Economic Growth Supportive of Growth Assets: Tactical Trading Decisions for November 2021

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

Inflation and supply chain constraints have weighed on global economic growth as evidenced by softer Q3 GDP prints in both China and the United States (US). While these issues are likely to continue well into 2022, the recent jobs report indicates that pressures may abate soon. October’s nonfarm jobs report exceeded estimates while estimates for the previous two months were revised higher. Improvement in labor market was crucial given labor shortages have contributed to supply chain difficulties. Elsewhere, there are still many factors suggesting that economic growth will continue to move higher at a solid pace.

A lot of focus has been on whether corporations could sustain strong profit margins with rising input costs, but Q3 earnings have been stellar. With roughly 90% of companies having reported, FactSet notes that the blended earnings growth rate for the S&P 500 of 39.1% is on track to mark the third-highest (year-over-year) rate since 2010. Margins have remained robust signaling that companies enjoy strong pricing power which bodes well for future earnings. The ability to pass on costs is aided by sturdy demand and healthy consumer balance sheets with households having built up savings in excess of US$2 trillion.

We have discussed the expectations for services to continue driving growth and the sector is receiving a boost through relaxed travel restrictions. As COVID-19 trends, at least in the US, continue to improve, the country is poised to lift a pandemic travel ban on international visitors from more than 30 countries, which could accelerate the reopening momentum and further buoy the service sector. When a still highly accommodative monetary policy and additional fiscal stimulus are factored in, the fundamental backdrop appears stout. While some near-term risks remain and caution is justified, our sanguine outlook for economic growth is supportive for growth assets (Figure 1).

Figure 1
Asset Class Views Summary

Source: State Street Global Advisors, as at 8 November 2021.

Directional Positioning

Persistent inflation pressures and concerns about a policy mistake leading up to the US Fed’s November meeting drove volatility higher toward the end of October. However, risk appetite remains supportive for risk assets with our Market Regime Indicator (MRI) remaining unchanged in October, residing in a normal regime. Spreads on risky debt rose swiftly to begin the month before leveling off in a high risk regime. Implied volatility on currencies rose modestly while implied volatility on equities precipitously fell throughout the month, moving from high risk to low risk. Improving COVID-19 trends and renewed reopening momentum helped fuel the easing of equity volatility as investors weighed a solid fundamental backdrop with implications from elevated inflation. Overall, the MRI resides in a regime that can still benefit growth assets, but justifies some caution.

Equities have experienced beneficial price action recently, which is reflected in the healthy momentum scores in our models. Valuations are stretched, but earnings and sales estimates are robust and our outlook for equities remains constrictive. However, a vigorous improvement in our high yield forecast has led us to reduce our equity overweight in favor of high yield bonds.

A host of factors helped improve our high yield forecast. Strong S&P 500 performance in October, up 7%, implies tighter future spreads while a meaningful drop in equity volatility suggests spreads will tighten. Additionally, seasonality is auspicious and high yield bonds should benefit from the favorable risk sentiment.

Relative Value Positioning

Within equities, we continue to build a position in Europe, which reflects the improving strength of our forecast. At our most recent rebalance, we extended our overweight by reducing our US small cap overweight and selling emerging market equities.

Europe tops our regional rankings, scoring well across most factors we monitor. Valuations remain enticing while longer-term price momentum and quality factors are advantageous. The biggest driver of our enhanced forecast is excellent sales and earnings estimates, which have been significantly upgraded.

US equities look reasonable within our quantitative framework as buoyant macro factors offset negative valuations. Price momentum, particularly longer-term measures, aide the outlook, but sentiment has moderated and is now neutral. Within US equities, we hold a preference for small caps, which demonstrate more attractive valuations and stronger sentiment then their large cap counterparts. US large caps still look attractive and stronger price momentum and better quality scores relative to small caps justify overweighting both sectors.

Prospects for emerging markets have deteriorated in our view. Growth has decelerated in China and we are skeptical policymakers will rush to alleviate weakening growth through policy support, which combined with restrictions, could produce further weaking. While our expectations for the US dollar are bearish longer term, there are near-term drivers for further appreciation, which is negative for emerging markets. Lastly, negative sentiment scores for cyclical sectors in our model weighs on the outlook for emerging markets.

Within fixed income, we have deployed the last of our cash while also extending our aggregate bond underweight. Proceeds were allocated to high yield bonds, which brings our exposure to neutral at the total portfolio level. As mentioned above, the forecast for high yield bonds has greatly improved and the re-allocation allows us to improve our expected return while picking up additional yield. Our models are looking for no change to the level of rates as short-term interest rate momentum has become neutral while softer (but still above average) economic growth implies less upward pressure on rates.

From a sector perspective, we have maintained our allocations to technology and financials (full allocation) and our split allocation to energy. We rotated out of consumer staples while initiating a split allocation in materials. Impressive sentiment and solid price momentum anchor our optimistic forecast on technology, and the sector ranks well across all factors. The energy sector has benefited from surging demand and a supply crunch, which has pushed prices to multi-year highs. In addition to forceful price momentum and firm sentiment, relatively inexpensive valuations promote an ebullient forecast. The backup in yields since August has ameliorated financials while the broad economic re-opening momentum bolsters the outlook. Fruitful sentiment and good price momentum lift the sector higher in our quantitative models.

The recent infrastructure package in the US provides long-term structural demand for materials while shortages, logistical bottlenecks and lofty inflation readings have pushed materials up our rankings. Price momentum is feeble, but attractive valuations and positive sales estimates support the sector. Our forecast for consumer staples has deteriorated as elevated input costs have put downward pressure on companies’ margins. Price momentum remains weak, but the biggest driver of our deteriorating outlook was a steep drop in earnings estimates, which is deeply negative in our models.

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