Reducing underweight in US Agg

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

The US economy is sending mixed signals as we approach 2026. On one hand, rising unemployment claims, layoffs, and voluntary quits suggest a softening labor market. On the other, several encouraging indicators point to the possibility of avoiding a major downturn.

Notably, NFIB optimism and hiring plans have been trending upward in recent months. CEO confidence is on the rise, and robust corporate profits may help sustain employment into next year. Additional tailwinds include anticipated Federal Reserve rate cuts, accelerated capital depreciation, and deregulation, all of which are likely to support business investment.

Meanwhile, gains in the housing and equity markets are enhancing the wealth effect for higher-income households, which continue to drive retail spending. Retroactive tax cuts under the One Big Beautiful Bill Act (OBBBA) could also boost refunds for lower-income groups in early 2026.

Recent data continues to highlight the resilience of the US economy. The Atlanta Fed’s GDPNow tracker estimates 3.8% growth for Q3, driven by robust corporate capital expenditures and steady consumer spending. Lending conditions are also showing signs of improvement, with the Senior Loan Officer Opinion Survey indicating a growing willingness to extend consumer credit, approaching pre-COVID levels.

Taken together, these developments, combined with supportive policy measures, rising business and consumer confidence, and easing uncertainty, suggest that the US economy is well-positioned for stronger growth in 2026.

We expect the Federal Reserve to implement two additional 25 basis point (bps) cuts this year, totaling 50 bps, followed by another 50 bps of easing in 2026. While Fed officials remain divided on the near-term outlook, signs of labor market softness are likely to keep them on track to reduce rates.

Inflation risks persist, particularly from tariff pass-through, but these pressures have remained manageable so far. Continued declines in rents, weaker labor conditions, and slower migration should help offset inflationary forces.

Recent projections from the Federal Reserve indicate a constructive economic outlook. Growth estimates have been revised upward through 2027, unemployment expectations for the next two years have been lowered, and although inflation forecasts for next year have edged higher, the outlook for the current year remains unchanged.

This combination points to stable yet sticky inflation and a solid growth trajectory, creating an environment that could benefit risk assets. Overall, the Fed appears poised to follow the path of least resistance and continue easing policy into 2026.

While we remain mindful of the risks facing the US economy, our base case continues to anticipate a rebound in growth next year, supported by multiple tailwinds. Key risks to this outlook include a resurgence in inflation, a sharper deterioration in labor market conditions, and heightened trade uncertainty.

One notable concern is the planned 100% tariff on imports from China, set to take effect on 01 November, as retaliation for tightened rare earth exports. Although we expect some de-escalation, similar to previous episodes, trade tensions remain a persistent source of volatility.

Overall, while these risks warrant close monitoring, the underlying supports, monetary policy easing, resilient consumer spending, and fiscal policy should help sustain growth momentum into 2026.

Directional trades and risk positioning

Over the past month, our outlook for both equities and bonds has improved, reflecting a more constructive market environment. While our models still favor equities, supported by stronger risk appetite and positive quantitative forecasts, we have taken this opportunity to rebalance our portfolios. This adjustment involved recalibrating exposures across risk assets and bonds to capture more attractive opportunities identified by our models, ensuring alignment with evolving market dynamics.

Despite ongoing challenges such as labor market weakness, the government shutdown, and cautious commentary from the Fed, investor risk appetite has remained resilient. Our Market Regime Indicator (MRI) reflects this optimism, remaining stable and signaling a constructive backdrop for risk assets. Strong corporate earnings, expectations of further Fed rate cuts, and the positive effects of the OBBBA have all contributed to improved sentiment. From a quantitative standpoint, multiple factors reinforce this favorable environment: equity trends continue to provide strong support, our sentiment spread factor indicates improved confidence, and measures of risky debt spreads and currency volatility suggest very low risk aversion. While credit market sentiment remains somewhat less favorable, the overall picture from our MRI points to sustained optimism for equities.

