After recent asset price gains and despite the expectation of central bank rate cuts, we expect lower returns than previously and are de-risking our allocation due to global economic concerns.
Though US elections and geopolitical events could bring short term volatility, we expect that to be short-lived.
Within our Model Asset Allocation*, we boost allocations to government bonds and investment grade (both to further Overweight), while reducing real estate and commodities (both to Neutral).
Over the past three months, we've observed further asset price increases alongside declining yields, leading us to expect lower returns going forward. As a result, we're taking steps to de-risk our Model Asset Allocation, believing that the current environment won't reward additional risk-taking.
We're now increasing our positions in government bonds and investment grade credit, moving both to an Overweight stance, while trimming our exposure to real estate and commodities to Neutral. Regionally, we prefer UK and emerging market (EM) assets, and we're further boosting our Japanese yen (JPY) exposure through hedges from the US dollar (USD).
The good news? We expect a rapid decline in central bank interest rates over the next 12 months, with markets already pricing in around 240 basis points of cuts from the Fed. However, the bad news is that some cyclical assets have likely priced this in, just as we believe the global economy is slowing. There are also potential geopolitical and election risks on the horizon, though we expect them to have a limited long-term impact. Optimisations based on our 12-month projected returns lead us to adopt a more defensive approach, though we’re careful not to overdo it.
What should we expect from the Fed? With over 40 central banks cutting rates in 2024, all eyes are on the US Federal Reserve. The Fed is likely to announce its first rate cut on September 18, 2024, with the only debate being whether it will be 25 or 50 basis points. Given that core PCE inflation is around 2.6% and economic growth is slowing, a cut seems almost certain.
Market expectations for Fed cuts have surged, with futures indicating 110 basis points of cuts by the end of 2024 and 235 basis points within a year. While this might sound dramatic, it’s consistent with past easing cycles, where the Fed has typically cut rates by about 180 basis points in the initial six months.
The question is: how low will rates go? Markets anticipate a 240-basis point drop over the next year, pushing rates to around 3.10%, with a possible low of 2.90%. The Taylor Rule suggests a “neutral” rate should be around 4% if inflation is 2%. However, with the Fed’s June 2024 median estimate at 2.8%, we expect these forecasts to rise as recent biases diminish.
Turning to the slope of the yield curve, Figure 15 highlights an intriguing trend: since 1980, 10-year yields have generally exceeded policy rates by an average of around 1.15% to 1.30%. This historical pattern suggests a “normal” 10-year yield range of 4.00% to 5.00%. Whether we hit this range will depend on the accuracy of our or the FOMC’s predictions about the neutral Fed policy rate. If the Fed’s policy rate moves in line with historical trends, we could see 10-year yields settling comfortably within this expected range.
The blue (left) area represents the period pre-1980, marked by:
The pink (middle) area represents the period 1980–2008, characterised by:
The green (right) area represents the period post-global financial crisis, featuring:
Note: Past performance is no guarantee of future results. Monthly data from July 1954 to August 2024 (as of 30 August 2024). Fed Policy Rate is the mid-point of the Fed’s policy range. “10y-Fed Rate” shows the average gap between 10-year yields and the Fed Policy rate over the period concerned. “Bretton Woods” was a fixed exchange rate regime that ceased to function in the early 1970s. “GFC” is the Global Financial Crisis.
Source: LSEG Datastream and Invesco Global Market Strategy Office.
We generally believe that elections don’t have a lasting impact on financial markets under normal circumstances. Our historical analyses challenge the conventional wisdom, suggesting that Democratic presidents have often been linked with better economic performance and stronger stock markets. Additionally, there appears to be no clear relationship between corporate taxation rates and future stock market returns.
Nevertheless, we’re keeping a close eye on the upcoming US elections. The candidates present some distinct contrasts: Donald Trump seems frustrated by his limited influence over the Fed, while Kamala Harris is likely to uphold its independence. Trump is expected to advocate for lower taxes, both personal and corporate, whereas Harris appears more focused on redistribution.
Asset allocation is the process of dividing an investment portfolio among different asset classes, such as stocks, bonds and cash and so on. Bonds generally tend to be ‘safer’ investments than stocks and are, for example, seen as more defensive. Assets are allocated based on economic and monetary expectations.
Spreading the risk and number of potential opportunities across various asset classes, such as equities, fixed income and commodities. The aim of diversification is to reduce the overall risk of the portfolio.
Central banks can ‘tighten’ policy by raising interest rates. This is done to curb inflation or an overheating economy. After the pandemic, inflation rose as pent-up demand was released and supply chains issues were cleared. Russia’s invasion of Ukraine further spurred inflation due to higher energy costs. Central banks responded with a series of rate hikes, which is the tool generally used to moderate inflation.
When an asset is assigned Overweight, an analyst or investor typically thinks that it will outperform others in the market, sector, or model. Underweight is indicative of the opposite.
Welcome to our Tactical Asset Allocation hub. Here you’ll find a selection of the most recent research from Invesco Solutions. Read our latest analysis that covers market strategy and opportunities across various asset classes.
In Uncommon Truths, Invesco experts Paul Jackson and Andras Vig’s provide a regular in-depth look at the big topics impacting markets.
Alternative Opportunities is a quarterly report from Invesco Solutions. In each new edition, we look at the outlook for private market assets.
*This is a theoretical portfolio and is for illustrative purposes only. It does not represent an actual portfolio and is not a recommendation of any investment or trading strategy.
**Please note that the document was published on 15 September 2024 (i.e. before the Fed decision to cut rates).
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.
Views and opinions are based on current market conditions and are subject to change.
EMEA 3866140/2024
