Non-US Equities Less Favored: Tactical Trading Decisions for April 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.
On the surface, the macro-economic outlook appears to be deteriorating with the headline inflation hitting a new 40-year high at 8.5%. According to Bank of America’s April Global Fund Manager Survey, optimism for global growth fell to an all-time low and stagflation fears rose to the highest level since August 2008. The Russia-Ukraine War has added a tail risk with the duration and total impact on global growth still unclear. While the pandemic has transitioned to being an endemic in most regions, China’s zero COVID policy is a material downside risk.
Under the surface, global economic growth appears to be holding up despite these headwinds, at least for now. We see this reflected in the March Purchasing Managers' Index (PMI), which has held up well. Manufacturing PMIs have moderated in the United States (US) and Europe but remain expansionary. The fading impact of Omicron has helped service sector PMIs to improve across developed economies. In the US, strong jobs growth in March reinforced the tight labor market with unemployment falling to 3.6%, a new two-year low. Additionally, wages have moved higher with the Federal Reserve Bank of Atlanta’s wage tracker estimating annual wage growth of 6% in March, the fastest pace since records began in 1997.
JP Morgan noted that employment is expanding globally at a pace nearly three times the average of the last expansion, which is likely to lift wages. A strong labor market and healthy consumer balance sheet should underpin demand, at least for now. Supporting growth is strong capex spending with S&P Global Ratings expecting capital expenditures by big companies worldwide to increase by 6.1% from 2021 levels.
Overall, the macroeconomic environment is less certain than it was entering 2022. The underlying fundamentals, ongoing supply shortages and elevated commodity prices will keep upward pressure on inflation and the longer it persists, the more impactful the hit on demand will be. The risks outlined above point to lower growth, but at present, we are not forecasting a global economic downturn and still expect growth to remain positive.
Figure 1: Asset Class Views Summary
Source: State Street Global Advisors, as at 10 April 2022.
Directional Trades and Risk Positioning
The risk appetite has remained poor as the Russia-Ukraine War drags on. The War exacerbates the already elevated inflation and increases the uncertainties overhanging the markets. Our Market Regime Indicator (MRI) began the month of March in a crisis regime where it remained for the majority of the month. Easing from the extreme risk-off sentiment at the beginning of March, the MRI consolidated lower into high risk where it leveled off at the end of the month. All three factors converged toward peak pessimism in March with implied volatility in currencies remaining there. Both the spreads in risky debt and the implied volatility in equities retreated lower, but still reside at the top end of high risk.
Our forecast for equities remains positive but has moderated in conjunction with a weakened risk environment. This prompted us to de-risk the portfolios by reducing our equity allocation, now underweight, in favor of cash and bonds. Sentiment continues to deteriorate but remains supportive of equities while quality factors also buoy the asset class. Recent performance has turned our momentum signals negative and this combined with negative valuations has weighed on our outlook for equities slightly.
Our forecast is not stellar, but bonds are supported by increased risk aversion as evidenced by our MRI, which resides in a high-risk regime, an environment that has typically been less favorable for equities. Our model is forecasting a modest rise in the level of interest rates with a meaningful flattening of the curve. Slowing PMIs and elevated inflation readings suggest lower rates, but strong GDP prints and interest rate momentum advocate for higher rates moving forward. Strong leading economic indicators and inflation expectations imply tighter monetary policy and a flatter yield curve. Cash could help cushion against elevated volatility and gives us some dry powder should sentiment improve.
Relative Value Trades and Positioning
Within equities, our models strongly favor the US and we continue to rotate out of non-US regions. During our last rebalance, we reduced our overweight in emerging markets to neutral while taking our position in Europe to underweight and extending our Pacific underweight. Proceeds were deployed to US equities, increasing our regional overweight and position in REITs.
Outperformance has left US equities more expensive, but improving quality factors, mainly a better return on assets and lower volatility, help offset rich valuations. Additionally, strong macro scores, positive sentiment and firm price momentum underpin our constructive outlook. Within the US, we have allocated to small-cap equities, which hold an advantage over large cap in our quantitative framework. Sentiments remain positive for both, but small caps hold an advantage and valuations are also more favorable relative to large caps. The addition of REITs helps reduce underweight and our improved outlook is influenced by better sentiment, which has continued to recover after deteriorating greatly during the early onset of COVID-19. Price momentum has remained steady and is slightly positive, which further supports the sector.
Valuations are attractive for Europe and Pacific equities, but feebler price momentum and worse macro factors lessen the attractiveness relative to US equities. Additionally, sentiments have improved across both regions but are less beneficial in the US. Within emerging markets, the biggest driver of our reduced forecast is worsening quality factors, which are materially negative. Valuations are meaningfully better but are offset by poor price momentum and subpar macro factors.
Within fixed income, we rotated out of aggregate bonds and long investment grade (IG) bonds into non-US government bonds and cash. The reduction in aggregate bonds is offset by the addition we made at the directional level and nets to a small buy. The selling of long IG bonds closes our sizable overweight and brings us to neutral. As mentioned earlier, our models are forecasting a modest increase in rates, which has negatively impacted forecasts for long IG bonds. Further, our model forecasts a widening of credit spreads, which dents the outlook. A flatter Treasury curve implies weaker economic activity, which is negative for credit. Additionally, the overall increase in interest rate levels weighs on our forecast and suggests more challenging financial conditions and wider spreads. The buying of non-US bonds is due to the relative attractiveness to their US counterparts. Our forecast is slightly improved, and the rotation allows us to target an asset with a better forecast risk-adjusted return.
From a sector perspective, our forecast for technology weakened with the sector falling in our rankings and is no longer an allocation. Energy, which was previously a split allocation, has been upgraded to a full allocation along with financials and materials. The longer-term price momentum supports technology, but shorter-term measures are weak and the large deterioration in sentiment and unattractive valuations has soured our outlook. The energy sector benefits from robust price momentum as oil prices have benefited from supply and demand fundamentals and supply disruptions from the Russia-Ukraine War. Valuations still appear enticing while healthy earnings and sales estimates further buttress our optimistic forecast. Materials scores well across all factors we monitor with advantageous price momentum, sturdy sentiment and attractive valuations buoying the sector. Financials ranks well across most factors with reasonable valuations and healthy sales and earnings estimates offsetting poor quality factors. The price momentum has softened but remains contributory.
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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