Day One

Reserve Management in a shifting geopolitical environment

After the last two events were held virtually due to the pandemic, the 28th Reserve Management Seminar was finally held in person again from 19th to 24th June. Massimiliano Castelli, Head of Strategy and Advice, Global Sovereign Markets at UBS Asset Management gave a warm welcome to all guests at the Wolfsberg auditorium.

The title of the first session was "Reserve Management in a shifting geopolitical environment", and the session offered a broad spectrum of views on macroeconomic development and its implications for financial markets and monetary policy. It started with Massimiliano Castelli presenting the results of the UBS Annual Reserve Manager Seminar Survey, now also in its 28th year.

A shift in investors' concerns

A standard question of the survey is one about the main risks the global economy is facing. For nearly 90% of all respondents inflation and/or uncontrolled rise in long-term yields is a key risk at the moment, and for 80% a further escalation in geopolitical conflicts. Commodity price developments and energy security comes third in the ranking with 50%. Compared with the 2021 survey, the number 1 and number 3 risks are new on the list. On the other hand, only 10% of participants stated that climate change is the risk they are most concerned about, compared to 32% in last year's survey.

Will the US Fed succeed in fighting inflation while at the same time keeping the economy on a growth track? This question is on the minds of most professional investors. Therefore, we asked survey participants where they see the Fed policy rate at the end of the current hiking cycle. 36% believe it will be in the range from 3.25% to 3.5%. The other major group representing 32% of respondents think rates will end up between 2.75% and 3.0%. Regarding the 40 year long bond bull market, more than half of the survey participants think that we have already seen the turning point.

The correlation challenge

For most survey participants, capital preservation is their primary investment objective. However, Massimiliano Castelli pointed out that the higher inflation, the more difficult it is to preserve capital. Another concern is the equity-bond correlation that has moved to positive territory in recent months. Against this background, finding the appropriate asset allocation is quite a challenge, given the fact that many central banks cannot invest in alternatives. On the contrary, investments in equities have become much more common in the past years. In the current survey, 50% of participants mentioned that equities are approved at their institution.

On the topic of sanctions against the central bank of Russia, more than 60% of respondents think that swap agreements with friendly central banks could gain popularity as a consequence.

Perspectives from the "Central Bank for Central Banks"

As the first guest speaker, Pierre Cardon, Senior Strategist at the Bank for International Settlement, gave an overview from his perspective. Global foreign exchange reserves reached a record high of USD 12.9 trillion in December 2021. Since then, the trend has reverted. The existing trend towards currency diversification continues, as the combined share of reserves in US dollar and Euro decreased to 80% of total reserve currencies globally. Also, diversification into less traditional asset classes should continue as well. Today, the majority of reserve managers are holding portfolios with a duration of two years and less.

When will it be time to extend duration? is a question that many central banks are also thinking about. In Pierre Cardon's view, it's not now, but probably in the second half of the year. He also made an interesting remark on the Euro. As European countries have ambitious targets for decarbonizing their economies, the Euro could benefit from the reallocation of assets with the aim of a declining carbon footprint. On the growing green bond market it was noted that issuance of green bonds slowed down in 2022 because of market volatility and concerns on green washing. It was also noted that the Task Force on Climate-related Financial Disclosures (TCFD) could be adopted by reserve managers as disclosure standards in the future.

Global economic and financial outlook

Economic growth is slowing from high levels at a time when most tailwinds from COVID reopening fade. Arend Kapteyn, Global Head of Economics and Strategy Research at UBS Investment Bank, pointed out that the strength of this deceleration could feel like a recession. However, he believes that there are various factors, such as excess savings or pent-up demand, to keep growth in positive territory, at least for the time being. He also expects the level of inflation to finally come down, as data indicates that the growth/inflation mix in the next few months should get better. On the contrary, the important US housing sector presents a negative picture. Relevant data such as housing affordability has fallen substantially.

