Financial Industry Insights from Advisors Asset Management


Bottom Line Up Front

The combination of a historically accommodative Federal Reserve (Fed) and a federal government with an incredible fiscal impulse has resulted in an economy that has proven immensely difficult to slow. At the beginning of this hiking cycle, few people — if any — thought the Fed would be able to push through 475bps (basis points) of tightening in under a year and see little to no progress on slowing the economy. While we likely have not seen the full impact of tightening to date it’s becoming apparent that consumers used pandemic dislocations in policy to build up savings and become less interest rate sensitive while companies are clearly reticent to lay off employees that they could barely hire in the first place.

It’s important to remember that as recently as January 2022 — in an economy with 7.5% inflation — the Federal Funds rate was at 0% and the Fed was pumping $60 billion in liquidity into the economy every month. That could prove difficult for the Fed’s mandate as we proceed through the year, especially as the more challenging aspect of disinflation is still ahead of us. Getting inflation from 9% to 5% is a much easier task than from 5% to 2% — particularly when so much of the drop to date can be explained by a collapse in used car and energy prices.

Since the onset of this inflationary episode, economist forecasts have always been for a quick and consistent path down to 2%. Inflation, however, is a psychological and largely unpredictable phenomenon that has defied most expectations up to this point. While we think it is unlikely that inflation ends 2023 at the 6.5% level it started with, we also believe there’s slim chance to see the glide path to 2% inflation markets expected at the start of the year.

market forecasts for the path of inflation
Source: Pence Capital Management

We believe inflation has very likely peaked. We also think the Fed likely goes on a rate-hike pause within two meetings and we do not expect a pivot in 2023. That said, there is still significant uncertainty around the ultimate direction of economies and markets, and we anticipate volatility as market participants tangle between pricing in a soft, hard, or no landing scenario. We still think the most likely result is a mild U.S. recession in the back half of 2023 as households burn off their excess savings cushion progressively through the year.

Markets, the Banking System, and the Federal Reserve

Contrary to expectations at the tail end of 2022, the Fed continues to be the main driving force for market performance though the conversation has shifted from “How high?” to “How long?” with regards to monetary policy. Having hit 5% for the target range after the March meeting, the Fed is likely within 50bps of finishing its tightening cycle. We view this as broadly positive as it is one less aspect of uncertainty in what is still a very difficult environment to forecast.

The March turmoil in the banking sector adds some uncertainty to the outlook but we note that — at this juncture — events in the regional banking space appear to be unique to their depositor base, business model, or capital structure, while the events of 2008 were the result of widespread fraud. We do not currently see signs of something systemic or structural in the banking system and note that all of the banking failures so far have been due to reasons specific to their individual bank combined with the ubiquity of mobile devices in hands of bank customers compared to past crises of confidence. In 2017 just 15% of households reported mobile banking as their primary method of bank account access; by 2021 the share of households primarily banking with their smartphone had nearly tripled. Smartphones have changed the banking industry just as they have reshaped how consumers shop — no one had to wait in line in order to withdraw cash from the bank. This wasn’t your grandfather’s bank run and the regulatory framework will need to be adjusted for that going forward.

quarterly path of consensus S&P 500 earnings per share growth
EPS = Earnings Per Share | Past performance is not indicative of future results.

Currently, expectations are for the first quarter to be the lowest point of the year in terms of earnings growth for the S&P 500 at a 7% decline, with markets returning to profit growth in the back half of this year, boosted by the impact of a weaker dollar compared to 2022 when the Bloomberg Dollar Index hit its highest level since 2002. We ultimately see downside to earnings expectations this year — particularly if a material slowdown were to occur in the back half of the year. Earnings revisions so far have been substantial, but have largely been contained to the first two quarters of the year.

