INSIGHTS

On December 12, 2022

AAM Viewpoints — 2023 Outlook — Asset Allocation in the Next Phase of the Regime Change: Still a Macro-Driven Market, Inflation Remains in the Driver’s Seat

“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” 
— President Ronald Reagan

Over a year ago we highlighted the emergence of a regime change that we believed would alter the investment landscape, perhaps for many years to come. This sea change meant we could no longer count on a continuation of the past 40-year run where lower and lower rates, and higher and higher fiscal stimulus propelled asset returns, muted volatility and acted as a tailwind for risk taking. For investors, during this time, “almost everyone got a prize” as returns on all manner of assets did well. However, in this new regime, we the investor, will likely have to “work for it” over the next several years. The gargantuan Covid-induced response of lockdowns, supply shortages and now war gave rise to the first phase of the regime change — the awakening of the “great thief” of inflation. 2022 proved a year in which the “thief” plundered our real incomes and increased our cost of living.

Inflation’s steep ascent in 2022 heralded the first phase of the regime change and we suggested investors prepare for three key impacts as they evolve over time:

1. Higher and hotter inflation
2. Driving a Fed further and faster in raising rates
3. Causing a slowing economy and depreciating asset prices (see Welcome to the Rorschach Market)

What asset allocation typically works in this type of macro-driven environment?

Underweighting duration in both equities and bonds seemed a pretty clear call. Seeking out quality and tilting toward value vs growth also made sense to us given their relative valuations and a slowing economy. Perhaps it was an easier call in early 2022 than versus what we face now when looking forward. After all, with inflation continuing to rise, the Fed starting from a funds rate of 0%, the 10-year Treasury at only 1.5% and P/E (price-to-earnings ratio) on low/no income stocks at very high levels, the “left/negative tail” of the return distribution for most assets seemed to us much wider than the “right tail” of positive outcomes.

As we enter the next phase of the regime change in 2023, the tails of the distribution of outcomes are a bit harder to discern. So, where do we go from here? Perhaps we should heed the advice of the famous “philosopher,” Yogi Berra: “When you see a fork in the road, take it!” 2023 could also be a year in which we need to take action with portfolio allocations. With that bit of wisdom in hand here are our thoughts as we enter the next phase.

Prepare to Enter the Next Phase of the Regime Change

From a longer-term perspective, we should be thankful the Fed finally acknowledged the risks and has already chopped a lot of wood with one of the most aggressive tightening campaigns in decades. Most economists and business leaders see that continuing, resulting in a recession sometime in 2023; we agree. This is the medicine necessary to quell inflation. We believe that while the Fed will slow the pace of increases and likely pause, we are of the camp that the Fed might be less quick to pivot than the market believes. 

1. They are not quite done yet and we likely have more tightening in store.
2. History shows that we don’t quite know when we are actually in recession until it has been occurring for a while.
3. Most importantly, once inflation gets going it tends to stick around for a while and a Fed that stops and starts could elongate that further.

Fed Chair Powell is a student of history and understands these components. Therefore, we believe that hopes of a pivot lower are still too early and why we are in a “hike and hold” camp. Current market pricing shows the terminal funds rate topping at close to 5% and then reversing very shortly thereafter which we think is perhaps still too optimistic.

Market: “Praying for the Pivot” vs “Hike & Hold”

So, why would they hike and hold?

Inflation Remains in the Driver’s Seat

Our view remains that inflation will continue to decline but will linger for longer well above trend which pushes out the pivot. Why is that? Simply, the Fed can only destroy demand; it can’t solve some of the more pernicious drivers of inflation — the Fed can’t drill for oil, grow food, increase supply chains or stop deglobalization. The other big challenge leading to sticky inflation is wages. Wage gains are running north of 5% and are broadening across many industries. The labor shortage will be very difficult for the Fed to solve without causing a deeper recession, particularly with growing unionization, job hording, long Covid, early retirees and aging demographics. As such, it is not an unlikely scenario that the Fed stays put at the terminal rate longer and does not quickly pivot rather than go even higher and do real damage regarding its second mandate: a stable job market. As for the pivot, it must be maddening for the Fed when the market’s reaction to any hint of a pause or pivot causes financial conditions to ease, when they still have not completed the job! Powell, being astute to the lessons of history, seems to be signaling that he will be patient and thus push out the pivot, which is not priced in. Importantly, history also shows that once inflation gets going, even if it is coming down, it can remain above trend for years (four years on average):­

