Neutral on Cash and Commodities

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

Where 2022 witnessed markets being whipsawed by central banks, 2023 is likely to be driven more by economic data, although central banks still play a pivotal role. In our view, while growth will continue to slow, the global economic backdrop has improved since 2022, but we are not out of the woods yet.

• Economic data has held up better than anticipated
• China has moved past its Zero-COVID policy and re-opened
• Central banks, while still tightening policy, have moderated the intensity of hikes
• And it appears the worst-case inflation scenario is behind us

Our baseline continues to be for a soft landing contingent on the Fed’s reaction function to incoming economic data.

GDP growth in the US and Europe surprised to the upside but looking below the surface reveals a more muted picture. The Conference Board’s Leading Economic Index measures for both the US and Europe continue to decline and suggest further headwinds. However, the IMF upgraded its global growth outlook due to China’s re-opening, abating inflation pressures and rising hopes for overall global economic resilience. Further, the Citi Economic Surprise Index improved for the US, Europe and Japan with the measure now positive for all three regions.

While manufacturing activity remains in contraction, JP Morgan’s Global Composite Manufacturing PMI Index did turn higher for the first time in ten months. Additionally, the future output measure, a more forward-looking survey, has now improved for three months in a row and sits at a ten-month high. To be fair, the story differs across regions, with the US manufacturing PMI moving lower again, whereas in Europe, the index improving slightly. Service PMIs rebounded in most regions and are in expansionary territory now.

The labor market continues to be an area of strength in the economy with positive developments over the past month. A higher-than-expected non-farm payrolls report suggests the job market remains robust but with wage growth continuing to cool. While unemployment fell to a 53-year low, both the average hourly earnings and employment cost index measure of wages have started to moderate. This suggests the risk of a wage price spiral remains low. However, these indices still remain elevated and suggest that the Fed will likely remain restrictive.

Overall, while economic growth slows and downside risks remain, there have been some improvements. On balance, the market environment appears to be more favorable for risk assets than it did in 2022.

Source: State Street Global Advisors, as at 10 February 2023.

Directional Trades and Risk Positioning

Since rolling over in October, investors have become increasingly amenable to taking on risk, with our Market Regime Indicator (MRI) falling into a low-risk regime. After a challenging 2022, investors continue to look forward with optimism that inflation will fall enough to allow the Fed to pivot and engineer a soft landing.

The improvement in risk sentiment is reflected in all three underlying factors, which have improved considerably. Implied volatility in equities remains benign with the measure sitting in euphoria. Risky debt spreads continued to tighten with our reading now residing in low risk. The move lower in currency implied volatility has not been direct, but the factor did finish toward the lower end of a normal risk regime. Overall, our measure of risk appetite continues to suggest a more favorable environment for risky assets.

Our outlook for both bonds and equities has improved, while our forecast for commodities has weakened. With the improved forecasts and supportive risk environment, we increased our equity and high yield exposures. Elsewhere, we sold cash and commodities, bringing our exposure back to neutral.

For equities, price momentum has improved with recent performance but still remains negative along with sentiment readings. Strong quality factors, attractive valuations and better macroeconomic readings buoy our positive forecast.

Momentum indicators for commodities remain constructive but have softened by a little. Additionally, the curve structure has turned negative and has soured our outlook.

Within fixed income, our model is forecasting lower rates with no change to the shape of the yield curve. Interest rate momentum and weakening manufacturing activity imply that rates will move lower, which supports the improvement in our fixed income outlook. For high yield, lower equity volatility and seasonality underpin our improved forecast.

Relative Value Trades and Positioning

Within equities, we held our regional exposures constant, maintaining a preference for non-US developed equities. Pacific and European equities continue to benefit from more attractive valuations, stronger price momentum and better sentiment relative to the US.

Within fixed income, we reduced our exposure to intermediate government bonds and sold the remainder of our cash. Proceeds were deployed to long government, extending our overweight, and high yield bonds. The purchase of high yield at both the directional and relative value levels brings our total portfolio allocation to neutral.

At the sector level, we maintained our allocation to consumer staples, but rotated out of financials and materials, into health care and industrials. Consumer staples remains our top ranked sector due to strong sentiment, earnings and sales estimates, still positive price momentum and improved quality measures. Financials has fallen out of favor due to weakening price momentum, valuation and sentiment factors which have turned negative.

Materials remains well supported in our quantitative framework with robust price momentum, sturdy earnings and sales estimates and attractive valuations. The sector has slid down our rankings slightly due to improvements in our outlook for both health care and industrials. Industrials ranks well across all factors in our model with a large improvement in sentiment driving our upgraded forecast. Valuations for health care are poor, but positive price momentum along with strong improvements in both sentiment and macroeconomic factors lift our outlook.

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