Reduce Allocation to European Equities

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

Last month, we noted that the range of possible outcomes from trade disputes was wide, though we did not expect the worst-case scenario to materialize. A month later, while a resolution remains elusive, there has been some clarity. From the softening of certain tariffs – such as auto-related measures and the 90-day delay on reciprocal tariffs – to the trade deal announced with the UK and progress with China, it is clear the US administration is seeking to make deals. Equity markets appear to have recognized this and have cautiously rebounded, erasing losses incurred after the announcement on 2 April.

At present, we maintain our view that growth will slow but not contract, prices will rise but significant inflation is unlikely, and the US Federal Reserve should continue to cut rates.

In the US, growing concerns about the economic outlook have been reflected in soft data, but actual economic activity (hard data) has yet to show meaningful weakness. Consumer confidence, as measured by the Conference Board, fell in April to levels last seen during the COVID-19 pandemic, with both the present situation and expectations components declining. The New York Fed’s April Survey of Consumer Expectations echoed this loss of confidence, showing falling earnings expectations and rising unemployment expectations. Businesses have also grown more cautious, as evidenced by the decline in the NFIB Small Business Optimism Index over recent months.

Unless the US experiences significant job losses or the high reciprocal tariffs persist for an extended period, a recession remains unlikely. During President Trump’s first term, tax cuts preceded tariffs, which helped mitigate concerns about tariffs’ negative effects. This time, however, policy has taken a different path, with DOGE and tariffs being prioritized, dampening sentiment. Nevertheless, pro-growth policies such as deregulation and the extension of tax cuts, along with the potential for further tax relief later in the year, should help support demand.

Despite lower sentiment, consumers have continued to spend, with retail sales remaining firm, though some of these may reflect the advancement of activity in anticipation of higher prices. Elsewhere, jobless claims remain low, the quits rate is rising, and household net worth as a percentage of disposable income remains high. Meanwhile, debt service as a share of disposable income is still below pre-COVID-19 levels. With consumers on solid footing, layoffs limited, the Fed expected to cut rates, and money supply increasing, demand could remain resilient.

However, given the uncertainty and the negative effects of tariffs, we have lowered our US economic growth forecast by 0.2 percentage points to 1.8%, and raised our unemployment forecast to 4.7%.

The Fed has adopted a more cautious tone – and rightly so. There is considerable uncertainty that could materially affect both labor markets and inflation – both sides of the Fed’s dual mandate. We continue to expect three rate cuts this year, though we have pushed the first cut to July. While the labor market has not deteriorated significantly, it has cooled enough that the Fed has less room to allow further weakening. Additionally, shelter disinflation is likely to continue, used car prices may decline as demand softens, and by July, the Fed should have greater clarity on trade policy direction.

While we now have a slightly clearer picture of trade policy, much remains unknown. The full impact of recent tariff announcements has yet to be reflected in the data or felt by consumers. We will continue to monitor trade negotiations and their effects on global economies, as well as reconciliation developments, which will have important implications for economic growth.

Directional Trades and Risk Positioning

Looking back over the recent past, it is remarkable that equity markets have largely round-tripped from the severe selling pressure triggered by the US administration’s tariff announcements in early April. If an investor’s only source of market news were their monthly portfolio statements, they might not have even noticed that their equity investments declined by less than 1% since 31 March. While that may seem like good news in the short term, our assessment of the situation is more cautious. The heightened uncertainty in the economic environment and the dramatic volatility in financial markets make us more circumspect about the near-term outlook.

Investor risk appetite, as measured by our Market Regime Indicator (MRI), has recovered slightly but remains weak. Tariff uncertainty has weighed heavily on sentiment, compounded by softer US economic data and rumors that the US administration may seek to remove Jerome Powell. From a model perspective, risk aversion is broad-based across our factors. The equity trend component continues to deteriorate and is approaching neutral. Our analysis of sentiment spreads and implied volatility indicates extreme levels of risk-off behavior. Overall, the MRI continues to signal a poor environment for risk assets.

Our outlook for equities is poor, driven lower by the deterioration across multiple factors in our model. Despite recent positive performance, our price momentum indicators have continued to weaken and have now turned negative. Additionally, we have observed a sharp decline in earnings and sales expectations, which, alongside weakening real gross domestic product (GDP) forecasts, weighs heavily on our equity market outlook.

In bond markets, we remain constructive, with our model anticipating meaningfully lower interest rates. Although yields have declined significantly in recent months, our estimated trend level remains well below current yields, suggesting further declines are likely. Weak equity momentum, reduced commodity price pressures, and elevated risk aversion all support this view. In credit markets, our model expects high-yield bond spreads to widen meaningfully. Our assessment of equity momentum, heightened volatility, and diminished risk appetite all point to wider spreads.

Against this backdrop, we have continued to reduce risk in our portfolios, implementing a broad-based reduction in equity exposure while increasing allocations to investment-grade fixed income. Additionally, we have extended our underweight position in high-yield bonds.

Relative Value Trades and Positioning

Within equities, we had been gradually increasing our allocations to non-US equities over the past several months. However, we are now beginning to see signs that momentum toward international equities may be waning. Our regional forecasts have weakened, with non-US forecasts declining more significantly. As a result, we now favor US and emerging market equities, while becoming less optimistic about developed ex-US markets.

The primary driver of this shift stems from our analysis of sentiment and macroeconomic factors – both of which have improved for the US but deteriorated for Europe, weighing on our outlook for developed non-US equities. Despite weaker sentiment, emerging markets remain supported by strong macroeconomic fundamentals and attractive valuations.

Within the US, our expectations for real estate investment trusts (REITs) have improved, supported by gradually strengthening price momentum and increasingly favorable sentiment indicators. During our May rebalance, we reduced allocations to Europe and the Pacific region, reallocating capital to US equities – both large – and small-cap – as well as to REITs.

At the portfolio level, we now hold a modest overweight to emerging markets and underweights to both US and developed non-US equities.

On the fixed income side, we sold non-US government bonds and increased our overweight to long-duration US Treasuries. Non-US government bonds appear less attractive on a relative basis, particularly given our model’s forecast for meaningfully lower US interest rates.

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