Extend Overweight in Equities and Gold

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.

^{Source: State Street Global Advisors, as of 13 April 2023. Investment grade bonds consist of investment grade credit, Treasuries and aggregate bonds.}

In the first two months of 2023, investors had adopted a more optimistic outlook—despite numerous uncertainties—on better macroeconomic data and some signs that inflation was easing. The improved risk appetite came to a screeching halt in March when several banks collapsed, sparking fears of financial instability. However, this proved temporary as the US Federal Reserve’s (US Fed) quick intervention and the overall health of the banking sector appear to have eased investor concerns. Still questions remain, including how tighter lending standards, given the banking crisis, on the back of higher interest rates, will impact an already slowing economy.

The economic growth picture is somewhat mixed. In the US, both manufacturing and non-manufacturing survey Purchasing Managers’ Indexes (PMIs) continue to decline, with the latter below the 50 threshold, and the former now just above it.

In addition, while overall unemployment is still very low by historical standards, weekly jobless claim numbers have been increasing, with the print for the week-ended 7 April coming in at 239k, which was higher than expected. While we continue to think that we will avoid a recession this year, we do think the risk has increased for 2024.

On the inflation front, fresh data showed that headline inflation increased in March by less than what was expected—+0.1% vs. +0.2% MoM—while core inflation increased +0.4% MoM, in line with estimates, and is up +5.6% from last year. While inflation is slowing, many think it is still too high, which will keep the Fed hiking

Directional Trades and Risk Positioning

The excitement in the banking sector unsurprisingly had an effect on investors’ risk appetite. However, after spiking toward the upper bound of a normal regime, our Market Regime Indicator (MRI) quickly retraced down and finished in a low-risk regime, after investors became more assured. A low risk regime is typically supportive for equities. While all three factors jumped on the banking news, implied volatility on both equity and currencies quickly eased, with both measures finishing in low risk. Risky debt spreads have narrowed slightly, but our reading remains elevated. The disparity between credit spreads and equity volatility gives us some pause, but overall, our MRI points to a favorable risk environment.

Our fundamental driven model remains modestly constructive on global equities. Price momentum has improved and is less of a drag, but earnings and sales expectations also weigh on our forecast. However, our estimation of valuation metrics, including free cash flow and buyback yields, remains slightly positive. Additionally, quality factors, which assess the health of corporate balance sheets, are supportive and our evaluation of top-down macroeconomic factors is favorable.

Within real assets, our quantitative model is forecasting a weaker environment for commodities. Our momentum indicator, which seeks to determine if the current environment is beneficial, remains supportive, but to a lesser degree. Additionally, our evaluation of the curve structure for various commodities suggests future prices may fall, weighing on our outlook. Gold looks attractive on many fronts. From a fundamental perspective, the weaker US dollar supports the precious metal, which can provide a safe-haven alternative. Further, our evaluation of technical indicators, analyzing long- and shorter-term trends in prices, suggests positive tailwinds.

Within fixed income, our expectations have improved, with our model forecasting lower rates and a steeper yield curve. Weaker manufacturing activity, as measured through the ISM PMI, relative to our lookback period, suggests rates will fall. Additionally, recent interest rate momentum—lower rates in both January and March—implies rates will continue to move down. When evaluating the shape of the curve, slowing investor inflation expectations and recent momentum indicate the curve will steepen. High yield bonds benefit from lower government bond yields—which imply lower refinancing costs—a reduction in equity volatility and the recent strength in US equities.

Against this backdrop, we have extended our equity overweight and bought high yield bonds, which takes our allocation to neutral. Additionally, we purchased gold, which brings us to a modest 3% overweight. Offsetting trades include selling aggregate bonds and commodities. For commodities, the trade now brings us to an underweight by 2%.

Relative Value Trades and Positioning

Within equities, we continue to rotate out of Pacific equities and into US large cap equities. In the US, valuations have improved, but continue to suggest the region is expensive. However, macroeconomic factors, in our top-down assessment, are attractive and quality factors, which evaluate corporate balance sheets, remain supportive.

Expectations for Pacific equities have deteriorated. While valuation metrics are neutral, a deterioration in price momentum, or the recent price movement relative to a specified look-back period, dents the outlook. Further, our sentiment indicator, which examines analysts’ expectations for both earnings and sales, is weak. Negative earnings estimate revisions outweigh the positive and weigh on the region. Within the US, we rotated out of small cap stocks, bringing us to a neutral allocation, into large caps. In our examination, shorter-term price momentum, sales expectations and top-down macroeconomic factors tilt us toward large cap stocks.

Within fixed income, we sold cash and long government bonds, maintaining overweight allocations in both, with proceeds deployed to intermediate government bonds. As mentioned above, our model is forecasting lower yields with a steeper curve, which benefits the short to intermediate part of the Treasury curve. Overall expectations for lower yields and the potential for diversification support maintaining a modest allocation to long bonds.

At the sector level, we maintained our allocation to industrials, but rotated out of energy and financials, into consumer discretionary and materials. Industrials continue to exhibit strength across most factors in our quantitative framework. Strong short- and long-term price movements, robust sales expectations and attractive buyback yields support the sector.

Our forecast for energy is positive but has weakened relative to other sectors. Numerous valuation metrics are attractive and longer-term price gains support the sector, but weaker oil prices have dampened sales and earnings estimates and dragged the forecast lower. Financials have demonstrated weaker price momentum for a few months, but the recent banking crisis exacerbated the trend. While some of our macroeconomic factors offer support, a significant decrease in earnings estimates and relatively weaker valuations soured our outlook on the sector. The material sectors have benefited from a weaker US dollar and slightly constructive metal supply and demand fundamentals, which are reflected in our strong short- and long-term price momentum in our model.

Elsewhere, strong free cash flow generation and solid buyback yield buoy valuations, while top-down macroeconomic factors are also helpful. Consumer discretionary has benefited from the optimism in 2023 around a Fed pivot and the continuation of the disinflation narrative and our evaluation of shorter-term price actions seems to confirm the positive trend. An improvement in expectations for both sales and earnings also boosts the sector, while our top-down macroeconomic analysis is positive.

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