Overweight in European Equities

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

Although uncertainty has significantly increased over the past few weeks, our outlook remains largely unchanged. While tariffs and general policy uncertainty present downside risks to our economic growth projection and upside risks to our inflation forecast, fears of stagflation are likely overstated. We continue to believe the risks to our outlook are balanced.

In the United States (US), recent softness in data has sparked recession fears, with the most recent Atlanta Fed’s gross domestic product (GDP) tracker reflecting Q1 growth at -2.4% – a sharp decline from over 2% a few weeks ago.

However, there are still some positive factors worth noting. First, corporate profits continue to grow, with FactSet reporting an estimated 7.3% YoY earnings growth rate for the S&P 500. Second, the labor market remains stable (recent layoffs were largely driven by the government sector), wage growth is solid, and service activity remains expansionary. Lastly, deregulation and tax cuts could serve as the next policy levers, providing potential support for the economy. Therefore, while consumer confidence is down, it does not appear to be fully supported by the data – at least not yet.

Outside of the US, the economic outlook is mixed. In Europe, the fiscal shift in Germany, with the recently announced increase in defense and infrastructure spending, has renewed optimism for a region that has been sluggish. That said, infrastructure spending is not immediate, and the eurozone remains sensitive to global trade and tariffs. Broader fiscal spending is needed to stimulate consumer demand, but recent developments are encouraging.

In Japan, Q4 gross domestic product (GDP) was revised lower due to weaker consumption and reduced inventories. Wages are rising at a healthy pace, but real wages have declined as core inflation has increased at the fastest rate since June 2023. Tariffs pose a threat, but unemployment remains close to pre-COVID levels, and rising wages should help support consumption. In China, deflationary pressures are a concern, as are the effects of tariffs. However, China has subsidized consumption and hinted at further measures this year.

We will continue to monitor US policy, labor market dynamics, inflationary pressures, and central bank actions. However, a soft landing remains our base case.

Directional Trades and Risk Positioning

Like last month, our outlook for risk assets remains mixed, though the factors driving this view have changed. Specifically, we have seen risk sentiment, measured by our Market Regime Indicator (MRI), make its first significant move toward risk aversion since peaking around the carry trade unwind in August 2024. In contrast, our modeling focused on equity market dynamics showed a slight improvement over the past month.

The jubilation following the US election has begun to fade, as softer US economic data, renewed stagflation concerns, and policy uncertainty weigh on the markets. This decline in investor sentiment is reflected in our MRI, which has weakened due to a deterioration across multiple factors. First, implied volatility in both equity and currency markets has spiked to extreme levels, indicating increased investor risk aversion.

Additionally, our assessment of risky debt spreads points to a weakening risk appetite. Lastly, our evaluation of sentiment spreads – comparing risk-on and risk-off market segments – has diminished materially, moving from risk-on to slightly risk-off. Overall, the weaker MRI suggests limited support for risk assets.

For global equities, the slight improvement is driven by more attractive valuations, particularly a stronger buyback signal. Although short-term price momentum has weakened, our assessment of balance sheet health remains positive. As a result, our model now anticipates a modest advancement for equities.

In bond markets, our model forecasts minimal changes in the level of rates but expects a meaningful flattening of the curve. Minor adjustments to our underlying factors show stronger manufacturing activity (pushing yields higher) offsetting interest rate momentum (pushing yields lower). From a curve perspective, two key drivers signaling a flatter shape were the sizable jump in the University of Michigan inflation expectations and slope momentum.

The most significant change in our research occurred in high yield, which now holds our weakest bond forecast due to declining equity momentum and rising equity volatility. While carry had previously supported high yield, our model now projects wider spreads.

For our March rebalance, we have increased our equity exposure but also de-risked in areas such as high yield. Given the weaker outlook for high yield, we reduced our allocation and sold some cash, redirecting the proceeds to aggregate bonds and global equities, which are relatively more attractive. The added exposure to equities brings us back to a modest overweight position.

Relative Value Trades and Positioning

Within equities, we rotated out of Pacific and into Europe due to a deteriorating outlook for Pacific equities and a stronger forecast for Europe. This shift was driven by price momentum and sentiment, both of which improved for Europe while weakening and turning negative for Pacific equities. As a result, we are now neutral on Pacific, underweight on the US, and overweight on Europe and emerging markets.

On the fixed income side, we reduced our high-yield exposure and invested in long government bonds and cash. After factoring in the directional trades, we executed a substantial sell-off in high yield, bringing us back to neutral. Overall, we now hold a modest cash position and overweight allocations to longer-dated investment-grade bonds.

At the sector level, we maintained full allocations to energy and communication services, both of which benefit from attractive valuations and positive sales and earnings estimates. The communication services sector also shows strong price momentum.

We rotated out of financials and into technology, driven by macroeconomic factors that have improved for tech but weakened for financials. The technology sector also benefits from enhanced quality factors, which align with strong sentiment indicators.

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