Diversifying Non-US Equity Exposure: Tactical Trading Decisions for February 2022

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.

Macro Backdrop

While 2021 witnessed a higher ascent, 2022 will be characterized as a descent from the peak to an environment of lower but above-trend growth with persisting inflation pressure. Fading impact of Omicron, robust household saving, strong job market and solid corporate financials should underpin economic growth.

Corporate profits rose at a torrid pace in 2021, up approximately 48%. While margins will moderate, profits should still be favorable and can potentially help offset the negative impact from higher rates. Corporate guidance has been subpar, but that appears to be COVID-19 related with a focus on inflation and supply/labor shortage, which could improve going forward.

Omicron continued to drift farther back in the rear-view mirror, particularly in the United States (US), where the number of states with COVID-19 emergency orders is dropping quickly. This should help re-normalize consumption at a time when fiscal policy is becoming less favorable and numerous uncertainties could alleviate some inflation pressures.

Elevated inflation and tightening labor markets have pushed central banks globally to a more hawkish stance than originally anticipated. However, the policy is set to remain accommodative and it is unlikely that rates will hit the terminal rate in 2022. January's payroll report was robust, which further stoked fears of rising inflation. However, taking a glass half full approach, the participation rate was up, which could limit wage growth and ease pressure on the Fed.

While monetary policy is shifting from being extremely accommodative to something resembling a neutral stance, the policy path is still unknown and the US Fed has suggested as much. Inflation is at the forefront, but the Fed will continue to balance multiple objectives. We favor a more measured tightening path that will include a mix of rate hikes and balance sheet reductions.

Overall, the macroeconomic environment is becoming more challenged, but it should remain supportive of growth assets.

Figure 1: Asset Class Views Summary

Products weighted chart

Source: State Street Global Advisors, as at 10 February 2022.

Directional Positioning

Risk aversion remained inflated with our Market Regime Indicator (MRI) being in high-risk territory. Risk debt spreads remained wide and the reading sat in crisis territory along with implied volatility on equities, which recently spiked into crisis regime. Currency volatility experienced a similar rise, but it was not as severe and now resides on the cusp of high risk. The hawkish pivot from the Fed and the subsequent rise in bond yields weighed on markets, particularly the high P/E growth stocks that dominate US large-cap equities. All the three factors in our MRI had been grinding higher beginning January when a series of worrying data prints followed by the Fed meeting drove volatility higher.

December's headline CPI topped 7%, the highest since 1982, followed by oil hitting a seven-year high as demand remained strong and political disruptions dented supply. Geopolitical disputes including the escalation in Russia-Ukraine tension are adding to the uncertainty. Fed's meeting did nothing to assuage markets with a neutral to a more hawkish assessment of the path for policy moves.

With our MRI signaling fragile risk appetite, we continue to tilt the portfolio defensively by moderating our exposure to growth-oriented assets while including an allocation to tail-risk assets such as long-term government bonds, cash and gold. While our MRI suggests a more restrained risk-asset position, our asset-class models continue to prefer equities and commodities while expectations for fixed income, particularly high yield, have weakened.

With the juxtaposition of our sentiment gauge suggesting risk-off and favorable equity forecasts, we reduced exposure to high-yield bonds with proceeds split between global equities and more defensive assets, such as long-term government bonds and cash, implemented through our relative value trading.

Deterioration of our high-yield outlook stems from poor equity performance in January and heightened volatility, which implies wider spreads. While seasonality remains conducive to positive performance, the spike in treasury yields creates a higher capital cost and is suggestive of widening spread.

The buy in equities still leaves us underweight but to a lesser magnitude and reflects the constructive outlook from our model. Recent equity weakness weighs on momentum, which has shifted lower and is now neutral. The flip side is valuations, which still a drag, have improved due to healthy corporate balance sheets. Elsewhere, strong earnings and sales sentiment offset poor macroeconomic factors.

Relative Value Positioning

Within equities, we reduced our US equity underweight and diversified our non-US equity exposure. During the last rebalance, we sold Europe and Pacific equities but remained overweight to those regions. Offsetting purchases were made to US large caps and emerging market equities, which moved to overweight. The rotation was driven by improvements in our US and emerging market forecasts.

Our more sanguine US forecast is driven by improvements across the macro factors in our models, mainly the macro-economic cycle and risk premiums. While valuations remain stretched, price momentum and positive sentiment buttress the improved forecast.

Emerging market equities exhibit respectable quality and sentiment characteristics, boosting our outlook. Strong economic growth, consistent with advancing global trade and improving manufacturing — a leading indicator for emerging market activity – bodes well for the asset class.

We remain overweight in both Europe and Pacific equities. Price momentum remains weak, but attractive valuations, advantageous sentiment and positive macro factors support Pacific equities. Our forecast for Europe has been steady with good earnings and sales estimates conjoined with enticing valuations.

Within fixed income, we reduced our aggregate bond holding, offsetting the purchase from our directional trade, with additions to cash and long-term government bonds. Our model is forecasting only a small rise in the level of interest rates with strong upward rate momentum and robust economic growth measured by GDP, which exceeds the nominal yield for long-term bonds. Similar to last month, our model expects the yield curve to flatten, which supports long-term government bonds. Our proprietary leading economic indicators are elevated and COVID-19 related disruptions have pressured consumer expectations for higher inflation, both of which are suggestive of tighter monetary policy and a flatter curve.

From a sector perspective, technology remains our top-ranked sector with full allocation. Valuations are unappealing, but stellar sales and earnings sentiment combined with substantial price momentum and healthy balance sheets buoy the sector.

Materials remain near the top of our rankings and was upgraded to full allocation. Strong commodity demand and solid manufacturing PMIs have bolstered the sector that benefits from auspicious short and intermediate-term price momentum. Desirable valuations and complementary macro scores help underpin our positive outlook.

Financials slipped down in our rankings and was reduced to a split allocation with energy, which replaced industrials. Short-term price momentum has weighed on Financials, but longer-term measures are still supportive. Additionally, attractive valuations, firm earnings and sales estimates helped anchor the sector.

Industrials benefited from solid balance sheets, but our measures for quality have continued to deteriorate. Poor sentiment and momentum indicators pushed the sector down in our rankings. Meaningful upgrades to both price momentum and sentiment indicators have produced a much-improved forecast for energy.

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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