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Allianz Investment Management LLC August Market Update

Each month, representatives from Allianz Investment Management LLC provide commentary on market and economic indicators, including Federal Reserve actions, interest rates, credit markets, and economic releases such as inflation, GDP, consumer confidence, housing, retail sales, and job unemployment news.

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Market outlook: Despite some near-term headwinds, a strong fundamental backdrop remains intact


The advance reading on second quarter GDP came in below expectations of 8.4% with a reading of 6.5%. While the headline number fell short of expectations, details in the report suggest strong economic demand is evident as real consumer spending rose at an 11.8% annualized pace. Part of the miss was due to spending from the government declining during the quarter with changes in the paycheck protection program. Additionally, with demand so strong, inventories were significantly depleted, which will likely lead to a payback of growth in the third quarter as inventories are replenished. Over the past few months, market participants have adopted this perception that growth has peaked and an abrupt slowdown is imminent in the coming year. However, given the amount of stimulus in the economy along with an underemployed economy, there is still gas in the tank for the economy to continue growing above trend in the coming years. The Delta variant of the COVID-19 virus has also caused jitters among investors around the growth outlook, but at this stage in the pandemic, it does not appear that the third wave of the virus will have much impact. Overall, despite some concerns, we expect growth to remain strong through the second half of the year and into 2022. Our forecast for GDP in 2021 still remains within a range of 6.00% to 7.00%.


Throughout the year it has been a tug-of-war between fundamental and technical factors for long-term interest rates, and at the current moment the technical factors seem to be winning the battle. At the beginning of the year, the unexpected boost to growth expectations led to a swift sell off in Treasury bonds and sent the 10-year yield up by 75 basis points. While the economy has remained fundamentally sound, bond purchases from the Fed combined with rising concerns from the virus have put pressure on long-term rates and flattened the yield curve. With the outright level of long-term interest rates not reflective of the current economic backdrop, investors have become more uncertain with regards to the direction of interest rates. That being said, what has become more certain in the rates market is that volatility has picked up. Over the past couple months the 10-year Treasury has experienced 13 days with yields moving 5 basis points or more in either direction. Given that the Fed has been getting closer to making a policy decision on their bond purchases, we don’t expect this trend to go away anytime soon. However, we still do expect the 10-year Treasury yield to end within our forecasted range of 1.50% to 2.00% by year end as concerns over the virus subside and the Fed signals their plan to reduce bond purchases in the near future.

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The Delta variant wave is putting a strain on the health care system, but the economic effects appear to be less pronounced

The third wave of the COVID-19 pandemic, the Delta wave, is in full force as over 35 million cases have been reported in the last 30 days. The Delta variant appears to be more contagious with community transmission, and hospital beds are filling up across the country. As a response some local jurisdictions have brought back some restrictive measures, such as wearing masks indoors again. On the positive side, evidence has suggested that individuals who have been vaccinated are less susceptible to the risks from the variant. From a market perspective, risk assets endured a brief sell off in mid-July, but investors seem to be undeterred by the Delta wave as stock indexes continue to reach new highs. Economically, there shouldn’t be much impact from the third wave of the virus as consumer adaptation has created an environment to keep the economy chugging along and the latest wave has encouraged more individuals to get vaccinated. Just over 50% of the entire population has been vaccinated, and the pace has started to pick up in recent weeks with vaccination rates almost doubling. Some companies are beginning to require vaccinations for workers that plan on coming into an office, and we could see that trend continue in the coming months. Overall, there continues to be lingering effects from the pandemic with this third Delta wave, but from an economic perspective we are less concerned. 


Excess monetary stimulus is becoming more problematic for income seeking investors

Market liquidity is an essential part to well-functioning markets, and when there is not enough there tends to be problems. However, when there is too much liquidity, like the current situation today, it creates an environment where too many dollars are chasing too few assets in the marketplace. It’s the Fed’s job to bring market liquidity back to equilibrium, and the longer they wait, the more problematic it is becoming for income-seeking investors. When the Fed purchases bonds in the quantitative easing program, they continue to inject more cash into the banking system in order to stimulate the economy. Consequently, the reverse repo facility at the Fed has surpassed $1 trillion for the first time as banks and money funds have nowhere to go with the excess cash. With the market awash in liquidity, we continue to see equity markets hit record highs and interest rate levels under pressure. Fortunately, we appear to be getting closer to the point where the Fed will make a decision on their asset purchase program and at least slow the amount of liquidity that is being pumped into the financial system. This should alleviate some of the pressure on long-term interest rates and allow the 10-year Treasury yield to drift higher.   