Our quantitative model maintains a constructive outlook for equities, projecting strong returns supported by broad-based strength across multiple factors. Although valuations have become more stretched following this year’s strong gains, improving price momentum has helped offset these concerns. Quality and sentiment indicators remain robust, signaling continued corporate strength. While earnings and sales estimates have softened slightly as analysts adjust to the evolving environment, they remain positive and point to further price appreciation. Additionally, measures of operating efficiency and balance sheet health continue to reinforce the resilience of corporate fundamentals. Taken together, these factors suggest that equities are well-positioned to extend their rally in the near term.

Our outlook for bonds has turned more positive, with expectations for yield compression. This view is supported by two key factors: the tendency for yields to revert toward long-term averages (mean reversion) and slowing momentum in commodity prices. Current yields remain above their long-term trend, suggesting room for further decline. At the same time, the deceleration in commodity price growth often signals weaker economic activity ahead, a condition typically associated with lower yields. Similarly, signals from equity momentum and risk sentiment confirm this deceleration; while both remain structurally supportive, the rate of improvement has slowed, producing a neutral composite signal. Collectively, these factors strengthen the case for a downward adjustment in yields, reinforcing a constructive stance on duration exposure within fixed income allocations.

Our outlook for credit has softened, with our model now projecting no change in spreads. While lower interest rates typically ease financing conditions and support tighter spreads, slower equity momentum and slightly elevated volatility suggest spreads could widen. Overall, while carry remains attractive and yields are expected to decline, the additional support from spread tightening seen earlier has largely dissipated.

Our outlook for commodities remains positive, though slightly less so than in previous months. We continue to see strength in areas such as energy and industrial metals, supported by favorable trends and curve structures that point to stable pricing and ongoing market support. However, improved investor sentiment could mean commodities may no longer offer the same relative value. While we still view commodities as an attractive asset class, they appear less compelling compared to equities at this time.

In light of shifting forecasts for both risk assets and bonds, we made a few adjustments to our positioning. First, we trimmed our overweight in commodities and reallocated those funds into equities, which we believe offer stronger near-term upside potential. Second, we reduced our exposure to high-yield bonds and redirected those proceeds into aggregate bonds. This decision reflects the narrowing outlook gap between these asset classes, extremely tight high-yield spreads, and our increased allocation to equities. Overall, we’re comfortable reducing high-yield exposure in favor of higher-quality bonds.

Relative value trades and positioning

Our regional equity outlook continues to favor the US and emerging markets, with an improved view on Pacific equities. The US remains strong across most factors, with price momentum and quality indicators, such as balance sheet health and operating efficiency, providing solid support. What truly differentiates the US is its strong sentiment and macro backdrop: analysts’ expectations for earnings and sales remain solid, and forecasted GDP growth has improved significantly, likely reflecting the impact of the OBBBA.

Emerging markets also benefit from firm price momentum and a notable turnaround in sentiment, which has now turned positive. The most significant change in our outlook is for Pacific equities, where stronger sales and earnings expectations, along with improving price momentum, have boosted our forecast. Reflecting these shifts, we reduced our underweight in Pacific equities by selling European stocks and REITs, both of which carry weaker forecasts.

Our fixed income outlook has improved, prompting us to add duration back into the portfolio as falling yields are expected to create a favorable environment for longer-term bonds. To implement this, we exited our cash position and removed exposure to intermediate corporate bonds. On the buy side, we reduced our underweight in aggregate bonds and initiated a targeted overweight in US long government bonds. As a result, the portfolio now holds modest overweight allocations to both high-yield bonds and US long government bonds.

In our US equity sector positioning, communication services, consumer staples, and health care remain our top three sectors. Each sector presents distinct strengths:

• Communication Services ranks near the top across most factors, supported by strong sentiment, robust price momentum, and solid fundamentals, despite some softening in earnings expectations.
• Consumer Staples present a mixed picture: while price momentum has weakened, valuations have become more attractive, and companies appear healthy with improving hiring trends—signaling a positive outlook.
• Health Care continues to benefit from strong sales expectations and appealing valuations, reinforcing a favorable view of 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.