Allocation to Europe Equities Increased

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 challenges our long-held view for the US economy, but, for now, we are maintaining our view that a soft landing can still be achieved.

The US labor market continues to exhibit strength, with employment data solid, the unemployment rate ticking lower, and wage growth remaining positive. While job openings in the JOLTS report fell, layoffs remained low and unemployment claims remain reasonable.

Elsewhere, non-farm payrolls disappointed on the surface — 33k less than forecasted — but the prior two months’ data was revised higher by 100k. There was some softness in service activity, with January’s ISM service purchasing managers’ index (PMI) declining as business activity and new orders increased less than previous months. While service activity declined, it remained positive and manufacturing activity in the US continued to rebound, expanding after 26 months of contraction. Overall, the Atlanta Fed’s gross domestic product (GDP) tracker reflects a solid 2.9% Q1 growth for the US.

Inflation in the US has remained firm; consumers have started to notice, with one-year-ahead inflation expectations in the Michigan Consumer Sentiment survey jumping a full percentage point to 4.3%. From a market perspective, the two-year break-even rate has climbed over 3% and sits at an 11-month high. After December’s hotter-than-expected headline inflation print, January’s consumer price index (CPI) — both headline and core — outpaced expectations. Shelter was a large driver of higher inflation, but there were broad price pressures as food, energy, core goods, and core services increased. While some of this could reflect the “January” effect, these numbers do not fully capture impacts from the tariffs that were recently announced. Further, three- and six-month trends in headline CPI have been moving higher over the past few months. Overall, while the disinflation trend has been challenged recently, we still believe some normalization in price pressures should allow inflation to move closer to the Fed’s target.

The Fed’s language has shifted since its hawkish cut in December, with officials stating that it does not need to rush additional rate cuts. Recent data seems to confirm it should hold for now. While our forecast for three Fed rate cuts this year is in jeopardy, we will hold off changing it until we see how employment and wages evolve over the next few months.

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

Directional Trades and Risk Positioning

Despite an uptick in inflation expectations, uncertainty around trade policy, and the disruption caused by DeepSeek, investor risk appetite continued to improve when evaluated through our Market Regime Indicator (MRI).

Numerous factors have helped buoy investor sentiment. Long-term yields have retreated, aided by the Treasury announcement that no changes were expected to auction sizes or coupons. US labor market dynamics remain solid, US manufacturing activity has improved, and corporate earnings remain robust. Like some of the macro signals, our underlying factors remain mixed, but continue to point to a modestly positive risk appetite. The improved outlook is due to lower levels of implied volatility on both equities and currency. Elsewhere, there was little change among our factors, with sentiment spreads and our evaluation of equity trends remaining supportive and offsetting signals from our risk support factor. Overall, our MRI continues to imply a slightly positive risk environment.

While risk appetite has gradually improved, our fundamental evaluation of equities has weakened, a trend that has been ongoing since the middle of 2024. Elsewhere, while our bond forecasts have improved, and now are slightly positive, our models prefer risk exposure in commodities and credit bonds.

With respect to global equities, while our evaluation of quality factors remains positive, and companies are still efficiently generating earnings and exhibiting healthy balance sheets, equity valuations remain stretched. However, other factors that were previously supportive have either softened or turned negative. After improving last month, our macroeconomic factor turned negative, and price momentum has become less beneficial. Sentiment indicators, analysts’ expectations for both sales and earnings, have deteriorated further and are now negative, which also weighs on our outlook. Overall, our model now expects very little return in either direction for global equities.

In bond markets, our model is forecasting minimal change to the level of rates or the shape of the yield curve. With manufacturing improving, and now in expansionary territory, the signal is suggesting higher yields. Offsetting this, however, the recent retreat in yields has flipped our momentum signal, which now expects rates to continue to decline. From a shape perspective, lower inflation expectations (flatter curve) offset lower leading economic indicators (steeper curve), indicating no real change to the shape of the yield curve.

While our bond forecasts have improved, our modeling prefers both high yield and investment grade credit. In addition to the attractive carry from these assets, we also see some support for spread tightening.

Strong risk appetite and equity forecasts pushed us to a healthy equity overweight for the first half of 2024. However, softening of both measures over the second half prompted us to take a more modest overweight to finish the year. While risk appetite has improved gradually, it is below levels experienced early in 2024 and our equity forecast has weakened. With our near-term equity expectations declining as our forecasts for fixed income markets edged higher, these dynamics prompted the broader de-risking and equity reduction. For this rebalance, we reduced our equity stance to neutral with proceeds deployed to cash and aggregate bonds.

Relative Value Trades and Positioning

Within equities, our model now prefers non-US equities and we have executed trades to position the portfolio accordingly. This updated stance is being driven by improved prospects for non-US developed equities and a weaker outlook for the US.

Valuations for US equities have been stretched for some time now, especially after the outperformance over the past couple of years. However, other indicators we consider, which previously favored the US, have now become less supportive. In particular, we are seeing a deterioration in earnings and sales sentiment. That is not to say that earnings or sales expectations are necessarily bad for the US in absolute terms, but we are seeing a more pronounced divergence whereby international equities are gaining ground in relative terms. In addition, although quality factors remain positive, they are relatively less attractive now than other regions. Finally, macroeconomic indicators have weakened and weigh on our outlook.

Outside the US, our Asia Pacific equity forecast remains strong, buoyed by those better sentiment indicators and favorable macroeconomic factors. Further, price momentum has improved. In Europe, analysts’ expectations for both sales and earnings have meaningfully improved, while valuations remain attractive. European companies continue to exhibit solid balance sheets and the ability to efficiently generate returns.

During our latest rebalance, we sold US large cap and small cap equities, while increasing allocations to Europe and Asia Pacific. Overall, we have rebalanced our equity positions such that we now hold an underweight allocation to US equities, maintain a neutral allocation to Europe, and hold targeted overweight allocations to Asia Pacific and emerging market equities.

On the fixed income side, we put some cash to work to buy long credit bonds due to our expectations for tighter spreads. While our equity allocation has been reduced, we now hold a healthy overweight to riskier debt, both investment grade and high yield.

Finally, at the sector level, we maintained a full allocation to energy and financials. We rotated out of consumer discretionary and into communication services. The energy sector continues to benefit from robust macroeconomic indicators, healthy balance sheets, and attractive valuations. Our positive expectations for financials are underpinned by sturdy price momentum, strong sentiment indicators, and favorable macroeconomic indicators. Our forecast for consumer discretionary remains positive, but weaker expectations for both sales and earnings, combined with softer price momentum and quality factor readings, pushed the sector down our rankings. The communication sector ranks well across all factors, except macro, followed by slight improvements to our sentiment indicator, which helped the sector move into the top three.

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