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Allianz Investment Management LLC May 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: Strong, stimulus-supported economic activity is leading to some unwanted consequences

GROWTH

The anticipation of strong consumption-driven growth has been a well-documented narrative in recent months, and it appears this story has begun to transpire in the first quarter. The combination of reduced mobility restrictions and pent-up demand lifted first quarter GDP to 6.4%. Much of the lift in growth was driven by personal consumption, which increased to 10.7%. With over $2 trillion in savings on consumer balance sheets from being in lockdown and added fiscal stimulus, the consumer is well-equipped to support growth in the coming quarters. What’s most notable is that the speed of this recovery is much faster relative to the last recession, and that differential has caught investors off guard since the beginning of the year as the pace of economic activity has been record-setting. Looking forward, we do expect the sugar-high from pent-up demand and stimulus to wear off eventually, but for the near term, investors should expect above-trend growth to persist. We still forecast U.S. GDP for 2021 will be in the range of 5.00%-6.00%, but recent data suggests it could end near the high side of our target. 

INTEREST RATES

The yield curve has already adjusted to higher growth expectations with the 10-year Treasury yield rising nearly 80 basis points since the beginning of the year, but the next catalyst for higher rates is not as conspicuous. Much of the uncertainty affecting the outright level of rates is related to the Fed and their dual mandate on employment and inflation targeting. On the one hand, the Fed would like to see substantial progress toward removing the labor slack in the economy before removing any accommodation. With roughly 8 million jobs that have not come back since the pandemic, there is quite a ways to go. On the other hand, the speed of the recovery has led to some distortions in the economy. In particular, we have witnessed some strong inflationary pressures in recent months that have some investors concerned the Fed may be making a policy mistake by letting the economy run too hot. We expect this tug-of-war between the market’s view of when monetary policy should be tightened versus the Fed’s view of patiently waiting to persist over the medium term and drive interest rate volatility. Eventually, rates will resume their drift higher as more clarity around monetary policy develops and the Fed telegraphs the timing on tapering their bond purchases. Thus, we are maintaining our forecast for the 10-year Treasury yield to end the year within a range of 1.50%-2.00%.

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The inflation debate continues as investors push back on the Fed’s “transitory” view

Market participants have anticipated a rise of inflation well in advance of it actually occurring, and now that it’s here, some investors believe the Fed is allowing it to run too hot. The swift reopening of the economy has highlighted specific supply and demand dynamics that have led to unwanted upward consumer price pressures. On the one side, the Fed has maintained a long-standing view that the increase in consumer prices will only be temporary and investors should look past the current price pressures until supply issues have abated. However, moving the base effects aside, it’s hard to ignore the sharp increases in airfares, used cars, and hotels. Currently, there is no timetable on how long the upward price pressures can persist, and with some supply issues related to shortages of labor, it’s likely the problem could take longer to work itself out. All said, the Fed is continuing to err on the side of caution and willing to maintain policy accommodation through the surge of inflation despite some market participants petitioning for policy change. The market is now pricing Fed hikes in late 2022, but it’s going to take more than a couple strong inflation prints to change the Fed’s view.

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Recovery of the labor market has not been as linear as expected

The pandemic resulted in just over 22 million jobs lost in the U.S. economy, and over the last year about 14 million jobs have come back, which means there is quite a bit of slack left in the labor market. With lockdown restrictions easing and consumer spending picking up, many market participants have expected outsized job gains in the economy. However, the big miss on the April employment report is a blunt reminder that it may take longer than expected for the labor market to fully recover. With the number of job openings increasing to the highest level on record, participants are blaming things like supplemental unemployment benefits as the culprit restricting job growth. Furthermore, the April jobs report validates the Fed’s stance in patiently waiting for labor recovery before preemptively removing accommodation.

