Financial Industry Insights from Advisors Asset Management


AAM Viewpoints — CIO Outlook: A Macro Regime Shift Requires a Portfolio Allocation Shift


"And they’re off!" Markets shot out of the gate the first two weeks of this year like horses at the start of a race with the S&P, Nasdaq 100 and even the investment grade bond market up over 4%, 5% and 4% respectively. Among many analysts’ forecasts, those numbers would have already hit the mark for full-year results. As last week’s market declines point out, unfortunately, the race has only just begun and continuing with the metaphor, all horses on a circular racetrack end in the same place they started (unless they break a leg!).

For domestically focused broad market beta, we think the year might not look too different (ending somewhere close to where we started) as the market still faces challenges around the path of inflation and rates against a backdrop of a slowing economy and recession. We think this early dash (and much to “trash”) is a bit premature and the market correction bottoming process is not yet complete as the Fed vows to “stay at it until the job is done.” Indeed, at the end of the week before last, the indices gave a bit back as a combination of hawkish Fed speak and weaker economic numbers challenged the notion that “bad news is good news.”

We choose not to fight the Fed at this point and believe we are entering the next phase of a regime shift with sticky inflation above the Fed’s 2% target and rates that can no longer provide the 40-year tailwind of the past. The silver lining is that we see many good investible opportunities right now both here and internationally, as well as across asset classes and sectors that can work well in this new regime environment. With the “Big Reset” of 2022 bringing bond yields up at the fastest pace in decades and dropping asset prices to attractive levels in certain sectors, the recent broad “risk on” bounce provides opportunity to consider shifting portfolio allocations to exposures that provide resiliency and alpha vs general broad market weighted beta.

Our allocations are guided by our key themes for 2023:

  1. Inflation continues to decline but sticky components keep it above the Fed’s 2% goal for a long while.
  2. Precluding the Fed from lowering rates in a way that inoculates every market wobble, causing a pause in the pivot and a hike and hold in Fed Funds.
  3. An economy that stalls and shrinks as the consumer exhausts excess savings, gets squeezed by higher rates and increasing job losses while businesses continue to tighten their belts.

We believe these dynamics will cause a decline in profit forecasts pressuring stocks toward lower valuations. From this bottoming process, we see positive opportunities. We are not suggesting to “do nothing;” rather, we think implementing shifts in asset allocation today can help create portfolio resiliency and opportunity this year and beyond. Our suggestions connect to our views on the longer-term path of inflation, rates, and the U.S. dollar as key foundational drivers.

Inflation at the Core

At the core, we believe that it is a macro-driven market with inflation still in the driver’s seat. Sure, inflation is coming off lofty levels, but the easiest and most predictable part of air coming out of the inflation balloon will soon be behind us. Put another way, inflation dropping from 9% to, say, 4% or 5% is the easy part. Getting it from 4 or 5% to the Fed’s 2% target…well, that will be hard yards. Supply chains are loosening a bit, but we still have secular supply/demand imbalances across a host of areas, not the least of which is labor. With aging demographics, early retirements, and lower workforce participation due to lingering Covid impacts — “labor has leverage.” Other key inflation drivers include slowing globalization, inefficiencies from onshoring, a rising global demand for commodities and energy all pointing to a stubbornness in getting inflation down to the Fed’s target. This week’s Core Personal Consumption Expenditures report (a Fed favorite) showed a slight uptick on the month at 0.3% while initial jobless claims touched a cycle low and both evidence the challenge of bringing inflation to target.

The Atlanta Fed “Sticky Price” chart captures the essence of the argument:

The Atlanta Fed “Sticky Price”

Expect a Pause on the Pivot

Since the Fed began to discuss slowing the amplitude of rate increases from 2022’s blistering pace, we have seen a growing divergence between the market and Fed. The latest Fed “dot plot” from December shows a terminal rate forecast of just north of 5% while as of this writing, the market-implied terminal rate is closer to 4.8%. The bigger “disagreement” is in the expectation of a pivot to lower rates with the market implying a drop to 4.4% by year end. As one can see below, not one Fed official forecasts a pivot which underscores their “hike and hold” posture. As a reminder, the market did have it wrong most of 2022, pricing in a pivot several times and Fed Chairman Powell made sure to let the market know his disagreement at his infamous Jackson Hole speech last summer. Recent Fed comments remain hawkish in this regard as well.

