Moving Toward Market Re-normalization in 2021

ISG “Alpha Meeting” Notes for December 8, 2020

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. Below are some of the highlights from the ISG team’s most recent “Alpha Meeting”

Asset Class Views Summary

Overall, we hold a sizeable overweight to equities and a preference for credit bonds. We continue to overweight gold as a tactical hedge.

Macro Backdrop

Despite soaring COVID cases globally, markets appear to be looking through near-term headwinds from increasing mobility restrictions and toward a re-normalization in 2021. Waning volatility, improved risk appetite, and positive expectations on risk assets led the team to increase active risk in the portfolio.

Rising COVID cases may weigh on fourth-quarter economic growth, and vaccine execution risks add some uncertainty into markets; however, prospects for stronger growth in 2021 continue to manifest. The prospects for additional fiscal stimulus in the US appear to have improved, which in combination with historically low rates, should provide a bridge until vaccines allow for the release of pent up demand. Improving economic conditions are reflected in manufacturing PMIs, where the breadth continues to grow. The NFIB small business optimism index, which stands at a historically high reading, has continued to rebound since bottoming in April and, despite some uncertainty, suggests an improving outlook. Further, the Conference Board’s Leading Economic Index (LEI) continues its ascent higher, and analysts’ forward earnings expectations have become more constructive (the next-twelve-month EPS estimate for the S&P 500 has recovered over 17.5% since bottoming in May).

Overall, we maintain a preference for global equities while also favoring credit and gold. We have become more sanguine on broad commodities, while REITs and core bonds look less attractive.

Directional Trades and Risk Positioning

Positive vaccine news and improved fiscal stimulus optimism has fueled an easing of our Market Regime Indicator (MRI), which moved into a Low Risk regime in mid-November. Implied volatility on currencies has become less severe, but remains slightly elevated due to lingering Brexit concerns that have weighed on the GBP/USD currency pair. Risky debt spreads and implied volatility on equities have eased meaningfully from recent highs, both finishing in a Low Risk regime and signaling improved risk appetite.

Directionally, we maintained our sizable overweight to equities, but did trim our position to fund broad commodities, which we are now overweight. Persistent strength in copper has lifted industrial metals, while momentum in agriculture has shown further improvement. Energy supply and demand dynamics are becoming more favorable, while a less negative futures curve has aided the improvement in our commodities forecast. In addition, the overweight to commodities helps diversify our growth exposure. Additionally, we extended our underweight to US aggregate bonds, with proceeds deployed to high yield bonds.

The prospect for global equities has improved as our forecast was driven higher by improving macroeconomic scores. While valuations remain extended, still supportive price momentum and constructive earnings and sales sentiment bolster the outlook.

Our view on high yield has become more optimistic as we anticipate further spread tightening for credit bonds. Recent strength in equity momentum, coupled with declining volatility, support our view that investors are willing to take on more risk in their portfolios, which should benefit high yield investors.

Gold remains attractive across all technical factors and most fundamental factors in our model. Real rates continue to grind lower while inflation expectations continue to firm. With the Fed expected to hold rates low for the foreseeable future, real rates should remain suppressed while weakening the US dollar, and therefore be supportive of the precious metal. Gold continues to provide a defense hedge against the risk-oriented positions in our portfolio.

Our forecast for core bonds marginally improved, with models now looking for slightly lower rates and a modestly steeper yield curve. Strong manufacturing PMIs and a softening in headline CPI signal higher rates, but were offset by level momentum and a slightly weaker nominal GDP print relative to last year, which predicts lower rates. Improving, but still depressed, LEI indicators coupled with slope momentum suggest a steeper curve.

Relative Value Trades and Positioning

Our outlook for equities remains positive, but there is greater dispersion among the regional forecasts. While we expect broad participation, US equities continue to exhibit strength and are preferred in our models. Against this backdrop, we have reduced our exposure to European equities and slightly trimmed our US large cap overweight. Proceeds were used to fund US small cap and US REITs

Our forecast for US equities has meaningfully improved and remains our highest-conviction position. Renewed optimism helped enhance macroeconomic factors that, combined with still supportive price momentum and sentiment indicators, have buoyed our forecast. The small cap purchase adds to a segment that could benefit from a vaccine-driven economic resurgence while also allowing us to diversify our US exposure.

Stricter mitigation measures in Europe have permeated our models via weakening price momentum and softer earnings and sales expectations, which have degraded the forecast. The potential for improved US-Euro area trade along with favorable vaccine news provides some optimism and supports our small overweight.

We remain underweight REITs, but decided to reduce the size of our long-held position. Mobility restrictions have weighed on the sector as evidenced by negative price momentum and sluggish earnings and sales expectations, and we expect this to continue. However, the potential re-normalization should boost demand and help support the sector. Moreover, valuation metrics such as price to funds from operations (P/FFO) and dividend yields suggest REITs are attractive, at least relative to equity valuations and bond yields.

Within fixed income, we increased our underweight exposure to non-US government bonds while extending our position in long-term corporate bonds. Our forecast for credit bonds significantly improved, with our model predicting further spread tightening. Forecasts for a steeper yield curve suggest positive future economic conditions and tighter spreads. Additionally, a more benign VIX reading suggests that spreads will tighten. Lastly, the rotation from non-US government bonds allows us to pick up additional yield in an environment that is typically conducive for riskier assets.

Finally, from a sector perspective, we are cutting technology in favor of allocations to both communications and materials. Technology continues to score reasonably well within our model but has experienced deterioration in both valuation and short-term price momentum factors. Conversely, valuations are supportive for both communications and materials, while broad macroeconomic factors are now providing more of a tailwind for both sectors. Notwithstanding the macro factors, a falling sentiment factor for two consecutive months renders the communications sector equal in ranking to the materials sector. As such, a split allocation between the two sectors is implemented in this round of rebalance. Consumer discretionary is now our top-rated sector, with robust scores on both earnings and sales revisions and strong momentum. Consumer staples falls to the second spot, as momentum has turned negative but retains strong support from sentiment, quality, and valuation measures.

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