Commodities Find Favor: Tactical Trading Decisions for January 2023

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

As we begin 2023, investors try to decipher the juxtaposition of competing economic thematics. On one hand, slowing Fed rate hikes, an accelerated reopening in China, strong labor markets, the potential peaking of inflation and so far resilient corporate profits point to a soft landing. On the other, higher for longer rates, slowing economic growth, sticky inflation and potential policy mistakes signal a hard landing. In our view, the outcome is equivalent to a coin flip and will depend heavily on data prints over the next few months and the Fed’s reaction.

Disinflationary signs have started to gain traction with a moderation across both headline and core inflation in the US. While we are not out of the woods, it appears the worst-case scenarios for inflation are off the table. In Europe, preliminary December inflation data might have brought the first signs of peaking inflation. In the US, December’s jobs report was encouraging, with robust employment growth and slower wage inflation.

It is quite possible that sequential wage gains may reaccelerate from December’s levels. However, we do believe the broad trend remains one of continued moderation, which is critical for the Fed. The Fed appears close to a pivot and while rates are likely to remain higher for longer, the pace of tightening has slowed. While small hikes to begin 2023 still seem probable, the Fed likely holds rates between 5.0% and 5.25% while allowing over 400 bp of hikes to work through the economy.

While slowing economic growth and uncertain policy risks remain headwinds, the macro environment appears more favorable for risk assets than it was six months ago, even if just a little bit.

Source: State Street Global Advisors, as at 11 January 2023.

Directional Trades and Risk Positioning

Investor risk appetite continued to improve in December with our Market Regime Indicator (MRI) moderating to the lower end of a normal risk regime. With China reopening, the Fed slowing its pace of rate hikes and concrete evidence that inflation is rolling over, investors appear to have become a little more amenable to risk. Implied volatility on equities, which dropped significantly in November, remained benign, residing in a low-risk regime.

Risky debt spreads eased slightly in December, but the big driver was a meaningful improvement in implied volatility on currency, which moved from the upper threshold of high risk to a normal regime where it finished the month. Overall, our measure of risk sentiment continues to improve, suggesting a more favorable environment for risky assets.

Our quantitative framework remains supportive for global equities and we slightly increased our overweight. Price momentum improved but remained negative along with sentiment, which deteriorated. However, positive quality factors and still attractive valuations buoy our outlook.

Our forecast for commodities has improved due to better curve structures within the energy complex while momentum indicators remain constructive.

Within fixed income, our expectations for bonds have deteriorated with our model now forecasting slightly higher rates and a steeper yield curve. Interest rate momentum and higher nominal GDP growth relative to the yield on longer date bonds imply rates will move higher. Additionally, both manufacturing activity and inflation readings weakened, and while the signals still point to lower rates, the magnitude has lessened.

A combination of lower inflation expectations, favorable momentum and a deceleration in our proprietary leading economic indicator basket suggests that we may have reached a turning point whereby the shape of the Treasury curve starts to steepen.

Overall, we increased overweights to risk assets, both equity and commodities, as well as cash. Given the weaker bond forecasts, we funded from US aggregate bonds.

Relative Value Trades and Positioning

Within equity, we continued to build our position in non-US developed equities with a rotation out of US large cap into Europe. The rebalance leaves us with sizable overweights to both Europe and Pacific equities and extends our underweight to US equities. Macroeconomic factors remain robust for the US, but European equities exhibit better sentiment and more attractive valuations relative to the US. Non-US stocks are also supported from a foreign exchange perspective, where our currency research depicts the US dollar as being expensive versus most other developed market currencies.

Within fixed income, our anticipation for higher rates and a steeper yield curve led us to reduce allocations to both US aggregate and US long government bonds. We now hold a modest overweight to long government bonds. Given the upward pressure on short-term rates from the Fed and slowing economic growth, long government bonds still look attractive and can provide some diversification to our equity overweight. Additionally, we sold high yield as higher interest rates weight on our forecast. Proceeds were deployed to intermediate government bonds, non-US government bonds and cash.

At the sector level, consumer staples and financials remain favored sectors. Elsewhere, energy slipped down our rankings while materials was upgraded to a full allocation. Our forecast for energy remains positive with robust price momentum and favorable valuations, but a drop in sentiment, both earnings and sales, coupled with a better outlook for materials led us to remove the allocation.

Consumer staples continues to ascend up our rankings and is now our top ranked sector. Strong price momentum, positive quality scores and stellar sentiment support consumer staples. Financials continue look attractive across most factors, but appealing valuations, strong macroeconomic and positive momentum in particular boost our outlook. Materials have benefited from recent dollar weakness which helped improve price momentum. Elsewhere, sturdy sentiment and attractive valuations helped bolster our forecast for materials.

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