Best Ideas for 2023

BEST IDEAS for 2023

advisors asset management's

Last year we started our annual review with “2021 was, in short, a challenging and unpredictable year.” Well, 2022 was more of the same.

Expectations for 2023

©2023 Advisors Asset Management. Advisors Asset Management, Inc. (AAM) is an SEC-registered investment advisor and member FINRA/SIPC. 18925 Base Camp Road • Monument, CO 80132 • www.aamlive.com CRN: 2023-0105-10553 R

Interest Rates Move Higher

Market Volatility Remains High

What is a bond ladder?

TAX-EXEMPT INCOME

Recession Likely in 2023

How It Works

Assuming an initial investment of $100,000, an investor purchases five bonds with staggered maturities extending out every two years. The laddered bond portfolio has a combined average annual yield of 3.42% and an average duration of 6 years.

2-Year

4-Year

6-Year

8-Year

10-Year

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

5.00%

2.05

2.65

3.60

4.15

4.65

At the end of year two, the shortest bond matures and the four remaining bond investments are now two years closer to their maturity date. Proceeds from the maturing bond are reinvested back into the 10-year bond. The combined average annual yield of the new laddered bond portfolio is 4.05% and the average duration would remain at 6 years.

Original Ladder

2-Year

4-Year

6-Year

8-Year

10-Year

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

5.00%

2.05

2.65

3.60

4.15

4.65

BOND A $20,000

BOND B $20,000

BOND C $20,000

BOND D $20,000

BOND E $20,000

ladder two years later

BOND MATURED

2-Year

4-Year

6-Year

8-Year

10-Year

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

5.00%

6.00%

0.00

2.65

3.60

4.15

4.65

5.20

BOND A $20,000

BOND B $20,000

BOND C $20,000

BOND D $20,000

BOND E $20,000

ladder two years later

BOND MATURED

2-Year

4-Year

6-Year

8-Year

10-Year

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

5.00%

6.00%

0.00

2.65

3.60

4.15

4.65

5.20

BOND A $20,000

BOND B $20,000

BOND C $20,000

BOND D $20,000

BOND E $20,000

Ladder Two Years Later >>

<< ORIGINAL LADDER

This hypothetical example is for illustrative purposes only and does not represent the performance of any specific investment. Bond income is not guaranteed and may be subject to call risk as well as default risk, which increases with lower-rated bond securities.

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This commentary is provided for informational purposes only. The indexes referenced in this publication are not available for direct investment. It is not an offer or solicitation of an offer to buy or sell any product or service. Unless otherwise stated, all information and opinions contained in this publication were produced by Advisors Asset Management, Inc. (AAM) and other sources believed by AAM to be accurate and reliable. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions are as of January 3, 2023 and are subject to change without notice. All AAM employees, including research associates, receive compensation that is based in part upon the overall performance of the firm. AAM may make a market in or have other financial interests in any given sector or security with which this analysis suggests may be benefited from its conclusions. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed in this report and should understand that statements regarding future prospects may not be realized. Past performance does not guarantee future performance.

Chart/Graph Disclosure: The charts/graphs included in this publication do not reflect past or current recommendations made by AAM, “they” should be considered an academic treatment of empirical data and should not be used to predict security prices or market levels. Any suggestion of cause and effect or of the predictability of economic cycles or investment cycles is unintentional. Best Ideas for 2023 was created using empirical research and analysis by highly experienced market observers and is designed for educational purposes only. This publication should only be considered as a tool in any financial professional’s investment decision matrix. Investors should consult their financial professional when applying the assumptions of these charts/graphs. Not FDIC Insured. Not Bank Guaranteed. May Lose Value.

