Improving US Macro Backdrop

ISG “Alpha Meeting” Notes for September 9, 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 slight overweight to risk assets, with a preference for credit bonds. We hold a modest overweight to gold.

Overview

The macro backdrop continues to improve as both employment and economic activity are gaining traction. In the US, recent employment data has been strong, with 1.371 million jobs added to the economy. In addition, manufacturing and service survey data has increased as well. Monetary policy will likely remain accommodative for some time, though fiscal policy has disappointed recently, as additional measures in the US have not materialized. Outside the US, improving economic activity has moderated a bit in Europe, but is still on the ropes in Japan, although industrial production has improved on the back of strong automobile manufacturing. Finally, from a politics and policy perspective, Brexit uncertainty has appeared again, and the US elections are fast approaching. Overall, the proprietary models in our toolkit currently favor global equities, credit (investment grade and high yield), and gold, while broad commodities, REITS, and bonds look less attractive.

Risk Environment

From a risk sentiment perspective, our Market Regime Indicator (MRI) is currently in the upper bounds of the normal regime. The equity implied volatility signal dipped its toes into the high-risk regime. Currency implied volatility also moved well into the high-risk regime, driven by reemergent Brexit concerns impacting the pound. Spreads on risky debt are calming the waters a bit, as this component remained more stable within a normal regime. The combination was a heightened reading in normal. Within this quantitative backdrop, we are also mindful of a number of macro risks – the US elections, COVID-19 resurgence, and the reemerging Brexit negotiations – and therefore we have taken less active risk than our targets would suggest.

Directional Trades and Positioning

The directional trades executed this month reversed our slight equity underweight relative to bonds that had been in place since May. Global equities continue to look attractive from a broad asset class perspective, driven by strong price momentum, improving earnings and sales sentiment, and positive macro support. Gold is attractive as well, supported by both strong technical and fundamental indicators. What’s more, the precious metal provides a defensive hedge for the risk-oriented positions in the portfolio. Finally, our view on high yield remains strong as we anticipate modest spread tightening for credit bonds. Favorable cost of capital from significantly lower levels of government bonds yields, along with expectations for a steepening yield curve, are the key drivers for this segment.

On the other side of the ledger, we further reduced our position to core bonds, as the expectations for modestly rising rates and yield curve steepening dim the outlook relative to other asset classes. Interest rate momentum, along with improvements in economic activity and increasing inflation expectations, support the case for higher rates, while slope momentum and improving leading economic indicators suggest a slight steeping of the yield curve. Finally, futures curves are contango, which continues to sour our appetitive for broad commodities.

Relative Value Trades and Positioning

We maintained our current relative value positions with both the equity and fixed income portfolios. Overall, we continue to favor US large cap equities, at the expense of the US small cap and non-US equities. US large cap stocks enjoy the tailwinds of strong momentum and strong earnings and sales expectations, although valuations have become a bit stretched. Although European equities have some favorable valuation and quality characteristics, earnings expectations are less attractive, muting the outlook. Finally, we have modest overweight to emerging market equities due to improved PMIs, a weaker US dollar, and better risk appetite, which all support the asset class. REITs remain our largest underweight within the equity portfolio. This is driven by a poor ranking across all indicators in our models. Higher financial leverage, negative valuations, and weakening earnings and sales estimates challenge the outlook.

From a relative value, fixed income perspective, we continue to be underweight core bonds and non-US government bonds in favor of both investment grade credit and high yield bonds. As mentioned, both investment grade and high yield are attractive because we expect spreads to tighten.

From a sector perspective, we’ve made a slight change to our favored line-up. The industrials sector improved, largely due to momentum and sentiment. Sentiment was better due to trends in earnings revisions that had been among the worst back in March but which have since recovered and are now among the best from a cross-sector perspective. At the same time, consumer discretionary declined modestly because of macro (cycle) and quality factors but still looks attractive overall. Consumer staples and technology continue to look attractive, with consumer staples scoring above average across all of the factors we evaluate and technology ranking above average for all factors except value. The technology sector has experienced some meaningful volatility in recent days but still looks quite strong using intermediate-term measures of momentum.

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