Commodities Now an Overweight

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

As we begin 2025, the US economy remains solid, with our growth forecast raised by 70 bp to 2.2%. Forecast for emerging markets has slightly improved, while expectations for both the euro area and Japan have declined.

Within the United States (US), recent data support expectations for a soft landing. Consumption drove growth in 2024 and is poised to continue in 2025. While tariffs pose a potential headwind, reasonable balance sheets, a stable labor market, and healthy earnings growth should buoy consumption. Household stress does not appear too onerous, with debt to disposable income at reasonable levels and savings still solid. Credit conditions are also improving, as indicated by the Senior Loan Officer Opinion Survey, with fewer banks tightening standards and more willingness to make installment loans, nearing pre-COVID levels.

Despite softness in the labor market, such as lower hiring rate and a weaker labor diffusion index, the overall picture remains modestly positive. The three-month moving average payrolls, the Job Openings and Labor Turnover Survey (JOLTS), and unemployment claims are all still supportive. Additionally, small business sentiment has improved, with the NFIB Small Business Optimism Index improving markedly and hiring plans picking up recently. Beyond consumption, government spending on US pro-growth policies should further aid economic growth.

Outside of the US, European economic growth has been weighed down by Germany. While healthy savings, solid wage growth, and expanding service activity are positive signs, the challenge in terms of convincing households to spend remains. Consumer confidence and employment expectations have declined, suggesting consumers may not open their wallets. On the positive side, disinflation has remained intact, paving way for further rate cuts by the European Central Bank.

In Japan, wage growth is solid, with reports indicating that Japanese companies will provide another 5% wage hike on average. However, household spending fell again as inflation eroded real wages.

In China, deflation continues to be a concern, with December’s inflation moderating to 0.1% YoY due to supply and demand imbalance. Additional tariffs pose a potential headwind and further stimulus may be needed to spur demand.

Despite global risks, the combination of solid labor dynamics, further disinflation, and more monetary easing should support economic growth.

Directional Trades and Risk Positioning

Fears of sticky inflation, fewer expected Fed rate cuts in 2025, and rising yields dented equity enthusiasm in December. However, risk appetite continued to improve when evaluated through our Market Retime Indicator (MRI). While signals in our quantitative framework remained mixed, ongoing improvements in certain signals biased our model towards positive risk sentiment.

Credit market sentiment and risk support have not changed, indicating elevated levels of risk aversion. However, equity trends strongly suggest risk-on environment. Sentiment spreads and implied volatility have improved, signaling increased risk taking. Overall, our improved MRI signals a moderately positive risk environment.

Within our quantitative framework, forecasts for equites and commodities improved, but expectations for bonds have weakened.

Our slightly better equity outlook was driven by improvements in our macroeconomic factor, which turned positive. While valuations remain stretched, they are slightly better than in December. Sentiment indicator has softened to marginally negative, but price momentum indicators are positive and quality factors remain favorable. Overall, our equity forecast stays positive.

In bond markets, expected returns have deteriorated meaningfully and we continue to favor cash and credit, both investment grade and high yield. Our model now expects a sizable rise in yields along with a modest steepening of the yield curve. While the recent manufacturing Purchasing Managers’ Index signals weaker activity, it improved and sits above our lookback window, implying higher rates. Third quarter gross domestic product remained firm, exceeding longer-dated bond yields, suggesting yields should rise.

Interest rate momentum flipped, signaling rates will continue to advance. Our model also expects yield curve steepening due to lower inflation expectations and lower leading economic indicators, compared to our lookback periods. For both high yield and investment grade credit, positive seasonality and lower government bond rates buoy our forecast.

Commodity markets rebounded in December, driven by higher energy prices. In our quantitative framework, improvement in the energy sector boosted our commodity forecast. Our carry factor, which examines the shape of the curve and tries to capture the supply and demand dynamics of commodity markets, is supportive. Momentum indicators also suggest commodities should perform well. Additionally, our estimation of anti-commodity investor bias signals a favorable environment for the broad commodity complex.

Given the improved forecast, we increased our commodity exposure to overweight. We also slightly increased our equity overweight due to better risk appetite and an improved equity forecast, funding these buys by reducing exposure to aggregate bonds and cash.

Relative Value Trades and Positioning

Our non-US equity forecasts improved, with our Pacific outlook turning positive, due to better macroeconomic indicators and strong sales and earnings expectations. For Europe, expectations improved, but our forecast remains negative, as weak price momentum offsets attractive valuations and positive quality factors. The US forecast remains positive but softer, with a preference for small-cap stocks over large-cap due to better valuations and similar sentiment indicators.

Emerging markets saw a deterioration in price momentum and sentiment indicators, both turning negative, weakening our forecast. However, strong quality and macroeconomic factors keep us cautiously optimistic.

Against this backdrop, we reduced our exposure to US large-cap and European equities, reallocating to Pacific and US small-cap equities, bringing our Pacific allocation to overweight, diversifying regional equity positions.

In fixed income, we reduced our overweight in intermediate corporate bonds in favor of cash, given expectations for higher yields and small spread tightening. Cash continues to offer attractive yields and protection from any further market consternation. Overall, we maintain a preference for cash and credit, both high yield and investment grade.

At the sector level, we maintained full allocations to consumer discretionary and financials, rotating out of communication services into energy. While communication services remain positive, weaker factors pushed the sector down our rankings. Price momentum is still firm, but sentiment, valuations, and quality indicators became less supportive. The energy sector benefits from favorable valuations, positive quality factors, and a strong macroeconomic indicator, which offsets poor sales and earnings expectations. Price momentum became more supportive for consumer discretionary, while sentiment indicators remained firm and quality factors turned positive. Financials are supported by robust price momentum, stable sentiment indicators, and positive macroeconomic factors, with less negative valuations.