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.
The global economy is rapidly slowing as the current monetary tightening cycle continues to tumble along full force while the geopolitical environment remains challenging. Central bank efforts to tame inflation will inevitably cause some harm in terms of growth and employment, but for now, this damage represents an acceptable tradeoff – economies will experience some short-term pain in exchange for long-term gain.
However, we are approaching the much-discussed proverbial fork in the road – a “soft” or “hard” landing. The outcome will depend on data prints over the next several months and reactions from central banks. The bifurcation of ramifications around each data point makes this extremely difficult to forecast.
Labor is a great example – it has been very resilient, which should help support demand and soften the impact of higher rates, but this in turn will keep wage pressure higher, which could compel the Federal Reserve to overtighten. Against this backdrop, the risks of overtightening seem considerable. Unsurprisingly, we continue to lower global growth forecasts, particularly for the next year, and risks remain on the downside.
Slowing growth, as evidenced by deteriorating leading economic indicators and PMI surveys, is gradually leading to a reduction in demand. While inflation remains unacceptably high at the moment, a range of inflation indicators suggests that a disinflationary episode lies ahead. While moderation is more certain, the extent of the decline is less precise given stickier factors making the Fed’s preferred 2% target difficult to obtain.
More favorable inflation data should allow the Fed to downshift from its hawkish stance, leading to a pivot from hiking to holding. Monetary policy is lagging, so there could be further negative impact, which the Fed has acknowledged. At present, small hikes to begin 2023 seem probable with the Fed holding between 5.0% and 5.5%.
Overall, slowing economic growth and uncertain policy skew risks to the downside and keep us cautious.
Figure 1: Asset Class Views Summary
Source: State Street Global Advisors, as at 10 December 2022.
A confluence of factors – easing of COVID-19 restrictions in China, optimism that we may have reached peak inflation/peak Fed hawkishness, and resilient labor markets – has boosted investor risk appetite. Our Market Regime Indicator (MRI), which spent most of the year oscillating between high risk and crisis regimes, has continued to ease into a normal regime. While all three factors have moderated to some extent, each variable depicts varying levels of risk appetite.
The biggest driver was a large reduction in implied volatility on equity, which dropped to the lower bound of a low-risk regime. Risky debt spreads have narrowed, but remain elevated and our measure sits at the upper end of a normal regime while currency-implied volatility remains in high risk. Overall, our measure of risk sentiment has improved but remains cautious.
Our forecast for equities has improved and is now slightly positive. While both price momentum and sentiment have improved, they remain negative and a drag for equities. This has been offset by attractive valuations and solid quality metrics, which support global equities in our quantitative modeling.
Our models remain constructive on bonds, forecasting lower government rates and further inversion of the yield curve. Stronger momentum within interest rates coupled with weaker manufacturing activity and elevated inflation readings signal lower rates. Although the US yield curve is already significantly inverted, inflation expectations and leading economic indicators are firm enough to suggest more flattening/inversion may lie ahead.
Commodities have cooled off as growing recession fears weigh on the demand outlook and offset favorable supply dynamics. In our models, both momentum factors and curve structures have deteriorated and while our forecast remains supportive, it has weakened considerably.
Improved risk sentiment and a slightly positive equity forecast (from negative) have led us to put cash to work while adding to equities. Additionally, we believe the ongoing pivot in central banks and slowing inflation can provide a short-term tailwind for equities. Overall, we reduced our commodity overweight and sold cash with proceeds deployed to aggregate bonds and equities, now overweight.
Within equity, we continue to favor non-US developed equities and our latest rebalance rotated out of US equities, both large and small, into Pacific equities. While macroeconomic factors for the US remain favorable, weaker valuations, softer price momentum and worse sentiment factors dent our outlook for US equities relative to other developed markets.
Within fixed income, improved forecasts create opportunities to deploy more cash by adding to both US aggregate bonds and US long government bonds.
At the sector level, meaningful improvements in our consumer staples forecast pushed the sector up our rankings – a move that was reinforced by heightened recession risks. Other factors that drove the improvement in consumer staples included price momentum, positive quality factors and strong sentiment. Financials continue to look attractive and exhibit strength across both sentiment and macroeconomic factors while valuations remain attractive.
Elsewhere, a combination of improved materials outlook and softer energy forecast led us to split the allocation amongst the two sectors. Energy ranks well across momentum and sentiment while valuations are still attractive. Materials have experienced a pickup in price momentum, which has pushed the sector up our rankings. Lastly, utilities fell out of favor due to deteriorating price momentum and weak valuations.
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 December 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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