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Allianz Investment Management LLC March 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: Higher growth begets higher interest rates

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While the official start to spring is just around the corner, for many of us it may feel like the seasonal change is coming a bit earlier. Recently, we have seen a significant decrease in virus cases accompanied by a strong push for the U.S. population to get vaccinated. The positive backdrop has created a transitional environment where the economy can begin to move from a more restrictive phase toward one that can slowly start opening things up. This will eventually unleash pent-up demand and allow the $2.4 trillion in excess savings to be deployed into the economy. Combined with the stimulus package coming out of Congress, we are setting up for a very strong year of economic growth. In this setting, jobs will be returning to the economy, consumption will be strong, and temporary inflation pressures could persist. All of which would be more reminiscent of the post-war recovery rather than the economic recovery that dragged out following the last financial crisis. All in all, we are expecting the U.S. economy to grow between 5.00% and 6.00% in 2021, which is something that hasn’t happened in over 20 years.

 

INTEREST RATES

Along with higher expected growth comes higher interest rates, and that has been the case throughout February and early March as the benchmark 10-year Treasury yield has risen quite precipitously. Ironically, the roughly 60-basis-point increase in 10-year yields has had nothing to do with the Fed as policy has been left unchanged, but more so with the market’s response to a higher growth environment. The Fed has been agnostic to the recent rise in rates, and Chairman Powell has sent a clear message that policy will remain accommodative until “substantial progress” can be made toward the dual mandate. Realistically, the Fed likely knew it had less control over long-term rates, and the positive sentiment that is building in the market plays into their forecast for the economy and reduces the risk of miscommunication around the taper discussion whenever that occurs. On the other hand, while yield curve control is still an option for the Fed, the recent rise in rates has not been damaging enough to financial conditions to warrant such a move. The bottom line is that the upward pressure on rates isn’t likely to go away in the near term, but the Fed will be watching and has the tools to keep rates from running away and damaging the economic recovery. Thus, it’s not inconceivable to see the 10-year Treasury yield higher by year end, and we are raising our target to a range of 1.50%-2.00% for 2021.

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The Fed is looking the other direction as long-term rates continue to rise

Fed officials reiterated their accommodative policy stance, indicating that they are not concerned with the recent sell-off in Treasury yields. Governor Brainard noted that while she is watching developments, she would only be concerned about a persistent tightening of financial conditions that would threaten achievement of the Fed's goals. With that, she reiterated that the Fed is going to look through any transitory spike in inflation rates driven by a surge in demand and/or supply bottlenecks. On the labor market, she noted the lower labor force participation and stressed the Fed views that as a shortfall of employment from its maximum level. Chairman Powell remarked in an interview that, “Today we’re still a long way from our goals of maximum employment and inflation averaging 2% over time.” Given the relatively large upward movement in rates over the past few months, investors were looking for Chairman Powell to hint toward the possibility of utilizing QE to slow the ascent of rising long-term rates. However, Fed officials, including Powell, are welcoming the increase in rates so long as it does not disrupt the recovery as it reduces the risk of miscommunication around the taper discussion. The bottom line is, rates can continue to drift higher as the Fed will likely continue to look the other way.

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Investor sensitivity to higher interest rates is beginning to show

Risk assets were under pressure throughout the month as market participants digested a higher interest rate regime. Price action in the government bonds sent gyrations across the market as the benchmark 10-year Treasury yield pierced through the 1.60% level for the first time since the pandemic. Until recently, market participants have been able to digest the upward drift in long-term rates, but it appears that the next leg up in interest rates is proving to be a bigger bite to chew. Taking the brunt of the rate-driven sell-off has been the large-cap technology sector which can be mostly witnessed though the price changes in the Nasdaq 100 stock index. As rates swiftly rose in February, the index gave up all its gains for the year and dropped nearly 10% from the peak. The recent volatility in risky assets is a sharp reminder for investors that interest rates can’t stay low forever and investors should be mindful of their positioning.

