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
As we begin the fourth quarter, data points continue to point toward positive economic growth in the near term. While the United States (US) continues to outpace, there have been some improvements in Europe and China.
In the US, the biggest driver of growth, the consumer remains on stable footing. Recent data suggest the labor market is accelerating, and while it may overstate the current condition, it is clear the labor market remains robust and is supportive for growth. Nonfarm payrolls almost doubled expectations at 336k. There were strong revisions, adding 119k over the previous two months. Job openings, measured by the JOLTS report, increased almost 700k to 9.6 million, while job openings to unemployment rate remained at a very elevated 1.5, suggesting still excess demand for labor. Further, both initial and continuing unemployment claims are falling with the four-week average continuing to trend lower. The labor force participation rate among prime age works has been rising, now at its highest level since 2002, which could help future growth and lower inflation.
Household balance sheets remain solid with big wealth gains for households, with the Fed’s fund flow data revealing that the net worth of US households rose to US$154.3 trillion in Q2, up US$5.5 trillion in the second quarter. Some of this was given back in Q3, with equities being lower, but when viewed through the relatively low debt to disposable income ratios, it points to continued support through the yearend.
Manufacturing may have found a bottom and could point to a recovery in activity. In the US, although the manufacturing PMI remains in contraction, it has increased for three consecutive months, hitting an 11-month high. In China, the measure has improved for four consecutive months and is now in expansion and the services PMI has also increased. Although these could suggest the worst is behind us, China is still faced with structural challenges related to housing and consumption. Europe exhibits a similar pattern, with recent improvements to both manufacturing and services, both showing signs of bottoming.
Moderating wage growth is a positive for disinflation, but house prices are rising again, which could put upward pressure on rents, posing further challenges for the Fed. In our estimation, the Fed should not hike rates further, but given the recent jobs reports and stronger GDP growth, the Atlanta Fed’s GDPNow is tracking at 4.9% for Q3, which means risks are high for another hike before the yearend. The surge in long-term rates has created tighter financial conditions, a positive for the Fed, but the US central bank remains committed to ensuring inflation reaches its target.
Overall, we still believe that several factors will eventually chip away at economies, and we continue to expect that global growth will slow to a more muted pace in 2024.
Investors shrugged off numerous headwinds over the course of the year, but risk sentiment weakened in September, with our Market Regime Indicator (MRI) shifting from euphoria to a normal risk regime. Bond yields have been under pressure from massive US Treasury issuances, ballooning US deficits and solid growth in the US, among others, as investors appeared to increase the premium demanded from bonds.
However, a hawkish pause by the Fed in September forced investors to re-price rate expectations, which arrested positive risk appetite, sending yields and volatility higher. Implied volatility in equities experienced the sharpest move, rising from the bottom of euphoria to the upper range of normal. Elsewhere, both implied volatility in currency and risky debt spreads moved toward a normal regime and highlighted anxiety in markets. While this environment is not outright negative for equities, it does suggest investors are a little more cautious, warranting a reduction in risk for our portfolio.
Our outlook for high yield has deteriorated with our model now anticipating materially wider spreads. Meaningfully higher rates imply rising cost of capital, which could create additional hurdles for lower credit companies to refinance, pointing to wider spreads. Increased equity volatility and overall equity weakness recently also signal wider spreads.
Against the backdrop of weaker risk appetite and a negative outlook for spreads, we sold equities, reducing our overweight, as well as high yield bonds, with proceeds deployed to aggregate bonds.
We chose to reduce a large source of active risk in our portfolios given the developments over the weekend with the Hamas Israel conflict, which brought more instability to the Middle East. While the impact of this event to global markets remains unclear, the potential for sanctions on Iran or further escalation of the crisis could meaningfully affect commodity markets, particularly energy, which is already faced with tight supply and demand fundamentals that could support higher prices. We decided to buy commodities, closing our underweight, by reducing our overweight to both gold and cash.
Our forecast for Pacific equities meaningfully improved, while our outlook for both the US and Europe have softened. Both short and long-term price momentum has improved, and on a relative basis, this favors Pacific equities. Elsewhere, analysts’ expectations for both sales and earnings have advanced and macroeconomic indicators are less of a drag. Our forecast for the US remains positive, but a reduction in sentiment tempered the outlook. In Europe price momentum is weaker and sentiment indicators also weigh on the region. Overall, we sold Europe and US large cap in favor of Pacific equities. These trades leave us neutral in Pacific, overweight in US and underweight in Europe.
Within fixed income, our model continues to forecast higher interest rates, a steeper curve and wider credit spreads. Interest rate momentum and nominal GDP that still exceed long-term Treasury yields continue to imply higher rates. With the potential for another Fed rate hike in November and our model looking for a bear steepener and wider credit spreads, the intermediate part of the Treasury curve looks most appealing. Against this backdrop, we sold aggregate bonds, high-yield bonds and long Treasury bonds with proceeds deployed to intermediate Treasuries, cash and non-US government bonds. The sale of aggregate bonds partially offsets the buy in directional, but we still added to the position at the total portfolio level. The sale of high yield brings us to underweight in the asset class.
Finally, at the sector level, we maintained an allocation to energy and industrials while rotating out of consumer discretionary and splitting an allocation between materials and communication services. Our expectations for consumer discretionary remain firm but have relatively softened and the sector has dropped down our rankings. The sector exhibits positive attributes across all factors except value, but price momentum and sentiment measures have become less supportive.
The energy sector has benefited from higher oil prices recently on the back of output cuts from Saudi Arabia and Russia, and is our top-ranked sector. After falling over the course of 2023, price momentum is now positive while analysts’ expectations for earnings have progressed. Industrial exhibited strength across macroeconomic and sentiment indicators while price momentum remained favorable. The materials sector has been bogged down by slower growth in China, but attractive valuations and improvement across multiple factors in our model pushed the sector up our rankings.
Sentiment indicators remain negative but are less of a drag due to improvements in analysts’ expectations for earnings. Elsewhere, our evaluation of balance sheet health has become more positive and trends in prices remain supportive. Despite rising interest rates, the communications services sector has ridden momentum from the AI hype and overall digital content trend. In our quantitative framework, the sector ranks near the top across price momentum and sentiment indicators and valuations remain enticing.
Click here for our latest quarterly MRI report.
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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The views expressed are of Investment Solutions Group through the period ended 10 October 2023 and are subject to change based on market and other conditions.
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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).
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