More Constructive on Global Equities: Tactical Trading Decisions for October 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.

Macro Backdrop

The global economy is rapidly slowing as central banks hit the brakes on economic growth through synchronized tightening. While a range of leading inflation indicators points to a moderation ahead, we are not convinced the Federal Reserve (Fed), or other central banks, will pivot and the risks of overtightening seem considerable in our estimation. Against this backdrop, we have again lowered our global growth forecasts, particularly for next year. We now see global growth at just 2.6% in 2023, half a percentage point less than our forecast three months ago and meaningfully below trend.

The Conference Board’s Leading Economic Index for both the United States (US) and Europe have now declined for six consecutive months, which points to a further slowdown in growth. Additionally, PMIs continue to cool with JP Morgan’s Global Manufacturing PMI moving into contraction, which also signals slower growth ahead. In the US, September job report highlights resilience in the economy but does little to quell the Fed’s concerns and likely cement another 75 bp hike in November. In Europe, headline inflation hit 10%, which puts more pressure on the European Central Bank to hike rates at a time when the energy crisis threatens growth. Strong consumer and corporate fundamentals could help limit negative impacts, but sticky inflation and restrictive policy put risks to the downside.

Overall, we continue to be cautious on risk assets, as uncertainty surrounding the macro backdrop persists and elevated levels of inflation causes the Fed to stay on a hawkish path.

Source: State Street Global Advisors, as at 10 October 2022.

Directional Trades and Risk Positioning

Investor risk aversion continued to increase late in September pushing the Market Regime Indicator (MRI) into crisis regime by the end of the month where it now resides. While implied currency volatility and spread on risky debt indicators have been consistently elevated, it was the spike in implied equity volatility that pushed the MRI into crisis regime. Equity volatility jumped in September as investors digested August’s higher than anticipated inflation report, resetting expectations for the central bank policy.

Our models have become more constructive on global equities, moving to a more neutral stance, as macro indicators improved and valuations remained strong. Sentiment however continues to be a headwind as momentum and earnings sentiment deteriorates.

Given the crisis regime, which typically indicates oversold conditions and a more neutral reading from our models, we chose to reduce our underweight position in global equities. This was also consistent with the team’s desire to take the less active risk given the uncertainty about the near-term macro backdrop. As a result, we funded the equity purchase by selling core bonds and commodities.

Our forecast for fixed income continues to be poor, driven by an expectation for higher rates as rate momentum and nominal GDP growth, compared with long bond yields, are supportive. Finally, we have seen a deterioration in our forecast for commodities. This change – combined with weaker economic conditions, and increased financing costs – drove us to challenge our long-standing active position, and reduce our position, though we remain overweight.

Relative Value Trades and Positioning

Within equity, we chose to reduce the position in US REITs, increasing the underweight to the segment in favour of US large cap equities. Price momentum for REITs has been poor as investors grapple with higher rates and lower growth, both headwinds for the sector. Earnings expectations have continued to deteriorate and further weigh on our outlook.

As mentioned within fixed income, we are forecasting a rise in rates and further curve inversion as the continued Fed hawkishness pressures rates on the front end of the curve. In addition, we are also forecasting some spread widening in both investment grade and high yield credit. As a result, we reduced exposure to intermediate and long-term US government bonds, placing the proceeds into cash.

At the sector level, there were no changes with energy, utilities and financials remaining our preferred sectors. Energy continues to exhibit strength across most factors and boasts top ratings for sentiment, price momentum and valuations. Financials benefit from attractive valuations and strong sentiment, both earnings and sales, while improvements in short-term price momentum help buoy the outlook. Utilities have experienced weaker short-term price momentum, but longer-term measures remain supportive. Elsewhere, robust sentiment indicators and positive macroeconomic factors help support the sector.

To see sample Tactical Asset Allocations and learn more about how TAA is used in portfolio construction, please contact your State Street relationship manager.