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. Here we report on the team’s most recent TAA discussion.
The recovery is not complete, but economies appear much improved and signs continue to point to accelerated growth over the second half of 2021. We maintain the view that the macro-economic backdrop will provide a positive tailwind.
Inflation remains a concern as COVID-19 related headwinds, logistical bottlenecks and increased demand continue to pressure prices higher. However, healthy consumer balance sheets and fading mobility restrictions should help soften the impact.
The Delta variant has created a pickup in cases, but positive vaccine trends globally should limit the health impact and prevent further containment measures that would impede growth. Vaccine distribution in Japan and Europe has accelerated, which should unleash substantial pent-up demand. Further, the US is rolling out a temporary child tax credit program, sending additional stimulus to an estimated 39 million families, which may further boost consumer spending.
JP Morgan estimates that global consumption still remains about 3% below pre-pandemic levels. Business optimism remains strong as business capital expenditures have logged three consecutive quarters of double-digit gains as noted by the Wall Street Journal. Robust capital spending is suggestive of confident businesses that see strong demand ahead. Second quarter earnings season kicked off and FactSet expects S&P 500 earnings to increase 64% year-over-year. It noted that bottom-up earnings-per-share estimates have increased 7.2% over the course of the second quarter.
Our preference for risk assets, both equities and commodities, stems from a positive macro-economic outlook and continued favorable quantitative forecasts (Figure 1).
Figure 1: Asset Class Views Summary
Source: State Street Advisors, as at 16 July 2021.
Market sentiment remained positive in June as investors appeared to have discounted elevated inflation along with rising COVID-19 infections from the Delta variant and “taper talk” from the US Fed. Risky debt spreads remained auspicious while progress in vaccine distributions and further re-openings bolstered implied volatility in equities and currencies, with both factors declining deeper into euphoria. Overall, our Market Regime Indicator (MRI) finished June near the bottom end of euphoria.
Our quantitative models still favor equities and other growth assets such as commodities, and we remain overweight, but our forecast for core bonds continues to improve. With our model souring on gold, we decided to liquidate our position and deploy the proceeds to core bonds.
Our expectation for core bonds is a meaningful decrease in the level of rates with a sizable flattening of the yield curve. The recent bond rally increased interest rate momentum. This combined with softer PMI readings points to the possibility of additional yield compression.
Elsewhere, lofty inflation readings are indicative of a future decline in rates. Recent yield curve flattening has strengthened our momentum indicator, while signals from our proprietary set of leading economic indicators remain strong, leading both factors to anticipate a flatter curve. Lastly, consumer predictions for inflation remained elevated, suggesting further curve flattening.
Technical indicators have been choppy, recently turning negative, and indicated poor price momentum for gold. While current levels of debt to GDP and negative real rates buttress the precious metal, recent US dollar strength dims the outlook for gold.
Relative Value Positioning
While the expanding economic growth backdrop supports equities broadly, we have become slightly less optimistic on emerging markets (EM), although we still remain overweight. At our recent rebalance, we reduced our overweight in EM, rotating into US small cap equities.
Prospects for EM remain attractive, but our framework has become more subdued on the short-term outlook. Robust manufacturing activity and buoyant risk sentiment frame our sanguine forecast, but increased regulatory pressures in China along with concerns on COVID-19 and vaccination trends weigh on the region.
Improvement in both short and long-term price momentum helps to offset negative valuations and underpins our encouraging forecast for US equities. Furthermore, positive macro factors and strong sentiment readings reinforce the constructive outlook. Lastly, relatively benign credit spreads are indicative of lower default risk and aid expectations for small-cap equities.
Within fixed income, we reduced credit exposure to both high yield and intermediate investment grade in favor of core bonds. As mentioned, our forecast for core bonds continues to improve and it now ranks near the top of our fixed income quantitative framework. A steeper current yield curve relative to our six-month lookback window implies positive future economic conditions and tighter spreads. But seasonality is negative and interest rates are relatively higher, which is disadvantageous for spreads. Lastly, with spreads being historically low, upside is restricted, and the rotation allows to enhance credit quality while improving expected return.
From a sector perspective, we maintained allocations to technology, energy and industrials while removing the split allocation with our rotation out of materials. The recent slide in yields has benefited technology stocks and helped spur a sharp uptick in short-term price momentum. Strong earnings and sales sentiment, salutary balance sheets and reasonable valuation factors propel technology into the top spot in our quantitative framework.
Improvements in economic growth have propelled energy up our sector rankings, owing to strong price momentum, both long and short term, beneficial sentiment scores and attractive valuations. Industrials score well across all factors except value, boasting strong long-term price momentum and demonstrating solid earnings and sales expectations. Weakening short-term momentum offset supportive sentiment and valuation scores to knock materials out of our top three sectors. Poor quality and macro scores further dent the prospects for materials.
To see sample Tactical Asset Allocations and learn more about how TAA is used in portfolio construction, please contact your State Street relationship manager.
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The views expressed are of Investment Solutions Group as of 19 July 2021 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
Investing in REITs involves certain distinct risks in addition to those risks associated with investing in the real estate industry in general. Equity REITs may be affected by changes in the value of the underlying property owned by the REITs, while mortgage REITs may be affected by the quality of credit extended. REITs are subject to heavy cash flow dependency, default by borrowers and self-liquidation. REITs, especially mortgage REITs, are also subject to interest rate risk (i.e., as interest rates rise, the value of the REIT may decline).
There are risks associated with investing in Real Assets and the Real Assets sector, including real estate, precious metals and natural resources. Investments can be significantly affected by events relating to these industries.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in commodities entail significant risk and is not appropriate for all investors. Commodities investing entail significant risk as commodity prices can be extremely volatile due to wide range of factors. A few such factors include overall market movements, real or perceived inflationary trends, commodity index volatility, international, economic and political changes, change in interest and currency exchange rates.
Illiquid risk/Asset investments may have difficulty in liquidating an investment position without taking a significant discount from current market value, which can be a significant problem with certain lightly traded securities.
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