The year started with the Omicron COVID-variant once again upending global economies and supply chains. Geopolitically, in response to EU sanctions, Russia stopped the flow of gas and two pipelines ruptured – most likely due to intentional sabotage – which significantly increased energy prices. In addition, US-China relations continued to decline as the two countries vied for military, technological and political power. North Korea conducted a record number of missile tests throughout 2022, escalating tensions with the US and its allies. Iran, Russia, and China all experienced public dissent, an unusual occurrence in these countries. In the UK, Liz Truss resigned as Prime Minister just six weeks into her tenure due to multiple missteps that sent the capital markets and pound sterling into freefall. And let’s not forget the death of Queen Elizabeth II after 70-plus years on the throne. Domestically, the US midterm elections did not end with the “red wave” many anticipated, as Democrats maintained the Senate majority and Republicans took the House with a slim majority. From an economic perspective, what was once expected to be “transitory” inflation quickly became entrenched with year-over-year inflation at 40-year highs throughout much of the year.

The Federal Reserve (Fed) responded by increasing rates fast and furiously;starting with a 25 basis points (bps) hike in March 2022, followed by another 50 bps in May and then a very aggressive policy move of four 75 bps hikes, and then a smaller hike of 50 bps in December 2022. The Fed Funds target rate went from roughly 0.25% at the beginning of the year to 4.25%-4.5%, the highest since December 2007. Expectations are for additional Fed rate increases in 2023 until the terminal rate reaches 5.00% to 5.25%. For their part, global equity and bond markets were challenging and volatile throughout the year, with few places to hide. US and international, large and small cap equities, growth and value all declined during the year (although value generally declined significantly less than its growth counterparts). Prices of bonds and equities often move in opposite directions, but not in 2022. The Bloomberg US Aggregate Bond Index, a proxy for the US investment grade market, posted a double-digit decline, while the S&P 500 declined 18.11%. With this difficult capital market environment in the rearview, what do we expect to see in 2023?

Inflation Remains Above the Trend

33.0

3.5

Germany

21.0

2.2

Japan

14.6

1.4

France

14.5

1.5

United Kingdom

12.1

4.9

United States

11.8

2.8

Canada

10.0

1.2

India

8.6

South Africa

2.9

5.5

0.6

Brazil

2008 financial crisis

COVID-19 crisis

6 Episodes of Post-WWII Inflation % change year over year

Source: Federal Reserve Economic Data (FRED), Haver Analytics, CEA Calculation

Interest Rates Move Higher

2008

2009

2010

2011

2012

2013

2015

2016

2017

2018

2020

-25

-15

-10

-5

Jobs

Housing

Retail

-20

2014

2019

2021

Confidence

Industrial

Inflation

Date: 10/25/2007 to 11/2/2020

Global Economic Strength (z-scores)

Recession Likely in 2023

Market Volatility Remains High

Top Investment Themes for 2023

Continue to favor value over growth, which we view as a multi-year trend.

Focus on recession-resistant industries such as health care, consumer staples, energy and some commodities, as well as those areas with additional secular tailwinds including materials, defense, infrastructure, and logistics.

Weaker economy and potentially falling US dollar could be supportive of international equities including select emerging markets.

Small cap stocks have typically outperformed large caps during elongated periods of above-trend inflation.

In fixed income, we favor short-to-intermediate maturities in both investment grade and higher-quality high yield bonds. We also favor municipal bonds for their tax efficiency, quality, and ballast.

Cautiously add duration, but only in top-rated corporate debt, as economic slowdowns typically punish lower-grade debt. Don’t make the mistake of rushing in too soon on a Fed pivot call. As we move through the downcycle, it is our opinion the yield curve inversions will flatten and eventually turn positive.

We believe strongly that being invested and staying invested are very important as market timing ultimately fails. Remember to dollar cost average. We think the first half of 2023 will be somewhat tumultuous, but the second half has real promise.

Anticipate income will be a key component of return generation and a volatility suppressor, focusing on dividend-payers and growers, low duration preferreds, and covered call strategies.

Bottom Line:

Remain patient, keep asset allocations 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 this new regime.

Record liquidity can be seen in frothy equity pricing. The higher level of optimism may begin to cannibalize future growth at some point. To offset this, we tend to see higher levels of merger and acquisition (M&A) activity that may be cynically masking lower growth metrics. For those that suffer this blessing, massive stock buy backs will likely be needed to help boost the growth needed to support fundamental metrics.