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Market indicators

Investors didn’t invite higher interest rates, but the party isn’t over yet
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Major equity indexes continue to be supported by strong amounts of monetary and fiscal stimulus. The Biden administration was able to successfully move forward a large fiscal spending package that will provide relief for individuals and companies impacted by the pandemic. On the other hand, rising long-term rates have not gone unnoticed by investors. The higher rate regime has created some market turbulence, but it has yet to send the recovery off course. Overall, combining the progress on the vaccination front and the savings on consumer balance sheets, we suspect risk assets will continue to perform through the balance of the year.
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Volatility measured by the Cboe VIX index jumped above 30 at the end of February as investor concern over higher interest rates began to take hold. Much of that volatility was felt in the technology related names in the S&P 500 index. As rates moved up, high growth names became more expensive on a relative basis and investors looked to shed some exposure there. Ultimately, the brief spike in volatility was short lived, but looking forward, we would expect similar episodes of volatility to occur as investors continue to adjust to a higher interest rate environment.
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The Treasury curve has steepened significantly since the beginning of the year with the spread between the 2-year Treasury notes and 10-year Treasury notes rising to the highest level since 2015. With the Fed signaling that short-term rates will remain low for the next few years, we expect the curve to continue to steepen as the strong growth environment will continue to put upward pressure on long-term interest rates.
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The strong growth environment has been positive for commodities and oil prices alike. The expected increase in demand is putting upward pressure on crude oil prices as West Texas Intermediate crude oil rose by over 17% in the month of February. Further compounding the supply and demand dynamics has been the Organization of the Petroleum Exporting Countries (OPEC) reluctance to increase production levels. For now, rising oil prices appear to be the likely scenario, but this can shift quickly as the supply-and-demand outlook evolves.
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Economic indicators

Recent data suggests the economy is beginning to emerge from hibernation
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Both consumer confidence and consumer sentiment figures were above estimates in February, but there appears to be a cautious undertone coming from consumers as we begin to emerge from the global pandemic. Consumer confidence measured by the Conference Board was 91.3 versus expectations of 90, while the University of Michigan’s Consumer Sentiment Index was slightly above expectations at 76.8. Overall, the global pandemic and accompanying lockdown measures continue to overhang on consumer sentiment.  However, there is a light at the end of the tunnel as more vaccines are being distributed and restrictions are slowly easing, and we expect sentiment to pick up in the coming months.
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Retail sales surged in January by 5.3%, far exceeding estimates of an increase of 1.1%, and marked the highest reading in seven months. Within the data, all components were positive but non-store retailers, dining and drinking, and vehicle sales contributed the most to the monthly increase. The second round of stimulus checks likely helped retail sales come in stronger than expected as consumers have additional funds to spend. Looking forward, with the additional savings on consumers’ balance sheets along with another and even larger stimulus package in the works, consumer spending will be unleashed like we have never seen during the second half of the year.
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The consumer price index (CPI) for January was softer than expected, rising just 0.3% on the month and 1.4% on the year. The headline figure was buoyed by an increase in gas prices of 7.4%, whereas underlying core inflation –excluding the volatile energy and food sectors – was flat over the month and rose 1.4% over the year. Core services prices were especially weighed down by COVID-related developments in mobility-sensitive sectors like airfares and recreation services. With virus cases falling, states easing restrictions, and base effects kicking in, we expect inflation to accelerate in the coming months.
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The most recent employment report suggests that the labor market is slowly embarking on a path of recovery. Non-farm payrolls came in better than expected in February at 379k and January’s figure was revised upward to 166k. Within the data, most of the jobs added were from the leisure and hospitality sectors. Additionally, the unemployment rate was nearly unchanged at 6.2%. Overall, there are many Americans (as reflected in the jobless claims data) that remain unemployed, and February’s job additions are still below the levels we witnessed last spring. That being said, the latest report is a well-received signal that we may be turning the corner in the labor market as more vaccines are distributed and restrictions are eased.
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Conclusion

As risks to the economic recovery continue to fade, the backdrop for a strong rebound in growth has been set in motion. Along with the additional growth comes higher interest rates, and investors are starting to pay attention to long-term rates. The higher interest rate regime will likely cause some bumps along the way, but it’s becoming more apparent that it’s going to take a lot more to derail this economic recovery. At the end of the day, there is too much pent up demand, and consumers will have the means to deliver the strongest growth numbers we have seen in decades, so enjoy the ride.

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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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