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.
Figure 1: Asset Class Views Summary
Source: State Street Global Advisors, as of 9 March 2023. Investment grade bonds consist of investment grade credit, Treasuries and aggregate bonds.
While there is still uncertainty about the economic outlook, recent data has generally been better than expected. This reinforces our view that near-term recession risks are low, but has drawn into question the disinflation narrative. It is likely that the recent data overstates the strength of the economy, but it is hard to dismiss the positive momentum. While inflationary indicators have surprised to the upside, highlighting the stickiness of elements, we still believe that the disinflationary trend will continue.
There are two sides to the current macroeconomic narrative. On one side, we have resolute economic activity. A strong rebound in January retail sales and continued robust labor markets suggest household consumption, a key pillar of growth, remains on solid footing. In the US, payrolls have outpaced expectations recently, while January’s Job Openings and Labor Turnover Survey reports surprised to the upside, with December’s reading revised upward.
In addition, the manufacturing sector appears to have stabilized, while the service sector continues to exhibit strength. The Federal Reserve Bank of Atlanta’s GDP Now tracker estimates a 2.6% YoY GDP growth for the US in Q1 2023, only slightly lower than Q4 2022 growth. Overall, the recent high frequency data suggests economic activity has held firm so far in 2023 and highlights the resilience of the US economy.
On the other side, resilience creates demand, and that fuels inflation. In the US, a string of data prints has given investors pause about the disinflation narrative. Consumer prices (CPI), producer prices (PPI) and even the US Fed’s preferred personal consumption expenditures (PCE) have exceeded expectations and point to stronger-than-expected inflation.
Manufacturing prices, from the ISM Manufacturing Purchasing Managers’ Index (PMI), have jumped back into expansion, suggesting a consolidation of core goods prices, while service prices appear sticky. Although the National Federation of Independent Business survey reported a fall in the net share of small businesses raising prices to 42% in January, which is well below the near-record high of 66% last March, it still remains elevated.
Outside the US, inflation in Europe was hotter than expected in February, particularly the core measure, which jumped to 5.6% YoY and posted a new high.
It is important to keep in mind that one month does not make a trend and we continue to anticipate inflation easing over the course of the year given the recovery in supply chains and a lagged effect from central bank tightening. Additionally, shelter costs in the CPI should soften soon, and wages have rolled over. Both should reduce service inflation over the course of 2023 and into 2024.
Even as they are in the latter stages of their policy tightening cycles, central banks still have more work to do. This fact was confirmed by Fed Chairman Jerome Powell during his recent testimony to the Congress, where he hinted that the terminal rate may be higher than previously anticipated. While we recognize the risk from recent data prints and the potential for a policy mistake, we think a transition from the hiking phase to a pause should be delayed, but not significantly altered.
The long and variable lags of monetary policy argue in favor of letting the already delivered tightening measures to work through the economy. As the year progresses, the continued easing of inflation measures should allow the Fed to ease off the brake. Overall, recent data have challenged markets and reminded us that the path to recovery is not linear. Focusing on longer-term trends keeps us optimistic that a recession is not imminent or inevitable.
Despite numerous uncertainties surrounding geopolitics, inflation and central banks, investor risk sentiment has continued to remain strong, with our Market Regime Indicator finishing toward the bottom threshold of a low-risk regime. Optimism from January cooled in February after a surprising jobs print and a number of inflation indicators – from CPI to PPI – came in hotter than expected. Investors quickly repriced Fed rate hike expectations by increasing the number of rate hikes and reducing expectations for a cut to close out 2023.
Both implied volatility on equity and risky debt spread measures rose for most of the month, but still remain in a low-risk regime. Implied volatility on currency has been more stable, while improving slightly and finishing in low risk. Overall, our gauge for investor risk appetite continues to signal a favorable environment for risk assets.
Our outlook for equities remains supportive, with our forecast slightly improved. In contrast, our expectations for bonds, both government and credit bonds, have deteriorated. Against this backdrop, we have sold high yield and aggregate bonds, with proceeds deployed into equities and cash. The selling of high yield now brings us to an underweight allocation from neutral.
For equities, the sell-off in February improved the already attractive valuations. Our macroeconomic and quality factors have cooled but remain supportive, and sentiment indicators are materially better and less of a drag on our forecast.
Within fixed income, our model is now forecasting modestly higher rates with a slightly steeper yield curve. Interest rate momentum, lower inflation prints and higher nominal GDP growth compared to long bond yields all imply higher future yields. For credit, both high yield and investment grade spreads are expected to widen, driven by elevated equity volatility and higher refinancing costs.
Within equities, our Pacific equity forecast deteriorated meaningfully and we reduced our overweight, rotating into US small cap equities. With the purchase of US large cap equities, resulting from our directional buy of equities, we have moved to a small overweight for both US large and small cap equities at the total portfolio level. US equities continue to benefit from strong macroeconomic factors, while improvement in sentiment, which is now slightly better than Pacific equities, supports the relative attractiveness.
Valuations for Pacific equities are still favorable, but a drop in sentiment and momentum has pushed the region down our rankings. Within the US, we have a slight preference for small caps due to the better price momentum and more attractive valuations.
Within fixed income, we sold more aggregate bonds and slightly reduced our overweight to long government bonds in favor of cash. We now hold a healthy allocation to cash, which boasts a generous yield and can provide some downside protection should investors continue to reprice Fed expectations.
At the sector level, we maintained our allocation to industrials, but rotated out of consumer staples and healthcare into energy and financials. Both consumer staples and healthcare experienced a weakening in price momentum and sentiment, which along with poor valuations pushed the sectors down our rankings.
Industrials remain our favored sector and continue to score well across all factors, particularly with strong price momentum and robust sentiment. Financials benefit from sturdy price momentum and positive macroeconomic factors, but a large increase in sentiment – both earnings and sales – has pushed financials up our rankings.
Sentiment indicators for energy have weakened considerably with the fall in energy prices, but longer-term price momentum factors are firm, valuations are attractive and quality factors are strong, which support the sector.
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The views expressed are of Investment Solutions Group through the period ended 9 March 2023 and are subject to change based on market and other conditions.
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Investing involves risk including the risk of loss of principal.
Equity securities may fluctuate in value and can decline significantly in response to the activities of individual companies and general market and economic conditions.
Because of their narrow focus, sector investing tends to be more volatile than investments that diversify across many sectors and companies.
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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).
There are risks associated with investing in Real Assets and the Real Assets sector, including real estate, precious metals and natural resources. Investments can be significantly affected by events relating to these industries.
Bonds generally present less short-term risk and volatility than stocks but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in commodities entail significant risk and is not appropriate for all investors. Commodities investing entail significant risk as commodity prices can be extremely volatile due to wide range of factors. A few such factors include overall market movements, real or perceived inflationary trends, commodity index volatility, international, economic and political changes, change in interest and currency exchange rates.
Illiquid risk/Asset investments may have difficulty in liquidating an investment position without taking a significant discount from current market value, which can be a significant problem with certain lightly traded securities.
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