Allianz Investment Management LLC 2023 3Q Market Outlook

U.S. Gross Domestic Product came in at +2.1% annualized for 2Q23, up from the1Q23 final print of 2.0%. Consumer spending continues to be one of the largest contributors to economic growth. The unemployment rate continues to be resilient, which is also supportive of the economy. The consensus probability of an economic downturn that was highly anticipated at the beginning of this year is decreasing or at least is seen being pushed into 2024. These reasons are all positive for economic growth to continue. In fact, the 2.1% economic growth rate in 2Q23 matches the average growth rate from 1999-2019, so it has returned to pre-COVID “normal.” We also believe that the pending slowdown has likely been pushed into 2024. This allows us to raise our outlook on Real GDP to +1.75% to +2.25% for 2023.

While the September FOMC meeting was widely viewed as a “skip” meeting, we think it still remains to be seen if another hike is in the cards later this year. Fed officials appear to be somewhat divided on whether higher policy rates are needed to bring inflation back down to their 2% target as seven of the nineteen Fed officials did not have another hike in the dot plot. In addition, there are significant risks to economic activity on the horizon with the autoworkers strike in motion and the potential for a government shutdown looming. Both these events have the potential to sideline the Fed from another hike this year, especially given that a government shutdown would effectively delay the economic data that the Fed relies on to make policy decisions. Thus, we believe there is a decent case building that the last rate hike during this cycle may already be behind us. However, looking beyond the terminal rate, the Fed’s projections did show fewer rate cuts in 2024. The idea of keeping short-term interest rates higher for longer gives the Fed more optionality should the economy fail to materially slow. When we think about rate cuts coming from the Fed next year, it will be important to track where real rates are, and real rates above 2% is considered relatively restrictive on a historical basis. For the balance of the year, we are forecasting Fed funds to end within a range of 5.25% and 5.75% should the Fed to decide to hike once more.

Inflation has declined over the past year according to both the Personal Consumption Expenditures (PCE) measure and the Consumer Price Index (CPI). The Federal Reserve monetary policy rate hikes have started to bite, stabilizing prices across many areas of the U.S. economy. One example of this is used vehicle prices, which have retreated -6.6% over the last 12 months according to the August CPI report. Rent prices remain sticky, however, preventing both inflation measures from feeling the full effect of the Fed’s tightening policy. Shelter was +7.7% year over year (yoy) in the July 2023 CPI data, but real time data by CoreLogic showed +3.4% over the same period. The Fed’s preferred inflation measure, Personal Consumption Expenditures, posted +3.3% year-over-year for July 2023, down from +4.2% just five months earlier. Core PCE (ex Food and Energy) posted +4.2% for July 2023, down from +4.7% in January. We anticipate that PCE inflation will continue to improve as the economy slows further. Given this environment, we maintain our range of +3.0% to +4.0% for core PCE to end the year.

A perfect storm for U.S. rates markets has shifted the yield curve yet again to levels we have not seen since before the Great Financial Crisis. The combination of the Fitch downgrade to U.S. government debt, a surge of new issuance after the debt ceiling was lifted, and resilient consumer spending throughout the summer months has pushed the 10-year Treasury yield to year-to-date highs north of 4.30%. The question many investors are asking is when will the eventual economic slowdown finally take hold. Despite falling inflation, 10-year yields have diverged and gone the opposite direction. However, we do believe the Fed is on the cusp of being done raising rates for this cycle and history has shown the 10-year Treasury yield has declined by more than 50 basis points in first three months after the last rate hike. We take note that the swift move higher in the 10-year yield following the September Fed meeting has pushed yield levels above fair-value models Thus, with the potential of a government shutdown emerging, we believe 10-year yields could be susceptible to a rapid shift lower. During the last government shutdown, in the weeks leading up to the December 2018 shutdown, 10-year rates declined by over 50 basis points from peak to trough. As a result, we are forecasting the 10-year yield to finish the year between 3.75% and 4.25%.