Fundamental Backdrop Broadly Positive for Growth Assets: Tactical Trading Decisions for December 2021
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.
Numerous uncertainties hang over the economic growth outlook – from Omicron to fears of a policy mistake. While potential headwinds such as supply chain constraints are likely to linger, we believe global economies will continue to demonstrate resiliency as the fundamental backdrop remains sturdy.
The US Fed’s shift on transitory inflation has spooked investors, but monetary policy should remain accommodative in the near term. Although tapering should accelerate by early 2022, the Fed will exhibit caution with rate hikes to maintain demand in a supply-constrained economy.
While consumer confidence has dipped, spending remains contributory, particularly in the United States (US) where retail sales remain firm and real personal consumption continues to move ahead even with elevated inflation. Despite a weak November payroll report, demand for labor is robust and hours worked and earnings were good, which support strong gains in wage and income and bode well for consumption. The improving labor market will be a key driver of growth in 2022.
Economic activity continues to hold up — evidenced by improved purchasing managers' index (PMI) numbers globally in November. In Japan, the non-manufacturing PMI hit a 27-month high, while in the US the survey hit a series high at 69.1, well into expansionary territory. Even with increased restrictions on mobility, there is a lot of room to cool while maintaining strong growth. Omicron may pause the rotation toward services, but it should not eliminate the transition, which should help alleviate some inflation pressures.
As we head into 2022, we maintain our optimistic view on economic growth while being cognizant of near-term risks. Some caution is warranted, but overall, the environment should be still supportive of growth assets.
Figure 1: Asset Class Views Summary
Source: State Street Global Advisors, as at 08 December 2021.
A myriad of risks has driven volatility higher with our Market Regime Indicator (MRI) moving all the way to a crisis regime. Elevated inflation remains a concern for investors and continues to pull forward expectations of Fed tightening, raising concerns about a potential policy mistake. We witnessed the yield curve flattening on these worries early in November and the Omicron outbreak toward end-November prompted countries to implement mobility restrictions, introducing more uncertainty and anxiety into markets.
Risky debt spreads continued to widen and finished in a crisis regime. Both implied volatility on equities and currencies moved precipitously higher during the month with both measures finishing near the top end of a high-risk regime. Overall, the MRI resides in a regime that signals fear may be on the wane, but some tail risk hedging is warranted to protect against extreme market movements.
Directionally, we increased our allocation to equities at the expense of high-yield bonds while also adding exposure to safe-haven assets that can help protect the portfolio from unexpected shocks.
Buying of equity is driven by our quantitative models, which remain supportive. Recent growth in PMI produced a better macro score, which was the main driver of our improved forecast. Elsewhere, robust sentiment and positive price momentum offset poor valuations and reinforced our overweight.
Our outlook for high yield has weakened as the recent spike in equity volatility implies wider spreads, while poor equity performance in November further tempered our enthusiasm. We reduced exposure to US aggregate bonds with proceeds deployed equally among gold, cash and US long government bonds. While long government bonds rallied during the late November market volatility, we continue to see resilience in the asset class from a quantitative standpoint and as central banks focus on inflation risks.
Gold provides some diversification to our equity and credit overweight and may help mitigate any short-term volatility or inflation surprises. Cash can also help cushion against elevated volatility and give us some dry powder when sentiment improves.
Relative Value Positioning
Within equities, we continue to see enhancements in our forecast for non-US developed equities. In the latest rebalance, we reduced our US large cap equity exposure in favor of Pacific equities. The add to Pacific equities brings our position to a slight underweight and was driven by strong upgrades to macro-oriented factors such as currency trends and business cycle considerations. Sentiment is marginally negative, but has greatly improved while valuations are attractive.
Our models are constructive on US equities, but improvements elsewhere lessen the relative attractiveness. US equities benefit from the strong price momentum, but degradation in the macro score and poor valuations weigh on the region. Moreover, sentiment remains positive but lags relative to other regions, which further encouraged our reduced allocation.
We have maintained exposure to our targeted sectors but slightly changed some of our allocations. Energy was upgraded and along with technology are full allocations while financials is now split with materials. Technology ranks well across all factors with vigorous price momentum and sentiment measures keeping the sector on top. Strong consumption and manufacturing have buoyed the energy sector, which ranks near the top of both price momentum and sentiment. Still attractive valuations bolster the outlook. Improving economic growth and focus on clean energy have boosted earnings and sales estimates for materials, strengthening the sector. Longer-term price momentum remains weak but is offset by enticing valuations.
The start of the Fed’s QE unwind and increased expectations for rate hikes in 2022 may provide a tailwind for financials. Additionally, sizable M&A and IPO activity has favored the sector. Positive price momentum and sentiment scores have earned the sector a spot near the top of our rankings.
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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