The ‘great moderation’ ended in 2022 when central banks were forced to start aggressively raising interest rates to bring soaring inflation under control. Geopolitical tensions escalated as Russia invaded Ukraine and the relationship between China and the US was put under further strain. Reserve managers have struggled too with the rise in interest rates impacting both fixed and equity markets.
However, 2023 started on a positive note largely as a result of growing evidence that we were past the peak in inflation. However, volatility returned in March with the sudden onset of a banking crisis in the US. Uncertainty grew over whether (core) inflation will continue falling rapidly and if the US will be able to escape a deep recession.
This was the economic backdrop for the 29th UBS reserve management seminar and the accompanying survey of reserve managers. Attended by more than 60 central bank officials from around the world, the survey and conference gave an insight into the implications of this ever-evolving economic landscape for the asset allocation environment ahead.
Of the overall economic set-up that reserve managers think is most likely to play out over the next few years, results varied. The majority of participants (64%) see a soft-landing scenario with a return to moderate growth and moderate inflation of 2-3% as the most likely economic regime over the next 5 years. However, 72% of survey participants also think that the period of the ‘great moderation’ is over and that we might experience more volatile business cycles going forward. 69% believe that we have entered a period of higher inflation that will persist for a longer period of time and 61% of participants expect US headline consumer price index to end up in a 3-4% range in one year time. No participant expects CPI to end up higher than 5% or below zero).
The uncertainty around how to navigate these challenges was discussed at length. According to a live poll, nearly 80% of participants believe that monetary authorities do not fully understand the nature of the inflation outburst. This is largely due to the ‘unusual’ nature of the rise in inflation experienced since 2021. Panellists were divided on whether inflation will prove temporary and rapidly fall to target or whether we are experiencing a ‘regime shift’ with high inflation for a prolonged period.
What does that mean for the asset allocation of reserve managers? In a scenario where the great moderation has ended, the asset classes, considered most attractive by survey participants are very liquid and safe assets like short-term government bonds (76%), followed by longer-duration global government bonds as deflation hedge (41%) and inflation-linked bonds as inflation hedge (41%). Since central banks usually do not invest in real estate, 9% of participants indicate that they would like to own this asset class in such an environment and 15% would like to own more energy-related assets and securities as macro hedge.
An adaptation of the approach to reserve management may be required. The main investment goal of reserve management is capital protection. Cash and short duration fixed income play a key role here. Another investment objective is asset appreciation: equity and spread products – corporates and emerging market debt in hard currency – can provide additional returns and diversification. Reserve managers should address the macro risks faced by the global economy: the instruments of choice here are long-duration government bonds (recession risk) and  inflation-protected securities/gold/commodities (inflation risk). Some reserve managers could address inflation risk by broadening the investable universe to alternatives. 22% of participants indicated that they now consider investing in illiquid asset classes (infrastructure and real estate) to enhance returns, while only 3% did so during our 2020 survey.
A more flexible management of duration can also help to reduce the volatility of reserves and take advantage of movements across markets and regions. 23% of respondents indicated that they have moved or considered moving passively managed assets back to their active management strategies (2022: 11%).
Figure 1. Towards a new reserve management concept
On a more tactical level, there is a strong interest in more conservative fixed income instruments including government bonds, supranationals and, in particular, green bonds, while there is a noticeable decline in the attractiveness of certain spread products. Green bonds are among the most frequently mentioned asset classes, which reserve managers are planning to increase in the coming year.
The increased attractiveness of fixed income assets was also echoed by panellists at the event. Although there is one more hike expected in July, the tightening cycle in the US does appear to be close to its end, and yield levels in all bond categories appear attractive. Many reserve managers are also looking at emerging market debt once again. Emerging markets are ahead of developed markets in terms of interest rate hiking cycles and local currency bonds could benefit from a weakening dollar.
Reserve diversification into equities is advancing, but incrementally. Passive equity is still showing solid results (but not the top results of the previous year) when it comes to the question of which asset class central banks have increased in their portfolio on a net basis over the past year, and which asset class they are planning to increase in the coming year. While relatively higher fixed income returns might remain a headwind for some time, reserve managers at the event, that were already holding equities, expressed their desire to further increase their allocation to this asset class in sectors and regions that appear undervalued.
Regarding foreign exchange allocations, the dollar and the renminbi were the most frequently mentioned currencies of those that were added on a net basis in the reserves of participating sovereign institutions during the past year. The Canadian dollar was the second-most frequently mentioned currency, with the euro, once again, the most frequently mentioned currency that participants had reduced over the course of the previous year.
Looking forward, the sentiment towards the euro has improved, with survey participants having a net positive outlook for additional euro allocations for the first time in years. Central banks are also planning to add further to their yen and renminbi positions as well as to commodity currencies like the Canadian, Australian and New Zealand dollar.
Massimiliano Castelli is Head of Strategy and Advice and Philipp Salman is Director of Strategy and Advice, Global Sovereign Markets at UBS Asset Management.