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Allianz Investment Management LLC February Market Update


Market Outlook: The economy is still on the path to recovery and is well supported by large amounts of both monetary and fiscal stimulus

While many of us would have liked to put 2020 in the rearview mirror, the reality is, the beginning of 2021 hasn’t looked much different from an economic perspective. The ongoing pandemic has kept many restrictions in place and to some extent constrained consumption in recent months. The labor market hasn’t fared all that well either as we have experienced three consecutive months of disappointing employment data. Despite the recent gloom, we still remain strongly hinged to our base case outlook of rebounding growth during the second half of 2021. Supporting that view is the continued increase in the pace of vaccinations combined with the declining number of cases. What matters from an economic point of view is an increase in confidence and effectiveness of the solutions to battle the virus, so that governing officials can continue to reduce restrictions and open the economy back up. The only unknown from a growth perspective is the amount of stimulus the government is willing to spend on moving the country beyond this pandemic. President Biden’s $1.9 trillion fiscal spending package has gained traction in recent weeks and has lifted growth expectations for the economy. We still have a ways to go before the size of the spending package is finalized, but given the current backdrop, we feel confident U.S. GDP will come in above trend in 2021 and within our range of 3.5% to 4.50%.

The theme of curve steepening is alive and well in the U.S. as long-term rates continued their ascent in January while short-term rates remained anchored by Fed policy. The sharp increase in rates can be attributed to rising growth expectations which pushed the 10-year Treasury yield up over 20 basis points since the beginning of the year. That being said, the pace has not kept up with the rebound in risk assets, as structural forces such as quantitative easing have kept a lid on how much Treasury yields can rise. As we look down the road, the next catalyst to put upward pressure on rates will be the discussion on the Fed’s bond-buying program and the timing around when they begin to reduce those purchases. Fed Chair Powell has made it clear that any signal to taper Fed purchases of bonds will be done well in advance of the actual implementation. This will be a delicate balance for the Fed as the last thing they want is a repeat of the 2013 “taper tantrum” while the economy is recovering. We suspect this discussion will start to pick up midyear with the expectation of a reduction in bond purchases sometime in the first part of 2022. Consequently, we are maintaining our view of modestly higher interest rates with the 10-year Treasury yield ending the year between 1.00% and 1.50%.

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With the path paved for an increase in fiscal spending, the Biden administration sets its sights on battling the pandemic

The transition of Presidential powers was officially underway in January, and the President’s first days in office were dedicated to executive actions focused on battling the ongoing pandemic, providing fiscal support to areas of need, and rejoining global discussions on climate change. In all, President Biden has executed over 50 executive orders in his first ten days on the job. Specifically, related to the pandemic, President Biden is aiming to distribute vaccines to 100 million people within the first 100 days to pave the way for better economic growth in the second half of the year. In order to support the fight against the ongoing pandemic, the Biden administration unveiled a lofty $1.9 trillion fiscal spending package as a template for Congress to act on. Recently, the Senate moved forward with the budget resolution process to fast-track the fiscal spending package, which will allow the bill to move forward on a simple majority rather than the need for 60 votes in the Senate. Overall, the positive news was welcomed by market participants as equity markets rose to record highs, but it will likely still be weeks before the complete spending package is finalized.

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Unintended consequences of fiscal and monetary stimulus are beginning to emerge in parts of the financial market

The combination of large amounts of both fiscal and monetary stimulus since the pandemic began has created an environment with more money chasing fewer assets, which has some market participants beginning to worry about financial stability in some pockets of the market. We briefly witnessed a small episode of this in late January as market volatility measured by the CBOE VIX index rose above 30 for the first time since last October. Some of the market gyrations were linked back to a small handful of stocks that were popular short trades for hedge funds, and the “short squeeze” on those stocks caused leveraged investors to reduce holdings in other areas of the market. Despite some pockets of froth beginning to show up in financial markets, the Fed continues to press the gas pedal on monetary stimulus, and Congress is moving closer to finalizing another large fiscal spending package. While the recent bout of market volatility was short-lived, investors need to be mindful of the unintended consequences these large stimulus plans are having on asset prices as this could become a bigger risk down the road.


