Allianz Investment Management LLC 2023 Mid‑Year Market Outlook

U.S. Gross Domestic Product came in at +1.3% annualized for 1Q23, down for the third consecutive quarter as government and consumer spending were the largest positive contributors. While the unemployment rate continues to be resilient as we proceed deeper into 2023, the number of job openings and the number of employee “quits” are declining as more companies and American workers prepare for a possible economic slowdown. Additionally, the number of indicators such as ISM Manufacturing Index, U.S. Leading Indicators, and the NFIB Small Business Optimism Index are adding to the signs of a pending downturn. Given this backdrop and our expectation for a mild economic contraction in 2H23, we are maintaining our outlook for Real GDP to finish -0.5% to +0.5% for 2023.

The Fed refrained from raising the policy rate at the June meeting, and this was the first meeting during this tightening cycle that the Fed has not raised rates. The explanation from Chairman Powell gave mixed signals, but the reality is the Fed is looking for time to evaluate how the economy will evolve from here with a Fed Funds rate north of 5.0%. The most recent meeting also gave some insight to where policymakers see rates at the end of the year, and while the committee is mostly divided on this topic, on average they see one or two more rate hikes by year end. We think the most plausible argument for a pause in rate hikes is the uncertainty around lagging effects to the economy, given the banking stress in March. Our base view is that most of the policy tightening is likely done and one or two more rate hikes from here is not likely to change the trajectory of the economy. With recent inflation data remaining somewhat sticky, we can see why rate cuts are being pushed out into 2024, but the closer we get to a real economic slowdown the higher the bar gets to continue raising rates. Therefore we believe the Fed is more likely to maintain a higher for longer policy stance rather than continuously raising rates, and we maintain our target for Fed funds to end in a range of 4.75% to 5.25% for the end of 2023.

Headline inflation has declined noticeably since year end according to both Personal Consumption Expenditures (PCE) and Consumer Price Index (CPI). Tighter financial conditions created by the Fed rate hikes are bringing prices down as intended. Energy has retraced back to levels last seen before the Ukraine War. Utility and used vehicle prices have also retreated over the last 12 months. Rent prices remain sticky, preventing both inflation measures from feeling the full effect of the Fed’s tightening policy. When gauging inflation with recent CPI prints, we have witnessed six consecutive months of core inflation at 0.4% or higher, which has become a concern for market participants. The Fed’s preferred inflation measure, Personal Consumption Expenditures, posted +4.4% (year over year) for April 2023, steadily declining from +5.3% just five months earlier. PCE ex Food and Energy posted +4.7% for April 2023 and has been in a narrow range over the past 12 months, unable to make progress as food prices remain elevated and stubborn. We anticipate that core inflation will begin to improve as the economy continues to slow. We maintain our range of 3.0% to 4.0% for FY2023 on Core PCE.

Rate volatility has certainly been a theme throughout the year, and the 10-year yield was not immune, with yields trading in a range as low as 3.30% and as high as 4.05%. However, more recently we have seen the 10-year Treasury fall into a narrower but elevated range around the 3.75% level. Part of this has been driven by the banking sector fear subsiding, but moreover the resilient economic data as of late has fostered an opinion that an economic recession is not a foregone conclusion. Despite a 5% Fed policy rate, labor market data has been more robust, consumer spending has maintained, and the potential for a more muted slowdown of the economy has been priced into the 10-year part of the curve. From here, it seems more unlikely that long-term rates can rise back above 4% as an economic slowdown is inevitable. Furthermore, most of the forward-looking survey-based economic data has been signaling economic weakness. At some point, perhaps in early 2024, monetary policy will likely be too restrictive and the Fed will have to cut rates. Therefore, we are maintaining our forecast for the 10-year yield to end the year within a range of 3.50% and 4.00%.