Non-US Equities Favored: Tactical Trading Decisions for June 2022

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.

Macro Backdrop

Economic growth is decelerating from the exceptional growth fueled by the fiscal and monetary stimulus to a more structurally sustainable level. However, the path still is cloudy with a plethora of headwinds threatening to derail solid underlying fundamentals. While we are not forecasting a recession, it is hard to deny that risks are skewed to the downside. Healthy corporations and consumer sentiments, expansionary purchasing managers’ indices, robust employment figures and demand for labor argue for slower, but positive growth. However, there are three main risks we are monitoring that can materially alter the outcome of this transition – central banks, inflation and the Russia-Ukraine War. These risks are not mutually exclusive.

The US Federal Reserve (Fed) is stuck between the proverbial rock and a hard place. It has to balance between letting inflation run hotter, which could destroy demand and send the economy into a recession, and pushing through rate hikes to tame inflation, which could again send the economy into a recession. The Fed is not alone on this undesirable path though. With inflation at a record high and broadening out, the European Central Bank has also announced its intentions to stop quantitative easing and lift rates in July, which would be its first hike in over a decade.

In London, the Bank of England exercised a fourth consecutive interest rate hike in May and warned that more hikes are in the offing despite forecasting a slowdown in GDP growth. Collectively, global central banks have fallen behind the curve and must now accelerate rate hikes to rein in inflation without arresting growth.

Not too long ago consensus anticipated that inflation would be transitory. Now it is a common belief that inflation will moderate, but remain elevated. We believe that we are entering an environment of prolonged high inflation. Additionally, the risks appear to be skewed to the upside, at least in the near term. There are signs that supply chains are easing, but we are not out of the woods yet with bottlenecks likely to linger through 2022 and ongoing lockdowns in China adding to the strain. The trends have been improving, but the risk of future lockdowns remains high.

Energy and food inflation has spiked and is set to remain high. In an attempt to fight high gas prices, which now average over US$5 per gallon, the White House has ordered more ethanol in the US fuel supply. This will likely increase the cost of fertilizer and agricultural products. OPEC+ agreed to increase its output target by 50%, but there are questions about whether countries can meet this quota. Additionally, the European Union’s decision to ban Russian crude imports adds to the positive supply and demand fundamentals of energy, which should keep prices elevated.

Shelter costs have been rising and these tend to constitute a large portion of the income. There are signs of a slowdown in the housing sector with mortgage rates spiking, which led to mortgage applications hitting a 22-year low. However, the upward pressures remain in line with the current undersupply, which is set to keep prices higher, offsetting the impact from softening demand. Lastly, normalization of consumption patterns should cool goods inflation but push up services prices.

The underperformance of Russian troops in Ukraine points to a war of attrition without any clear endgame. While major offenses seem improbable, the enduring conflict will likely lead to a continued escalation in tensions between Russia and the West. Prolonged warfare also could lead to an escalation in mutual sanctions. Beyond an energy price shock, disruptions in energy supply are bound to happen before the arrival of winter. Further, Russian warships and mines are blocking Ukraine’s ports in the Black Sea, which is restricting grains from being delivered, further exacerbating food prices.

Source: State Street Global Advisors, as at 10 June 2022.

Directional Trades and Risk Positioning

Risk aversion has eased slightly from extreme levels, but remains elevated with our Market Regime Indicator (MRI) consolidating into high risk. Our MRI has now bounced between high risk and crisis for over four months, signaling a deeper uneasiness amongst investors about the current market environment. All three factors began the month in crisis with persistent inflation, hawkish central banks and the lingering war creating a lot of uncertainty. The move into high risk was driven by implied volatility on equity, which retreated toward the low end of high risk where it finished the month of May. Implied volatility on currency and risky debt spreads has been inflated for most of the year, and while both measures declined slightly in May, they remain significantly elevated.

With the MRI in high risk, typically a period of high stress for risk assets, we meaningfully reduced risk in our portfolios. During the latest rebalance, we sold equities and gold with proceeds deployed to aggregate bonds. While our forecast for equities remains positive, poor risk appetite suggests a potential for challenging conditions ahead. Price momentum has weakened, but is offset by supportive value and sentiment scores.

Our outlook for bonds has greatly improved with our models forecasting meaningfully lower rates and a flatter curve. Higher nominal GDP relative to long-term treasury yields points to higher rates, but interest rate momentum, elevated inflation readings and slowing manufacturing PMIs signal lower rates ahead. Strong leading economic indicators and high consumer inflation expectations imply tighter monetary policy and a flatter yield curve.

Gold benefits from a still positive technical trend and an elevated risk aversion, but the prospects of enduring positive real rates and near-term US dollar strength weigh on our outlook.

Relative Value Trades and Positioning

Within equities, our models have become more enthusiastic about non-US equities and we continued to reduce our exposure to US assets while adding to both European and Pacific equities.

In the US, we reduced our overweight to small cap and brought our large cap allocation to underweight. Overall, we are now neutral to US equities. Positive price momentum and strong macro factors outweigh the deterioration in sales and earnings sentiment to support the US. Our model exhibits a preference for small caps due to better sentiment and more favorable valuations relative to large cap.

Our forecast for Europe continues to improve and the buy puts us to overweight in the region. Macroeconomic indicators are unfavorable, but robust earnings and sales sentiment along with appealing valuations underpin our improved outlook. We reduced our underweight to Pacific equities due to improving valuations and encouraging quality factors that offset poor sentiment.

Within fixed income, our model decidedly favors the US relative to international bonds. We sold non-US government bonds, now underweight, and cash in favor of intermediate government bonds and aggregate bonds. As mentioned above, our forecasts improved for aggregate bonds, which increased their attractiveness relative to cash. Outside the US, negative forecast for Australia, Germany and Italy dampens the outlook for non-US bonds.

From a sector perspective, there were no changes to our preferred sectors with targeted allocations to energy, materials and utilities. Energy continues to rank well across most factors with appealing valuations and macroeconomic scores offsetting adverse quality scores. Elsewhere, substantial price momentum, both long and short-term combined with robust sentiment bolsters the outlook. Materials benefitted from price momentum, attractive valuations and healthy sales and earnings expectations. For utilities, ongoing improvements in momentum combined with advantageous earnings and sales expectations outweighed poor quality factors stemming from high debt levels.

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