Appetite for Risk Wanes

Each month, the SSGA 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

The US tariff announcement on 2 April sent shockwaves through markets, leaving everyone struggling to figure out what lies ahead. Although the announcement was well telegraphed, investors were caught off guard by the size of the tariffs—which exceeded expectations—and the hawkish tone, which seemed to be less open to negotiations. As a result, market volatility has risen, and sentiment has weakened.

Here is what we know: a 10% universal tariff on all counties, along with individualized reciprocal tariffs on many others, will take effect on 9 April. These measures will remain intact until the President determines that the threat posed by trade has been resolved.

The 2 April announcement marks the opening salvo in a broader negotiation process. The tariffs are likely to be unsustainable in the long term, and therefore, not likely the end goal. The US’s ultimate objective is likely a combination of correcting the twin deficit issues, supporting national security, and a re-balancing of the US economy—to become a leader in AI.

The longer the tariffs persist, the more negative the impact will be on the global economy. However, the US appears to be fully prepared for negotiations, and we expect some tariffs to be delayed or removed within a few months at most.

Despite the outcry, the US holds a certain amount of leverage—deficit countries typically find it easier to get an alternative seller than finding an alternative buyer. The US is likely to seek improved terms of trade with allies, while holding a tougher stance on China. As for what remains, the 10% universal tariff could become permanent to help with trade imbalances, while sector-specific tariffs—such as on steel, aluminum, and autos—are likely to remain permanent for national security reasons. The reciprocal tariffs are the most open to negotiations, potentially in exchange for increased capital investment in the US or agreements to buy US energy. China will probably face increased pressure from the US and is likely the key focus moving forward.

There are a wide range of possible scenarios and outcomes, but not all are realistic. We are hesitant to make large changes to our forecast, as things can change quickly. We do not expect tariffs to be permanent, and their pass-through to consumers is unlikely to be 100%.

At a high level, we expect tariffs to raise inflation, reduce economic growth, and likely keep the Federal Reserve (Fed) on track for three rate cuts in 2025. However, the magnitude of the impact of these factors is difficult to forecast. If many tariffs are negotiated lower or away, the stagflationary shock will likely be less than initially feared after the announcement.

Assuming the US does not experience significant job losses, consumers and other parties in the supply chain should be able to absorb the one-time price increase from tariffs. Additionally, lower energy prices may cushion some of the near-term impact. Looking further ahead, potential tax cuts, deregulation, central bank rate cuts, and more open market access/fair trade could support the economy.

We will continue to monitor the changing trade policies, labor market dynamics, inflationary pressures, and central bank actions.

Directional Trades and Risk Positioning

Warren Buffet famously stated, “Be fearful when others are greedy, and greedy when others are fearful”—and right now, investors are clearly fearful. However, our evaluation of markets does not suggest it’s time to get greedy.

Our less constructive view on risk assets is driven by multiple factors. Our Market Regime Indicator (MRI)—our real-time, fast-moving, measure if investor risk appetite—continues to signal higher levels of risk aversion, with similar readings last seen in August 2024, and reminiscent of the pessimism experienced in March 2020 at the onset of COVID-19. Additionally, our equity return forecast remains benign, while our fixed income model suggests a more constructive outlook.

Given the uncertainty surrounding the recent trade policy developments—and the concern our models may not be fully capturing recent developments—we made the decision to reduce the expected tracking error when optimizing our portfolio. As a result, in our latest rebalance, we reduced the active risk in our directional and relative value positioning.

Our MRI shows investor angst has been rising since February, driven by softer US economic data, increased uncertainty, and renewed stagflation concerns. Shortly after risk attitudes appeared to stabilize, another wave of risk-off sentiment overcame investors—this time triggered by the long-awaited reciprocal tariff announcement.

The negative news was two-fold. First, the announcement was more hawkish than anticipated, featuring a 10% baseline tariff and reciprocal tariffs on a broad range of countries. Second, investors are beginning to question the purpose of the tariffs—are they simply a negotiating tactic, as initially thought, or a policy tool aimed at rebalancing global trade?

From a model perspective, we have seen a broad-based rise in risk aversion across the factors we monitor. The biggest driver of change recently is from our estimation of sentiment spreads and implied volatility. Our sentiment spreads have fallen from euphoric levels into clear risk-aversion territory. Implied volatility in both equity and currency markets has spiked, while spreads on risky debt have meaningfully widened—all suggesting greater risk aversion among investors. Together, these points to an unfavorable risk assets environment.

Our global equity forecast was stable month-over-month and remains muted. Sentiment indicators–—both earnings and sales—deteriorated as analysts turned more cautious on the outlook. This decline was offset by improved valuations. While still negative, valuations benefited from recent weakness in equity prices. Balance sheet strength remains a positive, though price momentum continues to lag.

Our bond market outlook is favorable. The model anticipates lower interest rates, a small steepening of the yield curve, and modest credit spread widening. Weak equity momentum and higher levels of risk aversion point towards falling yields, but credit spreads are expected to widen. Slope momentum and economic growth expectations imply a steeper curve. Despite expectations for wider spreads, positive carry and lower forecasted yields support credit bonds.

With risk appetite weakening, we reduced our equity exposure to underweight and reallocated the proceeds into our tail risk basket—long government bonds and gold. Additionally, we reduced our commodity exposure back to benchmark weight, sold high-yield bonds, while increasing our allocation to aggregate bonds.

Relative Value Trades and Positioning

Within global equities, our forecast for Pacific weakened but improved for the US, driven by a flip in our macro factor—now negative for Pacific equities and more supportive of the US markets. A key driver of our rebalance was the goal of reducing active risk. Accordingly, we sold emerging market and non-US developed equities (Europe and Pacific) and redirected proceeds to US large cap and REITs. While our active positions remain directionally similar to last month, they are now smaller in magnitude, with Pacific equities notably moved back to underweight.

On the fixed income side, we further reduced our high-yield exposure and sold some cash positions, reallocating to intermediate government bonds. While our forecasts for both cash and high yield remain positive, they are less attractive on a relative basis. This rotation also helps to reduce active risk within our fixed income sleeve.

Finally, at the sector level, we maintained full allocation to energy and communication services, supported by favorable macroeconomic factors and attractive valuations. Strong expectations for both sales and earnings buoy the communication services sector. While energy benefits from improved price momentum. We rotated out of technology and into financials, reflecting weaker signals for technology—including worsening valuations and negative sentiment indicators.

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