The outlook for macro policy and for the geopolitical

The outlook for macro policy and for the geopolitical environment remains uncertain Our fifth annual cycle of interviews took place between January and March 2017. In speaking with leading sovereign investors and central banks (with assets in excess of US$12 trillion) we identified a number of critical themes that shaped interview responses. Unsurprisingly, we noted that the outlook for macro policy and the potential for further geopolitical shocks dominated discussions. - Sovereigns see the end of QE (Quantitative Easing) without a clear indication as to the form or timeframe for further QT (Quantitative Tightening). While the US has begun to raise interest rates, the Federal Reserve is engaged in parallel measures that may reduce the quantum and pace of further increases; and there is uncertainty whether and when other major markets will follow suit - The bifurcation of the US and other developed markets (notably the UK, Germany and Japan) had significant implications for currency rates, challenging sovereign geographic allocations - Political change in developed markets (notably Brexit and the US election) created volatility in sovereign portfolios, challenging the robustness of sovereign risk models. As policy changes are worked through governments (e.g. the terms of Brexit and US corporate tax reform), there will be wider implications for long-term geographic and asset allocation - Emerging markets face various macro challenges, with commodity prices recovering slowly (e.g. oil, natural gas and copper) and an increasingly unstable political outlook in Brazil and South Africa 06 Sovereigns face a continuing ‘return gap’ These dynamics suggest a continuation of the ‘lower rates, lower return’ environment over at least the next 24 months. While the lower return environment has been a consistent theme in past years, in 2017 the implications are compounded, with low interest rates the factor of greatest importance to both strategic and tactical asset allocations in figure 2. Risk asset valuations have inflated over a number of years, while the near- uniform tilt to alternatives such as infrastructure has resulted in supply challenges and delays. In 2016, all sovereign profiles displayed a return gap (figure 3), driven by the low interest rate environment, however this shortfall was greatest among investment sovereigns. Traditionally, liability sovereigns have hedged fixed income against inflation (due to the focus on matching outflows to beneficiaries), while investment sovereigns have left their inflation exposure open. This has led to investment sovereigns having the greatest return gaps, as developed economies return to growth and inflation rises. While liquidity and development sovereigns are also suffering from low interest rates, respondents noted that investment returns were of secondary importance, relative to liquidity and development objectives. Furthermore, liquidity sovereigns noted that their long-duration fixed income assets had increased in value as rates fell. Against this, sovereigns are challenged by fixed return targets, which are typically set to match potential liabilities and do not adjust to market conditions. Despite return challenges, we do not see aconcurrent shift in investment activity year-on-year (as we go on to explore). HOUSE_OVERSIGHT_026686