Caution Given Recent Market Moves and Myriad Risks

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 are underweight risk assets, with a modest allocation to gold; we favour credit within fixed income.

Overview

The positioning in our portfolios remains largely neutral from an equity/bond perspective, with more of the risk budget applied to relative value positions. The global economy continues to work through the impact of shutdowns related to COVID-19. In many countries, initial opening plans appear to be working. The US must manage a recent spike in cases that has scaled back plans in some key states. While a potential negative in the short-term, we continue to see this as transitory with the expectation of improved economic growth in the second half of 2020 and into 2021.

Improving PMI readings and positive employment trends signal a pickup in activity, but the path forward will likely be choppy with lingering uncertainty about a potential second wave and the phased approach limiting capacity for businesses allowed to re-open. Further, the unprecedented amount of stimulus and commitment from central banks, to improve the functioning of markets and support economic growth, provide a tailwind for the recovery. In our view, recent developments are indicative of the early stages in economic recovery. While this suggests a tilt toward growth-oriented assets is warranted, we remain cautious given the recent market moves and myriad risks. We continue to target selective risk assets rather than position the portfolio with a full-on pro-growth stance.

Risk Sentiment

From a risk sentiment perspective, our Market Regime Indicator (MRI) has continued to ease from the extreme levels and has become more neutral on risk sentiment. The move lower was driven by a decline in implied volatility on currencies, which continued to moderate and points to some improvement in risk appetite. However, risky debt spreads and levels of implied volatility on equities, while less averse than last month, continue to signal global equity markets remain vulnerable to shocks.

Key Asset Class Views

From a bottom-up perspective, equities are balancing a good macro environment with waning price momentum, mixed earnings sentiment and stretched valuations. This view is moderated by the significant policy response providing an additional tailwind. As such, we maintained a slight underweight to equities, but there is material dispersion at the regional level. The US is the top-ranked region supported by strong long-term momentum indicators and positive earnings and sales estimates, which offset weak valuations. The potential bottoming of PMIs, better risk appetite and a weakening US dollar bolster emerging markets. The forecast for Pacific equities ranks poorly, driven mainly by negative momentum and sentiment indicators for Japan. REITs rank poorly across all factors in our model. Higher financial leverage, greater volatility and weak long-term price momentum weigh on the outlook.

The negative outlook for government bonds is driven by our models, which continue to forecast an increase in interest rates and a steepening of the yield curve. We don’t anticipate that this move will happen significantly in the near term. There has been some positive near-term data, but the overall depressed level of activity suggests that short-term rates are likely anchored for some time. However, we do see pressure that could arise at the intermediate and longer ends of the curve, driven by a still positive spread between nominal GDP and the yield on 30-year treasuries and the pickup in economic activity evidenced by improving PMI readings. Further, longer-term rates could start to pick up as investors look past the abyss that will be reported for second quarter GDP and start thinking more seriously about inflation Lastly, the potential for yield-curve control and central bank bond buying may limit the extent of the threat posed by higher interest rates, keeping expected returns for government bonds subdued.

Gold continues to look attractive across most technical and fundamental factors we monitor, and we continue to hold an overweight position. Negative real yields, rising debt levels, creeping inflation expectations as well as firm technicals all support an allocation to the precious metal.

Credit valuations remain attractive as our models anticipate meaningful spread tightening for both investment grade and high yield. This is partially driven by a lower cost of capital given historically low interest rates and the prospect for a steepening yield curve as the economic backdrop improves. While momentum for equities weakened slightly, it remains supportive and, combined with relatively lower volatility, suggests a beneficial environment for high yield bonds going forward. Despite the potential for an increase in defaults, the Fed’s commitment to limiting downside risks in credit markets along with the recovery in the energy backdrop, support further spread tightening.

Directional Trades

We maintain our small underweight position to equities while preserving our sizable overweight to credit bonds. We maintain the preference to take risk in the credit space, which appears well supported when compared to concerns about near-term risks for equities. This position allows for taking some risk in the portfolio is a way that provides a better risk-adjusted outcome.

Relative Value Trades

The rotation from REITs into US large cap equities expands on the view that REITs remain challenged, with many sectors still under extreme duress from high unemployment and social distancing guidelines, which have dented demand. This is likely to materially impact cash flows and dividends, disappointing investors. The sector scores below average across all broad factors, whereas US large cap equities are favored by our quantitative model. While uncertainty for the US market hinges around both COVID risks as well as the policy implications of the upcoming presidential election, the market also may have structural advantages in an economy that continues to become increasingly reliant on technology and communication services.

The Tactical Asset Allocation (TAA) Process

The State Street ISG team’s monthly alpha process has both quantitative and fundamental components. The process begins by assessing the market environment, combining a proprietary quantitative-based Market Regime Indicator with a qualitative assessment of the political environment provided by the State Street’s Politics and Policy group. The team then looks to evaluate investment opportunities and construct the portfolios by leveraging our quantitative asset class models with qualitative insights from our experienced investment team.

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