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.
Allianz Investment Management LLC 2Q 2022 Market Update
- Persistent inflation continues to be a problem for the Fed and they upped the ante on using blunt policy tools such as raising the Fed Funds rate in order to cool demand in the economy.
- The economy is expected to slow relative to the strong growth level in 2021, but it is not yet evident that a recession is in the cards for 2022 even though GDP was negative in the first quarter.
- Markets and the Fed alike are now projecting the Fed Funds rate to be north of 3% by year end as the Fed embarks on a very aggressive monetary tightening policy.
- The higher rate environment has taken a toll on equity markets and in particular growth stocks that have been a significant driver of market gains over the past few years.
- Market volatility has also been a persistent theme throughout the first half of the year and it has not been limited to equities as the bond market has experienced the most volatility since the financial crisis in 2009.
Market update: the heat is on
We knew the ride was going to be bumpy as the Fed embarked on one of the fastest monetary tightening policies in many decades, but the amount of volatility in both the bond and equity markets has been jaw-dropping. Fighting an inflation battle against a very strong economic backdrop is proving to be a very difficult challenge in the modern-Fed era. As a result, the committee has been forced to re-adjust policy guidance on an almost real-time basis. It wasn’t that long ago when Fed officials thought that tightening policy rates to 1.87% by the end of 2022 would be sufficient, but red-hot inflation pressures have pushed the expectation for policy rates to nearly 3.50% by year end. Perhaps the Fed could have seen this coming, but the reality is that massive shifts of consumer behavior in the post-COVID economy have been difficult to deal with on many fronts. Recent inflation data has been going the opposite direction of the Fed’s forecast, and the Fed will have to do more to pour cold water on the overheating inflation environment. Due to the rapidly changing investment landscape, we, like other investors, have been forced to make significant changes to our market outlook this year. While we don’t anticipate material changes to our forecasts every quarter, the abrupt shift to a more hawkish Fed has caught many market participants off guard.
2022 U.S. economic and market outlook
U.S. GDP 1.75% – 2.75%
From a headline perspective, the advance reading on Q1 GDP appears quite scary but the underlying demand components remain very solid. Real GDP declined by 1.5% during the first quarter and much of the weakness was attributed to the widening of the trade balance. In addition, the amount of inventory build was smaller than the previous quarter, which also subtracted from overall growth. Combining both the trade imbalance along with the decline in inventory build, there was a drag of about 4% to GDP. Referring to the strength in demand, personal consumption rose by 3.1% which was the strongest level since the second quarter of 2021. Overall, we don’t see a recession happening this year and growth should actually rebound with our year end estimate coming within a range of 1.75% - 2.75%.
Fed funds rate 3.25% – 3.50%
Whether you consider it a policy mistake or not, the abrupt change in the Fed’s path of policy rates has been quite dramatic. Many Fed officials expected inflation to cool rather quickly as most of the elevated inflation from earlier in the year was driven by supply chain disruptions. However, it didn’t take long for inflation to become embedded within other parts of the economy. The persistence of high inflation led the Fed to take a more aggressive stance which was ultimately dictated by the market. In June, the Fed delivered a 75 basis point hike for the first time since 1994. The hawkish pivot from the Fed to combat inflation is out of the norm from the past couple hiking cycles, which is likely why markets have been so volatile. There is still some uncertainty around the path of policy rates, but with another 75 basis point hike expected in July, we forecast the Fed Funds rate to end the year within a range of 3.25% to 3.50%.
Inflation 4.00% – 5.00%
Supply chain shortages and the Ukraine-Russia war are only partly responsible for the higher prices Americans are paying. It still comes down to the imbalance of dollars in the U.S. monetary system and supply and demand of goods and services by the U.S. consumer. The Bureau of Labor Statistics reported that the Consumer Price Index (CPI) rose to a year-over-year rate of 8.6% during May. This is the highest level since December 1981. While this is a broad look at U.S. goods and services prices in the economy, some of the most important expenditures for Americans, such as food, energy, and shelter, made the largest contribution. According to the U.S. Energy Information Administration (EIA), the average price of gas has increased to $5.01, up 61.2% over a year ago (June 13). This CPI reading is likely one of the data points that led the Federal Reserve to take a more aggressive stance on stabilizing prices. At their June meeting, the U.S. central bank increased the Federal Funds Rate by 0.75% in an effort to tame the rate of inflation. This is the first time since Chairman Alan Greenspan in 1994 that the Federal Reserve has been this aggressive. This will affect financing costs in many areas from short-term business funding to new mortgages and auto loans. The goal is to bring supply and demand for goods back to an equilibrium, and raising interest rates has historically been the remedy. The Fed adjusted their forecast that will hopefully put the U.S. economy back on the road to their goal of price stability and normalization of monetary policy. We feel that tighter monetary policy will eventually take hold, but inflation will be more persistent in the near and medium term. Under those terms, we are increasing our inflation forecast on Core PCE to 4.0% - 5.00% for 2022.
