Risk Assets for Improving Economic Conditions: Tactical Trading Decisions for April 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

Despite the potential for an inflation overshoot, US corporate tax increases, and changes to the Senate filibuster, the macroeconomic backdrop remains favorable. Though this view is not without risks, many signals point to further reopening momentum.

COVID-19 vaccination progress (particularly in the US) and improvement in high-frequency data have lessened concerns about virus mutations. Mobility indicators – airline and hotel spending, restaurant bookings, and credit card payments – all point to improved activity. In addition, service PMIs have improved globally. Manufacturing PMIs continue to reflect an expansionary environment. The US and UK are leading the vaccine rollout, but the pace should accelerate in Europe and Japan, providing further tailwinds for global economic growth.

Fresh off the $1.9 trillion American Rescue Plan, another round of stimulus in the form of an infrastructure package is being discussed, which could exceed $2 trillion. While the timing of passage is unclear and impacts are not likely to be felt quickly, the expectation, combined with still accommodative monetary policy, preserve one of the market’s biggest support systems.

Lastly, first quarter corporate earnings announcements could be the latest macro factor to endorse a sanguine economic outlook. Expectations are high. The estimated growth rate for the S&P 500 is 24.5%, which would be the largest year-over-year move since the third quarter of 2018.1

The macro backdrop and quantitative forecasts support our preference for risk assts that are positively correlated to improving economic conditions. Our current TAA maintains a sizeable overweight to risk assets, both equities and commodities, with a preference for credit bonds. See Figure 1.

Figure 1: Asset Class Views Summary

Source: State Street Advisors, as of April 12, 2021.

Directional Positioning

Elevated levels of risk aversion driven by inflation fears, combined with the backup in yields in February, lingered during the first week of March, keeping our Market Regime Indicator (MRI) on the upper limits of a low risk aversion regime. Fears started to abate and, following the Fed’s re-confirmation of its lower-for-longer outlook, equity volatility fell precipitously, touching the lower bounds of the euphoria regime. Elsewhere, credit spreads remained extremely tight while implied volatility on currency improved. The net result was a shift into the euphoria regime, which typically implies extreme investor optimism.

While a euphoria regime typically indicates investor complacency, when juxtaposed with favorable quantitative signals, the outlook appears more balanced. Against this backdrop, we have decided to slightly reduce risk while maintaining our sizable overweight to both global equities and broad commodities.

Equities remain buoyed by strong price momentum and earnings sentiment; macro factors also remain desirable, reinforcing our sizable overweight.

Higher government yields are suggestive of wider credit spreads, but positive equity momentum, beneficial seasonality, and relatively benign equity volatility support high yield bonds. We maintained our overweight, but decided to slightly reduce our position in favor of core bonds. We have sacrificed some yield, but the lower volatility associated with core bonds allows us to manage risk while preserving our overweight to equities, which are preferred by our quantitative models.

Gold has lost its shine in our quantitative models, as the precious metal has not responded well to the current reflation thematic. While fundamental factors like debt to GDP and real rates remain mildly constructive, most technical indicators we monitor have turned negative and advocate for the liquidation of our position. Further, as rates grind higher, gold becomes more expensive insurance for our exposure to risk assets; the opportunity costs to hold it also increase.

Core bonds have become slightly more attractive given the recent backup in yields. Our model forecasts a small change in both the level and slope as stronger manufacturing activity is offset by the spread between GDP and the yield on long-term nominal bonds, as well as by a weakening level momentum factor, which has become more neutral.

Relative Value Positioning

We continue to hold a diversified equity position and have made a minor adjustment within our relative value equity positions to better capture the re-opening momentum. The US remains our preferred region; we also have a modest overweight to Pacific and emerging market equities.

The US continues to exhibit strong price momentum and robust earnings and sales estimates, which offset poor valuations. Although our forecast for US small cap equity remains positive and still warrants an overweight, it has moderated, so we used this opportunity to reduce our underweight on European equities.

Valuations have remained attractive for European equities, but a recent rebound in earnings sentiment suggests an improving outlook. Further, the region is poised to benefit from re-opening momentum as the pace of vaccine rollouts increases and mobility restrictions are eased.

From a sector perspective, our targeted allocations include technology, energy, and financials. Longer-term price momentum has become less contributory for technology, but solid earnings and sales expectations – combined with positive macro and quality scores – bolster the sector. Valuations for financials are slightly stretched, but the prospect for higher yields has produced a more sanguine outlook for the sector – reflected by steady improvements in both earnings and sales estimates. Additionally, financials benefit from strong price momentum. Substantial short-term price momentum and positive valuations underpin the positive energy forecast. Elsewhere, strong demand and expectations for higher inflation have lifted sentiment scores, further supporting the sector.

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