History of Inflation: 6 Episodes — Inflation Above Trend for 4 years on Average
 

Fed Action Leads to Significant Slowdown/Recession

Our economic outlook then follows; with the Fed needing to create more demand destruction and job losses, consumers will finally pull back (following the trend of business layoffs beginning to pick up). Consumers have been resilient due to a tight job market, the ability to spend down savings and increase credit card borrowing. The latter two variables likely reach a natural limit by mid/late 2023 as job losses grow. While equity valuations have come a long way, they are still not priced for the earnings slowdown we foresee. Again, hopes that a mild pivot is all that is needed to prevent this hard economic outcome seem very optimistic. 

On the other side, although rates are still poised to go up to match off against inflation, we have come a long way by way of higher rates in 2022. The Fed has put income back into fixed income and certainly so on the front end of the curve. With starting yields in the 4–6% range, we see reasonable value and a positive total return year for short to intermediate fixed income. The other silver lining that could evolve later in 2023 may be that if the terminal funds rate hits 5%+ and the Fed doesn’t pivot too soon, inflation might drop to at or below 5% which puts the real funds rate in positive territory which is key to working down inflation from a longer-term perspective.

Era of Higher Market Volatility

We enter 2023 with no shortage of uncertainties which we believe will keep volatility elevated next year. The bigger construct to consider is that the historical suppressors of volatility — the Fed and fiscal authority puts we have enjoyed the past 40 years — are much further out of the money (“out of the money” is an expression used to describe an option contract that only contains extrinsic value). We are not saying the Fed wouldn’t lower rates and some stimulus might be forthcoming, but sticky inflation could hamper the Fed while our fiscal situation has put debt outstanding/GDP at historic highs which might limit the timing and forcefulness of stabilizing responses.

New Regime: Less Rate Tailwind Counting on Rate Rally/Pivot? We Can See Lower Rates, but…the 40-Year Put is Kaput

Source: AAM, St. Louis Fed

Summary of Economic/Market/Asset Allocation Themes for 2023:

2023: Still a Macro-Driven Market | Inflation Remains in the Driver’s Seat
Inflation decreases but remains above trend keeping rates sticky. The Fed hikes & holds until enough demand destruction slowly walks the economy into a recession. Although valuations are much lower, we still see capitulation in certain sectors (but not all, e.g., energy, commodities). 

Our outlook for the 3 main economic drivers for 2023:

• Inflation: Lingers for longer as we assume inflation stays above trend and possibly still as high as 4.5%+/- by year-end 2023.
• Rates: The Fed hikes & holds at ~5%+ and pauses any pivot given sticky inflation. The Fed needs to see weakness in the labor market to attain price stability.
• Economy: It will be a tale of 2 halves. A recession lands sometime during the year which hits earning; rate rises stall, valuations reach recession norms and the dollar rally ends.   

Implications for Asset Allocation:

We are sticking to our regime change script of looking toward quality stock and bond allocations entering 2023 with an eye toward emerging opportunities.

• Equities: Maintain our long-term view on a tilt toward value and income sectors.
  • Value factors are still attractive/cheap vs growth, and we think this is a multi-year trend. 
  • Focus on income generation in an era of elevated volatility. Income will be a key component of return generation and a volatility suppressor.
    • Favor dividend payers and growers, low duration preferred, and covered call strategies .
  • We favor sectors with secular tailwinds such as in Energy, Commodities, Materials, Defense, Infrastructure, Logistics.
  • Weaker economy and U.S. dollar in 2023 provides opportunities to further adjust asset allocation to areas that historically do well in both sticky inflation/rate environments:
    • Select Emerging Market and International.
    • Small Caps which have proven to outperform large caps during elongated periods of above-trend inflation.
• Fixed Income: Emphasize short to intermediate fixed income with yields at attractive levels.
  • Favor short to intermediate fixed income in both investment grade and higher quality high yield.
  • Favor municipals for tax efficiency, quality, ballast.

Bottom Line: Keep patient, keep asset allocation focused on resiliency, quality, value and income generation. We do not believe what worked the past 10 years is necessarily the right formula for the next 10 years in the new regime.

CRN: 2022-1201-10495 R