The appetite for risk assets is turning negative, and the world’s largest investors are scurrying away from emerging market equities and debt amidst a rising tide of woe.
Few would have predicted that the initial Covid market crash – in which it was determined, once and for all, that the windows on Wall Street don’t actually open – would give way to a reenergised bull run that lasted from March 2020 to (probably) sometime last month. Even fewer would have predicted that it could have lasted as long as it did.
The market has shaken these things off before; notorious prophet of doom Jeremy Grantham has described the market’s recent convulsions as those of a vampire surviving numerous grievous injuries before finally keeling over dead. But even if the party isn’t over, there’s not much more hope that it can continue.
State Street’s Behavioural Risk Scorecard Multi-Asset Flow & Holding scores – an aggregate measure of risk appetite derived from the capital flows and holdings of institutional investors – turned negative in early February, reaching its lowest point in two years. Supporting that finding, a new report from State Street and the International Forum of Sovereign Wealth Funds (IFSWF) shows that the risk-off behaviour of SWFs and other institutions has so far pinched emerging markets the most.
“The strong capital outflows from emerging markets – the largest level of selling observed over the previous five years – have been matched by robust demand for stocks in developed markets,” says the report, titled Post-pandemic shift: Evidence from institutional investor and sovereign wealth fund activity.
“Within sectors, institutional investors continue to show a strong preference for defensive sectors such as consumer staples and utilities, which is unsurprising as volatility has risen in response to military actions in Eastern Europe.”
Neill Clark, State Street Associates Europe, Middle East and Africa (EMEA) head, said in a statement that investors are repricing risk assets in light of global conflict, inflation and central bank policy moves.
“Following a period of opportunistic rebalancing and selective risk-taking during 2020, the past year has seen institutional investors moving towards safer assets and markets,” Clark said. “Their asset allocation decisions suggest they are no longer adding to their equity exposure – which they had been doing since Q1 2020 – and instead, are adding to their fixed-income and cash balances.”
Of course, there’s always a contrarian. At least one respondent took a larger position in emerging market equities as the value/price gap widened, saying the asset class was cheaper than six months ago “relative to its fair value estimates.” The report mentions no such contrarian in emerging market sovereign debt, which has been a victim of the same trend, while developed market sovereign bonds are maintaining stable capital inflows despite rising domestic inflationary pressures.
“Euro- and US-dollar-denominated corporate credit have also seen outflows, driven by a challenging combination of rising rates, high inflation and slower growth, tapering of quantitative easing from global central banks, and potential ripples from Russian sanctions,” the report says. “One beneficiary of the credit uncertainty and rising inflation pressures is the US Treasury Inflation-Protected Security (TIPS) market, where we have observed renewed appetite by institutional investors.”
And the march towards private markets continues unabated. With three quarters of data from 2021 available, the State Street Private Equity Index indicates that buyout and venture capital funds have surpassed the high-water marks of 2020, though private credit fundraising has slowed some compared to the previous year. The report found that sovereign wealth funds have increased their allocation to private markets for three reasons:
“First, they have long-term strategic asset allocation targets for private markets and are still building their private markets portfolio. Second, private markets can work as a diversifier in sovereign wealth funds’ portfolios due to idiosyncratic opportunities, various risk-return spectrums and asymmetric information. Third, some sovereign wealth funds are adding illiquidity premiums by allocating to private markets as they have long-term investment horizons.”
Exemplifying some of these shifts is Australia’s very own Future Fund, which has very modestly trimmed its equity allocation “given the run-up in prices and (a) view that risk is likely to be less well-rewarded in future” and upped its allocation to what CEO Raphael Arndt describes as “less liquid and more skill-based investments” – meaning more mandates for hedge fund and other alternatives managers, including in private equity, property and infrastructure. However, the Future Fund was still positioned for “close to” neutral risk in February.
Lachlan Maddock is contributing editor to Investor Strategy News (Australia)