Macro Backdrop Still Favors Risk Assets: Tactical Trading Decisions for September 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

On the surface, disappointing data prints have further stoked fears of peak growth and have at points introduced anxiety into markets. However, much of the softening can be attributed to ongoing logistical bottlenecks and resurgent COVID-19 fears, which should prove to be transitory. Some moderation in economic growth ought to be expected as it is difficult to maintain the torrid pace that we have witnessed so far. The pace of corporate earnings improvements will slow but should remain healthy. Similarly, monetary and fiscal policy will become marginally less favorable, but households should be able to draw on accumulated savings.

Despite these near-term headwinds, the underlying fundamentals remain firm and we continue to expect positive economic growth. Service sector activity continues to exhibit strength, and even though the recent purchasing managers' index numbers have slipped, they remain above the expansionary 60 level for a record sixth consecutive month. Bank of America noted that the earnings story remains robust with consecutive blockbuster seasons. It was also noted that 87% of US companies delivered positive earnings surprises, the highest since 2000, while 62% of European companies exceeded expectations, the third best season on record.

Improving leading economic indicators (LEI) give reason to believe earnings will remain strong. The Conference Board’s LEI index improved again in July and remains in an uptrend, indicative of strong economic growth in the second half of the year. Central banks have begun to discuss tapering, but monetary policy will remain accommodative with rate hikes and balance sheet reductions likely to remain on hold for now. Employment figures in August were a disappointment relative to consensus estimates, but there was a large upward revision to numbers of the prior two months. It is possible that the August data will also be revised higher at some point. The unemployment rate continued to tick down, which bodes well for future economic activity. Lastly, wages have moved higher and there are indications that this trend may persist, providing a further boost to consumers.

Overall, the still favorable macroeconomic outlook and favorable quantitative forecasts reinforce our preference for risk assets (Figure 1).

Figure 1: Asset Class Views Summary

Source: State Street Global Advisors, as at 10 September 2021.

Directional Trades and Risk Positioning

Risk appetite is still supportive of growth assets as evidenced by our Market Regime Indicator (MRI), which finished August in a low risk regime. Despite concerns about moderating economic growth and the potential for the US Fed to initiate tapering, investor sentiment remained positive. Risky debt spreads narrowed during the month, while implied volatility on equities declined, moving further into low-risk territory. Implied volatility on currencies increased during the latter part of August but still reflected a sanguine risk environment.

Equities and commodities remain favored by our quantitative framework and we have preserved our sizable overweight to both. Strong sentiment and price momentum underpin our constructive equity forecast, while commodities remain supported by an advantageous curve structure. Our expectations for core bonds continue to weaken with our models now forecasting a small rise in interest rates, which reinforces our current underweight.

Relative Value Trades and Positioning

Within equities, we held our regional exposures constant, maintaining a preference for US and European equities. Strong earnings and sales sentiment combined with positive price momentum and macro scores continue to buoy US equities. Improvements in price momentum support European equities, which also benefit from strong sentiment and macro forecasts.

Within fixed income, our model forecasts a flattening of the Treasury curve, which buttress the optimistic outlook for long government bonds. Surging realized inflation has produced a recovery in market-based inflation expectations, which remain elevated and imply the curve should flatten. Further, our proprietary leading economic indicators are stronger relative to the one-year lookback, suggesting additional curve flattening. Solid equity returns have produced firm price momentum, which implies spread tightening for high yield bonds. However, given the limited room for further spread compression and a still superior long government bond forecast, we decided to further underweight high yield bonds in favor of long government bonds.

From a sector perspective, we maintain our targeted allocations to technology and communication services but split out our current consumer staples position with materials. Technology remains a preferred sector, scoring well across all factors except price momentum. Robust earnings and stellar balance sheets helped propel technology to the top of our rankings. Improving price momentum and earnings and sales expectations combined with strong macro scores served as the foundation for our beneficial communication services forecast. The outlook for consumer staples remain constructive, supported by strong revenue and positive valuations. However, price momentum has deteriorated and the sector now ranks similar to materials. Accelerating sales expectations combined with encouraging price momentum and helpful valuations moved materials up our rankings.

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