Forecasts Improve for the Agg

Each month, the SSGA Investment Solutions Group (ISG) meets to debate and ultimately determine a Tactical Asset Allocation (TAA) to guide near-term investment decisions for client portfolios. Here we report on the team’s most recent discussion.

Macro Backdrop

Recent macroeconomic data marginally increases the odds of a US recession, but State Street Global Advisors still believes a soft landing is achievable. Although weak jobs data triggered investor anxiety and market volatility, further analysis suggests the economy remains stable. Recent economic reports support our long-held view that growth will slow but stay positive, inflation will continue to easing, and the Federal Reserve (Fed) will begin cutting rates.

Froth in the labor market seems to have dissipated, but the situation is not dire — there is still support for consumption. Some vulnerabilities persist, such as narrower job creation, as shown by the Bureau of Labor Statistics’ labor diffusion index — fewer industries are experiencing job gains. Additionally, quit rates in the JOLTS report – a reliable indicator of worker confidence and the labor market’s health – have normalized back to 2018 levels.

The unemployment rate has ticked up to 4.3%, driven by softer labor demand and a significant expansion in the labor force in recent years. This rise reflects the market’s reduced ability to absorb the expanding workforce rather than layoffs, which remain historically low.

Non-farm payrolls were disappointing but still positive with the economy adding jobs. Elsewhere, jobless claims are not alarming; the four-week average of both initial and continuing claims has moved higher, but still low on a longer-term scale — well below levels typically experienced during a recession.

After weakening in Q1, US gross domestic product accelerated more than expected in Q2, driven by strong consumption and business investment. Manufacturing activity remains weak, with global purchasing managers’ indices (PMI) declining in July, with many still in contraction.

After stumbling last month, service activity rebounded in July, with global PMI readings in the US and Japan improving and returning to expansionary territory. More broadly, the US Conference Board’s Leading Economic Index continues to fall; however, the year-over-year change has rolled over and the contractions have been smaller.

Wage growth has slowed but remains positive – still above the long-term pre-Covid average – helping to support consumption. Initial estimates of third-quarter growth are positive, with the Atlanta Fed’s GDPNow tracking at 2.9%.

Directional Trades and Risk Positioning

Investor risk appetite has weakened, as per our Market Regime Indicator (MRI). In July, volatile US election dynamics and concerns about more onerous trade restrictions unsettled markets. Over the past few weeks, escalating Middle East tensions, weaker economic data, and a Bank of Japan rate hike that triggered an unwinding of global carry trades further roiled markets. In our model, our evaluation of trends in equity prices is supportive, but weakness elsewhere reflects weaker risk appetite. Our leading economic index implies slower growth and heightened risk aversion.

Additionally, our analysis of sentiment spreads, pairs of risk-on and risk-off market segments, as well as higher levels of implied volatility signals investors are less willing to take on risk. Overall, our MRI indicates slightly elevated risk aversion, warranting a reduction in equities.

From a quantitative perspective, our forecast for equities softened but remains positive, while our outlook for fixed income improved.

The softening in equity forecast was driven by less supportive sentiment indicators and weaker macroeconomic factors. Although analysts’ expectations for both earnings and sales remain positive, they have been reduced. Meanwhile, price momentum measures remain sturdy and quality factors are still buoyant.

Yields have rallied due to several factors and our quantitative model expects them to fall further. Nominal GDP running above the yield on long-term Treasury bonds implies rates should rise and weak manufacturing activity suggests yields could continue to decline.

Additionally, interest rate momentum has flipped — which suggests yields should drop. Prospects for high-yield deteriorated, with our model looking for slightly wider spreads. Although equity momentum supports high yield, poor seasonality, higher equity volatility, and the level of government bond yields all weigh on our outlook.

Amid improved forecasts for investment-grade fixed-income and weaker risk appetite, we have reduced our overweight to equities and high-yield bonds — while putting some cash to work. Proceeds were allocated to aggregate bonds, with small additions to long Treasury bonds and gold.

Relative Value Trades and Positioning

Within equities, the US remains our top region, performing well across most factors. Although valuations are unattractive, price momentum and macroeconomic indicators are positive, with the US ranking at the top of both factors.

Our forecasts for Europe and the Pacific improved but remain negative. European equities offer attractive valuations; however, sentiment continues to deteriorate, and price momentum is less favorable on a relative basis.

For the Pacific region, analysts’ expectations for both earnings and sales improved, but valuations appear stretched, macroeconomic indicators are unfavorable, and quality factors are underwhelming.

Given our strong preference for the US, we reduced our exposure to European equities and bought US large-cap equities.

On the fixed-income side, more optimistic investment-grade bond forecasts prompted us to sell high-yield bonds and invest some of the cash sitting on the sidelines with additions to aggregate bonds and long-term Treasury bonds.

At the total portfolio level, we now hold a small overweight in cash and a modest overweight in long-term Treasury bonds, with a modest underweight in high-yield and non-US government bonds. We also remain underweight in aggregate bonds.

At the sector level, we maintained allocations to technology and communication services, but rotated out of energy — redistributing the allocation to consumer staples and financials. Communication services and technology continue to exhibit strong price momentum and benefit from robust sentiment indicators.

While technology valuations are unattractive, macroeconomic factors buoy the sector. Positive quality factors and favorable valuations support communication services. Although our energy forecast remains positive, the sector slipped down our rankings due to poor price momentum and weaker sentiment indicators.

Consumer staples rose up our rankings due to improved earnings estimates and more favorable macroeconomic factors. Elsewhere, valuations are attractive and balance sheet health appears stable. Financials are buoyed by better price momentum and increased expectations for earnings.

Click here for our latest quarterly MRI report.

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