Equities back to overweight

Each month, the State Street Investment Management Investment Solutions Group (ISG) meets to debate and ultimately determine a Tactical Asset Allocation (TAA) to guide near-term investment decisions for client portfolios. Here we report on the team’s most recent discussion.

Macro backdrop

Global growth has proven resilient in the wake of the recent Iran conflict, though the picture remains uneven across regions. Forward-looking indicators are constructive, with the J.P. Morgan Global Manufacturing PMI rising to 52.6, signaling expansion, while both US manufacturing and services activity remain in expansionary territory. Higher energy prices have emerged as a modest headwind, but they do not appear elevated enough to derail the cycle, more likely acting as a drag on the pace of growth rather than a turning point.

While we are encouraged by the relatively contained market response to the US–Iran conflict, risks remain. Importantly, the US consumer appears more insulated than in prior cycles: although higher gasoline prices may weigh on spending, sensitivity to oil shocks has declined, and still-elevated household net worth, alongside tax relief, should help cushion the near-term impact.
However, our views rely on the expectation that the effects of the Iran conflict will be less severe than initially feared, broadly in line with previous geopolitical shocks. A meaningful escalation or prolonged conflict would alter our forecasts.

The US economy continues to rest on a solid foundation, supported by a range of factors, though momentum appears to be stabilizing rather than accelerating. Monetary policy sits in a slightly positive zone, no longer restrictive and not overly stimulative, with the Federal Reserve (Fed) funds rate modestly below nominal gross domestic product and that gap widening.
Financial conditions are improving at the margin, as evidenced by easing bank lending standards, particularly for consumer loans, now approaching pre-COVID levels. Liquidity dynamics are also supportive: M2 money supply, a proxy for systemwide purchasing power, has been rising and, combined with ongoing wealth effects, should underpin consumption.

On the fiscal side, continued capex incentives and deregulation provide an additional tailwind. Meanwhile, tariff revenue has declined meaningfully from last year’s peak, and unless new measures are implemented following the expiration of Section 122 tariffs in July, which remains possible, the reduced burden could further support corporate margins and hiring.

Labor market dynamics reinforce the picture of stabilization. Private payroll growth has improved, jobless claims have eased, and business confidence is showing signs of recovery. While the unemployment rate has drifted higher, it remains historically low, and wage growth continues to moderate. Real wages are being pressured by still-elevated inflation but remain mildly supportive of consumption for now.

Corporate fundamentals also remain healthy, with earnings growth resilient and 2026 consensus estimates moving higher. That said, not all signals are benign, as elevated consumer delinquencies highlight pockets of strain. Overall, the data point to a steady but unspectacular growth backdrop, characterized more by resilience and stabilization than by reacceleration.

The latest CPI readings showed both headline and core inflation moving higher, with broad-based upward pressure. Energy prices were a major driver, while food inflation also accelerated, reflecting pass-through from higher energy and fertilizer costs. Beneath the surface, there are important offsets. Core goods inflation has softened, suggesting that earlier tariff-driven price pressures are fading. Core services inflation also rose, but much of that increase appears attributable to a one-off statistical adjustment related to last year’s government shutdown rather than a sustained trend. Looking ahead, near-term inflation prints are likely to remain elevated, particularly in May, as energy and food pressures persist.

At the same time, broader pricing dynamics warrant attention. Producer price data came in hotter than expected, even excluding food and energy, with year-over-year increases at multiyear highs. Survey-based measures reinforce this theme: prices paid components in both manufacturing and services Purchasing Managers’ Index are running hot, and small business pricing intentions remain elevated, according to data from the National Federation of Independent Business.

Despite these concerns, several offsets should help stabilize inflation over time, including easing tariff pressures, moderating wage growth, and improved productivity. The net effect is an environment where inflation remains sticky but not necessarily accelerating meaningfully from the current levels.

Against this backdrop, we continue to expect a gradual easing cycle, maintaining our call for 50 basis points of Fed rate cuts in 2026. We believe the Fed’s objective remains to move policy closer to a neutral stance, around 3%, while providing enough support to prevent further deterioration in the labor market and address emerging pockets of consumer weakness.

That said, the path forward is far from assured. Persistently elevated energy prices, even in a de-escalation scenario, alongside stable labor conditions and sticky inflation, could delay or limit the Fed’s willingness to ease. Importantly, we do not anticipate rate hikes from here, as further tightening risks undermining both consumption and employment.

Overall, while risks remain, particularly around inflation persistence and geopolitical uncertainty, we see sufficient underlying support to sustain solid economic growth and a modest Fed easing cycle. The backdrop is best characterized as one of resilience with constraints: growth remains intact but not accelerating; inflation is elevated but not spiraling; and policy is likely to adjust, but cautiously.

