Tactical Asset Allocation - August 2023

Synopsis
Economic data and market sentiment continue to validate prospects for a recovery in the second half of 2023. A peak in the global monetary tightening cycle, coupled with stable growth and falling inflation increases the probability of a near-term goldilocks scenario.
We overweight portfolio risk in the Global Tactical Asset Allocation model,1 favoring equities relative to fixed income, emerging markets, value, smaller capitalizations, and cyclical sectors. Overweight risky credit, neutral duration, and underweight the US dollar.
Macro update
Following our latest asset allocation changes reflecting a more favorable macro backdrop and investors’ appetite toward risk, global financial markets have continued to trade on a strong footing over the past month, with consistent and widespread outperformance in riskier and more cyclical sectors relative to defensives and safe havens. Near-term growth expectations are improving across most regions, led by resilience in US economic data above consensus expectations and important changes in central banks’ communications, showing light at the end of the global monetary tightening cycle. US Gross Domestic Product (GDP) statistics have shown evidence of a re-acceleration in Q2 growth relative to Q1, which has also been revised upward. More timely and leading economic indicators point to further positive momentum in Q3, led by orders for durable goods, manufacturing, and consumer sentiment surveys.
Federal Reserve (Fed) Chair Powell remarked on these improvements during the July FOMC press conference, highlighting how “given the resilience of the economy recently, the Fed staff is no longer forecasting a recession this year." More importantly, the Fed has clearly indicated the end of the tightening cycle is approaching, hinting at the September meeting being effectively a 50/50 call at this stage (hike or a pause), depending on the outcome of the two job reports and two inflation reports scheduled to be released between now and the next FOMC meeting. Either way, the outcome of these reports is likely to swing policy expectations by a modest 25 bps, an inconsequential magnitude for markets after 500+ bps increases in the Fed Funds rate.
This shift to near-term data dependency by the Federal Reserve has been mirrored by the European Central Bank (ECB). President Lagarde explicitly emphasized how, similarly to the Fed, the September meeting is a “decisive maybe” regarding a hike or a pause, that policymakers remain data dependent and open-minded but that, bottom line, she does not expect the ECB to have much further ground to cover in this tightening cycle. In contrast to the Fed, however, the ECB is likely to downgrade its growth projections as leading economic indicators still point to weakening momentum.

Sources: Bloomberg L.P., Macrobond. Invesco Solutions research and calculations. Proprietary leading economic indicators of Invesco Solutions. Macro regime data as of July 31, 2023. The Leading Economic Indicators (LEIs) are proprietary, forward-looking measures of the level of economic growth. The Global Risk Appetite Cycle Indicator (GRACI) is a proprietary measure of the markets’ risk sentiment. Developed markets ex-USA include the Eurozone, UK, Japan, Switzerland, Canada, Sweden, Australia. Emerging markets include Brazil, Mexico, Russia, South Africa, Taiwan, China, South Korea, India.

Sources: Bloomberg L.P., Macrobond. Invesco Solutions research and calculations. Proprietary leading economic indicators of Invesco Solutions. Macro regime data as of July 31, 2023. The Leading Economic Indicators (LEIs) are proprietary, forward-looking measures of the level of economic growth. The Global Risk Appetite Cycle Indicator (GRACI) is a proprietary measure of the markets’ risk sentiment.
Moving east, the Bank of Japan (BOJ) announced it would alter its yield curve control policy (YCC), effectively raising the upper limit for the 10-year Japanese government bond yield to 1.0% from the previous 0.5%. The move is intended to reflect the gradual rise in Japanese inflation expectations across market, business, and consumer sentiment surveys, allowing the BOJ to introduce greater flexibility in its purchases of government bonds. However, the central bank clarified how core inflation is still expected to hover around 1.7%-1.8% over the next two years, below the 2% inflation target, implying accommodative monetary policy is likely to be maintained. We don’t expect these developments to cause volatility and dislocations in Japanese or global government bond markets.
Markets have taken these developments in strides, seeing the potential for a near-term Goldilocks scenario with declining inflation, peaking policy rates, resilient labor markets, and stable/improving growth expectations. The cyclical repricing of the past month is evident in the compression of credit spreads across sectors and regions, the outperformance of global equities relative to fixed income and the outperformance of riskier segments such as emerging markets and small-cap equities relative to developed and large-cap equities. Our macro framework continues to suggest a recovery in the global cycle is likely to characterize the second half of 2023, hence supporting a cyclical stance for tactical asset allocation (Figure 1 and Figure 2).

