Increasing Risk Exposure: Tactical Trading Decisions for January 2021

In the middle of December, surging COVID cases, a fast approaching Brexit deadline, and the Georgia election run-offs all contributed to greater market uncertainty, steering us toward risk reduction. Since then – although the policy implications of the Brexit deal and US Senate race are not yet fully understood – some sources of uncertainty have been removed from markets. Rising COVID cases and more contagious COVID variants are still concerning and may weigh on economic growth in the near term, but early indications suggest current vaccines are effective against these variants and should allow for more targeted and less economically stifling restrictions.

Additional mobility restrictions have been implemented across Europe and parts of the US, but we’re encouraged by the fact that economic impacts haven’t been as devastating as they were following measures introduced at the beginning of the pandemic. The continued rollout of vaccines, with three additional vaccines in phase 3 clinical trials, should help support economic activity, and recently passed fiscal stimulus will help cushion the slowdown. Further, the recent Democratic sweep in the United States brings with it hope for additional stimulus, which should provide a bridge until the economic recovery can become self-sustaining.

Against this backdrop, we have decided to increase our risk exposure in our multi-asset tactical portfolio, pivoting from the more cautious stance we took in mid-December. Overall, we continue to favor global equities and credit and have become more optimistic on broad commodities (see Figure 1). REITs and core bonds continue to look less attractive, and gold remains our preferred tactical hedge.

Figure 1: Asset Class Views Summary

Source: State Street Global Advisors, as of January 11, 2021.

Directional Trades and Risk Positioning

Directionally, we remain cautiously optimistic on both global equities and broad commodities, holding a sizable overweight to both. As mentioned, we reversed the risk-reduction trade by eliminating our cash position and deploying proceeds into both global equities and broad commodities. In our view, the rationale for holding cash has diminished, as markets appear on better footing with numerous uncertainties behind us.

Equities remain favored by our quantitative models, as improvements in price momentum and earnings sentiment, coupled with positive macroeconomic factors, offset stretched valuations.

Our more enthusiastic outlook for broad commodities is driven by an improving outlook for the energy complex, where supply and demand dynamics continue to become more favorable; a less negative futures curve also aids the improved outlook. Industrial metals possess attractive fundamentals, while the agriculture sector has experienced strong price pressures. Finally, the addition to broad commodities allows us to diversify our growth exposure.

Relative Value Trades and Positioning

Vaccine-induced jubilation, along with the increased likelihood for additional fiscal stimulus in the US, have brightened the prospects for the reflation trade to continue. In this context, we have broadened out our equity overweight by adding to US small caps, Pacific equities, and emerging market equities.

While a rising equities tide may well lift all boats, our models remain disenchanted with European equities; we prefer to target other regions. Our outlook for Europe has continued to deteriorate, as still-poor intermediate-term price momentum and negative sales revisions have weighed on our forecast. The region should benefit from vaccine rollouts, and valuations have been attractive, but stricter mitigation measures have compressed economic activity and muted the short-term view.

Our US forecast continues to benefit from positive earnings and sales revisions, strong price momentum, and constructive macro scores. The addition to US small caps allows us to express our preference for the US while diversifying our position, given our sizable overweight to US large caps.

In emerging markets, improved risk appetite and still improving manufacturing activity (a leading indicator for emerging market activity) bode well for the asset class. In addition, further fiscal stimulus in the US could potentially benefit emerging markets in two ways: by working to improve demand; and by creating further downward pressure on the US dollar.

The slow but gradual improvements in both services and manufacturing in Japan have permeated into our models through improved sentiment scores for Pacific equities. While valuations have become less supportive, positive quality indicators help buoy the outlook.

Within fixed income, we continue to favor credit bonds and initiated an overweight to high yield by slightly reducing our targeted intermediate investment-grade bond allocation and further extending our underweight to aggregate bonds. Our forecast for aggregate bonds has weakened, with our models now anticipating slightly higher rates and modest yield curve steepening. Level momentum, a sharp pickup in manufacturing activity, and relatively low inflation all suggest higher interest rates.

Our forecasts for intermediate credit remain positive and still support our meaningful overweight. However, with spreads having tightened significantly, more so with investment grade, we believe there is greater upside with high yield, while the rotation also allows us to pick up a higher coupon all else equal. Forecasts for a steeper yield curve suggest positive economic conditions and tighter spreads, while lower equity volatility also supports further spread compression.

From a sector perspective, we continue to hold four sectors, but we are replacing communications with technology. Technology was propelled by an improvement in sentiment with strong upward revisions in earnings expectations coupled with more modest improvements in momentum and valuation. Communications lost ground mainly due to waning price momentum, but small declines in sentiment and quality also weighed on the sector. Consumer staples has moved back into the top spot with strong sentiment both in earnings and sales expectations, along with reasonable valuations. Consumer discretionary continues to experience positive earnings and sales revisions and strong momentum, offsetting some valuation headwinds. Finally, we retain our holding in materials as it scores reasonably well across all metrics.

To see sample Tactical Asset Allocations and learn more about how TAA is used in portfolio construction, please contact your State Street relationship manager.