Invesco’s Global Market Strategy Office (GMS) has published its quarterly asset allocation outlook for Q2 2021, highlighting its optimalasset allocation for the next 12 months. The Invesco experts anticipatethat 2021 will see a move towards economic normality, with strong economic and profit growth throughout the year. “Given the apparent success of vaccine rollouts in the developed world, we believe the global economy will show solid growth in 2021, partly as a function of a rebound from deep recession, partly due to a gradual release of pent-up demand and also due to fiscal support, especially in the US. At the same time, we expect major central banks to continue providing generous support,” says Paul Jackson, Invesco Global Head of Asset Allocation Research, Global Thought Leadership.
Based on this outlook, Invesco’s GMS experts continue favouring cyclical assets,with indicators signalling that the global economic cycle is heading in the right direction, and that market sentiment has improved markedly since a year ago. However, they also cite five factors that could potentially put pressure on cyclical assets: the risk that the pandemic doesn’t go away and economic disruption continues; collateral damage, particularly amid scaled-back government support to businesses and households, which could dampen the economic recovery; an increase in inflation, causing central banks to tighten their monetary policy, which could bring the risk of market dislocations; a potential change in correlation regimes, especially between equities and bonds, and the fact that markets have already priced in a lot of recovery.
“Each of these could lead us to adjust our preferences, usually in a more defensive direction,” Jackson notes. “We think the most likely problem is that markets have priced in a lot of recovery. If we are to remain positive about cyclical assets, we need to become even more aggressive in our assumptions about growth and future spreads/valuation multiples. We are happy to do this, given that we now feel more comfortable about the global recovery, but it has the downside of forcing us to accept that government bond yields will rise more than we previously thought.”
Specifically, their projections for the next 12 months are underpinned by the following assumptions: Central bank rates remain stable and asset purchases continue, but strong growth will bring the risk of central bank tapering. Yield curves steepen as tapering approaches, with US yields rising more than most. Investment-grade (IG) and high-yield (HY) spreads approach historical tights and default rates decline. The US dollar strengthens as bond yield spreads move in its favour. Equity dividends rebound but yields rise slightly, in line with bond yields. Real estate (REIT) dividends bottom and yields stabilise. Commodities consolidate recent gains, and gold falls due to rising yields/dollar.
“Perhaps our most important forecast is that the 10-year US treasury yield will rise to 2.00% and that consequently the US dollar will strengthen slightly,” Jackson says. “This suggests to us that some recent trends will continue, particularly the outperformance of value versus growth, and the weakness of gold and defensive fixed income assets. However, it also suggests that commodity prices may find it harder to advance from here, and that emerging market assets may face a headwind due to renewed doubts about the ability of emerging market countries to finance their debt burdens.”
Critically, the Invesco experts do not expect the rise in bond yields to undermine equity markets as they expect a continuation of the positive correlation between equity prices and bond yields witnessed since the turn of the century. Similarly, they remain optimistic about the outlook for real estate, where yields remain generous compared to other assets. While the rise in yields will penalise government bonds and will dampen returns on IG and HY credit, they suspect that credit spreads can tighten further, and expect a decline in default rates.
Over the next 12 months, Invesco’s GMS experts expect the best returns on equities, real estate, commodities and high-yield bonds. However, they are most optimistic on real estate as they believe that elevated REIT yields will mitigate against the upward pressure from bond yields. While real estate may suffer a loss of demand for office and retail space as a result of Covid-19, the Invesco experts find the yields to be attractive, with a lot of bad news apparently already priced in and expect growth to resume as economies recover. “Even if cash flows bounce less strongly than for equities, yields are high and we expect them to be stable,” Jackson says.
Conversely, they expect rising government yields to result in negative government debt returns and a near-zero return on investment-grade credit. Corporate high-yield is their favoured asset class among fixed income assets. As investment-grade yields are too low to mitigate against the rise in benchmark government yields, the Invesco experts believe that corporate IG bonds now hold no advantage over cash. While the government debt outlook has improved, they still consider this asset class unattractive.
Although commodities are supported by the cycle, Invesco’s GMS experts now consider some commodities – particularly energy and industrial metals – expensive and believe that gold will struggle in an environment of rising yields and a strengthening US dollar. Agricultural commodities are the only commodities group they currently consider cheap. Despite low returns, cash remains their defensive asset of choice on account of its stability and low correlation to other assets. Their best-in-class assets, based on 12-month projected returns, are UK equities, emerging market real estate, US high-yield and USD cash. Regionally, they favour Europe and the emerging markets as regions that they believe have most to gain during an expansionary phase of the global economy.
