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.
Over the course of the year, headwinds to global growth have intensified while sources of resilience have softened. Consequently, State Street Global Advisors’ 2022 growth forecast for the United States (US) has moved from a little above consensus of 4% in March to a little below consensus now at 2.3%. While global shocks have continued to compound on each other and weigh on our outlook, the downgrade reflects a much faster monetary tightening pace that shifts the economy from a gradual deceleration to one of a more abrupt downshift.
Whether or not we record two consecutive negative quarters of growth resulting in recession, the slowdown is real. After falling -1.6% in 1Q, the Federal Reserve Bank of Atlanta's gross domestic product (GDP) model now estimates 2Q GDP to be -1.2% as of 8 July.
At present, we appear to be facing a shallow technical recession, a material slowdown in growth, rather than a more typical business cycle recession. Contrast the current decline in GDP growth, driven primarily by inventories and trade (important, yet more peripheral components of GDP), with a typical recession that contains meaningful imbalances or excesses which create vulnerabilities and ultimately push down consumer spending and investment in response to higher borrowing costs. The latter scenario is not part of our baseline assumption yet.
The spike in goods demand during the beginning of COVID-19 created an imbalance, but it came at the expense of service consumption. The ongoing transition from goods to services should help keep aggregate demand solid. Further, we have not seen the profit margin compression and balance sheet deterioration typically present during business cycle recessions. However, the longer we remain in the current environment with elevated inflation and rising rates, the greater the chance.
Inflation is forecast to accelerate again in June and there are signs that consumers are feeling the impact with real consumer spending contracting in May. However, personal consumption has been resilient so far and JP Morgan notes that checking balances are currently well above 2019 levels. This combined with solid employment, wage gains and healthy balance sheets should support demand for a period, even if not at the same level that we have witnessed.
Central banks have confirmed their dedication to curbing inflation at all costs. Inflation is broad based and not solely demand driven and is proving to be stickier than anticipated. This has us less convinced that the Fed could administer a “soft landing.” Besides, geopolitical risks from the Russia-Ukraine War have seemingly increased. The potential of Russian gas being shut off to Europe has grown while G7 countries are discussing oil price caps for Russian oil. Both these factors could jolt energy prices with the resultant impact reverberating globally.
Overall, anxiety about global growth will persist in the near term and the risks are to the downside. There are still some positive fundamentals, but many headwinds have created a very delicate growth environment.
Figure 1: Asset Class Views Summary
Source: State Street Global Advisors, as at 10 July 2022.
The level of fear amongst investors remained extreme as stubbornly high and broad-based inflation persisted and central banks reaffirmed their commitment to tame inflation no matter the consequences. Our Market Regime Indicator (MRI) sits on the border of a high risk and crisis regime where it has oscillated since January. While all three factors remain elevated, increased risk anxiety is more prevalent in implied volatility on currency and risky debt spreads as both factors have resided in crisis most of June.
After touching crisis midway through June, implied volatility on equities moderated with our signal consolidating to the lower end of high risk. Overall, our MRI pointed to a very fragile risk environment, which warranted a reduction in risk assets. We reduced global equities and aggregate bonds in favor of cash.
The reduction in equities resulting in a modest underweight relative to the strategic benchmark was driven by a combination of poor risk appetite and weakening quantitative forecasts. Valuations have improved meaningfully but are offset by worsening price momentum, both short and long-term measures, and weakening earnings estimates.
Despite the risk-off sentiment, our reduction in aggregate bonds was driven by our deteriorated outlook for US bonds with our model now forecasting a rise in treasury yields. Elevated inflation readings continued to signal lower rates ahead, but higher nominal GDP relative to long-term treasury yields and interest rate momentum implied rates will move higher.
Cash provides some downside protection in this challenging environment where our forecasts for both equity and bonds have softened and volatility within equities and bonds has elevated.
Within equities, a deterioration in our US forecast has made non-US developed equities relatively more attractive in our quantitative framework. During our latest rebalance, we sold US equities, both large and small cap, and REITs, with proceeds deployed to Pacific equities.
We now hold net underweight to US equities, which have experienced a sharp drop in sentiment, both in earnings and sales expectations. Macroeconomic factors remained robust and valuations improved, but weaker quality factors lessened the relative attractiveness.
Our forecast for REITs declined in the face of growth recession fears and higher interest rates. Earnings estimates gradually moved lower during Q2 while price momentum became less supportive and macroeconomic factors remained unfavorable.
The buy in Pacific equities brings us to overweight, our largest within equities from a regional standpoint. While some of the macroeconomic factors remained weak, still attractive valuations and improvements across both sentiment and price momentum helped buoy our Pacific forecast.
Within fixed income, we reduced our exposure to aggregate bonds further while also selling intermediate treasury bonds in favor of cash and non-US government bonds. As mentioned above, our forecasts for US bonds turned less favorable, which reduced their attractiveness relative to cash and non-US bonds. Outside the US, our model forecasts relatively muted returns with forecasts for Australia, Canada and Japan aiding the outlook.
From a sector perspective, there were no changes to our preferred sectors with targeted allocations to energy, materials and utilities. Despite the recent market performance, the Energy sector benefited from powerful price momentum, healthy sentiment and still attractive valuations. For materials, advantageous longer-term price momentum measures offset weaker short-term price momentum. Elsewhere, sentiment softened but remained contributory and valuations were supportive. For utilities, steadily improving price momentum and sentiment measures underpinned our constructive 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.
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The views expressed are of Investment Solutions Group as of 10 July 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
Investing in REITs involves certain distinct risks in addition to those risks associated with investing in the real estate industry in general. Equity REITs may be affected by changes in the value of the underlying property owned by the REITs, while mortgage REITs may be affected by the quality of credit extended. REITs are subject to heavy cash flow dependency, default by borrowers and self-liquidation. REITs, especially mortgage REITs, are also subject to interest rate risk (i.e., as interest rates rise, the value of the REIT may decline).
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