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 Allianz Investment Management LLC 2022 Market Outlook

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:

  • From an economic perspective 2022 will look like a moderated version of last year, but investors should be cognizant that the prevailing tailwinds are beginning to calm.

  • Lingering effects from the pandemic are likely to bleed into 2022, but the outright threat from COVID-19 to the economy will continue to fade.

  • The Fed awakens to the persistently elevated levels of inflation and will attempt to unwind the largest expansive monetary policy in history.

  • Risk assets will likely have positive returns in the post-COVID economy, but headwinds are picking up and performance will be choppier than in past years.
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Market update: More headwinds, less tailwinds

Looking back on 2021, it will likely go down as one of the easiest years for investors as strong fiscal and monetary support paved the way for massive earnings growth and 70 record closes on the S&P 500® Index. The nearly 27% price return on the index represents the third consecutive year of double-digit returns. What is more impressive is despite all the headwinds with the resurgence of COVID-19 variants, multi-decade high inflation, and scarce labor, companies found a way to maintain margins and boost profits. Interest rates had a lot of catching up to do – and still do – as exuberance in the equity markets never aligned fundamentally with the outright level of interest rates. Perhaps this was intended by the Federal Reserve (Fed) as they ignored inflation signals and amassed a balance sheet that holds nearly one-third of all the US Treasuries outstanding. At any rate, the trillions of dollars of stimulus sloshing around the financial system led to too many dollars chasing too few assets resulting in strong performance across multiple asset classes. Looking ahead into 2022, the wind is shifting away from the “easy money” policy from the Fed to one that could produce some choppy waters for investors to navigate through. Being too far behind the curve is not the position the Fed wants to be in considering the upside risks to inflation and growth. We still expect a fundamentally sound backdrop to remain in place throughout the year, but recognize the headwinds to financial markets given current valuations. In our view, inflation will likely be one of the more important indicators to follow as the persistency of upward price pressures will have great influence on the pace of monetary normalization from the Fed. The faster the pace from the Fed, the greater potential for volatility in asset prices.

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COVID-19 implications

The global pandemic continued to disrupt many parts of the economy and our lives in 2021. Despite the recent worrisome spike in new cases with the Omicron variant proving to be much more transmissible, early indications are that Omicron causes less severe symptoms than the Delta variant. While the rapid spread of the Omicron variant is troublesome, we are better equipped to deal with the evolving virus than we were at the start of the pandemic. The vaccines have proven to be effective in reducing the severity of symptoms and greatly improving outcomes for those who become infected. The speed of developing the vaccines was remarkable and the science appears to be well setup to deal with new variants if needed. The FDA has recently authorized the use of two oral antivirals for the treatment of COVID-19 in patients after showing significant reduction in patients’ chances of being hospitalized or dying. This new development should add to our ability to improve outcomes for people at higher risk. As we continue to see a reduction in the severity of symptoms due to advancing therapeutics and existing immunity, we would expect that there would be less emphasis placed on new cases as an economic metric and instead focus on other data points that show the strain on the health care system or mortality rates. The CDC’s recent guidance to relax the duration of quarantines down to five days highlights that we are continuing to evolve on how we live with and manage the virus. There will no doubt continue to be localized surges and some unexpected surprises as we seek to emerge from this pandemic, but we remain optimistic that we will continue to see improvement in 2022 that should bring us closer to our pre-COVID world.

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Federal Reserve and monetary policy

Federal Reserve Chair Jay Powell formally announced a change in monetary policy at their December 2021 meeting. The Fed had been working under the pretense that inflation would be transitory as we recovered from the pandemic and monetary stimulus could be removed slowly. Last fall, economic data began to suggest that inflation had the potential to be longer lasting and more impactful, which prompted the Fed to change course and become more hawkish. Their plan included a more accelerated wind down of their asset purchase program than initially outlined just a month earlier, with measured interest rate increases to follow as needed. The Federal Reserve has indicated that it sees as many as three interest rate hikes to the Federal Funds rate in its 2022 forecast. While this tapering process is seen by the Fed as a way to pare back the amount of financial liquidity in the economy, this action has led to increased volatility in U.S. debt and equity markets in the past. We do expect to see elevated market volatility in 2022, along with more trends like U.S. equity market returns. However, unlike the Fed asset purchase tapers in 2013 and 2018, the current Fed’s transparent communication should minimize market surprises and make for a smoother transition to price stability than past regimes.

