High Yield Now an Overweight

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 inflation prints and the uptick in wage growth do not necessarily change our outlook for slower but positive economic growth, continued disinflation and modest Fed rate cuts in 2024, but they make it more difficult for the Fed to execute its first cut in March. Further, the upside surprises to inflation illustrate the non-linear path and challenges the Fed faces while trying to ensure inflation has successfully been defeated without tipping the economy into recession. The recent events in the Middle East, and growing geopolitical conflicts in general, are a threat to both inflation and economic growth.

After six straight months of deflation, goods deflation came in flat with the most recent CPI print, which could signal a bottom. In addition, upward pressure on goods prices, resulting from tensions in the Middle East, and rising supply chain pressures could emerge. Attacks in the Red Sea have spiked shipping costs as containers are diverted and Houthis are poised to continue to attacking ships in response to the US and UK offensive in Yemen. After easing considerably in 2022, stress on supply chains, as measured by the NY Fed’s Global Supply Chain Pressure Index, increased in 2023. Elsewhere in the CPI release, service inflation continued to moderate but remained elevated.

On the plus side, prices paid in the services and manufacturing surveys eased while wholesale inflation was cooler than anticipated, evidencing that price pressures are still easing in the US. Additionally, while the monthly reading outpaced expectations, a smoothed three month annualized rate for core CPI declined.

One month does not make a trend and results were mixed overall, but the Fed will likely need more evidence before committing to reducing rates.

Directional Trades and Risk Positioning

Investor risk appetite remains strong with our Market Regime Indicator (MRI) residing in low risk, a regime that is typically favorable for risk assets. Risk sentiment improved in November when cooler US economic data fueled increased hopes for a soft landing. The jubilation carried into December and was followed up by a somewhat dovish pivot from the Fed which further stoked risk appetite. While economic data has been mixed recently, adjustment to the summary of economic projections by the Fed for more rate cuts in 2024 elicited positive responses from investors. Implied volatility on currencies has risen and resides in a normal regime, but lower implied volatility on equities, low risk, and tight credit spreads, euphoria, keep our MRI in low risk, suggesting an improved outlook for risk assets.

Elsewhere, our quantitative forecast for equities remains sanguine with price momentum turning positive and valuations remaining attractive. While analyst expectations for sales have weakened, healthy balance sheets imply firms are able to generate good returns on operating assets.

Within fixed income, our outlook has declined for most assets with the exception of high yield. Sluggish manufacturing PMI readings and momentum from the recent decline in rates imply lower rates, but higher nominal GDP relative to long-term Treasury yields suggests yields should rise. The net result is an expectation for rates to remain fairly stable. Weak leading economic indicators and lower inflation expectations advocate for a steeper curve. Our expectations for high yield have firmed with positive seasonality and strong equity performance pointing to tighter spreads. Additionally, with government bond yields declining meaningfully, cost of capital for firms is lower, which supports tighter spreads.

Despite resilient economic growth, some policy support in China and production restraint from OPEC+, commodities have failed to find solid footing as other risk assets move higher. From our assessment, we anticipate muted returns ahead for commodities. Our momentum indicator, which seeks to determine if the current environment is beneficial, remains positive, but to a lesser degree. Additionally, our evaluation of the curve structure for various commodities suggests future prices may fall, weighing on our outlook.

Against this backdrop, we have increased our exposure to equities and high yield bonds using proceeds from the sale of commodities and aggregate bonds.

Relative Value Trades and Positioning

Within the equity asset classes, we did not execute any trades, maintaining our overweight to US and emerging market equities. The US stands out due to superior price momentum and macroeconomic indicators. Valuations appear stretched, but strong balance sheets and positive expectations for both sales and earnings reinforce our outlook. Sentiment for emerging market equities has turned slightly negative, but positive price momentum, attractive valuations and sturdy balance sheets anchor our constructive forecast. European and Pacific equities remain underweight with benign price momentum and weaker macroeconomic factors weighing on the outlook. Valuations for European equities suggest they are undervalued, but poor sentiment indicators cloud the outlook. Expectations for both sales and earnings has improved for Pacific equities but valuations remain unattractive.

Within fixed income, the returns forecast by our models, while still positive for the most part, have decreased modestly as our models are calling for rate levels to remain static but with a slight steepening of the curve. The key exception to this is high yield, which has the strongest forecast, while long US Treasuries have turned negative. From a positioning perspective, we sold US aggregate, intermediate and long-term government bonds, as well as non-US government bonds given the moderation in return expectations. This provided funding to increase the positioning to high yield. The buy of high yield now brings us overweight at the total portfolio level. Although spreads are tight, our models are indicating the potential for further tightening for high yield bonds.

Finally, at the sector level, we maintained an allocation to energy and technology while rotating out of communication services and into industrials. Energy is our top-ranked sector, buoyed by solid balance sheet health, positive macroeconomic indicators and attractive valuations. Technology is expensive based on valuations, but robust price momentum, analyst expectations for strong sales and earnings and sturdy balance sheets buttress the sector. Our outlook for communication services has deteriorated due to weaker macroeconomic factors and softer price momentum. Elsewhere, sentiment and quality factors are positive, but less attractive on a relative basis. The improved forecast for industrials was driven by better sentiment indicators and upgraded macrocosmic indicators. Additionally, the sector benefits from solid price momentum.

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