Record liquidity can be seen in frothy equity pricing.

The higher level of optimism may begin to cannibalize future growth at some point. To offset this, we tend to see higher levels of merger and acquisition (M&A) activity that may be cynically masking lower growth metrics. For those that suffer this blessing, massive stock buy backs will likely be needed to help boost the growth needed to support fundamental metrics.

Bond market’s lack of price discovery likely misprices the asset.

With historically low interest rates and inflation lurking, the secular move in rates has generally obscured poor credit selection over the last 40 years. While several cyclical rate moves are needed to make one secular move, the mere length of time it may take for certain fixed income assets to recover may reverse the massive bond inflows witnessed in the last 12 years. This could shift investors’ expectations, making them reassess their income needs and where to get it.

Federal Reserve’s actions force investors to increase risk.

Should inflation rise as we expect, asset prices may rise to severe levels. Should history be a guide, investors are often forced further out on the risk spectrum, seeking better performing, albeit riskier assets. This could lead an apathetic investor to be caught off guard when the Federal Reserve is forced to ultimately react to an overheating economy by raising interest rates.

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You work closely with your financial professional to develop a winning financial game plan to meet your goals. At AAM, we are committed to helping you succeed. We remain as dedicated today as we were over 40 years ago to developing innovative investment solutions that investors can leverage to meet your needs.

Inflation: Remains Above the Trend

In short, we expect inflation could remain above-trend, possibly still as high as 4.5%+/- by year-end 2023. Why is that? Simply put, the Fed can only destroy demand, it can’t solve some of the more pernicious drivers of inflation. For example, the Fed cannot drill for oil, grow food, increase supply chains, or stop deglobalization. Wages are another challenge that could lead to sticky inflation with gains north of 5% and broadening across many industries as the labor shortage could be very difficult to overcome given growing unionization, job hoarding, long-COVID, early retirees and aging demographics. Importantly, history also shows that once inflation gets going, even if it is declining, it can remain above-trend for years (four years on average).

Interest Rates: Continue to Move Higher, Pivot is Paused

History shows us that in order to combat inflation the Fed will need to raise rates above their favorite measure of inflation (the core Personal Consumption Expenditure Index, PCE) and hold them there for an extended period. We therefore anticipate the Fed will the slow pace of rate increases but will continue to hike until the terminal rate is approximately 5%. At that point, we expect the Fed to pause and push any pivot lower out beyond current market expectations. (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!) Fed Chair Powell is a student of history, and he understands that 1) we don’t quite know when we are in a recession until we have been there for a while, and 2) once inflation is entrenched, it tends to stick around for a while. Stopping and re-starting could elongate the inflation cycle, which supports our thesis of “hike and hold,” believing hopes of a pivot toward lower rates are still too early.

Source: Atlanta Fed

Expected Future Path of the 3-Month Average Fed Funds Rate Current Target Range: 375-400 basis points

Inflation Remains Above Trend

Recession: Likely in 2023

We agree with most economists and business leaders who expect a recession sometime in 2023, driven by demand destruction from rising rates, and supported by the steep inversion in the yield curve and real threat from inflation. 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 strong job market, the ability to spend down savings, and increase credit card borrowing. The latter two variables likely reach a natural limit by mid-to-late 2023 as job losses grow. Again, hopes that a mild pivot is all that is needed to prevent this hard economic outcome seem very optimistic.

Markets: Volatility Remains High

We enter 2023 with no shortage of uncertainties that we believe will keep volatility elevated this year. However, 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 no longer supportive of the markets. With regard to US equities, although overall valuations have come down significantly in 2022, they are still not priced for the earnings slowdown we foresee. On the fixed income side, although rates are still poised to go up, rates have already moved considerably higher in 2022. The Fed has put “income” back into fixed income particularly on the front-end of the yield curve. With starting yields in the 4–6% range, we see reasonable value and the potential for 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 if 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.

Scott Colyer Chief Executive Officer

Cliff Corso President & Chief Invesment Officer

Matt Lloyd Chief Invesment Strategist

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