hero july market commentary

Allianz Investment Management LLC July 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: Some economic signals may have peaked, but strong fundamentals indicate the economy still has room to run

GROWTH

Crossing the midyear point, the annual scorecard for the U.S. economy continues to look great as GDP is on track for the best-annualized rate since 1984. Pandemic-related restrictions have eased and activity across sectors broadly remains robust. Strong consumer demand has led to some supply chain constraints that have appropriately pushed prices higher in many consumer-related categories, but market participants, including the Fed, continue to believe this will prove to be temporary. Within the labor market, outright payroll increases disappointed during most of the first half of the year as idiosyncratic factors, such as increased unemployment benefits, likely prevented higher job additions. However, with additional jobless benefits ending, the pace of job growth should pick up during the second half of the year. Forward-looking indicators, such as business surveys from the Institute for Supply Management, may have indicated that economic data has peaked, but depleted inventory levels and supply chain issues are likely to keep the economy growing above trend into next year. Given what we have witnessed through the first half of the year and how we expect the economy to evolve in the coming months, we have raised our annual GDP forecast to a range of 6.00% to 7.00%.

INTEREST RATES

With some economic signals showing signs of peaking, some market participants are becoming more concerned with a more abrupt slowdown in economic growth. In turn, markets experienced some significant downward pressure on rates and the yield curve flattening. The market became very one-sided as many investors were positioned for higher interest rates. As economic data showed signs of slowing and the idea of the Fed removing accommodation sooner rather than later entered the picture, long-term rates moved significantly lower as the market shifted toward equilibrium. It appears the technical factors are prevailing over the fundamental factors for interest rate levels, but we think this will be short-lived as worries about economic growth begin to fade and the Fed begins the meticulous process of removing some of the accommodative policy that has been in place since the pandemic. With a high degree of uncertainty surrounding the timing of Fed policy changes, we continue to expect interest rate volatility to be elevated. However, we are maintaining our forecast for the 10-year Treasury yield to finish the year within our range of 1.50% to 2.00% as the current level is fundamentally too low.

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Reopening categories continue to push inflation higher, but how long can that last?

Just as the summer weather has started to heat up, so did inflation with a multitude of factors feeding into higher consumer prices. For the past three months, measures of inflation in the economy have been running well above expectations. Most of the upward price pressures have transpired through categories that were hit hardest by the pandemic, which include airfares, hotels, restaurants, and automobiles. Some of the issues related to higher prices are supply driven, as there simply is not enough inventory to keep up with the accelerated demand. On the other hand, labor shortages have become problematic in some sectors, like restaurants, where there is not enough workers to meet the demand. Either way, the rate of increasing prices is something we have not seen in a few decades, and market participants continue to be divided on whether higher inflation levels are a temporary phenomenon or something that may persist for a longer period of time. The majority of the Fed, including Chairman Powell, continue to believe elevated inflation levels will be “transitory,” but we just have to wait until later this year to see if the price pressures in the reopening categories finally simmer down.

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The Fed is moving closer to removing the punch bowl from the party

Nothing lasts forever, and that is the delicate message the Fed is attempting to deliver to market participants as the committee has started to shift the conversation to lay the groundwork for upcoming discussions on tapering bond purchases. Given the economic backdrop, maximum policy accommodation is hard to square with the levels of inflation and growth that are present in the economy. The reality for the Fed is that the inflection point in policy setting has come sooner than expected with the economy running well above the initial forecasts this year. Removing the punch bowl from the party will be a difficult challenge for Chairman Powell as he tries to balance an uneven recovery in the labor market with concerns over mounting inflation pressures. With Chairman Powell indicating in the past that bond tapering will occur well in advance of rate hikes, it would seem logical that bond tapering would occur relatively soon as the expectation for rate hikes has moved up.

