Sentiment Turns Positive for Emerging Markets

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

The narrative of the movie Groundhog Day is centered around a weatherman stuck in a time warp that forces him to relive the same day over and over. Following markets and writing commentary in 2024 feels akin to starring in the 1993 fantasy movie. It seems we are repeatedly discussing firmer-than-anticipated inflation prints, stronger-than-expected job reports and the delayed-but-eventual Fed rate cuts.

March nonfarm payrolls increased 303K, significantly higher than expectations, while the unemployment rate ticked lower to 3.8% despite the uptick in participation rate. The underlying data was not flawless – the majority of job gains were due to health care and government, but they still reflected demand for labor. The household survey also reflected a strong gain – however, full-time workers fell with gains tilting towards part-time workers and the percentage of multiple job holders rose. Activity measures remained encouraging with some manufacturing PMIs improving and service PMIs remaining in expansion. In the United States, ISM manufacturing moved back into expansion with new orders continuing their trend higher. The sturdy economic growth is reflected in the Atlanta GDPNow for Q1, which tracked at 2.5% and pointed to a moderating but resilient economy.

After the higher-than-anticipated inflation readings in January, February CPI and PPI prints also exceeded forecasts. What is more concerning is that 3-month and 6-month trends in core CPI and core PCE have turned higher so far in 2024, highlighting the stickiness of inflation. Elsewhere, prices paid in the service PMI were lower, but prices paid in the manufacturing PMI continued to grind higher, hitting a 20-month high.

After increasing most of 2023, the percentage of small business planning to raise prices in the NFIB survey has trended lower in 2024, although the number is still elevated relative to historical readings. There are signs of easing price pressures, but the ongoing strength in labor markets and still elevated wage growth may keep up the pressure on prices while other factors like geopolitical risks and the bottoming of rent deceleration could add to the pressure.

The Fed’s March summary of economic projections retained expectations for three rate cuts in 2024, but some recent commentary has been more cautious. Fed Chair Jerome Powell noted last week that policymakers generally agree rates can fall this year, but recent job and inflation data has surprised higher and policymakers will need greater confidence that inflation is moving sustainably lower. In a recent speech, Fed Governor Michelle Bowman noted that risks for a future rate hike remain and that reducing the policy rate too soon could result in a resurgence in inflation.

Recent data has provided no clear direction for the Fed or investors, leaving everyone in a re-occurring cycle of hotter-than-anticipated data, cautious commentary and hopes for a soft landing.

Directional Trades and Risk Positioning

Investors may be getting comfortable with stronger-than-anticipated economic data, believing a strong labor market will support the anticipated soft landing. Like in the past months, markets digested the firm inflation prints, solid jobs reports and some hawkish commentary from FOMC members. This created some higher volatility in equities to begin March, which was short lived. Sentiment improved by mid-March and received a jolt when the Fed held rates steady. Although, the Fed did revise rate expectations for both 2025 and 2026 higher, its updated summary of economic projections as well as comments from Chair Powell were still well received.

Our Market Regime Indicator (MRI) finished the month in euphoria. While this regime suggests there may be some complacency among investors, it is still a supportive environment for risk assets. From a quantitative perspective, our forecast for equities softened but remains positive, while expectations for fixed income improved but remain negative, except for high yield. Weaker macroeconomic factors pushed our equity forecast lower, but strong balance sheet health, robust price momentum and sturdy sentiment indicators buoy our outlook.

Our model continues to anticipate higher interest rates, but the magnitude is less aggressive. The March manufacturing PMI jumped into positive territory for the first time in a year and a half and sat well above our lookback value, which implied higher rates. Further, an elevated nominal GDP print suggested healthy economic growth and higher interest rates. Despite the recent rally in yields, current levels are below levels six months ago, implying lower cost of capital and tighter spreads. Additionally, strong equity performance and seasonality also support high yield bonds.

With no significant changes to the ranking of our forecasts, we maintain a healthy overweight to equities but made a small adjustment to the fixed income ledger, selling 1% aggregate bonds and buying cash. Additionally, we continue to underweight broad commodities, but hold a target overweight to gold, which remains supported by our model.

Relative Value Trades and Positioning

We continue our tilt towards US equities, but a modestly lower forecast and improvements to our outlook for emerging markets led us to adjust our regional allocations. Sentiment and price momentum remained strong for the US but have eased recently while valuations are unattractive. We reduce our overweight with proceeds deployed to emerging markets. Emerging markets rank well across all factors with sentiment flipping positive in March and price momentum slightly improving.

Given that our model is calling for higher government bond yields and tighter high yield credit spreads, we made no changes to our fixed income positioning. We maintain a healthy underweight in aggregate bonds with select overweight positions in high yield and cash.

Finally, at the sector level, we maintain allocations to industrials and communication services. Our forecast for technology remains positive, but improvements in our outlook for energy pushed us to split the allocation across the two sectors. Industrials rank well across all factors except value with very strong sentiment and vigorous price momentum keeping the sector atop our rankings. Interactive media and entertainment companies propelled communication services higher this year, which is reflected in our models with forceful price momentum.

Elsewhere, sentiment indicators are durable and valuations are favorable. Technology ranks well across all factors except value with beneficial sentiment and price momentum keeping the sector in our lineup. Our expectations for energy have greatly improved with the recent runup in oil prices. Price momentum and sentiment have improved, and are now less negative, while valuations are advantageous and balance sheets are healthy.