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.
Recent economic data points to a broadening of, and acceleration of, global growth led by developed markets. The biggest threat to strong near-term growth is likely on the supply side, where bottlenecks and labor shortages have kept inventories slim. But this is merely a delay, not a chink in the amor of an improving global economy. Overall, we continue to expect the macroeconomic backdrop to remain supportive.
US retail sales were disappointing, but that needs to be put in perspective. Goods spending is already eclipsing pre-COVID levels and is reflected in extremely strong global manufacturing PMIs. Spending in the more important service sector, which accounts for roughly two-thirds of GDP, is accelerating – as evidenced by the recent surge in service PMIs. The latest jobs reports, while below consensus, were still solid and point to the strengthening of consumer purchasing power. Further, progress on vaccine rollouts has allowed additional easing of lockdowns, with Europe and the US working toward a full reopening.
Elevated savings rates and rising consumer spending trends across all income groups are set to unleash pent-up demand, bolstering the service sector. The OECD recently upgraded its growth forecast which, though it can be backward-looking and reflect improvements in data, signals strength nonetheless. The Atlanta Fed’s estimate for Q2 US real GDP is 10.3% q/q annualized – despite labor struggles, waning vaccine rollouts in the US, and product shortages. Lastly, corporate earnings have continued to recover after posting a stellar Q1. Estimates for Q2 have increased by 5.8% over the first two months of the quarter per FactSet. Rising input prices are a concern, but companies have indicated that pricing power and productivity enhancements will help maintain profit margins.
We maintain a sizeable overweight to risk assets, both equities and commodities, which is reinforced by a sanguine macroeconomic outlook and still favorable quantitative forecasts. See Figure 1.
Figure 1. Asset Class Views Summary
Source: State Street Advisors, as of June 9, 2021.
Risk appetite remains strong and is undeterred by rising inflation and prospects for increased corporate taxes. Our Market Regime Indicator (MRI) entered the month in the “euphoria” regime, but precipitously jumped into a “low risk aversion” regime as a confluence of factors (ranging from erratic economic data to cryptocurrency crashes) fueled volatility in equity markets. Trepidation soon turned to tranquility as implied volatility on equities eased, settling back into the euphoria regime. Risky debt spreads are tight, and while implied volatility on currencies spiked in May, it has since eased. The ongoing vaccine rollout and loosening of mobility restrictions have reinforced a more confident outlook for investors, who remain complacent. Overall, our MRI finished in euphoria; equities can still perform admirably in this regime, but there is a greater risk of a pullback.
Our quantitative models still favor equities; however, against the risk backdrop we felt it was prudent to pare back our overweight to global equities in favor of gold and core bonds. Short-term price momentum for equities has become more neutral, but longer-term trends remain supportive and, combined with strong sales estimates and positive macro scores, buoy our forecast and merit an overweight.
The outlook for core bonds remains positive, with our quantitative framework forecasting a decrease in rates accompanied by a flattening of the curve. Level momentum points to lower rates, while May’s firm inflation print is also suggestive of declining future rates. Further, the manufacturing PMI has stabilized and the spread between the 30-year Treasury and nominal GDP has narrowed (with both signals becoming more neutral). Stronger readings from our proprietary set of leading economic indicators, coupled with stout consumer inflation expectations, suggest a flatter curve. Lastly, given the rise in yields to begin 2021, bonds could be better equipped to offer protection should equities falter.
Price momentum indicators are neutral, but low real rates and a negative short-term view of the US dollar drive the improved forecast for gold. Additionally, the precious metal is a solid diversifier, and mounting inflation pressures could further lift the yellow metal.
The broadening economic growth backdrop, conjoined with improvements across non-US forecasts, has pushed us to a more diversified equity exposure. We maintain an overweight to US large cap equities, but it has been reduced. We have extended our overweight to European equities, which have seen steady improvement in our quantitative framework. We have extended our underweight to Pacific equities.
Within fixed income we rotated out of high yield (becoming underweight) and added to core bonds. As mentioned above, the forecast for core bonds remains positive, driven by beneficial level momentum and stronger realized inflation. High yield has fallen out of favor in our models owing to negative seasonality effects and pass-through effects of higher government interest rates to the cost of capital for corporate borrowers. While a more benign equity volatility reading supports the sector, recent equity performance has become less favorable for high yield. Lastly, tight spreads, which sit below pre-COVID levels, imply limited upside for high yield bonds; with a similar forecast for core bonds, the move to core bonds allows us to improve credit quality without sacrificing much potential return.
From a sector perspective, we maintained our allocation to technology, but rotated out of communication services and financials. We rotated into materials while also implementing a split allocation to energy and industrials. The pro-cyclical rally, the Q1 uptick in yields, and prospects for higher taxes have weighed on price momentum for technology. However, strong sales expectations, favorable balance sheets, and positive macro scores anchor our positive forecast. Furthermore, thematic tailwinds such as work from home and technological innovation should support the sector.
Materials boast substantial price momentum and outstanding sentiment indicators, which have propelled the sector to the top spot. Advantageous valuations offset negative macro scores, and a weaker US dollar and budding inflation pressures could provide further benefits. Energy has prospered from the firming in economic activity, which buoyed price momentum. The sector scores well across all factors except quality, and the improvement in earnings estimates helps energy regain a spot among the top sectors. Industrials exhibit strong longer-term price momentum and healthy sentiment, which offset adverse valuations – infrastructure spending and a weakening US dollar provide long-term tailwinds. Compelling price momentum has aided financials, but a significant degradation in sales estimates weighs on the sector. Short-term momentum is desirable for communication services, but a meaningful weakening of sentiment scores dents the outlook.
To see sample Tactical Asset Allocations and learn more about how TAA is used in portfolio construction, please contact your State Street relationship manager.
The views expressed are of Investment Solutions Group as of June 9, 2021, and are subject to change based on market and other conditions. All information is provided in good faith, and there is no representation nor warranty that such statements are guarantees of any future performance. Actual results or developments may differ materially from the views expressed.
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