Directional trades and risk positioning

Our assessment of the current market environment suggests a modestly better outlook for risk assets. Risk appetite had deteriorated leading up to and around the Iran conflict. But now it has improved meaningfully, with our MRI returning to levels seen in late 2025 and early 2026. Though our equity forecast remains soft, it has improved recently, while our expectations for credit spreads have also strengthened. Overall, our quantitative framework has turned more optimistic, leading us to modestly increase equity exposure, moving back to overweight, while raising both total portfolio risk and active risk positioning.

While Middle East uncertainty remains elevated, peak concerns appear to be behind us, as investors increasingly fade worst-case outcomes. Supportive macro data, including resilient labor markets, solid earnings, and continued AI-driven demand, have further lifted sentiment. Internally, risk support has rebounded to neutral from extreme risk-off levels, while sentiment spreads have begun to recover, albeit remaining modestly negative. Volatility has been the key driver of this improvement, retreating from extreme risk-off levels at the onset of the conflict to a more moderately supportive environment.

Notably, risky debt spreads and currency implied volatility have tightened sharply, reverting to more supportive levels and offsetting still-elevated equity volatility. That said, credit markets remain in a risk-off posture, contrasting with equities, where trends have stabilized above pre-conflict levels but continue to reflect a risk-on bias.

For equities, the outlook has improved modestly, driven primarily by a recovery in sentiment. Beneath the surface, analysts’ expectations have strengthened meaningfully, with both sales and earnings levels rising to historically elevated points within our framework. Price momentum also remains supportive, with both short- and long-term indicators in positive territory, while balance sheet strength continues to point to a healthy corporate backdrop. That said, this more constructive view is tempered by weaker macroeconomic signals, which have continued to soften, and valuations that remain elevated, with equities appearing expensive across most of the metrics we monitor.

Within fixed income, our outlook is mixed. Expectations for duration-sensitive assets have softened, while the outlook for credit and non-US government bonds has improved. In the US, we now expect a modest rise in yields, reversing last month’s expectation for declining rates. While longer-term trends continue to point toward lower yields, improving risk appetite and stronger risk asset performance suggest reduced demand for duration in the near term and higher yields.

In credit, a more constructive outlook is driven by better risk sentiment and lower implied equity volatility. For non-US government bonds, the combination of attractive carry and expected yield compression, particularly in Japan, supports a more favorable return outlook.

From a positioning standpoint, we have modestly increased equity exposure, moving the portfolio to a 2.5% overweight, and added to high yield bonds. These adjustments were funded by a reduction in US aggregate bonds, resulting in a modest decrease in overall fixed income exposure.

Relative value trades and positioning

Within equities, regional forecasts have diverged more meaningfully. Our preferred regions, the US and emerging markets, have improved, while non-US developed markets have weakened. In the US, price momentum has rebounded following earlier softness around the Middle East conflict, supported by strong April performance. Sentiment indicators, including sales and earnings expectations, have recovered to levels seen late last year, while quality factors remain supportive. Large caps continue to lead, though the outlook for small caps has improved notably, driven by stronger sentiment and modestly better macro conditions.

Emerging markets have also strengthened, with improvements in macroeconomic and price momentum factors reinforcing an already solid backdrop. In contrast, non-US developed equities remain challenged, with Europe ranking poorly across most factors outside of valuations on a relative basis, and Pacific markets weakening amid deteriorating sentiment and macro conditions.
From a positioning standpoint, we reduced non-US equity exposure in favor of US small caps and emerging markets, extending our overweight to emerging markets and moving US small caps back above benchmark.

Within fixed income, we repositioned the portfolio to reflect a more constructive outlook for credit and international bonds. We reduced exposure to US long Treasuries and aggregate bonds, redeploying proceeds into high yield, now an overweight, and non-US government bonds, which we returned to benchmark neutral. While we retain a bias toward longer-duration assets, overall duration has been reduced in favor of a greater allocation to spread sectors.

Within equity sectors, Health Care moved lower in our rankings as both price momentum and sentiment indicators weakened and turned negative. Communication Services remains a preferred sector, supported by strong momentum, sentiment, and quality factors, all of which remain firmly positive. The Energy sector has benefited from the sharp rise in oil prices, reflected in significantly stronger price momentum, while valuations remain attractive and sentiment has improved from the weaker levels seen for much of last year. We round out our positioning with a split allocation to Industrials and Consumer Staples. Industrials continue to benefit from the AI-driven infrastructure buildout, with both momentum and sentiment indicators reinforcing this strength. In Consumer Staples, the outlook has improved on the back of better sentiment, particularly as sales expectations have turned positive, while valuations remain supportive.

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