De-Risking Portfolio by Favoring Gold: Tactical Trading Decisions for March 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

The Russia-Ukraine War has intensified the theme of reduced expectations for growth and a rise in inflation forecasts. However, the underlying fundamentals, at least for now, are still positive. The fading Omicron impact should improve mobility and sustain demand. Robust household savings can help consumers to weather out higher inflation and energy prices for some time, particularly in light of the strong job market. Corporate financials aided by solid profit also remains favorable. Inflation poses a threat, but all the above factors should help to underpin economic growth.

Typically, geopolitical events tend not to overly disrupt underlying fundamentals in the long term. But given the nature of the Russia-Ukraine War, uncertain duration, elevated level of inflation and the potential for meaningful and lasting commodity supply shock, the effect of the war on economic growth is currently unclear. Our expectation for global growth is being revised lower, but the magnitude depends on the timing of a resolution. A prolonged crisis through the summer with protracted resistance could have a broader stagflationary impact on the global economy. For now, this is not our base case.

Another scenario, less destructive to global economies, would be a multi-week war with significant de-escalation by April or early May. In this instance, the commodity price shock would be more contained, with larger negative impact for Europe and emerging market importers but less stressful for the rest of the world.

Overall, the macroeconomic environment is less certain than it was a month ago. At present, we are not forecasting a global economic downturn and still expect growth to remain positive, but we will be monitoring the developments in Ukraine.

Figure 1: Asset Class Views Summary

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

Directional Positioning

Investors have been digesting numerous uncertainties, which have weighed on the risk appetite as evidenced by our Market Regime Indicator (MRI), which has moved into crisis. In February, MRI started in a high-risk regime but quickly moved into a crisis regime mid-month where it has remained through March. Markets have struggled to determine the path forward for monetary policy with a more hawkish commentary from central banks globally but ambiguity around their tightening plans.

Another elevated inflation print at a multi-decade high of 7.5% has caused additional angst and the Russia-Ukraine War has further soured risk sentiment. These events have driven inflation fears higher and further clouded the outlook for central banks, which must balance even higher inflation, potential disruption to economic growth and financial instability. All three factors in our MRI have been trending higher since the start of the year and now firmly sit at the upper bound of the crisis regime.

Within our quantitative framework, a crisis regime typically means investors have become overly pessimistic, which can be a contrarian signal and support equities. However, the recent surge in volatility driven by the Russia-Ukraine War introduced new tail risks, which need to be taken into account. In this environment, we have decided to modestly de-risk our portfolios by reducing our equity allocations in favor of gold – where our modeling has improved meaningfully.

Our outlook for gold remains strong with both fundamental and technical factors supporting the precious metal. Impact from the Russia-Ukraine War has reverberated through markets, including measures of credit risk, which have increased, implying a positive future performance for gold. On the technical side, all our trend signals suggest higher prices for gold going forward.

Our forecast for equities is slightly improved on better quality and sentiment characteristics, which remain firmly positive. Poor performance at the start of the year has improved valuation metrics, given the strong corporate earnings. However, this has been partially offset by waning price momentum. Overall, our model remains constructive on equities, but on a relative basis, gold offers a better opportunity.

Relative Value Positioning

Within equities, we continue to see meaningful improvement in our US forecast with deterioration in the non-US regions. During our latest rebalance, we reduced our position in Europe and Pacific to neutral and underweight, respectively, in favor of US large-cap and small-cap equities.

Valuation for US equities has improved but remains negative, while constructive price momentum persists. The biggest driver of our upgraded outlook was better sentiment and macro indicators, both of which now heavily favor the United States. We now hold modest overweight to both large and small-cap equities.

Europe and Pacific equities are more exposed to impact from the Russia-Ukraine War, which is starting to permeate into our models through failing sentiment scores, which have turned negative. Elsewhere, valuation for both regions is complementary but has weakened and price momentum and is no longer conducive. Though there is an upside risk to the extent that geopolitical risks abate, our forward-looking baseline scenarios impart a more meaningful drag on these regions.

Within fixed income, our rotation from high yield (HY) into aggregate bonds increases our underweight to HY. Seasonality is advantageous but higher treasury yields, elevated volatility and poor equity performance, all imply a wider HY spread. Aggregate bonds are more attractive on a relative basis with our model now forecasting a small decrease in the level of interest rates. Weaker interest rate momentum, slowing PMIs and surging inflation prints slightly offset the upward pressure from higher GDP relative to 30-year yield.

From a sector perspective, there were no changes to the top sectors but we did adjust our allocations. Technology, a long-time stalwart near the top of our rankings, has slipped out of the top spot and is now a split allocation with energy. Short-term price momentum has plummeted while valuations have deteriorated further. However, favorable sales and earnings sentiment and beneficial longer-term price trends aid the sector.

Healthy demand, low inventories and disruption from the Russia-Ukraine War have propelled oil prices to a multi-year high and supported the energy sector. Robust sentiment and momentum indicators offset adverse macroeconomic factors. Financials scores well across most factors and has been upgraded to full allocation. Improvements in price momentum and valuations combined with sturdy sales and earnings estimates buoy the sector. Materials remain a full allocation, owing to reasonable valuation and healthy sales estimates. Additionally, solid short-term price momentum buttresses our positive forecast.

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