Insight

Quarterly Global Asset Allocation Portfolio Outlook - Q3 2023

Quarterly Global Asset Allocation Portfolio Outlook - Q3 2023
Key takeaways
1

Our stance remains defensive but we believe extra risk can be added to portfolios given that central banks are expected to stop raising interest rates over the next 12 months. 

2

We have decided to reduce government bonds to Underweight, while increasing investment grade (IG) credit to further Overweight and real estate to Overweight. 

3

The “riskiness” of the Model Asset Allocation is enhanced by maintaining a bias towards emerging markets. We also introduce a partial hedge from US dollar into Japanese yen.

Where are we now

We believe the global economy continues to decelerate, in what we categorise as a contraction phase. This leads to a defensive bias within our Model Asset Allocation. However, we have a 12-month horizon and within that timeframe we expect some major central banks to pivot away from higher interest rates (i.e. will end their ‘tightening’.)

An economic rebound could follow, which is likely to be anticipated by financial markets. This would lend itself to adding riskier assets – such high yield (HY) credit – to our allocations. As a result, we have chosen a middle path and have dipped a toe in the water and added some risk to what remains an overall defensive stance.
 

Our assumptions

Underpinning our projections for the next 12 months are the following assumptions:

  • Global GDP growth will slow and then recover
  • Global inflation will fall but remain above many central bank targets
  • Major Western central banks are approaching the end of their tightening cycles
  • Long-term government yields will be mixed; yield curves1 steepen during 2023 H2
  • Credit spreads widen in the US but narrow in Europe and defaults rise
  • Equity dividend growth moderates and equity yields fall in some markets
  • Real estate (REIT) dividend growth moderates and yields fall
  • Commodities struggle as the global economy slows (except agricultural products)
  • USD weakens as the US Federal Reserve (Fed) tightening ends
     

Changes to our Model

Our economic cycle analysis suggests we are in a contraction phase, which favours a cautious approach. However, we think the economic rebound will come within our 12-month horizon, which leads us to add a bit of risk to the Model Asset Allocation. We reduce government bonds to Underweight, while increasing IG credit to further Overweight and real estate to Overweight. The “riskiness” of the Model Asset Allocation is enhanced by maintaining a bias towards emerging market (EM) assets. We introduce a partial hedge from US dollar into Japanese yen.

Perhaps the most important feature of the forecasts is that we expect Fed rates to be lower in 12 months (even if they rise in the meantime). We suspect that European Central Bank policy rates will be little changed in 12 months (after rising in the interim) and that major Asian policy rates could be marginally higher. The Bank of England seems likely to tighten the most aggressively among Western central banks.

We have a preference for cash, IG, HY and real estate. The projected return on equities is reasonable but not enough given the risk involved.

Figure 1. Expected total returns (annualised, local currency) and Model Asset Allocation*

  Expected 1-year Total Return Neutral Portfolio Policy Range Model Asset Allocation Position Vs Neutral
Cash & Gold -0.1% 5% 0-10% 10% Overweight
Cash 3.5% 2.5% 0-10% 10% Overweight
Gold -3.6% 2.5% 0-10% 0% Underweight
Government Bonds 1.8% 25% 10-40% ↓ 20% Underweight
Corporate IG 3.9% 10% 0-20% ↑ 18% Overweight
Corporate HY 5.6% 5% 0-10% 8% Overweight
Equities 7.1% 45% 25-65% 34% Underweight
Real Estate (REITS) 11.7% 8% 0-16% ↑ 10% Overweight
Commodities -0.6% 2% 0-4% 0% Underweight

*This is a theoretical portfolio and is for illustrative purposes only. It does not represent an actual portfolio and is not a recommendation of any investment or trading strategy. Arrows show direction of change in allocations. See appendices for definitions, methodology and disclaimers. There is no guarantee that these views will come to pass. Source: Invesco Global Market Strategy Office.

 

Cash remains at a 10% allocation. Cash rates are the highest since before the Global Financial Crisis, and returns have little volatility or correlation to other assets. This makes for a better risk-reward ratio than other assets, in our opinion. Gold is another diversifying asset, but we think it has performed so well that sustained upside form here is unlikely.

Government bond yields are much higher than 18 months ago but they have fallen of late, which we think reduces the return potential, especially as we expect most long yields to be slightly higher in 12 months. We reduce the allocation from Neutral (25%) to Underweight (20%), preferring a combination of cash and credit.

The reduction in government bonds allows an increase in IG (to a further Overweight 18%, from 15%). Though still a relatively defensive asset, it brings more risk than government bonds and a better risk-reward trade-off, in our opinion.

We add to the allocations in the US, Eurozone and EM, all of which are Overweight (EM is preferred).

If IG is not particularly adventurous, the increase in our allocation to real estate brings more risk. In fact, the risks are so obvious that REIT yields are now quite generous, which is the attraction (we expect yields to fall). REIT dividends have started to grow again but we expect little growth over the next 12 months. We go to an Overweight 10% from the Neutral 8%, adding to allocations in the US and EM (both Overweight). Again, we expect the highest 12-month returns in EM.

Equities will be handicapped by weakening profits in the short term (we think) and it looks as though falling bond yields will be no help (the correlation is changing again). Our projections suggest there are better alternatives among risky assets (such as HY and real estate). We maintain an Underweight 34% allocation (versus the Neutral 45%). We continue to favour EM equities, in particular those of China (which we think are good value and that should benefit from better economic momentum).

We make no change to HY and remain Overweight. Commodities have recently generated losses and we expect weakening economies and normalising European natural gas markets to maintain downward pressure on prices. We maintain a zero allocation to the asset class.

From a regional perspective, we continue to prefer EM assets. This is partly because we find them to be relatively cheap (which boosts long-term potential, in our opinion) but also to balance the defensiveness of some of our other allocations. We make a first step to trying to benefit from the perceived valuation discrepancy between USD and JPY by partially hedging our USD exposure into JPY.

Footnotes

  • 1A yield curve is a line that plots yields, or interest rates, of bonds.

Investment risks

  • The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.  

Important information

  • This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.

    Views and opinions are based on current market conditions and are subject to change.

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