"Jerry in the box" |The Fed has never cut rates with the core consumer price index at current levels outside of a recession
CPI = Consumer Price Index

While at this juncture we do believe that the banking sector turmoil is more idiosyncratic than systemic, we do broadly see risk in equities and we think patience will be of great virtue for investors in 2023. Half of the S&P 500’s returns in the first quarter were driven by just three companies while interest rates remain elevated, growth appears to be shifting more toward a slowdown, and the market is back to forecasting significant reductions to the Federal Funds Rate and are now expecting cuts at every meeting between September and January. This outcome is highly unlikely to happen, in our view, because since 1985 the Fed has never cut interest rates with inflation rates as high as they are today without a recession. A cut in the Federal Funds rate would signify a serious deterioration in the broader economy and imply significant risk for corporate profits, in our view.

For over a decade, global interest rates being at or near zero meant investing had been dominated by the mantra “There Is No Alternative” (TINA). With interest rates near 2006–2007 highs, that theme is decisively different today. After 15 years of low interest rates, “Bonds Are Back Y’all” (BABY) and we broadly think fixed income now offers a meaningful alternative for investors. The yields offered by fixed income across the curve are a challenge for equities that are still commanding high multiples historically with a questionable earnings outlook and a backdrop of inflation that remains much too high for the Fed.


From a growth perspective, the economy continues to show strength but is beginning to display signs of moderation. After an exceptionally robust start to the year, data has started to become more mixed. Jobs numbers and overall economic growth have remained relatively strong compared to pre-pandemic levels, but we have started to see the early signs of cracks in the form of increased layoff announcements, upticks in jobless claims, as well as slight softness in retail sales and other consumer spending. Bank of America has found that spending across its network of cards has moderated in recent months while Visa’s Spending Momentum Index also shows a slowdown.

The labor market, however, remains extremely tight and job additions continue to be substantially outside of 2019’s monthly average. Employment levels are at record highs, the U.S. unemployment rate is at 3.5%, and prime-age labor force participation has recovered to the levels we saw pre-covid lockdown. We are beginning to see some cooling in the labor market, but it is important to point out that the current softening is from substantially elevated levels. While the ratio of open positions to unemployed workers has moderated substantially from the highs of March last year, the U.S. economy would need to shed nearly 2.8 million job openings just to get back to the average ratio of openings to unemployed workers we saw in 2019 — a level that was generally considered hot.

nonfarm payrolls, monthly change, in thousands | ratio of job openings to unemployed workers 

Layoff announcements have been pronounced of late, but we note that much of them are confined to technology and more representative of the massive expansion in headcount and focus on “growth at any cost” over the pandemic. For context, Amazon’s announcement of 27,000 layoffs represents just 3.3% of the 810,000 employees the company added between 2019 and 2021 — a period when the company more than doubled its headcount.

In total, the approximately 223,000 tech layoffs since the start of 2022 as tracked by Crunchbase is still below even the smallest number of monthly payroll additions over that same period. Even if every single layoff was announced and acted upon in the same month, the U.S. economy would not have seen a single negative payrolls number. It’s a bad time to be a participant in San Francisco’s economy, but much of the rest of the country remains strong.

Today’s consumer also appears less sensitive to interest rates than they have been in past cycles as many used pandemic-era fiscal and monetary regimes to reduce debt and strengthen balance sheets. Today, more than half of existing mortgages were originated in 2020 or later, 85% of which have a rate under 5%. The result is mortgage servicing costs as a share of disposable income are nearly half of what they were at their peak in 2007 and a housing market with a historically limited supply of existing homes available for sale

"happy homeowners" | more than half of existing mortgages were originated in 2020 or later and 85% of current mortgages have a rate under 5%

A strong labor market and a historically strong consumer certainly makes the Fed’s job harder, but it lends credence to the idea that a recession — were one to materialize — would be mild in nature. Consumer balance sheets remain strong, debt servicing costs as a share of income are low and wage growth is elevated — particularly for those in the bottom quartile income bracket.

Outlook for Inflation

While robust consumer balance sheets are a positive from the perspective of consumer spending and economic growth, it is a substantial challenge for a Fed that is very clearly trying to engineer a slowdown. Nobody told the U.S. consumer “Don’t Fight the Fed” and consumers are still relatively flush with savings to a point that 475bps of tightening has done little to curtail spending or job additions thus far.

