High Yield Finds Favor: Tactical Trading Decisions for August 2022
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.
We are currently amid an economic slowdown, one that is still unfolding. It is a very difficult macro environment with some positive data prints, such as the strong jobs report, and many weakening data points, including global PMIs, which generally remain expansionary but have softened and moved into contraction in some regions. Inflation remains stubbornly high while central banks remain laser focused on bringing inflation back to their respective targets. Overall, we continue to view risks to growth tilted to the downside.
The United States (US) hit a technical recession with two consecutive quarters of real negative GDP growth. While directionally the components were not surprising, the magnitude of some (residential investment down 14% saar, goods spending down 4.4% saar) was. Leading economic indicators, based on the Conference Board Composite Index, have rolled over and decreased for four consecutive months. Consumer and CEO confidence is waning as evidenced by the Conference Board indexes, with both measures dropping to 2021 lows.
The US Fed has now set rates at their “neutral” level and is widely expected to increase further in September, putting rates into “restrictive” territory. Market expectations for both inflation and rate hikes have shifted recently. Inflation expectations have fallen while markets now expect the Fed to cut rates in 2023.
We agree that inflation will moderate in the second half and see signs of this being underway. Commodity and gas prices have come down – both prices paid and prices charged metrics across various surveys have come down and supply chain stress is easing. However, “stickier” inflation signals remain elevated, and the longer we remain in this environment, the more baked in they become. The employment cost index continues to rise, hitting 5.1% year-over-year (YoY), the highest level since 1990. This keeps upward pressure on inflation and is a large obstacle for the Fed to undertake a dovish pivot. Housing has softened with the FHFA Single Family House Price Index, the Case-Shiller 20-City Composite Price Index and the Zillow Observed Rent Index all coming off highs but remaining elevated. Prices should ease further, but limited supply likely provides a floor.
Geopolitical risks remain with the ongoing Russia-Ukraine War and heightening tensions between the US and China. Russia has significantly limited natural gas supply to Europe, which threatens growth as countries scramble to stockpile supplies in the hopes of avoiding the need to ration usage.
In response to Nancy Pelosi’s visit to Taiwan, China announced military drills around Taiwan, which shut down the Taiwan Strait, a key shipping route for exports. While this was temporary, should China continue to conduct these trainings in the future, it could have a meaningful impact on supply chains.
While the tide may be turning, employment still appears to be a support. Jobless claims have been trending up and ISM employment surveys are in contraction, but job openings, as measured by the Job Openings and Labor Turnover Survey (JOLTs) report, are still historically high at close to 11 million while July nonfarm payrolls significantly outpaced expectations. We will be monitoring closely since softening employment situations should help reduce demand and in turn, inflation.
Overall, uncertainty and volatility are likely to continue in this very challenging macro environment.
Figure 1: Asset Class Views Summary
Source: State Street Global Advisors, as at 10 August 2022.
Directional Trades and Risk Positioning
Risk aversion eased throughout July as investors shifted inflation expectations lower and began to anticipate a less aggressive pace of monetary tightening from the Fed. Our Market Regime Indicator (MRI) started the month at high risk, and briefly moved into crisis before descending to the lower end of high risk. While all three factors trended lower, the biggest change was from implied volatility on equities, which moved into a normal regime as implied volatility on all underlying regional signals declined. Risky debt spreads have narrowed slightly, but the factor still resides in crisis.
The still-elevated risk regime coupled with further deterioration in our global equity forecast prompted us to reduce our allocation, now a sizable underweight. The rally in July improved short-term price momentum, but longer-term measures remain weak. While valuations are attractive, poor macroeconomic and declining sentiment factors weigh on our outlook.
Cash provides some downside protection in this challenging environment and we retain a healthy allocation, but improvements in our bond forecasts, both Treasury and high yield, prompted us to put some cash to work. This resulted in purchases of both aggregate and high-yield bonds amidst better near-term momentum in both sectors. In a reversal from last month, our model is now forecasting lower Treasury yields. Stubbornly high inflation readings and weakening PMI activity data continue to point to lower rates while a flip in the interest rate momentum factor now implies rates will fall.
Relative Value Trades and Positioning
Within equities, we made a small rotation out of US large cap and into US small cap equities. Macroeconomic factors favor large cap, but valuations for small cap are more attractive and sentiment is less negative. Price momentum has weakened for both but to a greater degree with large cap equities.
Similar to the directional trades, we reduced our cash allocation in favor of high yield bonds within relative value fixed income. As mentioned earlier, the improved bond forecasts supported the rotation, which now brings our high yield allocation to neutral at the total portfolio level.
From a sector perspective, energy and utilities remain targeted sectors while we rotated out of materials into both financials and healthcare, which are split allocations. For materials, a meaningful decline in price momentum, both short and long-term, and sentiment factors worsened the outlook and dropped materials down our rankings. Energy remains our top-ranked sector with still robust price momentum, advantageous sentiment and attractive valuations. Utilities have experienced steady improvements in price momentum which combined with healthy sentiment and positive macroeconomic factors buoy our outlook.
Financials moved up our sector rankings with improvements in sentiment and macroeconomic factors while valuations are in the top third amongst all sectors. The health care sector benefits from steadily improving, and positive, price momentum and supportive macroeconomic factors which offset weaker valuation metrics.
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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