Financial Industry Insights from Advisors Asset Management


AAM Viewpoints — 2nd Half of 2023: Entering the Next Phase of Regime Change


Market Commentary — A First Half of Concentrated Records

The first half of 2023 was certainly one for the record books with the Nasdaq 100 up an historic 39% while the largest tech stocks in the S&P also carried the day on the promise of AI (artificial intelligence). The concentrated and strong performance helped pull a reluctant rest of the S&P constituency (only up 2%) to an overall index total return of 16%. The market cap of the IT sector now approaches $10 trillion or close to half of U.S. GDP, with the market cap of one company alone topping $3 trillion — equal to the GDP of the UK. All the more remarkable when we consider the other record hit in the first half — a further inversion of the yield curve as the spread between the 2-year and 10-year Treasury pushed beyond a negative 100 bps (basis points). Even a more modest inversion is typically and highly correlated with a coming recession which has yet to land. Perhaps these mixed signals are not as much a dichotomy as they appear. Often a narrow market is a symptom of investor concern and could represent more of a flight to quality amidst a “FOMO” first half, and in a way, helps explain some of the dichotomy. For now, the economy is hanging on but we know rate increases operate with a long and variable lag so the impact is really still mid innings with the Fed still in play albeit likely closer to the end of hikes. 

U.S. Economy — Resilient but Slowing

The economy did slow as the Fed cranked the Funds rate up 500 bps from the floor over the past several months. However, one of the most highly anticipated recessions ever has yet to appear due to a resilient consumer. So, where is the recession that was so highly anticipated (admittedly by us as well)? History tells us that a stock market bottom only occurs months after a recession has occurred, and yet we have witnessed a market bounce from the bottom of the fall of 2022 without a recession. Have we dodged a bullet and are we witnessing another historic event unfold? We still find it hard to see an “Immaculate Disinflation” to a 2% Fed inflation target accompanied by a continued growing economy and also accompanied by continued low unemployment. We think the Fed will likely push just a bit harder on the brake and hold it there. We note the continued presence of sticky inflation (down from the peak but Core numbers are still 4.8%) and a hawkish Fed that will need to slow the job market much more to reach their goal. We also note the lack of many successful historical precedents of success given the inflation/rate jam we are in. To date, consumer spending has been solid, but we have to wonder if the consumer is like Wile E. Coyote, not powered by Acme rocket skates but rather, by the rocket fuel of excess savings, continued borrowing and pent up “revenge spending.” This fall the consumer will be hit with the exhaustion of excess savings, the restart of student loan payments, a continued increase in borrowing costs and all in the face of increasing job loss. Perhaps the consumer will look down later this year and realize they are a bit over the cliff. It might indeed take a small miracle if we are to avoid a downturn particularly given these dynamics and a Fed that “Hikes and Holds.” 

Regime Change — Inflation is Sticky

The June jobs report showed Wages and Shelter Costs remain sticky with Core CPI (Consumer Price Index) also “sticking” just shy of 5%. Both components comprise well over half of CPI and core inflation. The first phase of disinflation was the ‘easy part.” The final mile of disinflation may be hard to come by as both shelter and job markets suffer from a significant lack of supply vs continued demand. The doubling of mortgage rates took over 20% of the supply of existing homes out of the market. Existing homes available for sale are typically 4x the level of inventory of new homes on the market. So, ironically, the Fed rate increases have destroyed more housing supply than demand in the biggest contributing area of the CPI basket. It would take much more demand destruction to balance the market as new homes take time to construct. Wages are sticky too with job openings still 1.6x greater than job seekers. And just a word on energy, prices have softened and were a big driver to lower inflation…for now. We only caution that the energy market is not only controlled by supply and demand but manipulated by significant forces that seek to limit drawdowns and capital investment influences that do not reward adding supply capriciously.

These inflation dynamics mean the rate increases we have seen to date might not yet be over (the “Median Dot” shows two more hikes) and that a lower-rate regime is not in view. The punchline here is we have a sticky inflation problem which keeps the Fed in a “hike and hold” pattern. Powell is a great student of history and history shows that the real Fed Funds rate (Funds rate net of inflation) must be meaningfully positive (historically around 200 bps) and be held there for a while to bring inflation down and have it stay down. With Funds at 5.25% and Core CPI at 4.8% we are not there yet, and much will depend upon where the inflation “puck” is sliding. The Fed’s own forecast has two more hikes and a Core CPI heading toward 3.8% by year end. This would get us closer to the 200 bps real Fed Funds level but not until the end of the year; so, we don’t see rate relief in the near term. And it is key to also point out that the Fed forecasts a recession to get there. On that point we agree and think the probability of recession is still greater than avoiding one. We see it more probable that the economy slows into a mild recession which will impact earnings and multiples further.