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Market indicators

The Fed is your friend as risk assets continue to perform and rates remain low
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Equity markets gained for the fifth consecutive month in June with the benchmark S&P 500 Index rising by 2.22% over the month and leaving the annualized gain at 13.75%. Corporate profits continue to drive valuations higher as strong earnings growth from cyclical sectors boosted returns. With inflation levels moving higher, it will be more difficult for companies to maintain profit margins, and it is likely the price-makers will perform better than price-takers in the second half of the year. Lastly, we are mindful of the potential for changes in Fed policy over the near term, as any removal of accommodative policy will likely have an impact in equity markets.
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Volatility measured by the Cboe VIX Index declined again in June with the Index hovering below its five-year average. Markets have remained relatively calm throughout the summer as the reopening of the economy has been smooth and most economic data has either met or exceeded expectations. However, there is some uncertainty building around the expectations of Fed policy, and we could see a pickup in volatility if the Fed intends to make changes sooner rather than later.
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Two steps forward, one step back; that appears to be the story for rates this year as the wind in the sails of the reflation trade has completely died down. In discussions with other market participants, the consensus seems to be that the market was heavily positioned structurally for higher rates, and similar to a “short squeeze,” many investors have been forced to exit their position, thus exaggerating the move lower in rates. For 10-year Treasury yields, a rate of 1.25% seems to be a stronger point of resistance, but fundamentally, rates are too low given the economic backdrop. Overall, technical forces are winning the battle for now, and the only relief on the horizon is some clarity from the Fed and their plans on tapering bond purchases.
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The combination of last year’s 10% production cut from the Organization of the Petroleum Exporting Countries (OPEC) and the reopening of the global economy has sent oil prices on a one-way trajectory higher. For the month of June, West Texas Intermediate crude oil was up by 10.78% and the price per barrel rose above $70 for the first time since 2018. The obvious impact for consumers has been higher gas prices at the pump, but the overall increase in energy prices has yet to dampen the strength of the recovering economy. OPEC is working on an agreement to lift production as global supply and demand dynamics have shifted, but we expect any production increases to be measured for the time being. Thus, we do not expect any meaningful decline in oil prices in the near term, especially against a strong economic backdrop.
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Economic indicators

The strength in economic data is showing signs of peaking
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The final reading for the University of Michigan’s June consumer sentiment index slipped to 85.5 from a prior reading of 86.4, but was up from last month’s reading of 82.9. Consumer sentiment is still well below pre-pandemic levels and slightly below the post-pandemic high of 88.3 back in April. Factors weighing on sentiment are likely the uneven recovery in the labor market and rising consumer prices, which have shown up significantly at the gas pump. Notably, within the report, inflation expectations for one year ahead rose to 4.2%. Overall, sentiment is trending in the right direction, but consumers appear to have some weighing concerns.
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The value of retail sales declined by 1.3% in May. The retail sales control group, which removes volatile sectors, decreased by 0.7%. Despite the decline in retail sales, we view this more as a normalization of the exceptionally high spending levels that occurred in March. Additionally, the data suggests that it is not that consumers are not spending but instead that they are spending in different areas, like services instead of goods. This is not surprising, as COVID-19 restrictions had previously restricted consumers from spending on dining-, travel-, or vacation-related services. Overall, consumers have the wherewithal to spend and now more places to do so.
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Fresh data out on consumer prices appears to be an extension of what we witnessed back in April and May with the core consumer price index running hotter than expected. Headline CPI rose by 5.4% on an annualized basis and core CPI rose by 4.5%, the highest since 1990. Within the data, strong contribution continues to come from sectors that are rebounding quickly with pandemic restrictions easing. Additionally, it is still evident that supply chain issues are taking a toll on some sectors with used car prices increasing 10.5% over the month. While inflation pressure has picked up, the reality is that most of the increase is still attributed to the sectors hurt the most by the pandemic, and it’s going to take more time to determine whether the recent surge in prices is temporary or rather something more persistent.
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There was not any pre-Independence Day fireworks in markets following the June employment report as the results were mostly in line with expectations. The latest read on the labor market showed 850k jobs added during the month of June with the labor participation rate unable to budge from the previous level of 61.6%. Within the report, average hourly earnings rose to an annualized pace of 3.6% which indicates employers are still likely having a difficult time filling open positions. The unemployment rate actually ticked higher to 5.9% as more unemployed workers entered the calculation. Overall, the in-line employment report was representative of a recovering labor market that has improved significantly from the first quarter and is another sign the Fed should be getting closer to removing some of the unprecedented monetary accommodation.
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Conclusion

Strong economic data has characterized the recovery with economic activity and inflation exceeding the expectations of many market participants. Despite inflation running hot, the Fed has been able to refrain from beginning the process of removing accommodation, and interest rates remain low from a fundamental perspective. With some economic data starting to peak, investors are becoming more concerned about a swifter economic slowdown. Indeed, we expect the economy to slow from the blistering pace of growth, but given the amount of stimulus deployed, it is hard to imagine an economy where we are not growing above potential next year. Looking ahead, as the Fed works toward paring back their historic amount of monetary stimulus and attempt a soft landing for the economy, we expect there will likely be some turbulence along the way.

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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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