Each month, the State Street Global Advisors Investment Solutions Group (ISG) meets to debate and ultimately determine a Tactical Asset Allocation (TAA) that can be used to help guide near-term investment decisions for client portfolios. By focusing on asset allocation, the ISG team seeks to exploit macro inefficiencies in the market, providing State Street clients with a tool that not only generates alpha, but also generates alpha that is distinct (i.e., uncorrelated) from stock picking and other traditional types of active management. Below are some of the highlights from the ISG team’s most recent “Alpha Meeting”
Asset Class Views Summary
Overall, we hold a slight overweight to equities and a preference for credit bonds. We hold a modest overweight to gold.
While economic progress has moderated from its mid-year torrid pace, global economies have continued to recover. The continued easing of lockdown restrictions, coupled with the still upward trajectory in global PMIs, support an uneven, but gradual recovery. In the US, employment has continued to rebound, while consumers remain resilient as evidenced by the strong consumer confidence index and positive retail sales. Monetary policy remains accommodative and, while additional fiscal stimulus has disappointed so far, there remains optimism, albeit slight, that a package can be agreed upon before or after the election.
Outside the US, the picture is a little more mixed. In the Eurozone, consumer confidence improved slightly, retail sales beat estimates in August, and manufacturing activity continued to accelerate. The service sector, now in contraction, has been weighed down by a pickup in COVID cases. In Japan, the labor market is improving, but both manufacturing and service PMIs remain in contraction, suggesting the need for further fiscal stimulus.
Finally, from a politics and policy perspective, the US election is approaching and will likely bring about great uncertainty and volatility. Further, we believe markets may not be fully pricing in the extent of likely tax increases under a Biden administration. Overall, our quantitative toolkit continues to favor global equities, credit, and gold, while broad commodities, REITS, and bonds look less attractive.
From a risk sentiment perspective, our Market Regime Indicator (MRI) has stabilized in a “Normal” market regime. Implied volatility in currency markets has continued to keep that component of the MRI elevated, but the volatility factors from equity and credit markets have in large part continued to ease. A Normal reading from our regime indicator designates a more neutral risk positioning. In addition, we are cognizant of several risks, including rising COVID cases and the US election, that have the potential to introduce greater uncertainty and volatility into markets. Overall, we decided to target less active risk than our targets would suggest.
Directional Trades and Positioning
Directionally, we were not compelled to deviate from the current small overweight to equities. The forecast for global equities broadly improved with strong earnings and sales sentiment, positive price momentum, and supportive macro factors offsetting rich valuations. However, this outlook is tempered by election risks; the prospect for delayed or contested results creates greater uncertainty and headwinds for risk assets. Gold remains attractive across the technical factors we monitor and most fundamental indicators. What’s more, the precious metal protects the portfolio on the downside should election risk generate a risk-off shift. Our view on high yield has shifted, as we now forecast modest spread-widening, which would pressure prices. While easing volatility and still favorable levels of government bond yields support high yield, equity volatility in September tainted our favorable view of the higher-risk fixed income.
On the other side of the ledger, our forecast for core bonds slightly improved, with models now looking for marginally lower rates and a steeper yield curve. Improving level momentum and the current GDP to 30-year yield differential bolster the case for lower yields, while the recent decline in manufacturing PMI is less supportive of higher yields. Current inflation levels combined with leading economic indicators promote a steeper curve. Finally, futures curves are contango, which continues to sour our appetitive for broad commodities.
Relative Value Trades and Positioning
Changes to our relative value positions reflect a shifting of preferences within both equity and fixed income markets. Overall, we continue to favor US large cap equities, but have reduced the overweight in favor of US small caps, which we brought to neutral. An improvement in the relative health of small cap balance sheets when considering operating earnings versus free-cash-flow helped small caps look more attractive. The ongoing economic recovery and policy proposals that target firms with greater non-US operations and income also support neutralizing our underweights as we head into an uncertain election period. Lastly, this trade reflects our desire to hold our regional exposure consistent with a preference for the US relative to developed, non-US, and emerging markets.
US large cap stocks remain our largest overweight; they continue to benefit from strong earnings and sales expectations, with contributory momentum and macro factors offsetting unfavorable valuations. Although European equities have some favorable valuation and quality characteristics, earnings expectations are less attractive, muting the outlook. Finally, we maintain a modest overweight to emerging market equities due to improving economic activity, a negative medium-term outlook for the US dollar, and improved risk appetite – all of which support the asset class. REITs remain our largest underweight within the equity portfolio because the poor earnings and sales estimates, high financial leverage, and disadvantageous momentum weigh on the outlook.
As mentioned above, the outlook for high yield has deteriorated, causing us to reduce the position in favor of long-term corporate and aggregate bonds. We retain an overweight allocation to high yield as well as other credit sectors, but these reallocations increase our overall exposure in terms of credit quality.
From a sector perspective, we continue to like technology and consumer staples. Consumer staples appears attractive across all factors we evaluate except for momentum, where we see a neutral signal. Technology ranks above average for all factors except value and has regained much of the ground lost amidst the early-September volatility and options activity. We also hold an allocation to consumer discretionary – which is largely consistent with our allocations from last month. However, our near-term outlook for industrials dimmed amidst tighter correlation of stocks within the sector, which we view as an unhealthy development, all else equal. As a result, we moved away from the “split” allocation between consumer discretionary and industrials and made a full allocation to consumer discretionary.
To see sample Tactical Asset Allocations and learn more about how TAA is used in portfolio construction, please contact your State Street relationship manager.
The views expressed today are the views of Investment Solutions Group as of October 8, 2020, and are subject to change based on market and other conditions. All information is provided in good faith, and there is no representation nor warranty that such statements are guarantees of any future performance. Actual results or developments may differ materially from the views expressed.
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