Valuations at the Index Level Seem too High

The conundrum today is that earnings have been revised meaningfully lower over the last three quarters and yet the market has rallied strongly. This has been a result of P/E (price-to-earnings) expansion. Strategas Research notes that the S&P 500’s entire +14.6% price gain year-to-date has been due to multiple expansion, not earnings growth. 

S&P 500 Index & 2024 S&P EPSSource: Strategas Research  Past performance is not indicative of future results.

This, of course, is the exact opposite of what happened last year when the entire drawdown was due to multiple contraction. Quite the reversion, and with the 10-year back closer to 4%, it begs the question, what has changed and is it sustainable? With sticky inflation, a Fed that hikes and holds and a possible recession hitting earnings further we think the market is at risk of a pullback. So, how should one think about asset allocation?

Focus on Predictable Sources of Return and a Margin of Safety

Given our outlook, we suggest taking advantage of the recent rally to reposition to sectors with more resiliency and which provide some protection through cheaper and more attractive valuations. Quality, value and dividend-paying sectors can add to that resiliency. Fears over a slowing economy and higher rates helped shelter this type of portfolio construction in 2022 as dividend-paying equities were one of the few places to hide. Through the first half of 2023, dividend-paying equities have not participated as strongly in the rally as non-dividend paying, and growth stocks have led the way. However, we would note that the full impact of rate increases has not yet hit the economy and the likelihood of a Fed that keeps rates higher for longer will favor staying with our aforementioned playbook. We also note, despite the recent rally and looking back to the beginning of the cycle (January 2022), dividend-paying equities have still outperformed, despite the rebound in growth stocks this year.

S&P 500 contribution to return - dividend yield

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

Mind the Gap — Adding Diversification

Market concentration is at a high level with a large gap between the top 10 names and the rest of the market. Narrow markets eventually broaden out. We believe we will begin to see a reversion sometime in the second half and we believe looking at strategies that don’t hug the indices. The lack of diversification can cut both ways. Strategies that equal weight or actively risk manage away from undue concentrations should be part of the playbook looking forward, in our opinion. Whether one is a bear or a bull, the idea of a broadening market and reversion could easily be supported in either case.

Alternative Income Opportunities

The Fed moves have put “income back into fixed income.” Given sticky inflation we still err on the side of staying moderately short duration and like staying in the shorter to 7-year areas of the curve in taxables and slightly longer in the higher quality tax-exempt markets. We also favor high quality and shorter duration preferreds which have cheapened in sympathy with regional bank woes as many issuers in this market are financial institutions. Given current discounts on well capitalized and large bank issuers, we see this as an opportunity to add income and quality. We also see good opportunities in alternative areas such as select REITS (real estate investment trusts) which have been painted by the broad-brush fears over commercial office risks. This has created discounts for subsectors in residential and industrial which have stronger fundamentals and are supported by secular demand drivers vs current and future supply. Finally, we believe covered call strategies have the potential to be a solid way to add steady income into the portfolio in a market that has rallied to a high valuation range.

Regime Change Enters Next Phase

Over the past 12 months, the Fed has moved aggressively, and inflation has come down off its peak of 9.1%. However, it is not the time to drop the mic and go back to the old playbook. The last 20+ years saw lower and lower inflation and lower and lower rates. Both flirted with and bottomed near zero. Yes, we are not in a ‘70s inflation scenario but nor are we in the scenario of the last two decades. We are in a new regime of sticky to moderate inflation and sticky rates. We can’t count on a decade of rate rallies to carry the day as we look forward. And we shouldn’t rely on a continued bazooka of fiscal rescues either (politically this could still happen but with fiscal debt now over 100% of GDP it will be a further bumpy ride for rates as we saw recently in the UK). The last decade of low/no profit growth sectors trouncing value/quality dividend sectors was quite unusual from a historic perspective. But then again, so was zero rates. Looking forward, adding resiliency, diversity and steady income to portfolio construction will be paramount as we enter this next phase of the regime change.


CRN: 2023-0706-10975 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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