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Allianz Investment Management LLC January Market Update

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Market outlook: The base case continues to be centered on a rebounding economy with the help of stimulus, but the virus remains the major threat

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There is no doubt market participants have priced in a sense of optimism for the U.S. economy in the months ahead, as it’s becoming more difficult to square up the optimism in risk assets against the current state of the real economy. The most plausible explanation for this can be linked back to the unprecedented levels of both monetary and fiscal stimulus being pumped into the economy. In addition, the news of Democrats gaining a narrow control of the Senate by winning both seats in the Georgia run-off elections only increases the prospects for additional fiscal spending. On the other hand, the most recent report on the labor market showed the U.S. economy lost jobs for the first time since April of 2020. It is apparent that the influence the pandemic has on the real economy remains high and will be the main risk to the economic recovery in the months ahead. As the final results are tallied, we still expect GDP in 2020 to end in negative territory, but growth should rebound in 2021 as economic activity moves back toward pre-pandemic levels. However, the virus is still the key risk to the economic recovery, and if the rate of vaccinations continues to be slower than expected, the rebound in growth for 2H could be dragged out over a longer period. All considered, our base case is for an economic rebound during the second half of 2021 with GDP ending the year within a range of 3.50%-4.50%. 
INTEREST RATES

Heading into 2021, our baseline view was for interest rates to increase on the back-end of the curve as increased growth prospects would lift long-term yields while the font-end of the curve would remain anchored by accommodative policy by the Fed. While that view hasn’t changed, recent events on the political front have increased expectations for additional fiscal stimulus and pushed long-term rates up faster than anticipated. The 10-year Treasury yield has risen over 20 basis points during the first week of January, and while the increase in rates is welcomed by income investors, market participants will become more concerned if the trajectory continues at this pace. Keep in mind the Fed has tools at their disposal to keep rates from rising too quickly, and one of them that has been the topic of conversation in recent weeks is weighted average maturity (WAM) extension of the current bond purchases. On the flip side, some market participants are beginning to talk about asset purchase tapering as current risk asset levels are beginning to raise concerns around financial stability. That being said, the last thing Chairman Powell wants is a repeat of the taper tantrum episode in 2013 when bond yields rose nearly 100 basis points over a three-month period. The bottom line is that we do expect long-term rates to continue to drift higher this year, but it’s likely the swift upward movement in rates we witnessed during the first week of 2021 will take a pause in the near term.

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Fiscal spending is set to increase as a unified government takes shape for the incoming administration to set policy

With the U.S. election cycle completed, the markets have even more clarity and certainty on how policy in Washington D.C. will shape the economy and markets going forward. What has changed is the prospects for additional fiscal spending as the run-off elections in Georgia went in favor of the Democratic party. The result creates a unified government for the incoming administration with the Democrats gaining a narrow majority in the Senate. Directionally, our forecasts for 2021 remain the same, but the potential for additional fiscal stimulus could lead to marginally higher growth, slightly more inflation, tighter labor markets, and ultimately higher interest rates. Market participants were enthused with the idea of additional stimulus, and risk assets have continued to perform exceptionally well with equity indexes reaching new all-time highs. In addition, the 10-year Treasury yield pierced through the 1% level for the first time since last March. The divergence between the financial markets and the real economy is wide, but investors appear to find comfort in the notion that fiscal stimulus will bridge the economic gap until vaccinations are deployed and the pandemic has subsided. Over the medium term, we will be watching to see if economic conditions eventually converge with the enthusiasm in the financial markets, as this appears to be the main risk market participants will be facing.

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The economy faces a headwind in the near term as the ongoing battle with the pandemic is showing signs of a slowdown in economic activity

Regarding the economy, the most recent economic data signals that the economy may be heading through a soft patch in the first quarter of 2021. Despite strong survey-based economic indicators in both the manufacturing and services sectors, the hard economic data on the household and retail sectors was somewhat weak. On the household side, personal income declined for the second straight month in November and personal spending was negative for the first time since last April. Retail sales declined by 1.1% in November and only three out of 13 categories showed positive tracking. Most notable was the recent labor market data for December, which indicated the economy lost jobs for the first time since last April. Admittedly, signs of weakness were evident leading up to the report as jobless claims were on the rise, but a shrinking number of people employed doesn’t bode well for the economy in the near term. Overall, the recent headwind for the economy has been closely correlated with rising virus cases and additional lockdown measures that have been put in place by local authorities, but we expect the wind to eventually shift direction as continued progress is made on the vaccine front.