FOMC participants' assessments of appropriate monetary policy

Source: Federal Reserve

The “Second Shoe”

With the Fed on the move and considering the lag effect from previous tightenings, we believe the economy continues to stall into a recession. We believe the “second shoe” follows as earnings revise downward causing a bottoming process playing out sometime mid-2023. If this occurs, it sets up an optimistic scenario and additional attractive opportunities to consider. Before jumping right into what sectors we suggest to favor or underweight, we have found it helpful to first define and highlight key and durable themes to consider to frame our asset allocations.

Given our outlook, we suggest three broad themes:

3 AAM Themes for 2023
Source: AAM

There are also commonalities of factors in asset allocation decisions that cut across these themes that help create a resiliency in portfolio construction. For instance, focusing on quality companies, with solid business models that generate profits and steady cash flows and dividends which can provide resiliency.

Quality and the Power of Dividends

As the economy slows, we are allocating toward quality companies with strong franchises and solid cashflows. Quality companies are often also dividend payers. We believe dividend payers and growers will be well rewarded as we move into this new phase. Work done by Strategas Research shows that throughout U.S. history, the power of dividends has been a significant component of total return. Since the 1930s, dividends have contributed close to 60% of total return over the decades. The last few years were quite unusual to say the least in its undersized dividend contribution to total return. We believe dividends will represent a much larger percentage of total return during the new regime without the tailwind of negative real rates:

dividend contribution to total return
Source: Strategas Research | Past performance is not indicative of future results.

Small/Mid Cap Equities Posed for Outperformance

With inflation remaining persistent, we have found that mid- and select small-caps have historically been top asset classes when inflation has run in a range north of 2% and below 5% (our view is on the higher end of the inflation range). Valuations on small- and mid-caps are also relatively attractive as well with large-cap P/E’s (price to earnings ratios) remaining stretched compared to mid-caps:

stretched compared to mid-caps 

Source: Strategas Research

Value Leadership is a long-term trend

With the end of the 40-year bull market in rates and the exit of global central banks from negative interest rate regimes, style selection is also critical. We believe the leadership change from growth to value that we saw in 2022 will continue as rate tailwinds driven over the past 15 years disappear. We believe this leadership change is durable and likely to last several years.

International Markets and Emerging Markets (EM) Provide Diversification at Lower Valuations

Geographical allocation decisions can add diversity and performance across portfolios as the U.S. dollar rolls over with major, global central banks catching up to the Fed and the U.S. economy slowing down. Valuations in international markets compare favorably to the U.S. while the world’s second largest economy, China, reopens kickstarting the Chinese/EM growth machine. Inflation and increasing demand in EM as China reopens also makes a good case for exposure to commodities and energy markets, which we believe are also multi-year trends. The chart below shows how unusual the last 10-or-so years have been versus history for many asset classes, styles and geographies as the final crescendo of lower and lower rates, and bigger and bigger fiscal bazookas concluded with Covid.

compound annual rates of return by decade 

Source: Strategas Research | Past performance is not indicative of future results.

Income is Back in Select Areas of Fixed Income

Finally, it should not go without pointing out some opportunities in fixed income. The Fed has put income back into fixed income and certainly so in short to intermediate parts of the yield curve. With 2- to 5-year rates above 4% and even higher in credit sectors, we think the risk-reward equation is now attractive. We do not think it is time yet to extend durations with significant rate uncertainty; however, allocation to shorter-maturity bonds offer the possibility of earning 4–5% income streams without a lot of duration, and represents an attractive risk-reward equation.

ICE BofA BBB US Corporate index effective yield
In sum, we believe the “off to the races” start thus far in January provides opportunity for reallocation toward sectors that can “go the distance” during this next phase the regime change.

CRN: 2023-0109-10558 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit


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