Perspectives 2020-2021 Public Sector

Citi Perspectives for the Public Sector 14 15 Fig. 2: Negative YTM – Sovereign Debt (USD billion) A total of 45 countries have negative yielding sovereign bonds, worth US$17.9 trillion 1 After government bonds, equities account for the second largest allocation, with almost 25%. These are concentrated in SWFs and PPFs; corporate bonds are third with about 10%. The remaining 15% includes a variety of other investment types, although allocations vary greatly between the categories. Fig. 3: Global Public Investors' Asset Allocation Snapshot % of Portfolio (2019) PSIFs face a wide range of financial and economic challenges Even before the COVID-19 crisis, the period of prolonged low interest rates following the GFC was squeezing returns. Globalization, more integrated markets and numerous other factors have made it harder to diversify as inter-market correlations have risen over the past 30 years. At the same time, equity indices are shrinking and fewer private firms are going public. Those that do list are taking much longer to IPO, leading to reduced opportunities for investors in public markets, and particularly for those investing in index funds. The COVID-19 crisis has exacerbated many of these trends and created additional challenges. There is now greater uncertainty, higher volatility and more intense competition for assets and returns. Valuations are even harder to interpret given the amount of liquidity provided and the various asset purchase programs implemented by central banks. Consequently, asset prices provide less information about risk and return. At the same time, there are rising expectations around responsible and sustainable investing despite the criteria for these types of assets being ill-defined. There are many risks, both old and new, for PSIFs to take into consideration as the world recovers from the pandemic. Ironically, in such a low yield environment, inflation may be one of the most significant risks. The new policy announced by the Fed in late August 2020 – allowing higher levels of inflation for longer to make up for failure to meet past inflation targets – signals that inflation is less of a threat from a policy perspective. However, the same may not be true from an investing perspective. 1 Bloomberg, September 24 2020 2 https://www.nytimes.com/2020/05/13/business/economy/china-tsp-federal-retirement-fund.html Investing Post-COVID-19: Challenges and Responses Source: OMFIF 2020 report Source: Bloomberg Government Bonds Equities Corporate Bonds Real Assets Gold Other Private Equity Cash Global Public Investors Central Banks Sovereign Funds Pension Funds 3.3 2.6 2.8 3.0 4.1 9.9 22.3 51.9 4.5 0.4 0.1 3.9 5.7 11.0 8.0 66.3 1.4 9.2 12.3 5.8 51.7 18.9 2.3 2.9 2.1 6.4 10.3 30.4 45.4 0.7 0.4 Anemic growth prospects and low confidence given the uncertainties surrounding the pandemic suggest that government and central bank stimulus measures will continue for a considerable time. Against this backdrop, many expect yield generation to become ever more difficult and the trade-off against risk increasingly challenging. That poses a problem for public sector investment funds (PSIFs), which, like all investors, have a duty to meet a range of current and future obligations and liabilities. The scale of their problem is especially significant, however. PSIFs, which include central banks (CBs), public pension funds (PPFs) and sovereign wealth funds (SWFs), collectively manage close to $50 trillion – over half the world’s professionally managed assets; PPFs manage around $30 trillion, followed by CBs and SWFs with $12 trillion and $8 trillion respectively. Negative yields create asset allocation problems How can PSIFs manage their assets in a near zero rate environment where historical allocations and strategies have been undermined by the structural shift in the investment landscape? There is no one-size-fits-all approach, as the starting point for each individual PSIF is different. Moreover, liabilities aside, the different groups have distinct asset mixes. Overall, PSIFs have more than 50% of their assets in sovereign debt, reflecting the competing priorities of safety, liquidity, returns, regulation and their mandates. However, allocations vary significantly (fig. 3). CBs have the largest exposure to sovereign debt (66%) as safety and liquidity remain their overriding considerations, while SWFs have the lowest exposure. PPFs, with their unique set of liability-matching obligations, hold just under 50% of their assets in government bonds; they face the greatest immediate challenge from the current yield environment. Japan — 7,550 Spain — 859 Italy — 1,013 United Kingdom — 1,308 United States — 1,371 Germany — 1,648 France — 1,970 Other — 328 Switzerland — 76 China — 99 Brazil — 110 Denmark — 113 Sweden — 120 Portugal — 123 Finland — 126 Ireland — 138 Austria — 234 Belgium — 358 Netherlands — 401