Our macro regime framework continues to signal that
the global economy and all its major regions and countries are in a contraction
regime. As widely expected, the economic data are beginning to reflect the
disruption caused by quarantines and lockdowns, resulting in a significant
deterioration in our leading economic indicators, which we expect to continue
for some time. While global market sentiment has stabilized over the past
month, it remains in a downward trend, suggesting markets are still expecting downward
revisions to global growth expectations. As previously
discussed, we believe this macro environment
warrants a defensive portfolio posture. We have not made major changes to our asset
allocation and continue to favor an overweight exposure in investment grade
credit and defensive equity factors.
This month we investigate the potential paths forward
for the global economy and the likely evolution of our macro regime framework
over the next twelve months, conditional on the hypothetical evolution of the
Covid-19 pandemic. While it is impossible to make predictions on the medical
front, we focus our attention on possible scenarios pertaining to the duration
of the pandemic, and how its impact on economic data and growth expectations may
drive our regime framework. A brief narrative of three hypothetical scenarios is
illustrated in Figure 1. Since our investment process is geared towards adjusting
to the changing economic environment, our objective is not to identify the most
likely scenario for the next twelve months and position the portfolio
accordingly. Instead, we want to evaluate the most likely range of market
outcomes, their associated risks, and investment implications.
Figure 1: Three hypothetical scenarios for how the
pandemic may unfold
Under these three scenarios, we expect our global
framework to oscillate between a recovery and a contraction regime, given the
economy today is in a below-trend environment. Next, we outline our tactical
asset allocation, style, and factor views for each scenario, as summarized in Figure
Bear scenario: We would expect broad-based risk aversion and outperformance of (relatively) defensive assets. In this case, investors may want to consider below average risk expressed via overweight exposures in long-duration government bonds and high-quality credit, favoring US dollar or US dollar-hedged assets given the potential for further US dollar appreciation. Other considerations include underweight riskier credit assets, especially emerging markets (EM) local currency and hard currency debt, or underweight equities, especially in emerging and developed markets ex-US. Within equities, we would favor growth over value, large caps over small caps, and defensive factors such as quality, low volatility and momentum.
Base scenario: We would expect
sideways markets with alternating bouts of volatility. In this case, investors
may want to consider average risk exposure, overweighting credit assets through
an underweight position in equities and government bonds. Within fixed income, hold
an overweight position through high-quality credit – such as investment grade
corporate and muni debt – or a combination of riskier credit (i.e. high yield)
and long-dated, longer duration government bonds, while reducing exposure in
short and medium term government bond maturities. Within equities, we may favor
US equities over developed ex-US and emerging markets, growth over value, large
caps over small caps, and defensive factors such as quality and low volatility.
Bull scenario: We would expect broad-based outperformance in cyclical and risky asset classes. In this case, investors may want to consider an above average risk posture, expressed via overweight exposures to riskier credit assets and equities and underweight exposures to government bonds and high-quality credit. Within credit, we favor high yield, structured credit, EM hard currency and local currency debt with the expectation that US dollar depreciates. In equities, we may favor emerging markets and developed markets ex-US over US equities, and cyclical style and factor exposures, including a preference for value over growth, small caps over large caps, and underweight positions in factors at risk of short-term reversal effects such as low volatility and momentum.
Figure 2: Three hypothetical scenario tilts
Our analysis is an over-simplification of what we
think is likely to occur. There may be several unexpected developments, related
or unrelated to Covid-19, which may affect these scenarios and the market
response. Nonetheless, from our perspective this type of analysis provides a
useful context to think about potential outcomes and design action plans given
that, as we described in the past, asset prices tend to experience large and
rapid adjustments at the inflection points of a cycle, i.e. during a recession
and coming out of it.
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measures interest rate sensitivity. The
longer the duration, the greater the expected volatility as rates change.
EM hard currency are bonds denominated in a
non-local currency, most likely USD or EUR.
The opinions expressed are those of Alessio de Longis as
of May 5, 2020, are based on current market conditions and are subject to
change without notice. These opinions may differ from those of other Invesco
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