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2022 U.S. economic and market outlook

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U.S. GDP 3.50% - 4.50%

While it’s easy to associate COVID-19 headlines with weaker economic growth, the reality is that the current economy is more apt to handle new variants of the virus. Sure, growth is likely to moderate in 2022, but the tailwinds from the trillions spent on economic stimulus will ensure growth remains above potential for the next couple of years. Consumption spending will remain robust as consumers shift away from goods spending and back to services, which should in turn increase labor participation as more workers enter the service sector. Supply chain bottlenecks should start to normalize, but building back inventories will likely be a priority and should be supportive for growth in 2022. Overall, we are expecting another strong year of GDP growth in the 3.5% to 4.5% range for the U.S. despite shifting monetary policy from the Fed as the latter will take time to have a meaningful impact on economic output.

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U.S. inflation 2.50% - 3.50%

The persistence of rising prices over the past year has been surprising for some market participants including the Fed, but higher input costs from rising commodities, supply chain bottlenecks, and labor shortages have been pushed down to the consumer. While it’s widely expected that there will be some relief in upward price pressure as supply chains adapt, we do expect some price pressures to pick up in the service sector as higher input costs from wages become a factor. Inflation levels should peak at some point in 2022, but the overall expectation is that elevated inflation will persist throughout most of the year. Our forecast for core PCE inflation is centered on 3% with risks remaining to the upside should input costs continue to rise.

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Fed funds rate 0.25% - 0.75%

The Fed orchestrated a massive shift in monetary policy expectations in 2021 as many market participants were not contemplating a rate hike until at least 2023. Fast forward to today, and we have a Fed that recently doubled down on the pace of tapering bond purchases and has begun to prepare markets for rate hikes to start at some point in 2022. The pivot on monetary policy largely reflects the economic backdrop with much higher and persistent inflation as well as tighter labor market conditions. In terms of satisfying the dual mandate of price stability and full employment, it became clear that the Fed needs to react before they get too far behind the curve with regards to monetary policy. Thus, we expect the Fed to hike policy rates at least once in 2022, but likely not more than three times at a 25 basis point pace.

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

On the back of a policy shift from the Fed, we expect the interest rate curve to be flatter by year end, but there should be some marginal upward pressure in long-term rates throughout the year for several reasons. First, the economic backdrop remains supportive of higher interest rates and current levels are fundamentally too low given the state of the economy. Second, technical factors holding rates down, such as the massive bond-buying program from the Fed, are coming to an end and a large supply of Treasuries will need to be absorbed by more price-sensitive buyers. Lastly, with inflation levels remaining a concern not just in the U.S., but globally as well, we expect other sovereign rates to rise and eventually lift all boats. For 2022, we forecast the 10-year Treasury yield to rise above 2% at some point and finish the year within a range of 1.75% and 2.25%.

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U.S. equity returns 0% - 10% 

The U.S. equity market will not have the same tailwinds it enjoyed at the start of 2021 as the significant fiscal and monetary support provided for the pandemic will be pared back. Despite the anticipation of reduced policy support from Congress and the Fed, we see overall monetary policy moving toward a more neutral stance. This combined with strong earnings and a healthy consumer should provide a favorable backdrop for U.S stocks. Relative to other asset classes, U.S. stocks continue to look attractive due to the lack of comparable alternatives that provide the same growth opportunity. We expect to see higher volatility against this rising interest rate environment with valuations remaining elevated. The equity market will likely need to navigate new global COVID-19 restrictions at the start of the year, especially in countries that remain committed to a zero-COVID policy. This may put further strain on global supply chains in the first half of the year and add to inflation concerns. Overall, we expect positive returns for U.S. stocks, albeit more moderate than those experienced in 2021. This leads us to expect returns for the S&P 500® Index in the 0%-10% range in 2022.
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Conclusion

We are cautiously optimistic heading into 2022 as science appears to be winning the battle against the virus that has gripped the world’s economies for two years. Our base case looks for a more moderated level of U.S. economic activity in the year ahead, likely slowing the trajectory of asset prices. We also forecast more volatility for financial assets as the Fed embarks on a vast sea-change in policy. The pace and quantity of moving toward a neutral or tighter stance on monetary policy will depend on their ability to cool the overheated U.S. economy. This policy will also impact U.S. financial markets, particularly those in interest rate sensitive sectors of the economy. Lastly, reducing the Fed’s accommodative policy will likely slow GDP growth, but tailwinds from the stimulus injected in 2021 should keep economic activity above potential throughout the year. U.S. equity returns should remain positive under this scenario, however investors will need deeper research to match their lofty gains of 2021.

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The views, opinions and estimates expressed above reflect the views of Allianz Investment Management LLC (AIM LLC) as of 06/2021. 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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