Market indicators

Large amounts of stimulus continue to propel asset prices to new levels
Overall, equity markets have performed well since the beginning of the year with the S&P 500 gaining almost 4% year-to-date. The combination of strong earnings reports and an increasing pace of vaccinations has been a tailwind for risk assets. The majority of companies in the S&P 500 that have reported earnings for the fourth quarter have beat both on earnings as well as revenues. Looking ahead, strong earnings growth rather than multiple expansion is the theme that should drive risk assets higher through the remainder of the year. However, the strength of the economic recovery during the second half of the year will likely influence whether this plays out.
Market volatility spiked near the end of January as a “short squeeze” on investors holding short positions caused leveraged investors to sell positions and pare back risk. The CBOE VIX Index has steadily remained above 20 since the pandemic began, but there has been brief periods where we have seen a wave of volatility and the resulting index jumps like it did in January. We have witnessed very strong performance in equity markets over the past six months, and investors typically use the volatility index to gauge the amount of fear in the equity markets for the weeks ahead.
The curve-steepening theme continued to play out during January as prospects of additional fiscal spending are putting upward pressure on long-term rates. The 10-year Treasury yield pierced through the 1% level for the first time since last March and was up over 20 basis points since the end of last year as market participants priced in higher expected growth targets for 2021. While we don’t expect yields to take off from current levels, interest rate sensitivity will be something investors will be paying close attention to going forward as yields are coming off such a low base.
Despite the ongoing pandemic, the supply and demand picture in oil markets continues to be favorable and prices continue to drift upward. The main driver can be attributed to production cuts from OPEC and their adherence to those stated cuts. Overall, the positive sentiment around economic growth fueled by fiscal stimulus should keep oil prices well supported as we get to the other side of this pandemic.

Economic indicators

Softer consumption and disappointing employment data indicates we still have a ways to go on the path to recovery
The Consumer Confidence Survey for January came in slightly ahead of market expectations at 89.3 points, improving moderately from 87.1 in December. With COVID-19 still being front and center, consumers’ appraisal of present-day business and labor market conditions weakened further in January, falling by 2.8 points to 84.4. However, with vaccinations on the horizon, consumers foresee conditions improving as evidenced by the expectations index advancing further by 5.5 points to 92.5. It is interesting to note that the percent of consumers who said they intend to purchase a home in the next six months improved, suggesting that the demand for homes should remain robust in early 2021.
The holiday season ended on a dismal note as retail sales unexpectedly declined in December and November’s sales were revised lower. Within December’s report, the advance figure declined 0.7% while the control group, which removes volatile categories, edged lower by 1.9%. Non-store retailers and dining were the main culprits for the decline. Overall, it is evident that the pandemic and recent resurgence of virus cases affected consumers’ willingness to spend even during the holiday season. With the vaccine now being distributed in the U.S., investors will be keeping a close eye on retail sales to see if December’s report is temporary or an indication of future weakness.
CPI for December came out in line with expectations, rising by 0.4% month-over-month and 1.4% YoY. The increase was driven by a rebound in gas prices. Core CPI was up 0.1% month-over-month and 1.6% year-over-year. Shelter prices increased by 0.1% showing signs of stabilization after a marked deceleration over the recent months, but still reflecting the weakness in labor markets. Strong base effects linked to the temporary collapse in prices in the early stages of the pandemic last year mean that headline and core inflation will likely surge in the spring.
The labor market continues to show signs of weakness as only 49k jobs were added to the economy in January. The small addition in jobs was likely more reflective of jobs restored and not jobs added. In addition, jobs lost in the economy during December were far greater than originally estimated with the December report revised to -227k. Surprisingly, the unemployment rate dropped from 6.7% to 6.3%, but this is due to nearly 400k people leaving the labor force. Overall, bad news is good news as the weak labor report should provide some runway for the Biden administration to push for a higher spending package.
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Overall, while the pace has slowed in recent weeks, the economy is still on the path to recovery. Supported by large amounts of fiscal spending and very accommodative monetary policy from the Fed, output in the economy is on track to reach pre-pandemic levels. From a market perspective, we have witnessed some pockets of froth in areas of the market that have brought on a brief surge in volatility. Going forward, investors should be mindful of the risks to financial stability with the unprecedented amounts of stimulus going into the economy. Additionally, we believe risks to the economic recovery are still hinged to the pace of vaccinations and the potential of new variants of the virus. Ultimately, we will have to wait and see how things unfold in the coming months.


List of definitions

Here are the definitions of the key terms used in this market report.

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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