The macroeconomic picture remains attractive for growth assets despite some near-term headwinds. Weaker labor data, a drop in some mobility trends, and a slight softening of global PMIs suggest economic growth momentum may have slowed to start the year. However, a myriad of factors suggest the recovery is on solid footing and the current reflation trade has further room to run.
COVID cases, both new infections and hospitalizations, have been improving; despite some hiccups in vaccine rollout, countries are making good progress administering treatments and containing the virus while also loosening mobility restrictions. The global economy is showing resilience as evidenced by supportive PMIs, which have softened a bit but are generally improving – signaling healthy levels of activity, especially in the US. Another round of stimulus is expected in the US, and all indications point to a large and more targeted package that should sustain consumer demand. Corporate profits continue to rebound as measured by the S&P 500, with about 81% of reporting companies beating expectations – a projected growth rate of +1.7% would be the first positive quarterly year-over-year growth since 4Q 2019. This improvement, coupled with ultra-low rates, opens the door for increased dividends and buybacks, which might represent an additional tailwind for equities. Lastly, the Fed has re-committed to staying accommodative, quelling any concerns about the possibility of a taper tantrum similar to 2013.
Overall, we continue to deploy our risk budget toward equities and broad commodities, while tilting our fixed income portfolio toward credit, both investment grade and high yield. Core bonds and REITs continue to look unattractive and remain our largest underweights. See Figure 1.
Asset Class Views Summary
Source: State Street Advisors, as of February 8, 2021.
Vaccine optimism and increased expectations for further fiscal stimulus buoyed risk appetite in early January as our Market Regime Indicator (MRI) moved toward the bottom end of Low Risk with improvement in currency implied volatility and still supportive risky debt spreads. As the month progressed, vaccine delivery delays, disappointing vaccine news from Johnson & Johnson, and the retail short squeeze created some uncertainty, driving implied volatility on equities higher, into the upper end of Normal. Risky debt spreads increased, but remained in Euphoria while implied volatility on currencies continued to improve and helped keep the MRI in Low Risk, which supports our overweight to growth assets.
On balance, we continue to hold a constructive view of higher beta assets, including both equities and commodities. Equities remain favored by our quantitative models, as improvements in price momentum and earnings sentiment coupled with positive macroeconomic factors offset stretched valuations. In commodities, futures curve dynamics deteriorated modestly; however, firm momentum supports the asset class broadly while the ongoing reopening of global economies should be supportive for sectors such as energy and industrial metals. Given this outlook, we maintained our current directional positions with an overweight to risk assets.
With the expectation for a return to positive global economic growth in 2021 and supportive quantitative forecasts, we continue to hold a diversified equity overweight with the US remaining our favorite region. In the latest rebalance, we further extended our underweight to European equities in favor of Pacific equities.
Our forecast for Europe continues to deteriorate, as difficulties with the rollout of vaccinations along with more stringent lockdowns have weighed on the region. Feeble price momentum, both short and intermediate term, conjoined with weak sales and earnings expectations offset positive valuation metrics.
The buoyant outlook for Pacific equities is driven by strong and improving sentiment associated with earnings and sales prospects in the region. Additionally, positive valuations and supportive quality scores reinforce the more optimistic forecast.
Within fixed income, we continue to prefer credit exposure, and we added to high yield bonds at the expense of non-US government bonds. We also adjusted our investment grade bond exposure by trimming our intermediate-term credit allocation and deploying proceeds into long-term credit.
Our forecasts for a steeper yield curve imply positive future economic conditions, which supports further spread tightening. Elsewhere, favorable seasonality and advantageous equity volatility readings also promote tighter spreads. Although higher government interest rates may result in more expensive financing costs, we continue to see momentum in credit spreads and a sturdy economic backdrop amidst recent curve steepening. Notwithstanding the fact that yields and spreads are relatively tight (much like valuations for most assets), the environment for credit still looks attractive. The rotation within investment grade credit allows us to pick up additional yield while the duration impact on the portfolios is minimal.
Our models are looking for a slight increase in non-US interest rates, which combined with a record negative yielding debt dim the outlook for non-US government bonds. Further, recent US dollar stability may persist for the short-term, removing a potential tailwind for the asset class. Lastly, the rotation allows us to pick up additional carry and tilt toward an asset more positively correlated with economic growth.
From a sector perspective, our targeted sectors include technology, consumer discretionary, and communication services. Technology looks attractive across all our quantitative factors except value. Consumer discretionary ranks well due to strong momentum and sentiment readings. Communication services bounced back up in our rankings based mainly on improved sales expectations. The rebalance results in sales of existing allocations to consumer staples and materials. With economies reopening and inflation expectations picking up, sentiment data related to both earnings and sales took a turn lower for the consumer staples sector. Materials moved to the middle of the pack amidst weaker readings across all factors, with the exception of momentum.
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 February 8, 2021, 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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