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Allianz Investment Management LLC 1Q 2022 Market Update

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. Here is their updated insight on the economic and market outlook for the rest of 2022.

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Key points:

  • Economically speaking the U.S. economy remains relatively sound, but persisting inflation is causing the Fed to make swift adjustments to monetary policy.

  • Uncertainty around geopolitical events and the path of inflation has exhibited elevated levels of volatility in both the bond and equity markets.

  • The Fed’s behind-the-curve realization caused a wave of repricing within rates markets, and the ripple effects are having lasting impacts in the equity markets and, in particular, growth stocks.

  • While markets have made significant adjustments since the beginning of the year, there is still a considerable amount of uncertainty in the outlook going forward.

Market update: behind the curve

We expected market headwinds in 2022, but the turn of the calendar ushered in higher volatility right from the start. Persistently high inflation has ratcheted up the market’s expectations for the number of Federal Reserve rate hikes this year. In turn, this has forced the Fed into a more hawkish tone to convince market participants they are ready and willing to shift their monetary policy to achieve price stability. Fears of an escalating conflict between Russia and Ukraine introduced another unexpected headwind that has led to increased volatility and elevated oil prices. Higher commodity prices across the board have been feeding into concerns that inflation will not be quick to moderate. Against this backdrop, U.S. consumer sentiment has taken a hit as rising prices are imposing on their ability to spend. Equity markets have continued to weaken as we transition to a period of tighter monetary policy amid higher interest rates. The headwinds from rising geopolitical concerns and elevated inflation levels have resulted in a tremendous amount of uncertainty within markets. When conviction levels are low, we often see more volatility in markets, and there has been no shortage of market volatility this year within both bond and equity markets. In order for markets to stabilize, we need to see more clarity on the path of inflation, more clarity on the economic impact from heightened geopolitical tensions, and more clarity on the Fed’s reaction from a monetary policy perspective.


Geopolitical implications

Countries around the world have been on alert since Russia began assembling troops and military equipment around Ukraine in the fall of 2021. By Christmas, there were over 100,000 soldiers surrounding the former Soviet country, the largest Russian deployment since Crimea was seized in 2014. Several Russian diplomats and government officials refuted the plans to invade Ukraine until just days before the military operation commenced. Commodity prices quickly increased following the invasion on February 24 as producers feared supply concerns. The most immediate impact was felt in Europe, as many countries rely on Russian oil, coal, and natural gas for gasoline, power, and heat. Russia is also the world’s largest exporter of nickel and wheat. Countries and companies alike scrambled to find alternative suppliers for oil, metals, and grain as Vladimir Putin ordered a ban on exports, including commodities, in response to sanctions imposed by the U.S. and others. This ban immediately led to the price of nickel spiking 250% in 24 hours, forcing the London Metals Exchange to halt trading for several days.

While other countries are more reliant on Russia for imports, restricting global supplies affects commodity prices in the U.S. as well. Americans were already feeling the effects of rising inflation prior to the invasion; higher oil prices were not what Americans wanted to endure. Unfortunately, the Russian military action is adding to the cost Americans pay to fuel their cars. According to the Lundberg Survey, the U.S. average price for a gallon of gasoline increased 22% to a record high in the two weeks since the invasion of Ukraine began. We can hope that this military action in Ukraine is short lived, foremost for humanitarian reasons but also so we can get back to some price stability here in the U.S.

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Federal Reserve and monetary policy

It is hard to imagine that elevated inflation levels are not keeping Fed Chairman Powell up at night, and geopolitical tensions are not doing any favors for him at the moment. The Fed has a very difficult road ahead as they attempt to normalize monetary policy without sending the economy into a recession. They started what is expected to be a series of interest rate hikes in March. Chairman Powell believes the Fed can achieve a so-called “soft landing” in which the economy can continue to grow, prices stabilize, and employment conditions remain favorable. While it is widely accepted that the Fed will be tightening policy, market participants differ in opinion on how the Fed’s objective will be achieved. On the one hand, moving faster upfront to tighten policy will allow greater flexibility to adjust to incoming economic data down the road. However, uncertainty around inflation and how it will respond to monetary policy provides the case for more slow and deliberate moves. Lastly, the Fed’s balance sheet will likely be in play during the second half of the year. A swift reduction of assets also could act as an alternative tool to control inflation. Either way, the Fed will be walking a fine line in the coming months as they work to meet their policy tightening objectives. Against a backdrop of an uncertain path for policy rates, we expect the bond market to remain volatile in the near term.


