File picture from the listing of two 'green' sukuks issued by the Indonesia government on Nasdaq Dubai, with a total value of $2 billion. Image Credit: Nasdaq Dubai

Looking to 2020, the global sukuk market has become increasingly relevant as uncertainty in the financial markets persists.

With unresolved geopolitical issues, ongoing trade wars, and even weaker economic performance in more developed markets at top of the mind for investors, we think that investing in the sukuk market is worth considering. There are several reasons why the asset class can help reduce risk, diversify portfolios and, ultimately, help navigate some of this market tension.

Firstly, sukuk market volatility has remained low. With a 2 per cent handle over the past five years, it’s more than a third less than other emerging markets and a significant reducer of portfolio risk. Not only has volatility been low historically, we expect this trend to persist, given that the market is comprised of many high-quality issuers and home to a dedicated, liquid, investor base.

Low linkages

Secondly, sukuk exhibits low correlations to other fixed income sectors. This is where we think investors get the benefits of diversification, which again, in an environment where we see growing concerns about risk, becomes increasingly important. We expect the global sukuk market to outperform its US and emerging market peers on a risk adjusted basis in 2020, as it has done for the much of the previous five years.

Finally, as the global sukuk market has developed and matured, it has gradually exhibited smaller drawdowns during periods of market stress. For all these reasons - lower volatility, lower correlations and smaller drawdowns - we think investors should consider the global sukuk market, which is continuing to grow and innovate.

In 2019, we saw about $46 billion in total issuance, ahead of 2018, and we think the market is on pace to grow by just under 30 per cent, as we continue to see more sovereigns and corporates tap Islamic finance to develop their financial markets or diversify sources of funding.

But watch out for these

Despite our positive outlook, there are a few areas of concern we are closely monitoring. We have been predicting that the Fed would turn increasingly dovish, and we expect the US central bank to remain focused on looser monetary policy in the face of softer economic data and increased financial market volatility.

The US-China trade relationship also appears to be further tested, and we believe this will weigh on the Fed as it contemplates the next rate cut of this cycle. In addition, any further negative surprises in US economic data may also weaken the assumptions behind forecasts of relative outperformance by the US economy compared with other countries and could help dampen the performance of the US dollar from current, relatively elevated levels.

It seems to us that the more prudent approach at this juncture would be to defend portfolios against rising risk premia versus an upswing in global growth metrics.

More broadly, we would like to see an improvement in how ESG (Environmental, Social and Governance) issues are measured and assessed. While there are philosophical overlaps between Islamic finance and ESG, we are not seeing them translated in competitive ESG scores.

This is a critical aspect to address if the Sukuk market is to grow from $500 billion today to our estimate of $2.7 trillion by 2030.

There is no doubt that there is a lot to look forward to for the sukuk asset class. We feel confident that the defensive characteristics of the market will persist. This gives us comfort that should any global stresses migrate into sukuk issuing markets, they should be able to handle the potential turbulence.

- Mohieddine Kronfol is Chief Investment Officer of Global Sukuk and MENA fixed income at Franklin Templeton.