the consumer price index to exceed 5% or go below zero.
The blog section extensively covered the discussions surrounding the difficulties of dealing with these challenges. Based on a real-time survey, almost 80% of the attendees expressed their skepticism towards monetary authorities' complete comprehension of the inflation surge. This skepticism stems mainly from the unique circumstances that have led to the increase in inflation since 2021. The panelists had differing opinions on whether the inflation spike will be short-lived and quickly return to the intended level, or if we are entering a situation of prolonged high inflation, indicating a significant change in the economic landscape.
What does this signify for the way reserve managers divide their assets? In a situation where the period of stability has concluded, the types of assets that survey participants find appealing are those that are highly liquid and secure, such as short-term government bonds (76%). This is closely followed by global government bonds with longer maturity periods, which act as a safeguard against deflation (41%), and bonds linked to inflation, which serve as a protection against inflation (41%). Since central banks typically do not invest in real estate, only 9% of participants express an interest in including this asset class in their portfolios during such a period. On the other hand, 15% would prefer to have a larger portion of energy-related assets and securities to serve as a safeguard against macroeconomic risks.
A modified approach to managing reserves may be necessary. The primary objective of reserve management is to safeguard capital. Cash and short-term fixed income investments are crucial in achieving this goal. Additionally, there is a focus on increasing the value of assets through investments in stocks and fixed income products such as corporate bonds and emerging market debts in strong currencies. To mitigate risks to the global economy, reserve managers should consider long-term government bonds to address the possibility of a recession, and inflation-protected securities, gold, or commodities to mitigate the risk of inflation. Some managers may choose to diversify their investments by including alternative asset classes. In our recent survey, 22% of participants expressed an interest in investing in illiquid assets like infrastructure and real estate to improve their returns, compared to only 3% in our 2020 survey.
Implementing a more adaptable approach to time management can also contribute to minimizing the unpredictability of savings and leveraging opportunities that arise in different markets and regions. Around a quarter of the participants (23%) revealed that they have either transferred or contemplated transferring assets managed passively to their active management strategies, indicating an increase from 11% in 2022.
Image 1. Moving towards a fresh approach to managing reserves
At a more strategic level, there is a significant inclination towards safer fixed income options such as national bonds, international organizations' bonds, and specifically, environmentally friendly bonds. Conversely, certain forms of investments with wider profit margins are becoming less appealing. Green bonds rank highly among the asset categories frequently discussed, and reserve managers are looking to boost their allocation in the upcoming year.
The growing appeal of fixed income assets was also voiced by speakers at the gathering. While an additional increase is anticipated in July, it seems that the US tightening cycle is nearing its conclusion, and interest rates on all types of bonds seem appealing. Numerous reserve managers are once again considering investing in emerging market debt. Emerging markets are already ahead of developed markets when it comes to increasing interest rates, and local currency bonds could benefit from a decline in the value of the dollar.
Investment diversification towards stocks is slowly progressing. Although passive stocks are not performing as well as they did last year, they have still shown satisfactory results compared to other asset classes. Central banks have been increasing their allocation to stocks in their portfolios over the past year and plan to continue doing so in the future. Even though higher returns from fixed income might pose a challenge for some time, reserve managers at the event expressed their intention to further increase their investment in undervalued sectors and regions within the stock market.
In relation to the allotment of foreign currency reserves, the dollar and the renminbi were the most commonly cited currencies that were added to the reserves of participating sovereign institutions in the past year. Following closely behind was the Canadian dollar, while the euro remained the currency that participants mentioned reducing the most during the previous year.
Moving ahead, there is a more positive attitude towards the euro, as indicated by the respondents of the survey who are now anticipating an increase in their euro allocations. This change in sentiment is a significant development after years of negative outlook. Furthermore, central banks are also in the process of increasing their holdings of the yen, renminbi, and currencies associated with commodities such as the Canadian dollar, Australian dollar, and New Zealand dollar.
Massimiliano Castelli holds the position of Head of Strategy and Advice, while Philipp Salman serves as the Director of Strategy and Advice for Global Sovereign Markets at UBS Asset Management.
