Trimming risk, staying constructive
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
At the start of the year, a backdrop of resilient growth, easing monetary policy, and pro-growth fiscal dynamics supported our expectation for continued economic expansion. Recent geopolitical developments in Iran have increased uncertainty, but they have not changed our core view. Unless the conflict becomes prolonged and leads to meaningful disruptions in energy markets, we believe the outlook for solid growth, manageable inflation, and additional Fed easing remains intact.
We continue to believe the Federal Reserve (Fed) is on track to continue easing policy this year, with approximately 75 basis points of rate cuts remaining as our base case, though not a hard conviction. The war in Iran has complicated the outlook by introducing renewed energy-driven inflation risks at a time when downside risks to growth are also increasing from the spike in energy prices.
Given the Fed’s prior sensitivity to upside inflation risks, policymakers may initially place greater weight on the recent rise in energy prices. However, they are likely to ultimately look through what is likely to be a temporary shock and refocus on a clearly softening labor market. Employment conditions have weakened meaningfully, with the BLS diffusion index deteriorating, the gap between jobs plentiful and jobs hard to get continuing to narrow, and recent payroll data undershooting expectations alongside a rise in the unemployment rate. While wage growth ticked higher in the latest data and remains above pre-pandemic levels, the broader trend has been one of moderation.
At the same time, longer-term inflation expectations remain well anchored, which should help keep the Fed on track to cut rates further. Additionally, we anticipate rent measures will continue to soften, and the unwinding of prior tariff effects should provide additional disinflationary support, albeit with some uncertainty following recent Supreme Court developments. We acknowledge risks to this view, including elevated prices-paid components in manufacturing and services PMIs, rising price-increase intentions among small businesses, and persistent pressure in essential categories such as electricity, particularly given AI-related demand growth, as well as medical and insurance costs. Nonetheless, taken together, recent data suggest the Fed remains positioned to cut rates this year despite energy-related inflation concerns tied to the Iran conflict.
In the US, we continue to expect growth to remain solid despite elevated risks, supported by several important tailwinds. The labor market is softening but not collapsing, with recent payroll weakness partly distorted by one-off factors, while retail sales tell a similar story as headline spending slowed but the control group remained resilient.
Financial conditions are easy, central banks have eased policy, and fiscal stimulus from the One Big Beautiful Bill Act (OBBBA) is flowing through the economy, helping support businesses and consumers. Survey data reinforce this constructive backdrop, with PMIs, particularly services, showing positive momentum, ISM manufacturing expanding for a second consecutive month, and global activity indicators also improving. Corporate fundamentals remain healthy, with broad-based revenue and earnings growth and strong balance sheets continuing to support labor demand.
At the same time, the lagged effects of Fed rate cuts and fiscal stimulus appear to be lifting business confidence, as reflected in improving small business optimism and a notable rise in CEO confidence, alongside an increasing share of firms planning to raise capital spending. Meanwhile, initial jobless claims remain low and continued claims appear to have stabilized, reinforcing the view that labor conditions are cooling but not deteriorating sharply.
While wage growth has moderated, it remains elevated, and real wage growth has returned to pre-pandemic levels, which, combined with a strong wealth effect from equity markets, should help underpin consumer spending. Even as the Atlanta Fed’s GDPNow estimate has moved lower, it continues to point to solid growth near trend. Overall, the data suggest an economy that is slowing, but not breaking, and one that still offers reasons for cautious optimism.
Overall, while uncertainty has clearly increased, we believe the fundamental backdrop remains supportive of continued expansion and further policy easing. That said, risks around geopolitics, energy prices, and inflation dynamics warrant close monitoring, as shifts in these factors could meaningfully alter the outlook. As conditions evolve, we remain focused on assessing incoming data and market signals to ensure our views and positioning appropriately reflect the balance of risks and opportunities ahead.
Directional trades and risk positioning
When assessing the current market environment, we see continued softening in overall support for risk assets, even as select segments have shown slight improvement. While investor risk appetite remains constructive overall, our Market Regime Indicator (MRI) has continued to moderate. In tandem with this assessment of market sentiment, our outlook for equities remains positive, but expectations have tempered.
