Stick or twist? Tough questions ahead for reserve managers

A return to diversification or a ‘wait-and-see’ approach?

Between the banking turmoil in the US, falling inflation and inflamed geopolitical tensions with the outbreak of war in the Middle East, 2023 was a year of ups and downs for investors. Expectations for interest rates were in flux throughout the year, undulating between fears of a higher-for-longer environment and, at times, anticipation of rate cuts. China’s economy experienced headwinds but, while fears of a US recession abounded, they never materialised.

In spite of these challenges, reserve managers’ performance in 2023 was ‘better than expected’, explained Max Castelli, head of strategy, sovereign institutions at UBS Asset Management, in a conversation with OMFIF. Among UBS’ institutional clients, public investors actually recouped the losses they experienced in 2022. ‘For reserve mangers largely exposed to fixed income… they had a return which oscillated between 5% and up to 10%.’ For the most diversified central banks, ‘return oscillated between 8% and 9%’.

But whether this will prompt a return to the diversification drive is not yet clear. As public investors look to calibrate their asset allocation strategies in a rapidly changing environment, what are some of the key themes for reserve managers’ asset allocation strategies?

Euro and renminbi to benefit from diversification

The trend towards de-dollarisation slowed last year. OMFIF’s 2023 Global Public Investor survey of 75 central bank reserve managers revealed that 90% of respondents were looking either to increase or maintain their dollar holdings over the next two years. However, in the context of geopolitical tensions, we anticipate currency diversification to continue and the dollar’s share of global reserves to gradually decrease.

Given China’s growing importance in the global economy, we anticipate further renminbi accumulation. But this is likely to be a longer-term trend. Last year, reserve managers’ sentiments towards the renminbi were cautious, with the share of respondents looking to increase holdings over the next two years more than halving to 13% from 30% in 2021 and 2022.

While interest stalls on the Chinese currency over the short term – owing to factors ranging from market transparency, geopolitics and the regulatory environment – the euro may be well-placed to benefit.

Last year, the euro was the currency with the highest net demand among survey respondents at 14% (Figure 1). Rising real interest rates in Europe mean a positive return on the euro and euro-denominated assets, making European bonds more attractive. For those looking for low risk, decent yield and diversification away from the dollar, the euro and euro-denominated assets may offer an attractive alternative.

Figure 1. Euro most in demand in the short term

Over the next 12-24 months, are you planning to increase, decrease or maintain your exposure to the following currencies? Share of respondents, %

Source: OMFIF GPI 2023 survey


Resilience in emerging markets

Another group offering potentially attractive investment opportunities is emerging markets. Last year, there was no difference in the anticipated net increase in exposure to emerging markets versus developed markets, with a net 10% of survey respondents looking to increase allocation to both (Figure 2).

But emerging markets have proven resilient in the face of macroeconomic tumult and tightening cycles in advanced economies. Policy-makers in a number of emerging markets began hiking earlier and higher than their advanced economy counterparts. Sound economic and financial policy-making has led them to be more resilient in the face of Federal Reserve rate hikes.

For this reason, Castelli remains ‘pretty positive’ about emerging markets, both for fixed income and equity. In particular, emerging market debt generated ‘very good return’ last year. The question for investors will be whether a high yield on riskier emerging market debt is more attractive than a reasonably high yield on safe advanced economy debt, namely US treasuries. This is likely to depend on interest rates in advanced economies, especially the US.

Figure 2. No major changes between developed and emerging market holdings last year

Over the next 12-24 months, are you planning to increase, reduce or maintain your exposure to the following groups? Share of respondents, %

Source: OMFIF GPI 2023 survey


Are bonds here to stay?

There are still many risk factors to consider in deciding asset allocation strategies. This year also marks a super election year. Rising geopolitical tensions and constrained fiscal policy are issues to watch in markets with 2024 elections. Meanwhile, inflation is beginning to approach target-consistent levels, but it remains sticky in the US and Europe, especially services prices.

In a higher interest rate environment, fixed income would remain attractive for reserve managers. In the face of heighted uncertainty, these and other risk factors may prompt central banks to take a more cautious, ‘wait-and-see’ approach to their asset allocation strategies. This would be a continuation of last year’s trends – a panel of reserve managers declared that ‘bonds were back’ at the GPI 2023 launch event.

Still, more diversified central banks had a higher return in 2023. And with the normalisation of bond-equity correlation, some may look to continue the pre-pandemic trend of asset class diversification into equities and other non-traditional reserve assets.

But reserve managers no longer needed to diversify beyond fixed income assets to seek yield as their government bond portfolios delivered lacklustre returns. By recalibrating their portfolios to diversify their currency and regional holdings, reserve managers can balance risk and return. Perhaps, in 2024, reserve managers will pursue a mix of both strategies.

Taylor Pearce is Senior Economist, Economic and Monetary Policy Institute at OMFIF.

These themes will be explored in depth in OMFIF’s forthcoming Global Public Investor report. 

To find out more about how public investors are rethinking their asset allocation strategies in the current macroeconomic environment, register to attend the Global Public Investor seminar on 26 March.

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