Global supply chains still remain stressed and they are still far from normal levels, but there were signs of improvement recently. Interestingly, the impact of the Russia/Ukraine war and the COVID situation in China were limited relative to what was feared.

  • Trade with Russia has recovered despite the continued sanctions. It has been able to accumulate foreign exchange reserves and the ruble has appreciated to levels before the invasion.
  • China has largely managed to protect its exports by diverting products originally destined for Shanghai to other ports in the country.

One of the most severe bottlenecks has occurred in the computer chips (microchips) industry, but global semiconductor production has improved in recent months thanks to strong production numbers in Taiwan and South Korea.

Jonathan Davies, Senior Portfolio Manager, Investment Solutions at UBS Asset Management, started with good news that after bond prices have fallen significantly, higher yields will lead to improved returns going forward, thus making bonds more attractive. In his view, return perspectives for bonds depend on which situation we are in. It's about the answer to the question as to whether secular stagnation is over.

Arguments of the "No camp"

  • Much of the recent inflation rises are due to COVID lockdowns (demand support during lockdowns and temporary supply bottlenecks)
  • Commodity prices are temporarily supported by the consequences of the war in Ukraine

Arguments of the "Yes camp"

  • There is a slowdown / reversal of globalization
  • Fiscal policy is going to be more expansionary (more investments in green infrastructure and rising military expenditure)
  • Demographic change: the falling ratio of a working age to a non-working age population
  • More political emphasis on tackling inequality

In the discussion afterwards, the experts were asked to give a brief outlook statement. Arend Kapteyn expects equity returns of 4% to 6% p.a. over the next 5 years - and Jonathan Davies advises to be vigilant when investing in corporate bonds, as there will be pockets of financial distress.

When asked whether financial markets have entered a “new regime” or not, Jonathan Davies said that there is a 50% chance that we are in a new regime that will be very different from what we experienced since the Global Financial Crisis (GFC). Arend Kapteyn was more skeptical on regime shift as reflected in his views on inflation which is expected to fall to policy target in the course of 2023.

Current geopolitical landscape and pressure points

There's also a tradition at the Reserve Management Seminar to have a session on politics. This year, the panel discussion was moderated by Philipp Salman, Strategy and Advice, Global Sovereign Markets at UBS Asset Management.

Preston Keat, Head of Political and Country Risk at UBS, explained that the conflict in Ukraine is now in phase 2 as a war of attrition, primarily in the Donbass region. From today's perspective, phase 3 (a negotiated settlement) seems far away, but he wouldn't rule out that this could happen by the end of the year. As a citizen of a Baltic country, Raivo Vanags, Head of Market Operations at Latvijas Bank, spoke about the high level of anxiousness throughout the Baltics since the war broke out. He also emphasized that it's not only Ukraine's war, but a war about Europe's future as well.

The risk that China could soon start a military intervention in Taiwan is not imminent, Preston Keat added, and referred to recent signals coming from the Chinese defense minister. On the zero COVID policy, he thinks that the government won't abandon this any time soon. Once Xi Jinping is confirmed by the Communist party congress as the head of state for another term, there might be a change in tone towards the West.

On the topic of deglobalization, Massimiliano Castelli compared the current situation with the 1970s/80s. At that time, like today, globalization had reached a point of stagnation in growth. We might be entering a period of "newbalization", to use a new term. It means that trade will slow in tangible areas, like the trade of goods, while in other areas it will speed up like in services and cross-border data. This could be characteristic for a slow but growing trend to a multi-polar system of regional blocks within the global economy.

When it came to the topic of tensions between energy security and the ongoing energy transformation in Europe, Massimiliano Castelli opined that these are two sides of the same coin and that the green agenda could in fact get a boost from the national security agenda, which might be able to mobilize even more effectively. But the “tragedy of horizons” looms in the background, while in the long-term there is no incompatibility between energy security and energy transformation, actions might be needed in the short-term that could bring setbacks for the green agenda.