10-year treasury 3.25% – 3.75%
Based on our expected path for the Fed Funds rate and the point that we don’t expect a recession to happen in the near future, the upward bias for the 10-year Treasury yield remains intact. While the 10-year Treasury yield has already risen over 160 basis points, we think there is more room to run and recession fears are somewhat overblown. In addition, the Fed will be aggressively shrinking their balance sheet in the coming months, which will ultimately leave more supply to be absorbed by the market. Our view for the 10-year yield hinges on the idea that we don’t expect a material inversion of short- and long-term rates by year end. As such we are forecasting the 10-year yield to end in a range of 3.25% - 3.75%.
U.S. equities -20.00% – -10.00%
Equity markets have struggled as inflation has compressed earnings multiples and the fear of an economic slowdown took hold of investor sentiment. Elevated market volatility has also persuaded investors to cash out and wait for calmer times. Higher gasoline cost is cutting into household discretionary income, inhibiting their ability to purchase other goods and services. First quarter company profits posted stronger-than-expected results, however companies began to guide future earnings lower due to higher transportation and production costs. Companies that announced declining or negative profits also sold off. Retail names saw a pullback as consumer spending trends changed from goods to services. Energy and materials based stocks were a bright spot as oil and other commodities continued to rise with inflation. Homebuilders initially greatly benefited from the low-interest-rate environment but have turned cold on higher mortgage rate expectations. Value style stocks have outperformed growth names, with price-to-earnings compression disproportionately hurting the latter. We expect stocks to have a difficult time in the near term with earnings, geopolitical, and economic uncertainty so prevalent. It is for these reasons that we have reduced our range on the S&P 500® return for the year to -20% to -10%.
List of definitions
Here are the definitions of the key terms used in this market report.
Previous – Observation as of the end of the prior month
Survey – Economist survey prediction for current month’s observation
Actual – Actual observation as of the end of the current month
Next – Date of next period’s observation
ISM Manufacturing Index
Based on a survey from the Institute for Supply Management, this index indicates a positive growth in the manufacturing sector when the figure is above 50 and a contraction of the sector when it is below 50. An increase in the figure indicates either slowing contraction or accelerating growth. The index represents underlying figures in employment, inventories, new orders, production levels, and deliveries. (Source: Bloomberg)
Based on a monthly survey of households, the unemployment rate is one of many figures in the Current Population Survey that move markets by indicating what portion of the population is at work, looking for work, what they are getting paid, and how many hours they work. The unemployment rate is the percentage of workers unable to find work who are actively seeking a job. The survey is conducted by the Bureau of Labor Statistics.
Retail sales measure the total amount of purchases by consumers in stores that sell merchandise, food, and other services to end consumers. This measure is a significant indicator of trends in consumer spending, which moves markets because consumer spending accounts for over two-thirds of U.S. economic output. Data is compiled by the U.S. Bureau of the Census.
Consumer Price Index (CPI)
The Consumer Price Index measures the prices of a fixed basket of goods that reflect an average consumer’s cost of living. CPI is a popular indicator of inflation, driving prices on U.S. inflation-linked bonds, and is used to adjust tax brackets and Social Security payments. CPI is compiled by the Bureau of Labor Statistics monthly.
Home Price Index
The S&P CoreLogic Home Price Index is the seasonally adjusted average price of residential homes in 20 major cities in the U.S. Data is published with a two-month lag (numbers available in March reflect price changes from January). Housing prices affect consumer wealth and consumers’ ability to borrow and spend, which in turn affects U.S. economic growth.
Gross Domestic Product (GDP)
Gross Domestic Product is the sum of the value of all goods and services produced in the economy. It is one of the most comprehensive benchmarks for economic performance. Real GDP measures economic productivity adjusted for inflation, which measures growth that is not due to goods getting more expensive. GDP is published by the Bureau of Economic Analysis.
University of Michigan Consumer Sentiment Index
The index is derived from surveys of 500 households by the University of Michigan on consumer finances and attitudes regarding the economy. The index is set to 100 as of 1966, reached a high of 107.3 in June of 1999 and a low of 56.4 in June of 2008. High consumer confidence levels lead to robust consumer spending, whereas low consumer confidence levels lead consumers to pull back on spending.
S&P 500® Index
The S&P 500® Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies by market value.
Chicago Board Options Exchange (CBOE)
Volatility Index® (VIX® Index)
Created by the Chicago Board Options Exchange (CBOE), the Volatility Index®, or VIX®, is a real-time market index that represents the market’s expectations of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500® index options, it provides a measure of market risk and investors’ sentiments.
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The views, opinions and estimates expressed above reflect the views of Allianz Investment Management LLC (AIM LLC) as of 7/2022. 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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