Favoring Cash Against High Yield: Tactical Trading Decisions for September 2022
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 economic growth outlook remains cloudy and numerous risks have led us to periodically reduce our growth forecasts. Recession fears have intensified as growth continues to downshift from the post-COVID-19 recovery, an energy crisis threatens Europe, China struggles with COVID-19 lockdowns and the housing sector is battered, all while central banks continue to become more hawkish. Despite the downgrades, we are not forecasting a recession and continue to believe that sources of resiliency remain.
Growth has slowed and will likely slow further as elevated inflation and rising rates reduce real disposable income and corporate profits. Activity measures have deteriorated, and while the US Services Purchasing Managers' Index (PMI) unexpectedly strengthened in August, PMIs globally are generally weakening. Additionally, leading indicators point to further declines with the Conference Board’s Leading Economic Index declining for a fifth consecutive month in July. However, while activity is slowing, employment remains robust and wage growth is still solid, both of which can support demand. Healthy corporate balance sheets and profits should help maintain demand for labor.
We continue to see signs of declining prices but are steadfast in our belief that inflation will remain elevated for quite some time barring a deep recession. Headline inflation in the US moved lower in August, the second consecutive month of declines, but core inflation spiked signaling that price pressures continue to strengthen broadly. Gas prices have been the big driver of easing price pressures, but shelter, medical, food, electricity and others continue to grind higher. Prices paid measures have softened and supply chain pressures are abating, both of which should pass through to consumers, but absolute levels are still high and risks remain.
OPEC+ agreed to cut output in October as recession fears have weighed on prices while little is being done to increase overall supply. Labor unions at major US freight railroads have been unable to reach an agreement, setting the stage for potential strikes, which would negatively impact supply chains. Overall, an easing of inflation pressures from extreme levels can help further support demand, but a meaningful decrease may not be imminent.
Despite the heightened recession fears, central banks continue to strike a more aggressive tone while reiterating their intent to bring inflation down to targets. Unfortunately, banks have not provided an indication of which rate levels will trigger a pause, which only increases the fears of a policy mistake. In our view, the Fed is likely to slow the pace of hikes by year-end to assess the economy and the impact of higher rates, decelerating growth and inflation. We still believe it is wiser to pause in restrictive territory rather than continue to push until the economy is in a recession. Outside the US, the European Central Bank (ECB) will need to continue raising rates to gain credibility in its fight against inflation, while the Bank of England (BoE) is expected to hike again despite increased recession fears.
Ongoing uncertainty around growth and monetary policy will continue to weigh on investors and create a challenging macroenvironment.
Figure 1: Asset Class Views Summary
Source: State Street Global Advisors, as at 10 September 2022.
Directional Trades and Risk Positioning
Risk aversion intensified during the second half of August as mounting fears of an energy crisis in Europe and more hawkish central banks threatened global growth. Our Market Regime Indicator (MRI) began the month moving down into a normal risk regime before pivoting and finishing in high risk. The move was driven by implied volatility on equity and currency with both measures moving up meaningfully into a normal and crisis regime respectively. Risky debt spreads narrowed, but the measure remains in high risk.
Global equities suffer from poor price momentum, but meaningful improvements in sentiment along with still attractive valuations helped upgrade our forecast. However, the deterioration in risk appetite largely offset this improvement and propelled us to make a minor adjustment to equity, further increasing our underweight. The result was a small sell in US large cap equities.
Contrary to last month, our model is now looking for higher government rates, which depressed our fixed income forecasts. We sold both aggregate bonds and high-yield bonds while also increasing our overweight to cash. The sell in high-yield bonds now brings us underweight from neutral. The biggest change in our outlook for bonds was a flip in interest rate momentum, which along with a higher nominal Gross domestic product (GDP) print relative to longer-term yields suggests higher rates ahead. For high yield, poor seasonality and higher levels of government yields weighed on the outlook, but the recent decline in risk sentiment soured our forecast, which now suggests wider spreads. Cash offers a healthy yield and provides some downside protection in this challenging environment.
Relative Value Trades and Positioning
In line with our directional trades, we moved from neutral to underweight in high yield, which also leaves us underweight at the total portfolio level. Elsewhere, we increased our overweight allocations to cash and intermediate government bonds. While our models are now forecasting higher yields, on a relative basis, intermediate government bonds offer a more attractive opportunity.
From a sector perspective, energy and utilities remain targeted sectors while we rotated out of healthcare and upgraded financials to a full allocation. Healthcare benefits from positive macroeconomic factors, and even though price momentum remains positive, a decline in August pushed the sector down in our rankings. Despite weakness in oil markets, energy remains our top-ranked sector. Price momentum has softened but remains solid, while robust sentiment and enticing valuations all support the sector. Utilities experienced improvements in sentiment, which combined with sturdy price momentum and supportive macroeconomic factors buoy our outlook. Price momentum has been poor for financials but improving sentiment and attractive valuations keep the sector near the top of our rankings.
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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