Outlook Improves for Fixed Income

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

Looking back, 2023 had in store many notable events for markets to navigate. Inflation moderated but remained elevated, prompting central banks to continue to aggressively tighten monetary policy. Economic growth in the United States (US) outpaced expectations, but growth disappointed elsewhere. The banking crisis in March was short lived but was followed by S&P downgrading a list of banks over the summer. Bond volatility was high as inflation surprises, the repricing of expectations for the Fed Funds Rate and massive bond issuances by the Treasury pushed yields higher before softer jobs data in Q4 sent yields tumbling.

The strength in US economic growth is unlikely to continue as consumers become more restricted given the high rates and the higher cost of living. At some point, the refinance wall that is set to hit corporations in 2025 will stunt investment and hiring, which will likely lead to a rise in unemployment rate and a slowdown in household consumption. Additionally, fiscal impulses will become less of a tailwind in 2024. The strong starting point for both consumers and corporations should help avoid a recession, but much depends on the Fed, and the Fed could upend economic growth, trying to balance inflation and recession risks.

Developed economies have made meaningful strides towards brining inflation down and we expect that to continue through 2024, albeit at a slow and uneven pace. We received some encouraging signs in November when there was a more meaningful drop in inflation across the Eurozone and the United Kingdom, while prints in the US also surprised to the downside. Energy prices produced a meaningful decline in inflation, but escalating geopolitical tensions in 2024 could challenge this thematic.

Food prices are still high and rising while many of the core services (housing, healthcare, insurance and transportation) remain hot. Further, wage growth continues to cool but remains elevated and the labor market remains tight, which will keep pressure on services inflation. Rates are restrictive and eventually will bring down consumption, which should lower both economic growth and inflation.

Developed market central banks have likely reached their peak rates given the progress on inflation and magnitude of rate hikes working their way through economies. In the US, labor, wages and core services inflation remain too high. The Fed released updated economic projections, which reflected lower inflation and the Fed Funds rates for 2024, but markets might be too aggressive with their current expectations.

Looking forward, 2024 could be another turbulent year as global growth slows while heightened geopolitical tensions and rising debt levels challenge the resiliency of economies. Additionally, central banks will need to balance inflation risks with recession risks as they attempt to administer a soft landing.

Directional Trades and Risk Positioning

After being neutral in October, our Market Regime Indicator (MRI) moved back into Low Risk in early November where it remained for most of the month before ending in Euphoria. This change in the MRI was driven by both implied volatility for equities and currencies, with both components moving into Euphoria while spreads on risky debt remaining in Low Risk.

Overall market sentiments improved partly on the assumption that central banks have reached the peak of their tightening cycles, given signs of economic moderation in the US and falling inflation across developed markets. However, a reading of Euphoria indicates a worrying level of complacency among investors that warrants a cautious view toward risk assets. As a result, we reduced our active exposure to global equities.

Our more fundamentally driven models have become less constructive on global equities, where we are observing some of the weakest forecasts in a year. While valuation and quality metrics are still supportive, poor macro and deteriorating earnings sentiment indicators are detracting from the view.

Although our outlook for commodities continues to be negative, we continue to see strength in gold, which is supported by both fundamental and technical indicators. In addition, central bank demand continues to be strong and a recent surge in purchases could lead to a record breaking year.

Finally, our forecast for high yield has improved on the back of better equities performance recently, which indicates further spread tightening.

Relative Value Trades and Positioning

Within equities, we continue with our previous positioning and did not execute any trades. Strong momentum and macroeconomic indicators combined with continued positive quality factors keep the US atop our regional rankings. Within the US, our framework continues to favor large caps relative to small cap equities. Outside of the US, we continue to hold a modest overweight to emerging markets driven by strong quality and reasonable valuations, but are underweight Europe and Asia Pacific equities.

Within fixed income, we have seen a notable change in the direction of our forecasts. For some time now, our models have been calling for higher level of rates and a steepening of the yield curve leading to unattractive return forecasts for fixed income. This month, however, the forecast has flipped with our models now calling for a decrease in the level of rates and a slightly flatter curve. These drive an improvement in our fixed income return forecasts across the curve. As a result, we add to both core and long duration bonds to increase the duration of the portfolio. In addition, the aforementioned improvement in our expectations for high yield drove us to reduce our underweight position.

To fund the buys in core, long-government and high-yield fixed income, we sold non-US bonds, where we have seen a deterioration, and cash.

Finally, at the sector level, we maintain an allocation to energy, which continues to look quite attractive on valuation. Despite the recent pullback in oil prices, energy remains one of our top-ranked sectors, buoyed by positive macroeconomic factors, attractive valuations and robust price momentum. In addition, we rotate out of financials and into communication services as the sector is supported by the fundamental indicators that we consider. Information technology is our highest-ranked sector, and although expensive, healthy balance sheets, solid price momentum and sentiment drive this sector to the top of the list.

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