Moderate Near-Term Caution Warranted: Tactical Trading Decisions for October 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 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

Markets have started to encounter some more serious, though not debilitating, disturbances. Supply chain troubles, labor shortages and soaring energy prices have underpinned stagflation fears, driving inflation higher and stunting economic growth. Logistical bottlenecks are likely to continue into 2022, and these, along with ongoing COVID-19 related restrictions, remain the biggest threat to global growth.

However, the backdrop is not all bad as the pandemic situation is improving, appearing to have peaked in mid-September, and the percentage vaccinated or with natural immunity continues to climb. Further, the global economy has exhibited resiliency and there is no reason to believe this would not be the case moving forward. Overall, we still believe the recovery will continue, albeit at a more moderate pace.

Internally, State Street Global Advisors’ expectation of global growth exceeds 4% in 2022 and the level of nominal sales swirling about the economy should be enough to sustain strong corporate profits. One of the foundations of the current recovery, easy monetary policy, is poised to remain accommodative. While the disappointing September jobs report is unlikely to delay the US Fed’s tapering plans, taper does not equal tightening and policy is set to remain supportive into 2022. According to the Bank of America, the contraction of aggregate balance sheets of the G-4 central banks is a bigger concern for markets and is not expected to happen until 2022 with balance sheets expanding further in 2021.

We continue to expect the service sector to help sustain the positive economic growth with non-manufacturing purchasing managers' indices (PMI) remaining firm and improving in the US, China and Japan. After providing the initial engine for growth during the onset of the recovery, manufacturing has slumped, but a recent uptick in the J.P.Morgan Global Manufacturing Output PMI, while small, gives hope that activity is stabilizing. Lastly, economic surprises in the US have become less negative as evidenced by the Citi US Economic Surprise Index, which has trended higher since rolling over in mid-September.

While some near-term caution is warranted, our constructive view on the global economy points to support for corporate profits and risk assets.

Figure 1: Asset Class Views Summary

Source: State Street Global Advisors, as at 11 October 2021.

Directional Trades and Risk Positioning

Risk appetite, while having lessened recently, remains contributory for risk assets when evaluated through the lens of our Market Regime Indicator (MRI), which finished September in a normal risk regime. The shift from low risk to normal regime is owing to a spike in risky debt spreads and implied volatility on equities, both jumping into high risk. Additionally, implied volatility on currencies increased modestly. A confluence of events has weighed on investor risk appetite and pushed volatility higher. Slower, and at times disappointing, economic data dampened the near-term corporate earnings outlook. Ambiguity around the pace and timing of monetary tightening combined with uncertain fiscal plans, the debt ceiling and stimulus, introduced anxiety into markets. Lastly, fears of contagion from China’s broadening regulatory crackdown and debt-laden property sector along with rising energy prices soured investor sentiment. All else being equal, the current reading warrants some caution and reinforces our modest overweight in risk assets.

Our forecast for equities has moderated due to a weakening of the macro factor but still positive momentum and sentiment buoy the asset class. We have maintained our overweight in both equities and commodities.

During our latest rebalance, we deployed some of our cash raised in mid-September by rotating into US aggregate bonds, which allows us to pick up a more attractive yield with a better expected return. Price pressures have persisted longer than anticipated with realized inflation readings remaining elevated, which indicates rates should fall. However, strong economic growth over the past few quarters implies upward pressure on rates. Overall, our forecast for aggregate bonds remains positive with expectations for only a small rise in the level of rates.

Relative Value Trades and Positioning

We have reduced our exposure to US large caps but remain overweight. Sentiment and momentum remain positive but have softened recently and combined with poor valuations, justify our modest reduction. We extended our overweight in European equities, which continue to score well in our quantitative framework. Macro-oriented forecasts are favorable, while sentiment remains strong, and valuations are supportive.

Within fixed income, we increased exposure to US aggregate bonds at the expense of high-yield debt. As mentioned above, our outlook for aggregate bonds remains constructive while our models remain unenthusiastic about high yield. The recent decline in yields is favorable, but heightened equity volatility, poor seasonality and the recent subpar performance in equity markets all point to wider spreads.

From a sector perspective, we maintain our targeted allocations to technology and consumer staples but rotate out of materials and communication services and split the allocation between energy and financials. Technology remains a favored sector due to excellent earnings and sales sentiment, while price momentum is beneficial and the sector exhibits strong balance sheets in aggregate. Advantageous valuations conjoined with sturdy sentiment and healthy quality scores buoy the consumer staples sector.

Price momentum remains encouraging, but a deterioration in earnings expectations pushed communication services down our rankings. Less ebullient earnings expectations and weak price momentum have weighed on our forecast for materials, which weakened. In addition to stout earnings expectations, inflation fears and the global energy crunch have produced vigorous price momentum, which pushed the energy sector up our rankings. The enhanced outlook for financials is driven by durable price momentum and helpful trends in market structure, including fund flows and greater stock level dispersion.

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