More Constructive on Bonds: Tactical Trading Decisions for November 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.
Global economic growth has softened but has so far remained resilient in the face of multiple headwinds. Our baseline assumption remains meaningfully slower but continued positive growth in 2023. With central banks still battling inflation, geopolitical tensions heightening and financial conditions tightening, risks remain skewed to the downside.
After beginning the year with two negative quarters of growth, the US economy expanded in the third quarter, with GDP up 2.6% year over year. On the surface, the rebound appears strong, but digging deeper, both consumer and business spending was lower while net trade added 2.8%. The US manufacturing Purchasing Managers' Index (PMI) held above the key 50 level, portraying signs of resiliency, but the overall trend is still lower and toward contraction, illustrating a meaningful deceleration in manufacturing activity. The US services PMI, which has held up fairly well, was noticeably lower, but underlying factors were mixed, although not universally negative – business activity was robust, but employment and export orders were weaker.
Overall, economic activity is slowing and leading economic indicators point to a further slowdown in activity moving forward. Supporting the economy has been consumers, who have benefited from a strong labor market and accumulated savings. While the latest jobs reports are not fully healthy, they still signal support. Further, Bank of America notes that some of the accumulated deposits from the pandemic are being gradually drawn on, but that as long as an economic slowdown is gradual, the accumulated buffers should continue to support consumers for a significant time period. The fact that household leverage is fairly low should help as well. However, inflation remains a threat for consumers as personal savings rates have now sunk well below pre-Covid levels.
Disinflationary forces have formed, but we have not seen that meaningfully reflected in Consumer Price Index (CPI) readings yet. In the release, utilities and used car prices drove both the headline and core readings lower, but price increases were still fairly broad-based. Anecdotally, prices paid measures have softened, supply chain pressures are abating while shipping ports are seeing less traffic and retailers have built up inventories, which could soon produce markdowns. All this should lead to further declines in prices.
Energy has been the biggest driver of lower headline inflation, but oil has turned higher with OPEC+ cutting production and hopes for a partial re-opening in China driving WTI prices up in October and pushing gas prices higher. After several months of decline, fuel oil and gas turned higher in October’s CPI print. Housing prices have rolled over, but are unlikely to significantly drop given the low inventory. Real-time rent measures point to lower rent increases, but with vacancy rates low and housing less affordable, a retreat to pre-pandemic trends is less conceivable.
Elsewhere, corporate plans to raise prices and wages have both rolled over while earnings measures suggest wages may have peaked, although they remain too high for the Fed’s liking. Overall, inflation should start to moderate further soon, but the extent of the decline and over what time period are uncertain. It is unlikely that we revert to the Fed’s preferred 2% inflation target anytime soon without an overtightening monetary policy that produces a recession.
Central banks have struggled to contain inflation and remain the biggest source of risk for economies with rates expected to continue rising. The Bank of Canada recently hiked another 50 bp while stating they still expect rates will need to rise further. The Bank of England rolled out a 75 bp hike despite forecasting the economy will contract through June 2024. The European Central Bank has remained hawkish, recently stating a mild recession may not be enough to tame inflation and stressing that more hikes are needed with inflation way too high.
Then there is the Fed, having just raised another 75 bp in November, bringing their policy rate up to 4.0%, a 3.75% increase in just eight months. While Chair Powell maintained a fairly hawkish tone during the press conference, there was an important change in the statement that suggested December will bring about a smaller hike: “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” Another 50 bp hike appears most likely in December with another hike in early 2023 probably needed.
The midterms have not been finalized yet, but the projected split Congress could stop any future fiscal plans. Will this lead the Fed to pump the breaks a little and assess the impact of previous hikes? It is hard to say, but looking at each of the last eight hiking cycles, the Fed has not stopped raising rates until policy rate exceeds CPI. Given the Fed’s belief that overtightening is more favorable than the alternative, it appears we are not done hiking yet.
Overall, we continue to be cautious on risk assets, as uncertainty surrounding the macro backdrop persists and elevated levels of inflation cause the Fed to stay on a hawkish path.
Figure 1: Asset Class Views Summary
Source: State Street Global Advisors, as at 10 November 2022.
Directional Trades and Risk Positioning
Investor risk appetite recovered in October after weakening over the past two months. Our Market Regime Indicator (MRI) oscillated between high risk and crisis for the first half of the month before starting its steady descent into the lower bound of high risk where it finished the month. The biggest driver was a large reduction in implied volatility on equity, which finished in a normal regime. After starting near crisis, the improvement in equity volatility coincided with increased hopes for a possible slowdown in Fed rate hikes and the possibility of a mid-term bounce. Elsewhere, measures of implied volatility on currency and risky debt spreads also improved, however, both remain in high risk. Overall, our measure of risk sentiment has improved but remains cautious.
Our models have become more constructive on bonds, now forecasting lower government yields and further inversion of the yield curve. The ongoing weakening of manufacturing activity and elevated inflation readings have consistently pointed to lower rates. However, interest rate momentum recently flipped, and now signaling rates will fall. Our leading economic indicators have rolled over, but remain weaker relative to the look-back period and when combined with still high inflation expectations, signal a more inverted yield curve.
Our forecast for equities has deteriorated with all five factors weakening to various degrees. Valuations remain attractive but to a lesser degree. Price momentum remains poor and fell further, but the biggest drivers were a meaningful retreat in our sentiment and macro factors, both of which are deeply negative now.
With our MRI signaling cautious risk appetite, the deterioration in our equity forecasts and improved fixed income outlook, we have sold global equities, extending our underweight, in favor of aggregate bonds.
Relative Value Trades and Positioning
As mentioned, within fixed income we are forecasting a mild decline in rates and further curve inversion, which is supportive for longer-duration bonds. Additionally, a cautious economic outlook and expectations for the Fed to continue pressuring rates at the front end of the curve higher make longer-dated bonds more attractive. Against this backdrop, we reduced our overweight to intermediate government bonds, deploying proceeds into US long government bonds and non-US government bonds.
At the sector level, there were no changes with energy, utilities and financials remaining our preferred sectors. Financials benefit from meaningful advances in short-term price momentum, continued improvements in sentiment and attractive valuations and macroeconomic factors. Energy continues to exhibit strength across most factors and sits near the top of our rankings across sentiment, price momentum, macroeconomic and valuation factors. Utilities have experienced weaker short-term price momentum, but longer-term measures remain supportive. Elsewhere, robust sales expectations and positive macroeconomic factors help buoy 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.
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