Within real assets, our outlook for gold and commodities remains firm, supported by numerous factors. With updated quantitative signals and a desire to reduce active risk amid ongoing Middle East tensions, we have reallocated within risk assets, lightened duration in our fixed income allocations, and maintained existing allocations to commodities and gold.
Our assessment of risk appetite continues to reflect a generally positive environment, although support has moderated modestly over the past couple of months. Similar to last month, our MRI has signaled a small uptick in risk aversion rather than a shift to a defensive posture. Geopolitical, trade, AI, and labor market uncertainties have weighed on sentiment, partially offset by strong earnings, softer inflation, clearer Fed leadership, and pro-growth political developments in Japan.
From a model perspective, the recent increase in the MRI has been driven primarily by two factors:
- Sentiment spreads, measured through pairs of risk-on and risk-off market segments, have shifted from clearly supportive to modestly risk averse.
- Volatility measures have normalized, moving from low, near-euphoric levels toward neutral, reducing a key source of tailwind for risk assets.
Elsewhere, our broader measure of risk support has moved toward neutral, while equity trend signals remain firmly positive. Taken together, the MRI continues to point to a moderately positive environment for risk assets, but with increased levels of risk aversion.
While uncertainty has begun to surface more prominently among equity investors in recent days, our model has been signaling a gradual decline in support over the past couple of months. Importantly, there are still reasons for optimism. Measures of sentiment, sales and earnings expectations, and quality—such as balance sheet strength and the ability to generate revenue efficiently—remain positive, though they have softened relative to the stronger levels seen late last year.
Price momentum continues to hold up well and has not meaningfully wavered despite an increasingly complex risk backdrop. By contrast, lofty valuations remain a headwind despite recent weakness. Taken together, we remain constructive on equities but have moderated our optimism modestly.
Bonds have come under pressure in recent days as higher energy prices have reignited inflation concerns. In our quantitative framework, expectations have deteriorated modestly this month, with the model now forecasting little change in yields.
From a factor perspective, longer-term trends and signs of softer risk appetite have offset stronger equity momentum, resulting in a largely neutral yield outlook. We also anticipate a modest steepening of the yield curve, driven by recent momentum and indications of slowing economic activity. One area of improvement has been credit markets, particularly high yield, where we now expect spreads to tighten as lower yield levels and firm equity momentum provide a more supportive backdrop.
Overall, we reduced our equity allocation and redeployed assets into high-yield bonds. We continue to hold a meaningful overweight to equities, complemented by modest overweight allocations to commodities and gold.
Relative value trades and positioning
Within equities, dispersion across our regional forecasts has narrowed, with a notable improvement in the Pacific region. The stronger outlook reflects more favorable signals across several dimensions, including price momentum, sentiment, and valuations. We continue to view the US as attractive, though our forecast softened modestly this month. Sales and earnings expectations remain solid but have weakened, while balance sheet strength and macroeconomic factors continue to provide support.
Within the US, our small-cap forecast weakened relative to large cap as macroeconomic indicators deteriorated, and sentiment became less supportive on a relative basis. In response to these shifts, we implemented a modest rotation out of US small-cap equities and into the Asia Pacific region. Overall, we maintain a sizable overweight to US equities across both large- and small-cap segments, alongside targeted overweights to emerging markets and Pacific equities.
Within fixed income, we implemented a modest rotation out of long-duration US government bonds and into non-US government bonds. This shift reflects our model’s expectation for muted US Treasury returns, with little anticipated change in yield levels, contrasted with more attractive opportunities outside the US where favorable currency dynamics and stronger momentum point to further declines in yields. Overall, we continue to maintain an overweight to longer-duration assets across both credit and Treasuries.
In equity sectors, communication services continues to rank well in our quantitative research. Though the sector has exhibited choppy performance over the past several months, we continue to see some of the strongest earnings and sales expectations, as well as solid quality metrics. Health care also continues to look attractive, with support coming from most factor groups. Rounding out our preferred sector allocations are technology and industrials. Technology improved incrementally from a momentum standpoint, while industrials perked up alongside improving manufacturing data and widening dispersion within the sector.
To see sample Tactical Asset Allocations (TAA) and learn more about how TAA is used in portfolio construction, please contact your State Street relationship manager.