Despite the weakening in global leading economic indicators, our framework still points toward an expansionary regime. Find out why from Alessio De Longis in this month’s tactical asset allocation update.
Macro update
Leading economic indicators have decelerated across all regions around the world. In the United States, declining consumer confidence and housing market indicators have been the primary driver of recent weakness. In the eurozone and the UK, peaking production expectations and falling inventories suggest that the rebound in the inventory cycle of the past few months is likely to pause in the near term. In Asia, deceleration in manufacturing surveys, housing indicators, and industrial production have contributed to a noticeable slowdown in growth.
Despite this broad-based softening in economic data, our macro regime framework remains in an expansionary regime, driven by a rebound in global risk appetite which, in our opinion, signals market expectations for a rebound in growth later in the year (Figures 1 and 2).
Figure 1: While the global economy remains in expansion, some regions have shifted toward a slowdown cycle
Figure 2: Invesco Investment Solutions leading indicators – GRACI and the global LEI
Among potential drivers of the recent improvement in market sentiment, we are witnessing early evidence of a peak in delta variant infections and a well-telegraphed tapering by the U.S. Federal Reserve (Fed):
- Recent experience with the delta variant in the UK suggests daily reported cases could decline rapidly in the coming weeks. Short-term fluctuations in asset prices still show a high sensitivity to COVID-related news, as shown by the positive market reaction to the recent FDA approval of the Pfizer/BioNTech vaccine. Hence, positive news flow on the COVID front could provide another catalyst in favour of risky assets, cyclical factors/sectors, and higher bond yields. Importantly, we believe emerging market (EM) equities and currencies should prove resilience against (gradually) rising long-term U.S. bond yields, given the meaningful cheapening in EM assets caused by China’s regulatory crackdown over the past two months.
- Fed Chair Jay Powell’s speech at the Jackson Hole Economic Symposium confirmed the well-telegraphed tapering in asset purchases in the fourth quarter. The dovish market reaction post-Jackson Hole confirms to us some negative risk premia were built into asset prices ahead of the meeting. Going forward, we don’t expect communication around tapering to matter as much, and the attention should shift to what the Fed described as a “different and substantially more stringent test for liftoff” in interest rates later next year.
We believe inflation has peaked. Our inflation momentum indicator (introduced last May) suggests U.S. inflation statistics over the past three months have stabilized and begun to roll over (Figure 3). These developments provide tentative support to our thesis that the spike in inflation would prove transitory, and that inflation should soon return to an average annual rate in line with recent history.
The bottom line is that while there are several economic and market developments that could shake markets in the near term (COVID infections, monetary policy communication, and upcoming U.S. debt ceiling and budget deadlines, to name a few), our macro framework still points toward a positive backdrop for equities, cyclical assets, and emerging markets, leading us toward a tactical buy-the-dip strategy rather than a risk reduction strategy.
Figure 3: U.S. Inflation Momentum Indicator (IMI) and categories
Investment positioning
- Within equities, we favour emerging markets, driven by above-trend global growth, rising risk appetite, and medium-term U.S. dollar depreciation to support the asset class. We remain tilted in favour of (small) size and value across regions. In addition, we are tilted in favour of momentum, which currently captures value and smaller-capitalization equities, therefore concentrating risk in cyclical factors and reducing factor portfolio diversification relative to the past few years.
- In fixed income, we favour risky credit despite tight spreads, seeking income in a low-volatility environment. We are overweight high yield, bank loans, and EM debt at the expense of investment grade credit and government bonds. We favour U.S. Treasuries over other developed government bond markets given the yield advantage.
- In currency markets, we maintain an overweight exposure to foreign currencies, positioning for long-term U.S. dollar depreciation. We remain constructive on EM foreign exchange given attractive valuations, an improving cycle, and a favourable backdrop for capital inflows, favouring the Indian rupee, the Indonesian rupiah, the Russian ruble, and the Brazilian real. Within developed markets, we favour the euro, the yen, the Canadian dollar, the Singapore dollar, and the Norwegian kroner, while we underweight the British pound, the Swiss franc, and the Australian dollar. (see Figure 4)
Figure 4: Relative tactical asset allocation positioning