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Market indicators

Vaccination progress and strong consumer spending created a favorable market environment 
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Equity markets enjoyed another month of strong gains in April as red-hot economic data combined with solid earnings reports helped propel broad market indexes to new all-time highs. For the most part, equities have typically reacted negatively to increases in interest rates, but throughout the month of April interest rates were unresponsive to stronger economic data, which allowed stocks to continue on their upward trajectory. The challenge for equity markets going forward will be a balance between a maturing recovery and the timing of the Fed removing some of the accommodative policy that has been in place since the pandemic began.
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Volatility in the equity markets declined to the lowest level this year as the Cboe VIX Index declined to 16.25 in mid-April. With investors favoring risk assets throughout the month, the market situation remained calm. With that said, we expect the calm environment to be short-lived and market turbulence to pick up as the Fed contemplates unwinding some of the massive monetary stimulus they have been providing.
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The Treasury curve steepened slightly with rates in the belly of the curve falling while rates in the long-end of the curve moved up. With data from the April labor market report falling well short of expectations, market participants repriced Fed expectations and sent the yield on the 5-year Treasury down by over 7 basis points. Outside of the noise around the employment report, the 10-year Treasury has remained stable throughout April, but this could change as taper talk starts to pick up and the economic recovery makes further progress.
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Oil prices continued to firm as several factors on both the supply and demand side helped lift West Texas Intermediate crude oil above $65 per barrel. On the demand side, restrictions are easing and mobility is increasing as more Americans are driving and consuming gasoline. On the supply side, OPEC continues to curb production, and Saudi Arabia has agreed to cut production by 1 million barrels daily. Additionally, idiosyncratic events like the computer hacking of the Colonial pipeline also lifted energy prices. Overall, the supply imbalance caused by the pandemic is slowly abating, and inventories are moving back to more normalized levels. However, should demand continue to pick up, we could see further upward price pressure in the near term.
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Economic indicators

A stronger-than-expected economic recovery is taking shape
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Consumers are becoming more confident with the present and future situation as the University of Michigan’s sentiment index rose to 88.3 for the month of April. While this level is still below pre-pandemic levels, the positive sentiment is needed to lead a consumption-driven rebound in the economy. Furthermore, the Conference Board’s index on consumer confidence surged to 121.7 in April, which is a testament to the effect that stimulus checks and progress on vaccinations are having on consumers’ attitudes. Overall, we expect sentiment to move back toward pre-pandemic levels in the coming months as the labor market gap continues to close and areas hit the hardest from lockdowns rebound further.
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Retail Sales surprised to the upside in March, increasing 10.7% versus estimates of 5.8%. Within the data, all categories were positive in March, but vehicles and parts, dining and drinking, and general merchandise contributed the most to the monthly gain. It is evident that consumers are emerging from hibernation with pent-up savings to spend. Additionally, as the labor market continues down a path of recovery, it would not be surprising to see additional strong retail prints as consumers have the wherewithal to spend and the in-person restrictions lifted.
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The Consumer Price Index (CPI) came in above market expectations, increasing 0.3% from February and 2.6% from a year ago. While the headline number was driven by a 9.1% increase in gas prices, CPI Core, which excludes the volatile food and energy prices, increased by a solid 0.3% month-over-month and 1.6% year-over-year. That mostly reflected stronger services prices, as prices in sectors worst affected by the pandemic finally began to rebound. By contrast, core goods prices rose by a muted 0.1% from February, which is surprising as the stimulus checks boosted demand against a backdrop of severe global supply constraints. Base effects and a cyclical improvement in the economy should drive core inflation higher going forward.
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Recent data released on the state of the U.S. labor market was a big miss relative to expectations. Nonfarm payrolls added in April were only 266k and were well below expectations of 1 million jobs added for the month. In fact, this was the biggest miss on estimates going all the way back to 1998. Within the report, the unemployment rate ticked up to 6.1%, average hourly earnings were stronger than expected at 0.7%, and the labor participation rate inched up to 61.7%. The initial reaction from the bond market on the news was quite aggressive with the 10-year Treasury yield dropping over 10 bps and falling to 1.46%, but the overreaction has since reversed. While this is only one report, the big miss is causing market participants to reassess the timing of bond tapering and rate lift-off from the Fed. Going forward, we expect there will be more uncertainty around the timing of those events which will, in turn, bring more volatility to interest rates.
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Conclusion

A strong rebound in growth has taken shape with many economic indicators reaching record levels. The Fed has taken note of the faster-than-expected recovery, but they appear to be unconcerned with rapidly rising levels of inflation. We are only in the beginning phase of the robust rebound in growth, and we expect economic activity to remain strong through the balance of the year as consumers will finally have the means and ability to spend. That being said, the party cannot last forever, the Fed will eventually face the challenge of removing the punchbowl, and investors should be mindful of the unintended consequences of the Fed’s actions.

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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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