Invesco Canada blog

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Alessio De Longis | August 13, 2021

Tactical asset allocation update: August 2021

The global economy remains in expansion, but a near-term peak in the cycle is increasingly likely, as evidenced by some shifting dynamics in the relative performance between sectors, regions, and factors.

Leading economic indicators for the major regions around the world are peaking (Figures 1 and 2) at the same time global risk appetite is stabilizing at what we think are cyclical highs. Our macro regime framework remains in an expansionary regime, but it is increasingly flagging the potential for an inflection point in the next few months.

In our opinion, these transitions at the peak of the growth cycle are notoriously unstable, characterized by range-bound price action in asset prices and shifting themes, with overall positive performance for risky assets. While we believe the early-cycle reflation trade is not exhausted, it is approaching its last stages as evidenced by the recent pullback in the performance of value relative to growth, the performance of small-caps and mid-caps relative to large-cap equities, and the meaningful rally in long-term bond yields.

Figure 1: While the global economy remains in expansion, some regions appear to have shifted toward a slowdown cycle.

Sources: Bloomberg L.P., Macrobond. Invesco Investment Solutions research and calculations. Proprietary leading economic indicators of Invesco Investment Solutions. Macro regime data as of July 31, 2021. 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. For illustrative purposes only.

Figure 2: Invesco Investment Solutions leading indicators – GRACI and the global LEI

Sources: Bloomberg L.P., MSCI, FTSE, Barclays, JPMorgan, Invesco Investment Solutions research and calculations, from Jan. 1, 1992 to July 31, 2021. 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 illustrative purposes only.

Emerging market (EM) equities have continued to underperform over the past month. We believe our overweight positioning to the asset class relative to developed market (DM) equities is certainly the most challenged active exposure in our portfolio, but one we continue to hold based on our macro framework. Several factors have contributed to the setback in EM equities after their strong outperformance between Q4 2020 and mid-February 2021.

  • First, the rise in U.S. bond yields in the first quarter of this year, coupled with a stronger U.S. dollar, led to a tightening in EM financial conditions due to a higher dependance on external/U.S. dollar funding relative to developed markets.
  • Next, slower vaccination progress, coupled with a resurgence of the virus via the Delta variant, moderated the expectation that the broad-based global reflation trade would lift local EM equities.
  • Finally, China’s recent regulatory crackdown on the technology sector, among others, introduced additional uncertainty for foreign investors, causing additional underperformance in local equity markets.

In our opinion, this last development deserves more attention, given its potentially erratic nature, and the nexus between regulatory policy, macroeconomic policy, and investor confidence. Chinese authorities have shown a strong commitment to regulate market sectors that are growing rapidly with insufficient scrutiny over issues such as data security, consumer rights protection, fair competition, and oversight of overseas share listings.

While the uncertainty of these steps can certainly shake investor confidence in the near term, the willingness to introduce a solid regulatory framework in fast-growing sectors should benefit investors in the long term.

Furthermore, despite their ongoing efforts to tighten rules on technology firms, Chinese leaders are also expected to intensify policy support in the second half of the year to help support the economy.

The Politburo meeting on July 31 signaled more targeted support for the local economy through a focus on medium and small businesses, boosted fiscal spending, and the potential reduction of the reserve requirement ratio for banks.

Finally, the Politburo formally stated its aim of “enhancing independence of macroeconomic policy,” which could also imply an increasingly independent People’s Bank of China (PBOC) policy from the U.S. Federal Reserve (Fed). We believe this would allow the Chinese monetary stance to be more accommodative to local growth needs at a time when the Fed is entering into a gradual policy normalization path.

Our overweight exposure to EM equities is driven by two key factors:

1. Expectations that the global business cycle is in an expansionary regime, with rising risk appetite signaling the potential outperformance of riskier, more cyclical asset classes such as EM equities.

2. Expectations for medium-term U.S. dollar depreciation, supported by more favourable currency valuations outside the U.S., both in DM and EM; easing financial conditions; and capital inflows into EM assets.

The three broad developments that in our opinion have negatively affected the perfor­mance of EM equities have thus far slowed, but not derailed, market sentiment and global risk appetite, therefore leaving our investment framework tilted in favour of the asset class.

While our investment process is not expected to anticipate idiosyncratic fundamental de­velopments such as the recent regulatory clampdown by Chinese authorities, we expect our framework to react in the event such policy shock derails global market sentiment and global growth expectations, in which case we would adjust our positioning accordingly.

Investment positioning

Within equities, we favour EM, driven by above-trend global growth, rising risk appetite, and medium-term U.S. dollar depreciation to support the asset class. We have neutralized our exposure to DM outside the U.S., relative to U.S. equities, as leading indicators seem to point to a near-term softening of the cyclical upturn in Europe. However, 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 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 DM, 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 (Figure 3).

Figure 3: Global cycle remains in expansion regime

Source: Invesco Investment Solutions, August 2021. DM = developed markets. EM = emerging markets. For illustrative purposes only.

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Important information

Header image: Todd Beltz / Stocksy

Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from your advisor or from Invesco Canada Ltd.

As illustrated in our previous research, we define the four stages of the business cycle based on the expected level and change in economic growth: recovery, when growth is below trend and accelerating; expansion, when growth is above trend and accelerating; slowdown, when growth is above trend and decelerating; and contraction, when growth is below trend and decelerating.

Size (in factor investing) represents the potential higher-than-benchmark returns associated with relatively smaller stocks within the universe being considered.

Value (in factor investing) applies to investments trading at discounts to similar securities, based on measures like book value, earnings or cash flow.

Momentum (in factor investing) identifies investments with positive momentum (recent strong returns) or negative momentum (recent weak returns) in order to calibrate portfolio exposure to either.

Companies that issue quality stocks may experience lower than expected returns or may experience negative growth, as well as increased leverage, resulting in lower than expected or negative returns to Fund shareholders.

Spread represents the difference between two values or asset returns.

Diversification does not guarantee a profit or eliminate the risk of loss.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.

Issuers of sovereign debt or the 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 debt holder approval, some governmental debtors may be able to reschedule or restructure their debt payments or declare moratoria on payments.

The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

There is no guarantee forecasts/outlooks will come to pass.

The opinions referenced above are those of the author as of Aug. 12, 2021. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.