Allianz Investment Management LLC Market Outlook – March 2023

Gross Domestic Product in the U.S. finished 2022 with +2.6% annualized for 4Q22, down from +3.2% in 3Q22, led by private inventory replacement and consumer spending. The labor market continues to be strong in the early stage of 2023, which is supportive of economic growth. However, layoff announcements are increasing and job openings are declining, a sign that the Federal Reserve’s tighter monetary policy is taking hold and is slowing the economy as intended. Additionally, the inventories that we saw get replenished in 4Q22 will likely not continue at the same pace, potentially providing less tailwind for GDP in upcoming quarters. The consensus view among U.S. economists is that economic growth will slow, but the probability and depth of any recession will likely depend on the consumer’s willingness and ability to spend. At this point in the cycle, we are unchanged in our GDP growth estimate with a range of -0.5% to +0.5% for 2023.

After 475 basis points of policy rate tightening since March of last year, many market participants are beginning to question how much further the Fed could possibly go. Indeed, inflation has been trending lower over the course of the hiking cycle, however the high level of inflation combined with the nonlinear path lower has made it a difficult environment for investors and the Fed alike to gauge how much policy tightening is needed. In addition, the swift increase in interest rates over the past year has also highlighted some risks in the banking sector. Rising interest rates have increased the level of unrealized losses on their balance sheets. While nobody wanted this to happen, the timing of the stresses in the banking sector and the failure of two community banks could not have come at a better time for the Fed. Cautious sentiment in the market will likely play a role in slowing the overall economy through tighter lending standards, which will be welcomed by the Fed. As a result, we are revising our expectation for the Fed funds rate to a range of 4.75% to 5.25%. This implies that the Fed has one more hike in May before it pauses, likely maintaining the policy rate at an elevated level until a mild recession hits in late 2023.

Inflation measures have come down as tighter financial conditions have taken hold, but there is still further to go based on the Fed’s inflation target of 2%. One of the largest components, Energy, has retraced back to levels last seen before the Ukraine war. The Federal Reserve preferred inflation measure, Personal Consumption Expenditures (PCE), posted +5.0% (year over year) for February 2023, steadily declining from +6.1% just five months earlier. PCE excluding Food and Energy posted +4.6% for February 2023. Food prices continue to be stubbornly high, which is restricting declines in the Core measure. Shelter also continues to be persistently elevated despite high-frequency industry data showing declines in rent cost. With steady declines in PCE, it appears that the Federal Reserve’s plan to rein in inflation is working. While they seem to be coming to the end of their tightening cycle, it does not necessarily mean that the next move is to cut rates. We believe that the Federal Reserve will hold rates steady at an elevated level for some time, allowing inflation to further moderate toward its 2% target before easing monetary policy. Given this scenario, we are keeping our inflation forecast on Core PCE at +4.0%-5.00% for 2023.

Yields have bounced around quite significantly since the beginning of the year. Interest rate volatility has been driven by uncertainty around the path of Fed policy. Stronger employment and inflation data in January and February pushed the 10-year yield briefly above 4%, but yields quickly retreated on the back of bank closures and ongoing stress in the banking sector. More recently, market participants have focused on the economic slowdown, which, in turn, put more pressure on long-term rates. Despite a potential recession on the horizon, inflation is likely to remain quite sticky between the 3% and 4% level. This will make it difficult for the 10-year yield to drop into the sub-three-percent range. Given this thesis, our expectation is for extended inflationary pressures to keep longer-term rates relatively elevated, and we maintain our expectation for the 10-year yield to end the year between 3.50% and 4.0%. Unless the economic data turns around, the plot for higher Fed policy rates continues to fall apart, and a 4-handle 10-year yield will likely be in the rearview mirror.