Sources: Bloomberg L.P., MSCI, FTSE, Barclays, JPMorgan, Invesco Solutions research and calculations, from Jan. 1, 1992, to July 31, 2023. The Global Leading Economic Indicator (LEI) is a proprietary, forward-looking measure of the growth level in the economy. A reading above (below) 100 on the Global LEI signals growth above (below) a long-term average. The Global Risk Appetite Cycle Indicator (GRACI) is a proprietary measure of the markets’ risk sentiment. A reading above (below) zero signals a positive (negative) compensation for risk-taking in global capital markets in the recent past. Past performance does not guarantee future results.
Investment positioning
Following last month's portfolio repositioning, we maintain an overweight risk stance relative to the benchmark in the Global Tactical Allocation Model, with minimal portfolio adjustments this month. We are overweight equities relative to fixed income, favoring emerging markets, cyclical sectors, value, and smaller capitalizations. We are overweight credit risk via lower quality sectors and maintain a neutral duration posture, but increased exposure to TIPS relative to nominal Treasuries following a modest increase in our inflation momentum indicator for the US economy (Figure 3). We maintain an underweight exposure to the US dollar (Figures 4, 5, 6, 7). In particular:
- Within equities, we overweight cyclical factors with high operating leverage and a higher sensitivity to a rebound in growth expectations, such as value and smaller capitalizations, while we underweight defensive factors, such as low volatility, quality, and larger capitalizations. We underweight momentum as inflection points in the market cycle tend to generate reversal effects between recent winners and losers. Similarly, we favor exposures to cyclical sectors such as financials, industrials, materials, and energy at the expense of health care, staples, utilities, and technology. From a regional perspective, we overweight emerging markets, supported by improving risk appetite and expectations for US dollar depreciation. We maintain a neutral stance between US and developed ex-US equities, as growth momentum in Europe is still weakening.
- In fixed income, credit spreads continue to tighten and volatility to decline. We remain overweight in risky credit2 via high yield, bank loans, and emerging markets hard currency debt. In this environment of below-trend but improving growth, we expect volatility to remain subdued and credit markets to offer stable yield and total returns. We remain underweight in investment grade credit and government bonds and maintain a neutral duration stance. We have moved to an overweight exposure in TIPS versus nominal Treasuries following a modest increase in US inflation momentum while we continue to register decelerating inflation in the eurozone and the UK, hence favoring nominal government bonds in these markets (Figure 3).
- In currency markets, we underweight the US dollar, as regimes of cyclical recoveries are typically accompanied by strong reflationary flows into non-US assets. While yield differentials still support the US dollar relative to foreign currencies, expensive valuations provide headwinds to the greenback when safe-haven flows are abating. Within developed markets, we favor the euro, the British pound, the Norwegian kroner, and the Swedish krona relative to the Swiss franc, Japanese yen, Australian, and Canadian dollars. In EM, we favor high yielders with attractive valuations as the Colombian peso and Brazilian real, relative to low yielding currencies such as the Korean won, Taiwan dollar, and Chinese renminbi.

Sources: Bloomberg L.P. data as of July 31, 2023, Invesco Solutions calculations. The US Inflation Momentum Indicator (IMI) measures the change in inflation statistics on a trailing three-month basis, covering indicators across consumer and producer prices, inflation expectation surveys, import prices, wages, and energy prices. A positive (negative) reading indicates inflation has been rising (falling) on average over the past three months.

Sou rcCurre: Invesco Sent positioningolutions, A ug us t 1, 2023. TPrior positioningIPS = Treasury inflation protected securities. DM = developed markets. EM = emerging markets. Non-USD FX refers to foreign exchange exposure as represented by the currency composition of the MSCI ACWI Index. For illustrative purposes only.

Source: Invesco Solutions, August 1, 2023. For illustrative purposes only. Neutral refers to an equally weighted factor portfolio.

Source: Invesco Investment Solutions, August 1, 2023. For illustrative purposes only. Sector allocations derived from factor and style allocations based on proprietary sector classification methodology. As of November 30th, 2022, Cyclicals: energy, financials, industrials, materials; Defensives: consumer staples, health care, information technology, real estate, utilities; Neutral: consumer discretionary and communication services.

Source: Invesco Solutions, August 1, 2023. For illustrative purposes only. Currency allocation process considers four drivers of foreign exchange markets: 1) US monetary policy relative to the rest of the world, 2) global growth relative to consensus expectations, 3) currency yields (i.e., carry), 4) currency long-term valuations.
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.
FOOTNOTES
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1
Benchmark is 60% MSCI All Country World Index and 40% Bloomberg Global Aggregate Index (Hedged).