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.
Although some economic data points have started to miss consensus expectations and the spread of the Delta variant raises concern, the overall economic backdrop remains firm in our view and market-based risk metrics continue to point to a favorable environment for risk assets.
The US second quarter GDP of 6.5% fell short of expectations, but this shouldn’t be mistaken for a weak report. Consumer spending exceeded expectations, indicating strong consumer demand (improving consumer confidence reinforces this). Service sector spending improved, particularly in healthcare, transportation, and food services. Employment in the US is rebounding, as evidenced by recent jobs reports. July nonfarm payrolls were strong and exceeded expectations, and both the May and June reports have been revised higher. Also, the US service PMI hit an all-time high in July; its employment component had shifted from contraction to growth in June.
The Eurozone’s second quarter GDP print of 8.3% moves the region out of recession. The Eurozone service sector continues to recover, with the latest PMI reading reflecting the steepest pace of expansion since 2006; job creation is close to a three-year high.
COVID remains a large threat to our positive global view, as the Delta variant spreads and the potential need for booster shots is discussed. However, to the extent that draconian lockdowns are avoided, global growth should continue to accelerate in 2021. Continued advancement in the service sector should help offset some headwinds, while an easing of logistical nightmares within the supply chain should also prove beneficial.
Overall, our optimistic macroeconomic outlook complements the auspicious quantitative forecasts underpinning our preference for risk assets (for which we maintain a sizeable overweight in both equities and commodities) as well as our preference for long bonds. See Figure 1.
Figure 1 : Asset Class Views Summary
Source: State Street Advisors, as of August 10, 2021.
Our Market Regime Indicator™ (MRI) finished July in a Low Risk Aversion regime, as all factors moved off their prior Euphoria readings. As we moved through July, concerns about peaking economic growth and rising Delta variant cases globally, as well as the covering of US Treasury short positions, combined to help fuel a rally in bond yields. This influenced our MRI via widening risky debt spreads and rising implied volatility on both equities and currencies. However, markets remained resilient, with implied volatility easing toward month-end for both equities and currencies, with each factor remaining in Low Risk Aversion. Our risky debt spreads factor remains elevated; however, the factor still appears favorable when putting the events of the past 18 months in perspective. Overall, our MRI still points to a favorable environment for equities.
Our quantitative models continue to advocate for equities and commodities, and we maintain sizable overweights to both. Strong earnings and sales sentiment, along with positive price momentum, buttress our positive expectations for equities. Commodities remain supported by beneficial curve structure along with positive reopening momentum. The forecast for core bonds has softened, with our models now forecasting no change to rates, which supports our current underweight.
Relative Value Positioning
We have maintained our pro-growth positioning but have shifted some international equity exposure into domestic markets. We reduced an overweight allocation to European equities and we moved neutral on emerging markets (from a small overweight). Proceeds were redirected to US equities, both large cap and US small cap, along with REITs.
REITs benefit from improvements in both short- and long-term price momentum, while earnings and sales expectations have moved off the poor readings experienced over the past year. REITs may also benefit from lingering effects of outsized fiscal stimulus and the continuing resumption of economic activity.
European markets have been bolstered by improving price momentum and sentiment indicators, which warrant an overweight. However, a slowing in PMI data does weigh on the cyclical market from a macro perspective and argues for less exposure.
Our outlook for emerging markets (EM) continues to weaken. Risk-on sentiment remains supportive, but EM has been tripped up by regulatory interventions in China, which may continue to cast a cloud over EM more broadly. Weakening earnings sentiment across cyclical sectors also suggests moving to a neutral allocation.
US equities are supported by most factors in our quantitative framework, and domestic markets have often been able to generate strong relative returns following periods where economic growth has reached near-term peaks. US equities boast strong macro scores, and exceptional Q2 earnings helped improve earnings sentiment. Both long- and short-term price momentum buoy the region.
From a sector perspective, we maintain our preference for technology. Prior preferences for the energy and industrial sectors have been replaced by preferences for communication services and consumer staples. The deterioration in our outlook for energy shares was driven mainly by shorter-term momentum factors and a drop-off in earnings and sales expectations. Industrials sank on weaker sales expectations amid a likely topping in PMIs. By contrast, earnings and sales expectations for communication services rebounded strongly, and consumer staples have been propped up by improving sentiment and favorable company data from credit markets. Technology scores well across all factors except momentum, which is neutral.
To see sample Tactical Asset Allocations and learn more about how TAA is used in portfolio construction, please contact your State Street relationship manager.
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Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
Investing in REITs involves certain distinct risks in addition to those risks associated with investing in the real estate industry in general. Equity REITs may be affected by changes in the value of the underlying property owned by the REITs, while mortgage REITs may be affected by the quality of credit extended. REITs are subject to heavy cash flow dependency, default by borrowers and self-liquidation. REITs, especially mortgage REITs, are also subject to interest rate risk (i.e., as interest rates rise, the value of the REIT may decline).
There are risks associated with investing in Real Assets and the Real Assets sector, including real estate, precious metals and natural resources. Investments can be significantly affected by events relating to these industries.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in commodities entail significant risk and is not appropriate for all investors. Commodities investing entail significant risk as commodity prices can be extremely volatile due to wide range of factors. A few such factors include overall market movements, real or perceived inflationary trends, commodity index volatility, international, economic and political changes, change in interest and currency exchange rates.
Illiquid risk/Asset investments may have difficulty in liquidating an investment position without taking a significant discount from current market value, which can be a significant problem with certain lightly traded securities.
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