2022 U.S. economic and market outlook

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U.S. GDP 3.00% - 4.00%

The U.S. economy has been resilient in the face of ongoing COVID-19 headlines, but the surge of the omicron variant has been a near-term drag on economic activity. Persistently high inflation is becoming a bigger threat to the economy, and it is clear that monetary policy needs to reflect the current environment. Rising energy prices will likely further reduce consumer demand, acting as an additional tax on consumer spending. The U.S. economy is over 70% consumption-based, and rising gasoline prices are going to crimp some of the consumer’s ability to spend. Additionally, higher levels of inflation have started to significantly weigh on consumer attitudes. Fortunately, the outlook for the labor market remains strong; while wages have not kept up with inflation, they are rising at a relatively strong pace. Despite the headwinds consumers are facing, output in the economy is still likely to remain above potential for the year. Overall, we expect solid GDP growth in the range of 3% to 4% for 2022, albeit at a slower pace than we originally expected in our initial 2022 forecast.

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U.S. inflation 3.50% - 4.50%

Inflation has remained persistent with ongoing supply chain issues and labor shortages as the primary factors. Commodity prices continue to increase, and geopolitical tensions are causing upward pressure for energy inputs. This will further add to inflationary pressures for consumers. As we look ahead, we anticipate demand for durable goods to moderate. In turn, we expect that this will be offset by increased demand in the service sector as the post-COVID economy further normalizes. We increased our year-end inflation target due to the recent Russia/Ukraine situation and the resulting impact on higher oil and commodity prices. Our forecast for core PCE inflation at the end of the year is centered on 4%.


Fed funds rate 1.00% - 1.50%

To argue the Fed is behind the curve on monetary policy tightening is an understatement. While finally wrapping up their bond purchase program on March 8, the Fed wasted no time in moving rates off zero with the first of a series of expected rate hikes at the March FOMC meeting. With persistently elevated inflation levels disproving the transitory theory from the Fed, the market recognizes the Fed has a lot of catching up to do. Throughout most of January and February the market was repricing rate hike expectations, and it felt like an arms race watching headlines on which dealers could price in the most hikes for the year. Given the recent history of the Fed, it is difficult to envision an aggressive policy-tightening path. The Fed has committed to an average inflation target, and even with the elevated levels of inflation today, the average of core inflation over the past 10 years is still below 2%. Overall, we expect the Fed will conduct a series of rate hikes throughout the year, but we suspect the bar is too high for the Fed to achieve the market’s expectations of seven rate hikes in 2022. As such, we think the Fed will be able to raise rates at 25 basis point increments four to six times this year, putting the Fed funds target between 1.00% and 1.50%.

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U.S. rates (10 yr) 1.75% - 2.25%

Since the Fed announced their plans to end quantitative easing back in December, the rate on the 10-year treasury has climbed over 50 basis points and is back above 2.00% for the first time since 2019. Even heightened geopolitical tensions weren’t enough to halt the upward trajectory of the 10-year yield as the combination of elevated inflation and a Fed loosening its grip on the treasury market has kept upward pressure on rates. Undoubtedly, bond markets have remained quite volatile this year as uncertainty around growth and Fed policy has been high, but it doesn’t change the fact that the largest buyer of treasuries over the past couple of years is now exiting the market. Additionally, central banks around the globe are ending emergency pandemic monetary measures, which kept global rates artificially low. We think 10-year yields can move marginally higher throughout the year as the Fed normalizes policy, but slowing growth and geopolitics could put a cap on how high the 10-year rate will go. Thus, we are maintaining our forecast for the 10-year treasury yield to end the year in a range of 1.75% to 2.25%.  

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U.S. equity returns -5.00% - 5.00%

The S&P 500 closed at a year-to-date high on the first trading day in 2022. U.S. stocks were nearly fully valued given the level of interest rates at the time as high price-to-earnings multiples were fueled by extremely low interest rates. Elevated levels of personal savings accounts helped fund stock purchases that were at the highest levels seen in some time. Pent up savings has waned with higher consumer prices, and while it is possible that we return to the lofty level of 4,796 this year, stocks now face several headwinds to produce positive returns this year. Amid higher levels of uncertainty, we continue to expect elevated volatility. This uncertainty often leads some investors to hide out and wait for calmer markets. Lastly, given the unpredictable events and the invasion of Ukraine by Russian forces, market participants remain uneasy. The recovery from this downdraft will depend on how stocks respond to these headwinds. We initially forecasted trend-like returns of 0% to 10% for the S&P 500 this year. However, greater geopolitical uncertainty stemming from the Russian invasion and elevated inflation has led us to slightly reduce our target range for equity returns to -5% to +5% for 2022.
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Conviction levels were already low heading into 2022, and with risks materializing around the inflation outlook and increased geopolitical tensions, we have been forced to recallibrate our market outlook for 2022. The headwinds appear to be stronger than originally thought, and swift shifts in monetary policy expectations are taking a toll on asset prices. While markets have made significant adjustments since the beginning of the year, there still is a considerable amount of uncertainty in the outlook going forward. Risks remain elevated on the geopolitical front as the Western allies continue to work toward defusing the tensions between Russia and Ukraine. The inflation problem has only worsened in 2022, and the reaction from the Fed will be a key driver to market performance going forward. Overall, we expect markets will continue to face strong headwinds until more clarity on the path forward comes to light.


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 3/2022. 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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