Tactical asset allocation - June 2023

Synopsis
We remain positioned for a contractionary environment, given low growth and declining risk appetite. The unprecedented narrow leadership in US equity performance poses challenges to factor strategies, but it is historically a mean-reverting, short-lived phenomenon.
Underweight risk relative to the benchmark in the Global Tactical Allocation Model,1 favoring fixed income over equities, developed markets over emerging markets, defensive sectors, and factors. We favor investment grade relative to high yield, loans, and emerging market debt.
Macro update
The global economy remains in a holding pattern. Leading economic indicators continue to be broadly stable, with renewed deceleration in developed markets, mainly Europe, and further improvements in emerging markets, led by China. We expect global growth to remain low and below its long-term trend. Global risk appetite remains weak and on a declining trajectory, suggesting growth risks remain tilted to the downside, keeping our macro framework in a contractionary regime (Figure 1 and Figure 2).

Sources: Bloomberg L.P., Macrobond. Invesco Investment Solutions research and calculations. Proprietary leading economic indicators of Invesco Investment Solutions. Macro regime data as of May 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, and Australia. Emerging markets include Brazil, Mexico, Russia, South Africa, Taiwan, China, South Korea, and India.

Sources: Bloomberg L.P., Macrobond. Invesco Investment Solutions research and calculations. Proprietary leading economic indicators of Invesco Investment Solutions. Macro regime data as of May 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.

Sources: Bloomberg L.P., MSCI, FTSE, Barclays, JPMorgan, Invesco Investment Solutions research and calculations, from Jan. 1992 to May 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.
While labor markets remain very resilient, with unemployment rates hovering around generational lows across the largest economies, various measures of economic activity point to a slowing economy, in line with the picture painted by our leading economic indicators. US real gross domestic income (GDI) contracted for two consecutive quarters, 2.3% in Q1 2023 and 3.3% in Q4 2022 in annualized terms. Furthermore, the average of real GDP and real GDI growth computed by the Bureau of Economic Analysis (BEA) has contracted in four of the past five quarters, highlighting the deceleration in growth over the past year.2 Based on historical relationships between monetary policy, the economy and financial markets, the economic impact of the tightening cycle is likely to be still in its early stages, suggesting further deceleration ahead. As illustrated in Figure 3, monetary policy cycles – proxied by the shape of the yield curve - have historically anticipated the peaks and throughs in equity market volatility with up to a two-year lead. As policy tightens, via a flattening of the yield curve, credit conditions become more restrictive over time, increasing the likelihood of rising default rates and higher implied market volatility. Hence, these historical patterns suggest the full impact of this tightening cycle may only be evident in early 2024. While this illustration is an oversimplification of complex monetary transmissions to the economy and financial markets, it suggests risks are still directionally skewed towards higher volatility going forward. Furthermore, inflation remains stubbornly slow in its deceleration back toward policy targets, increasing the probability of a “tighter for longer” policy scenario (Figure 4).

Sources: Bloomberg L.P., Invesco Investment Solutions research and calculations, from January 1985 to May 2023. Past performance does not guarantee future results.

Sources: Bloomberg L.P. data as of May 2023, Invesco Investment 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.
Last month we highlighted the narrow leadership in US equities, driven by quality mega-cap names in the technology sector, leading to the highest market concentration since the 1980s. These trends intensified further over the past month, with the 10 largest stocks in the S&P 500 now representing approximately 30% of the market capitalization and explaining all the market returns year-to-date as of May 31. Historically, markets characterized by broader participation see higher returns in subsequent years relative to markets with narrow leadership. Intuitively, broader participation is more likely to reflect an improving economy, while narrow leadership is often driven by idiosyncratic or thematic forces. While market performance is to be respected, this narrow leadership raises questions about the sustainability and duration of the rebound, especially when performance is driven by defensive names with quality characteristics and cyclical sectors continue to lag. We remain cautious about the prospects for cyclical assets in the near term.
Investment positioning
We maintain a defensive positioning, with an underweight risk stance relative to the benchmark in the Global Tactical Allocation Model, favoring fixed income over equities, defensive sectors and factors, and underweighting emerging market equities relative to developed markets. We underweight credit risk and overweight duration, favoring investment grade and government bonds relative to high yield, loans, and emerging market debt (Figure 5, 6, 7, 8). In particular:
• Within equities, we favor defensive factors with low operating leverage and lower exposure to economic risks, such as quality and low volatility, at the expense of cyclical exposures, such as value and small/mid caps. The unprecedented narrow leadership in equity markets poses a challenge to factor strategies, which are designed to be more diversified. We expect this narrow leadership phenomenon to mean revert and factor performance to resume over time. We favor defensive sectors such as health care, staples, utilities, and technology, at the expense of financials, industrials, materials, and energy. We remain underweight emerging markets given the headwinds from declining risk appetite and remain neutral between the US and other developed markets.
• In fixed income, we underweight credit risk3 and overweight duration, favoring investment grade credit and government bonds, underweighting riskier sectors such as loans, high yield, and emerging markets debt. We continue to favor nominal treasuries relative to inflation-linked bonds, given declining inflationary pressures.
• In currency markets, we have moved to a modest overweight in the US dollar as growth outside the US is surprising consensus to the downside, and yield differentials are widening again in favor of the greenback. Within developed market currencies, we favor the euro, the British pound, Norwegian kroner, and 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 as the Korean won and Chinese renminbi.

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

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

Source: Invesco Investment Solutions, June 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).
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2
In national economic accounting, GDP and GDI are conceptually equal. GDP measures economic activity by final expenditures, and GDI measures it by the incomes generated from producing GDP. In practice, GDP and GDI differ because they are computed using different sources of information and different source data, leading to different results due to sampling errors, coverage differences and timing differences in data collection and reporting. Over time, however, GDI and GDP provide a similar overall picture of economic growth. US Bureau of Economic Analysis (BEA).
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3
Credit risk measured as DTS (duration times spread).