Through Alessio de LongisCFA, Senior Portfolio Manager, Invesco Investment Solutions
Global recovery begins to mature, leading to expansion
The year 2020 will certainly go down in history as one of the most disruptive for societies around the world, with lasting social and economic consequences for years to come. 2020 will also be a banner year in the history of financial markets, with stories and anecdotes to tell future generations of investors. It was the year when oil prices traded at -38 US dollars per barrel,1 or when the worst global recession in history was accompanied by a market sell-off that only lasted four weeks, to name a few.
Financial markets enter 2021 with strong positive momentum, thanks to vaccine breakthroughs followed by near-instantaneous roll-out around the world. The global recovery continues. Our macroeconomic framework now suggests that US growth should return above its long-term trend on an annual basis for the first time in six quarters. Consequently, we see the United States entering an expansionary regime, joining China and the rest of the emerging markets. While other developed economies continue to improve at a slower pace given the renewed lockdown measures in Q4 2020, we expect them to catch up with the rest of the world over the coming quarters. Overall, we see strong evidence of a “clockwise” development of the global economic cycle, that we expect to move forward into an expansionary regime, rather than backtracking into a contraction. , unless there is an exogenous shock. Investors’ appetite for risk remains strong, suggesting an improvement in growth expectations. Moreover, economic and financial market volatility tends to decrease as the economy enters an expansion phase, which should further support risk taking and investor confidence in the coming months.
Our research indicates that risky assets could continue to perform well as the economy shifts from a recovery to an expansionary regime. However, return engines tend to be different. In the recovery phase, risky assets are mainly stimulated by an accommodating monetary policy, falling bond yields and improving financial conditions despite a weak growth environment. In an expansionary phase, we expect earnings growth and lower market volatility to be the main drivers of investor risk appetite and asset prices, while bond yields gradually normalize to higher levels assuming limited inflationary pressures.
We expect Senate Democratic control to have a positive impact on our model portfolio, with emerging and developed markets outside of the U.S. being the primary beneficiaries of reduced trade uncertainty, and the U.S. dollar expected to rise. depreciate in parallel.
Figure 1: Key economic indicators and market sentiment suggest that the global recovery is continuing, despite rising infection rates and the resumption of lockdowns in some parts of the world.
We believe the macro backdrop remains supportive of equity and credit premia, cyclical factors and risk assets more generally. We maintain a higher risk posture than our benchmark in the Global Tactical Asset Allocation model,2 from an overweight exposure to equities and credit at the expense of government bonds. Specifically:
We have not made any changes to our exposures within fixed income securities. We remain constructive on risky credit despite the spread compression. As the cycle matures from a recovery regime to an expansion regime, financial market volatility tends to decrease, shifting the investment argument for the credit of the capital appreciation (i.e. spread compression) to income generation. We are overweight US high yield credit, bank loans and emerging market dollar sovereign debt at the expense of investment grade corporate credit and government bonds. We favor US Treasuries over other developed government bond markets. Overall, we are overweight credit risk3 and an underweight duration relative to the benchmark, expecting yields to rise and the curve to steepen in an orderly fashion.
In the foreign exchange markets, we maintain an overweight exposure to foreign currencies, positioning ourselves for a long-term depreciation of the US dollar. Within developed markets, we favor the euro, Canadian dollar, Singapore dollar and Norwegian krone, while we are underweight the pound sterling, Swiss franc and Australian dollar. In emerging markets (EM), we favor the Indian rupiah, Indonesian rupiah, Russian ruble and Colombian peso. We expect the EM FX carry trade to catch up in 2021, having lagged most recovery trades in 2020.
Figure 2: Incipient expansion translates into a shift to non-US DM and a reduction in overweight to value relative tactic asset allocation positioning
Figure 3: Factor tilts within the expansion regime result in reduced overweight to size and value, while increasing momentum exposure, relative to the recovery regime
Regime Dependent Factor Exposures – Dynamic (Shaded) vs. Benchmark (Black)
1 Source: Bloomberg LP as of December 31, 2020
2 60/40 Global Benchmark (60% MSCI All Country world Index / 40% Bloomberg Barclays Global Agg USD Hedged)
3 Credit risk defined as DTS (duration times spread).
Blog header image: Nikolai Chernichenko / Unsplash
propagated represents the difference between two asset values or returns.
the MSCI All Country World Index is an unmanaged index believed to be representative of large and mid cap stocks across developed and emerging markets.
the Bloomberg Barclays Global Aggregate Index is an unmanaged index believed to be representative of the global high quality fixed income markets.
the Russell 1000® Indexa registered trademark/service mark of Frank Russell Co.®, is an unmanaged index believed to be representative of large cap stocks.
Credit risk defined as DTS (duration times spread).
Tracking error measures the divergence between the price behavior of a portfolio and the price behavior of a benchmark.
The risks of investing in securities of foreign issuers, including emerging market issuers, may include foreign currency fluctuations, political and economic instability and foreign taxation issues.
Fixed income investments are subject to issuer credit risk and the effects of interest rate fluctuations. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may not be able to meet interest and/or principal payments, thereby causing a decline in the value of its instruments and a decline in the issuer’s credit rating.
Junk bonds involve a greater risk of default or price change due to changes in the credit quality of the issuer. The values of junk bonds fluctuate more than those of high-quality bonds and can drop significantly over short periods of time.
Sovereign debt issuers or governmental authorities that control repayment may be unable or unwilling to repay principal or interest when due, and the Fund may have limited recourse in the event of default. Without the approval of the debt holder, some government debtors may be able to reschedule or restructure their debt payments or declare moratoriums on payments.
The dollar value of foreign investments will be affected by changes in exchange rates between the dollar and the currencies in which such investments are traded.
In general, the value of shares fluctuates, sometimes widely, in response to specific company activities as well as general market, economic and political conditions.
Stocks of small and medium-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or resale-restricted.
Tactical Asset Allocation – January 2021 by Invesco US
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.