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Market indicators

The path of least resistance continues to drive the direction of asset prices
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Despite uncertainty from the Georgia run-off election and the slow pace of vaccine distribution, equity markets rose to record highs in December, as the passage of another round of fiscal stimulus outweighed any negative uncertainty within the market. Overall, all three major equity indexes rallied throughout the month and closed out the year at new record highs.
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Volatility, as measured by the VIX Index, edged higher throughout December before ultimately ending the month close to where it began at 22.75. Driving the intra-month pops were concern about the likeliness of additional stimulus as well as the discovery of a COVID-19 variant in the UK. However, an agreement on additional stimulus coupled with positive details about the current vaccine’s effectiveness on the variant strain of COVID-19 calmed markets at the end of December. 
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Aside from minor shifts in the belly of the curve, the Treasury yield curve was nearly unchanged over the month of December. However, this was short lived as the new year brought with it significant curve steepening as the 10-year Treasury yield surpassed the 1% level for the first time in more than nine months. Increased growth expectations are putting upward pressure on long-term rates while front-end rates remain anchored by Fed policy.
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In anticipation of the economic recovery, oil prices trended higher throughout December and the beginning of January with the price of West Texas Intermediate crude climbing to the highest level since last February. The impact on the demand side of the equation has been less pronounced in recent months, and prices have firmed as OPEC has made a strong commitment to curb production and reign in the supply of oil. Lastly, weaker dollar conditions have also played a role in supporting the price of oil. Overall, the market is becoming more balanced, but there is some risk that remains on the demand side as the global economy continues to recover and bring economic activity back to previous levels.
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Economic indicators

The recovery continues to be stronger than market participants had anticipated, but will that continue?
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The third wave of the virus, along with additional virus-related restrictions, is taking a toll on consumer confidence. The Conference Board’s Index on consumer confidence declined from an initial reading of 96.1 in November to 88.6. The University of Michigan’s consumer sentiment index also declined to 80.7 from its initial reading of 81.4. That being said, the drawn out pandemic continues to weigh on consumer sentiment, and we suspect this could have some impact on consumer spending down the road.
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The surge in coronavirus infections and the re-imposition of restrictions drove retail sales lower. The headline number came in below market expectations at -1.1% in November, down -1.0% from revised October data. Mirroring what we saw earlier this year when shelter-in-place orders were issued, grocery store sales increased by 1.9%, while restaurant sales fell by -4.0% and gasoline sales fell by -2.4%. Data also indicates that Black Friday sales were below expectations, with electronics and clothing sales declining -3.5% and -6.8%, respectively. With virus numbers trending higher, it is likely we could see additional headwinds for consumer spending in the near term.
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The core Consumer Price Index, which excludes the volatile food and energy prices, rose by 0.2% in November, above expectations of 0.1%. However, the year-over-year figure for core inflation stayed at 1.6%. COVID-sensitive categories of inflation that were hit hard during the first phase of the pandemic showed some improvement, with airfares up 3.5% after a 6.3% increase in October, and hotels up 4.5%. Overall, underlying price pressures in other sectors were more muted as inflation measures remain in check.
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The anticipation of a weaker labor market report was met as December’s report showed that the economy lost 140k jobs during the month. However, the decline was not unexpected as jobless claims rose over the past two months as additional lockdown measures weighed on the labor market. Despite the decline in payrolls, the unemployment rate held steady at 6.7%. Overall, the ability for Congress to provide additional fiscal support has increased, and December’s employment report simply beckons them to do so.
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Conclusion

To conclude, the base case view of a recovering economy remains intact, but the virus continues to be the foremost threat to that view as headwinds to the recovery have started to develop near the end of 2020. For the most part, markets have been able to look beyond any potential economic soft patch as risk assets have performed exceptionally well in recent months. Our focus for the first half of the year will be tied to the ongoing progress with vaccinations, which should lead to an eventual acceleration of economic activity. At that juncture, we expect the real economy will be more closely aligned to financial markets.

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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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