Ultimately, we do think inflation has convincingly peaked and we expect to see a rapid decline in year-over-year prints through June — largely the result of base effects from the supercharged inflationary period in the wake of Russia’s invasion of Ukraine when gasoline prices peaked at $5.01 nationally.

After June, we likely begin to see a deceleration in housing costs as the broader market catches up to private indicators of rent growth. CPI (Consumer Price Index) shelter costs have lagged private market indicators by approximately 12–18 months over the course of this episode, and new rent growth is now below the rate seen by all tenants, according to the Cleveland Federal Reserve. Estimates from the Federal Reserve Bank of Boston put shelter costs rising 5.9% year over year in September compared to the 7.9% rate we saw in January.

consumer price index year over year | the largest drivers of inflation are now in the service sector

crossover | in a hopeful sign for inflation, new lease rent growth is now below the rate for all tenants

That said, there is a significant difference between peaking inflation and acceptable inflation, particularly from the Fed’s point of view. Supply chains can only heal once and the last several months of weak inflation have largely been explained by just a few categories and the Fed has seen limited progress on unemployment and “core services excluding housing.” This is the Fed’s preferred indicator and is much more correlated to the health of the labor market and other areas that are less sensitive to interest rates.

While the combination of Fed action and supply chain recovery has made substantial progress on the price of goods, there is risk that a lift in market sentiment — alongside Europe likely avoiding a recession and a reopening China – could lead to a situation where goods prices reaccelerate on top of a services segment that is still at worrying levels. As an example, Manheim data shows that used car prices have increased three months in a row and the CarGurus used vehicle index has returned to price growth. Combined with the recent OPEC+ (Organization of the Petroleum Exporting Countries Plus) cuts and a China recovery that may see record crude demand, there is a chance that there may be significant challenge to the disinflation narrative and we expect the path of inflation to remain volatile.


The fundamental problem for markets is that the economy is too strong, which is a substantial change from past periods of volatility. While we are hesitant to make a call on the ultimate direction of the U.S. economy in 2023 based on three months of highly volatile data, growth in the first part of the year has been strong. Looking forward, early data since the collapse of Silicon Valley Bank has shown muted impact on the broader economy or households. The Fed’s balance sheet has resumed its downward trend and banks have reduced their borrowings from two Fed backstop lending facilities for four straight weeks as liquidity constraints continue to ease. Time will tell when it comes to Silicon Valley’s impact on credit creation, but so far the aftermath has not matched the worry — the banking system resumed deposit growth in early April, and consumer sentiment has rebounded along with inflation expectations in what is a worry for the Fed.

We have seen some progress on inflation with the early signs of peaking shelter inflation but that comes alongside a worrying rise in pricing for oil, gasoline, and used cars and trucks. This could prove challenging for markets when the bond market is priced for cuts to the Fed Funds rate by July and the equity market continues to see a robust back half of the year for profits. It’s difficult for us to envision both outcomes happening and we think near-term risks lean more toward interest rates going higher instead of lower given the robustness of the labor market. At the end of the day, the Fed likely does have to go higher for longer than markets expected at the start of the year, but the end result is that after 15 years investors finally have an interest rate — patience finally pays.

CRN: 2023-0508-10868 R

Opinions in this piece are those of Pence Capital Management and are not necessarily that of AAM.

AAM was not involved with the preparation of the articles linked to in this email and the opinions expressed in these articles are not necessarily those of AAM.

Pence Capital Management, LLC (“PCM”) is an investment adviser registered with the State of California that provides institutional level portfolio consultancy services to certain Unit Investment Trust (UIT) product sponsors, as well as asset management model development offered through LPL Financial, LLC’s (“LPL Financial”) Manager Select program. PCM’s Chief Investment Officer is Dryden Pence. Dryden Pence is also a registered representative and investment adviser representative of LPL Financial, member FINRA/SIPC and a registered investment adviser. PCM is not affiliated with LPL Financial.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

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The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

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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