Strengthening Global Recovery: Tactical Trading Decisions for May 2021


Macro Backdrop

The global economic recovery continues to strengthen, led by the US, as the rollout of vaccines has accelerated globally and restrictions in most areas are starting to ease. Inflation is poised to spike, testing the Fed’s resolve, but the US central bank remains committed to a dual objective of price stability and maximum sustainable employment – which points to a long-term, lower-for-longer positioning. As the Fed tries to thread the needle between recovering employment levels and rising inflation, the shift from manufacturing to services is set to pressure GDP growth higher. Overall, we continue to expect the macroeconomic backdrop to remain supportive.

Powered by a strong consumer, US growth picked up steam with a 6.4% Q1 GDP print. Further, large inventory draws point to increased production over the next few quarters, and a rise in savings rates suggests plentiful demand. While the path in Europe has been challenging, the region is set to join the US and China on a sharp recovery, which should provide further support for global growth. Business sentiment remains healthy, while CAPEX plans are rising. Recent employment data in the US disappointed, but the news wasn’t all bad. The leisure and hospitality sectors witnessed an increase of 331,000 jobs, suggesting a pickup in the services sector, which comprises about two-thirds of GDP. US PMIs continue to exhibit extraordinary strength, but it’s the improvements in Europe (both services and manufacturing) and Japan that are encouraging. Corporate earnings have exceeded expectations. A record five times more companies provided higher forward guidance relative to consensus estimates than provided lower forward guidance.1 Also encouraging is an analysis of earnings call transcripts that found new highs in corporate optimism.2

The ebullient macroeconomic backdrop, conjoined with constructive quantitative forecasts, supports our continued preference for risk assts, particularly equities and commodities, as well as for credit bonds. See Figure1.

Figure 1: Asset Class Views Summary

Source: State Street Global Advisors, as of May 10, 2021.

Directional Positioning

The ongoing vaccine rollout and re-opening of economies continue to sustain risk appetite, which signals some level of complacency among investors. Improvements in high-frequency data – mainly mobility indicators, airline and hotel spending, and restaurant bookings – bolstered optimism. This jubilance led to tighter risky debt spreads and lower implied volatility on currencies, with both factors moving into the “Euphoria” regime of our Market Regime Indicator (MRI) framework. Elsewhere, implied volatility on equities remained benign. Overall, our MRI finished in the Euphoria regime, where it’s been since the beginning of April.

While our models remain supportive for equities, our forecast for core bonds improved in May. The upgraded outlook, combined with our MRI still flashing euphoric signals, led us to make a small rotation out of equities and into core bonds.

Relative Value Positioning

The buoyant economic backdrop and supportive risk appetite should benefit equities broadly, but we are seeing dispersion among our regional forecasts. During the recent rebalance, we reduced our exposure to Pacific equities, initiating an underweight, while re-allocating to US large cap and European equities. In Europe, we have brought the position to neutral, which reflects the improvement in our quantitative framework.

The US remains our favored region, and we recently expanded our overweight position. Better results in terms of economic re-opening have continued to lift the US, and this has permeated our models, which remain constructive. Vigorous earnings sentiment and immense price momentum continue to underpin the region. While valuations are unfavorable, macro factors remain complementary.

In Europe, valuations have been attractive, and short-term price momentum has turned positive, but the biggest driver of our enhanced outlook for this region has been the recovery of earnings expectations, which have turned sentiment positive. Additionally, the region should benefit from an expansive US and an acceleration in vaccine rollouts.

The outlook for Pacific equities deteriorated, as valuations became less favorable and price momentum weakened. Further, vaccine distribution has been suboptimal, and Japan just extended its COVID emergency protocols until the end of May – as they try to get infections under control prior to hosting the Olympics in July. This is reflected in worsening earnings expectations, which further weigh on our forecast.

Within fixed income, our model is looking for a sizable decrease in the level of rates along with a flattening of the curve. Our evaluation of the market suggests that recent upward momentum in interest rates is likely to exhaust itself in the near term. Despite a solid GDP print, the backup in long-term yields to pre-COVID levels influences the model toward lower future yields. Additionally, level momentum and the recent spike in reported inflation also imply that rates will move lower. Lastly, accelerating economic growth and a volatile upcoming period for reported inflation data pose risks to bonds, but the asset class has sold off meaningfully so far in 2021 and these trends have been known for some time.

A relatively steeper yield curve, positive equity price momentum, and benign equity volatility support credit bonds, both high yield and investment grade, and reinforce our overweight. However, given the limited room for further spread compression and significant improvement in our long government bond forecast, we decided to reduce our overweights to high yield and intermediate credit in favor of long government bonds.

From a sector perspective, we maintained allocations to technology and financials, but rotated out of energy into communication services. Technology struggled in February and March and has produced poor short- and intermediate-term momentum scores. However, thematic tailwinds have supported earnings and sales estimates, which when combined with positive macro and quality scores, propel technology into the top spot. Financials, which benefit from rising long-term yields, exhibit strong momentum and sentiment scores. Valuations are slightly negative, but neutralized by contributory macro scores. Adverse short-term price momentum for communications services is offset by strong sentiment and quality attributes, and valuations are still beneficial. Energy valuations remain attractive, but a significant decline in earnings estimates and worsening momentum pushed energy into the middle of our sector rankings.
