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
Source: State Street Global Advisors, as of 9 March 2023. Investment grade bonds consist of investment grade credit, Treasuries and aggregate bonds.
While there is still uncertainty about the economic outlook, recent data has generally been better than expected. This reinforces our view that near-term recession risks are low, but has drawn into question the disinflation narrative. It is likely that the recent data overstates the strength of the economy, but it is hard to dismiss the positive momentum. While inflationary indicators have surprised to the upside, highlighting the stickiness of elements, we still believe that the disinflationary trend will continue.
There are two sides to the current macroeconomic narrative. On one side, we have resolute economic activity. A strong rebound in January retail sales and continued robust labor markets suggest household consumption, a key pillar of growth, remains on solid footing. In the US, payrolls have outpaced expectations recently, while January’s Job Openings and Labor Turnover Survey reports surprised to the upside, with December’s reading revised upward.
In addition, the manufacturing sector appears to have stabilized, while the service sector continues to exhibit strength. The Federal Reserve Bank of Atlanta’s GDP Now tracker estimates a 2.6% YoY GDP growth for the US in Q1 2023, only slightly lower than Q4 2022 growth. Overall, the recent high frequency data suggests economic activity has held firm so far in 2023 and highlights the resilience of the US economy.
On the other side, resilience creates demand, and that fuels inflation. In the US, a string of data prints has given investors pause about the disinflation narrative. Consumer prices (CPI), producer prices (PPI) and even the US Fed’s preferred personal consumption expenditures (PCE) have exceeded expectations and point to stronger-than-expected inflation.
Manufacturing prices, from the ISM Manufacturing Purchasing Managers’ Index (PMI), have jumped back into expansion, suggesting a consolidation of core goods prices, while service prices appear sticky. Although the National Federation of Independent Business survey reported a fall in the net share of small businesses raising prices to 42% in January, which is well below the near-record high of 66% last March, it still remains elevated.
Outside the US, inflation in Europe was hotter than expected in February, particularly the core measure, which jumped to 5.6% YoY and posted a new high.
It is important to keep in mind that one month does not make a trend and we continue to anticipate inflation easing over the course of the year given the recovery in supply chains and a lagged effect from central bank tightening. Additionally, shelter costs in the CPI should soften soon, and wages have rolled over. Both should reduce service inflation over the course of 2023 and into 2024.
Even as they are in the latter stages of their policy tightening cycles, central banks still have more work to do. This fact was confirmed by Fed Chairman Jerome Powell during his recent testimony to the Congress, where he hinted that the terminal rate may be higher than previously anticipated. While we recognize the risk from recent data prints and the potential for a policy mistake, we think a transition from the hiking phase to a pause should be delayed, but not significantly altered.
The long and variable lags of monetary policy argue in favor of letting the already delivered tightening measures to work through the economy. As the year progresses, the continued easing of inflation measures should allow the Fed to ease off the brake. Overall, recent data have challenged markets and reminded us that the path to recovery is not linear. Focusing on longer-term trends keeps us optimistic that a recession is not imminent or inevitable.
Despite numerous uncertainties surrounding geopolitics, inflation and central banks, investor risk sentiment has continued to remain strong, with our Market Regime Indicator finishing toward the bottom threshold of a low-risk regime. Optimism from January cooled in February after a surprising jobs print and a number of inflation indicators – from CPI to PPI – came in hotter than expected. Investors quickly repriced Fed rate hike expectations by increasing the number of rate hikes and reducing expectations for a cut to close out 2023.
Both implied volatility on equity and risky debt spread measures rose for most of the month, but still remain in a low-risk regime. Implied volatility on currency has been more stable, while improving slightly and finishing in low risk. Overall, our gauge for investor risk appetite continues to signal a favorable environment for risk assets.
Our outlook for equities remains supportive, with our forecast slightly improved. In contrast, our expectations for bonds, both government and credit bonds, have deteriorated. Against this backdrop, we have sold high yield and aggregate bonds, with proceeds deployed into equities and cash. The selling of high yield now brings us to an underweight allocation from neutral.
For equities, the sell-off in February improved the already attractive valuations. Our macroeconomic and quality factors have cooled but remain supportive, and sentiment indicators are materially better and less of a drag on our forecast.
Within fixed income, our model is now forecasting modestly higher rates with a slightly steeper yield curve. Interest rate momentum, lower inflation prints and higher nominal GDP growth compared to long bond yields all imply higher future yields. For credit, both high yield and investment grade spreads are expected to widen, driven by elevated equity volatility and higher refinancing costs.
Within equities, our Pacific equity forecast deteriorated meaningfully and we reduced our overweight, rotating into US small cap equities. With the purchase of US large cap equities, resulting from our directional buy of equities, we have moved to a small overweight for both US large and small cap equities at the total portfolio level. US equities continue to benefit from strong macroeconomic factors, while improvement in sentiment, which is now slightly better than Pacific equities, supports the relative attractiveness.
Valuations for Pacific equities are still favorable, but a drop in sentiment and momentum has pushed the region down our rankings. Within the US, we have a slight preference for small caps due to the better price momentum and more attractive valuations.
Within fixed income, we sold more aggregate bonds and slightly reduced our overweight to long government bonds in favor of cash. We now hold a healthy allocation to cash, which boasts a generous yield and can provide some downside protection should investors continue to reprice Fed expectations.
At the sector level, we maintained our allocation to industrials, but rotated out of consumer staples and healthcare into energy and financials. Both consumer staples and healthcare experienced a weakening in price momentum and sentiment, which along with poor valuations pushed the sectors down our rankings.
Industrials remain our favored sector and continue to score well across all factors, particularly with strong price momentum and robust sentiment. Financials benefit from sturdy price momentum and positive macroeconomic factors, but a large increase in sentiment – both earnings and sales – has pushed financials up our rankings.
Sentiment indicators for energy have weakened considerably with the fall in energy prices, but longer-term price momentum factors are firm, valuations are attractive and quality factors are strong, which support the sector.
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.