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Market indicators

Prolonged stimulus and low rates are outweighing virus concerns
The rally in the equity markets continued in July as the S&P 500 Index gained for the sixth month in a row. The second-quarter earnings season has been quite robust so far as a majority of firms has beat both top- and bottom-line estimates and helped propel equity indexes to all-time highs. Despite the negative headlines around the COVID-19 variant and the possibility of corporate profits hitting their peak, stocks continue to move in an upward direction as stimulus continues to buoy markets. Looking ahead, the direction for equities may not be as linear as inflation begins to eat into corporate margins and the Fed prepares to reduce their bond purchase program.  
Market volatility briefly spiked in July as the Cboe VIX Index rose to 25.09 as the Delta-variant scare in the markets pushed equities lower. However, the sell-off seemed to resemble more of a 24-hour bug rather than something more meaningful as markets rebounded considerably throughout the rest of the month. The price action indicates that equity market participants are putting less weight on the negative headlines around the virus. However, going forward we expect the uncertainty around the Fed’s plans in policy to drive volatility marginally higher.
Within the bond market, technical factors have certainly weighed on the outright level of interest rates, but more noticeably, we have witnessed increased volatility within rates. The rise of COVID-19 cases is partly to blame for the downward pressure in rates during the month of July, but without clarity from the Fed on their plans regarding bond purchases, longer-term interest rates have been bouncing around more frequently. Fundamentally, we believe the 10-year Treasury yield remains too low given the current economic backdrop, and it is more likely that interest rates will eventually resume their upward trend heading into the end of the year as the Fed crystalizes their plans for future policy. 
After reaching a post-pandemic high of $75/barrel in July, West Texas Intermediate crude oil declined in early August as concerns about peak economic growth and the virus helped ease commodity prices. In addition, the Organization of the Petroleum Exporting Countries (OPEC) continued to ramp up production throughout July with an additional 420k barrels produced per day. Overall, the additional supply appears to be met with strong demand, but prices continue to jump around as investors try to gauge both the supply-and-demand picture going forward.

Economic indicators

Labor conditions are improving and inflation is running hot
The Conference Board’s Index on consumer confidence rose for the sixth consecutive month to 129.10. Looking into the details, the employment situation improved while inflation expectations eased slightly. It appears that the resurgence of COVID-19 through the Delta variant has not rattled consumers as the gauge rose to the highest level since February of 2020. Overall, we expect the upbeat attitude from consumers will augment economic activity in the coming months.
Additional information on consumption showed retail sales surprisingly rose during the month of June with spending elevated across a broad set of categories. Consumer spending rose by 0.55% while economists surveyed were looking for a decline of 0.3%. Restaurant spending, online sales, and gas station sales were the largest contributors to the gain. Overall, the solid spending results reiterate the strength of economic activity, and it does not appear that the economy is slowing anytime soon.
Just like the recent stretch of summer weather, inflation continues to run hotter than expected with the annualized CPI figure at the highest level since 1992. The reopening categories contributed the most to upward price pressures for the third consecutive month. Headline CPI came in at 0.9% for the month of June and lifted the annual figure to 5.4%. Within core CPI, prices also rose by 0.9%, lifting annual core CPI to 4.5%. With almost two-thirds of the increase coming from airfares, autos, and hotels, the Fed continues to exercise patience until later this year to ascertain the trajectory of inflation.
July’s labor report was stronger than expected, delivering payroll additions of 943k versus estimates of 870k. This was the second month in a row with payroll additions above 900k as expiring unemployment benefits in some states likely enticed workers to fill vacant job openings. As a result, the unemployment rate fell more than expected to 5.4% from 5.9% in June. Finally, average hourly earnings rose by 0.4% month-over-month as the demand for labor continues to put upward pressure on wages. Overall, July’s strong labor report will likely put further pressure on the Fed to act as the strength in the labor market is further evidence of progress toward the committee’s goals.
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Entering the mid-cycle of the recovery, some investors are flashing warning signals around the peak growth and inflation for the economy. Particularly with the third wave of COVID-19 cases picking up, bond yields have been under pressure throughout the month. Regarding inflation, the story appears to be still developing, but market participants have become more comfortable with the “transitory” narrative that the Fed has hitched their wagon to. In our view, the bigger hurdle for markets will be the transition developing from the Fed moving away from peak policy accommodation to a stance that is more in line with the current economic backdrop. The Fed has purchased a massive amount of assets since the pandemic and getting markets cozy with the idea that the largest buyer of Treasuries and mortgage-backed securities will be stepping away. At any rate, this will be a challenge going forward for the Fed and investors alike as the recovery continues to mature.


List of definitions

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The views, opinions and estimates expressed above reflect the views of Allianz Investment Management LLC (AIM LLC) as of the date of publication. This document is provided for informational purposes by AIM LLC, a registered investment adviser that is a wholly owned subsidiary of Allianz Life Insurance Company of North America. These views may change as interest rates, market conditions, tax rulings, and other investment factors are subject to rapid change which may materially impact analysis that is included in this document. This report does not constitute a solicitation or an offer to buy or to sell any security, product, or service. It is not intended and should not be used to provide financial advice as it does not address or account for an individual's circumstances. Consult with your advisor and tax professional before taking any action based upon the information contained in this document. Past performance does not guarantee future results and no forecast should be considered a guarantee. Any investment and economic outlook information contained in this document has been compiled by AIM LLC from various sources, including affiliated entities. AIM LLC takes reasonable steps to provide up-to-date, accurate, and reliable information, and believes the information to be so when provided, but no representation or warranty, express or implied, is made by AIM LLC as to its accuracy, completeness, or correctness.

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