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.
The recent backup in yields, which has introduced some volatility into equity markets, signals continued improvement in global growth expectations. We continue to view the macroeconomic backdrop as favorable, supported by numerous tailwinds that point to an acceleration in economic growth.
The rapid rise in US 10-year yields to pre-COVID levels has raised concerns that the Fed may be forced to act to combat inflation. However, the Fed has downplayed the threat of rising inflation and signaled a willingness to let the economy run hot while focusing on the restoration of jobs. Central banks are therefore poised to remain accommodative while governments inject fiscal stimulus into economies. In the US, a $1.9 trillion stimulus package is set to deliver more money to consumers at a time when savings are already high, which should continue to buoy consumer demand.
Despite headwinds to start the year, major manufacturing PMIs continue to improve, residing above 50 and implying solid expansion and growth. While the service sector has been hampered by a collapse in demand, the approval of another vaccine, from Johnson & Johnson, coupled with a sharp drop in COVID cases and continued easing of mobility restrictions, points to better future prospects.
Lastly, improving corporate profits could provide another catalyst for growth – the S&P 500 is expected to post its strongest year-over-year growth rate since 4Q2018, and a majority of companies providing forward guidance have been positive.
The promising macro environment bolsters our positive discretionary view which, combined with a favorable quantitative backdrop, supports our preference for higher beta assets, both equities and broad commodities. Within fixed income, core bonds reman unattractive and we remain tilted toward credit, both investment grade and high yield. See Figure 1.
Source: State Street Advisors, as of March 8, 2021.
A pickup in vaccinations, improving COVID trends, and a positive macro outlook supported risk appetite at the beginning of February, when our Market Regime Indicator (MRI) moved into the euphoria risk regime. As the month progressed, concerns about rising inflation, resulting from the upcoming fiscal stimulus and from less restrictive mobility measures, led to a selloff in US Treasuries. This backup in yields caused consternation for equities as volatility spiked, thrusting the MRI into the low risk regime. Risky debt spreads remain tight and, although implied volatility on currency has increased, the reading remains relatively benign. Overall, the MRI finished in a low risk regime, which is supportive of an overweight to risk assets.We maintain our sanguine outlook on both equities and commodities and continue to dislike core bonds. While the prospects for high yield remain positive, our models suggest a more cautious stance.
Our quantitative models continue to prefer equities as sentiment (earnings and sales expectations), coupled with positive momentum factors, outweighs stretched valuations and softening quality scores.
Expectations for higher rates and a steeper yield curve dim the outlook for core bonds. Level momentum, improvement in manufacturing activity, and relatively low inflation are suggestive of higher interest rates. While leading economic indicators have rebounded, they remain well below levels witnessed a year ago, which implies further improvement ahead accompanied by a steeper yield curve.
The sharp rise in government yields suggests a higher cost of capital and wider spreads for high yield bonds. Additionally, recent equity volatility has weighed on the forecast, but seasonality is advantageous. High yield bonds should benefit from the improving economic outlook and resumption of the reflation trade, and we believe an overweight is still warranted.
With global growth on track to accelerate in 2021 and positive quantitative forecasts, we maintain a diversified equity overweight. We now hold sizeable overweights to US, Pacific, and emerging market equities while staying underweight to European equities and REITs.
The US continues to be our favored region due to strong price momentum, positive macro scores, and robust earnings and sales estimates, which offset unfavorable valuations. Further, the US is likely to continue leading the recovery given faster vaccine distribution, more stimulus, and a stronger economic backdrop pre-COVID.
Our European equity forecast has been steady, but negative, as the region struggles with vaccine rollouts and is behind in the economic recovery due to more stringent lockdowns. Valuations remain attractive, but weak price momentum and poor earnings estimates weigh on the region.
Prosperous earning and sales prospects have produced a more auspicious forecast for Pacific equities. Additionally, improvements in momentum and still supportive valuations buoy the outlook.
From a sector perspective, our targeted allocations include technology, energy, and financials. Technology continues to benefit from strong sales expectations and positive intermediate price momentum while looking attractive across all factors except value. The ongoing reflation thematic and recovery in demand has boosted the outlook for energy, which ranks well due to positive price momentum and strong value and sentiment readings. The backup in longer-dated yields has supported financials as the sector moved up thanks to strong earnings and sales expectations, which continue to improve. In addition, positive short-term momentum and macro scores buoy the sector. Momentum and sentiment remain supportive for consumer discretionary, but stretched valuations, poor quality, and a decline in macro scores dampen the outlook. Our forecast for communications services remains constructive, but the sector has declined in favorability due to a slight deterioration in valuation scores and poor macro factors.
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 March 8, 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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