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Allianz Investment Management LLC November 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: The economy is poised to rebound from the Delta-induced slowdown

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The outright number of daily COVID-19 cases peaked for the second time in September, but the sheer number of cases throughout the summer and most of the third quarter took a toll on economic activity in the U.S. Additional headwinds caused by supply chain issues and rising consumer prices resulted in the advance reading on third quarter GDP coming in at a measly 2.0%. When compared to the prior two quarters of growth above 6%, the outcome was quite disappointing. However, when gazing through the monocular lens over the horizon, we expect the recent soft patch of activity to be short-lived as bottlenecks begin to correct and service activity picks up in conjunction with declining virus cases. A boost in consumption during the holiday spending season is likely to push growth back above the 6% level in the fourth quarter, but admittedly, it will not likely be strong enough to hit our forecasted range of 6.0% to 7.0% for the full year. Looking into next year, we do expect growth to moderate, but not to the level we witnessed in the third quarter. 

INTEREST RATES

It has not been smooth sailing for investors in the rates market recently, and that will likely be the case for the near future as investors continue navigate the choppy waters created by the Fed. Higher-than-expected inflation data has caused the Fed to pull forward their timeline on reducing asset purchases, which otherwise removes a large agnostic buyer from the Treasury market. Additionally, higher inflation levels have changed market expectations for rate hikes with the first rate hike from the Fed expected to occur as soon as mid-2022. In turn, there has been some upward pressure on interest rates with most of the increase channeled through the belly of the curve. Since the beginning of the fourth quarter, three-year and five-year Treasury rates have risen 37 and 35 basis points respectively, while the 10-year yield has only increased by 17 basis points. Regarding the outlook for rates, we still expect some marginal upward pressure on the 10-year point of the curve, but recognize that there is still a considerable amount of uncertainty and, in particular, uncertainty around the policy path of the Fed. The 10-year Treasury yield should end the year within our expected range of 1.50% to 2.00%, but additional upward pressure on rates could occur into next year should the Fed get closer to moving policy rates off the zero bound.

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Inflation is not looking so transitory anymore

It is becoming more difficult to square up the transitory narrative on inflation given the latest data in the October Consumer Price Index (CPI). No longer can we attribute upward price pressures to reopening categories, as it appears inflation is becoming more widespread. The headline CPI registered a 0.9% increase for the month of October and lifted the annual rate of inflation to the highest level in three decades at 6.2%. Energy costs were up across the board and, more painfully for consumers, gasoline prices rose by more than 6%. Putting pandemic-related categories aside, the latest data is showing strong price increases in categories like food, which was up 0.9% for two consecutive months. Additionally, categories like medical care substantially increased from the prior month and is further evidence that the inflation genie is now out of the bottle. Unfortunately, this picture is unlikely to change in the coming months as the Fed has only begun to pare back asset purchases and we are a long ways away from financial conditions becoming any tighter. 

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What matters more to the Fed: price stability or full employment?

The Fed is starting to have a bit of a conundrum on their hands as higher-than-expected inflation levels are causing the committee to act more quickly rather than waiting to meet their employment goals. Inflation levels are at a 30-year high while the labor market still has 4 million fewer jobs than when the pandemic started. Many workers have delayed re-entry into the labor force for numerous reasons, such as access to childcare. As such, the labor force participation rate has not budged in 2021 and the Fed has taken notice. Within the labor market, there remains a record number of job openings and the issue at hand appears to be a labor shortage, which, in turn, is causing wage pressures to rise. With the Fed only in the beginning stages of reducing monetary accommodation, many market participants are questioning whether the Fed has been too slow to react. It is clear the Fed has placed more emphasis on the labor market by adopting the transitory inflation view during the first half of the year. However, we expect this narrative to pivot as inflation has become more persistent and the Fed eventually writes off the labor market shortfall as a structural change. Against that shift, we could see a Fed reacting more quickly during the first half of next year as they attempt to counterbalance higher inflation without stunting growth in the economy.

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Market indicators

Financial conditions remain very loose
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Equity markets performed well in October as the S&P 500 Index had the best monthly return since November of 2020. The 6.91% return in October was fueled by stronger than expected corporate profits and was a sign that higher input costs have yet to eat into corporate profit margins. The annual return for the index is well above 20% and is not surprising against an economic backdrop that was injected with large amounts of fiscal and monetary stimulus. Looking ahead, we expect equity returns to moderate next year as financial conditions are reigned in from the Fed.
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Equity market volatility declined significantly during October as the Cboe Volatility Index declined by nearly 30%. The brief correction in the equity market during September was met with strong buying demand the following month, as investors appear comfortable with valuations at these levels. However, with the Fed moving along with changes to monetary policy, it’s possible the expected volatility in the S&P 500 Index could pick up again. 
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With the Fed owning nearly a third of the Treasury market and monthly purchases expected to continue into next year, there has been some technical resistance to an upward path in rates. Interest rates, however, did manage to drift higher in October in anticipation of the Fed announcing a reduction of their purchases. As such, the 10-year Treasury yield rose to 1.70%, which is a level that has met some strong resistance a few times this year. On balance, our expectations have not changed in that we continue to expect the 10-year yield to drift higher in a world where growth and inflation remain above trend.
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The Organization of the Petroleum Exporting Countries (OPEC) has yet to increase production enough to meet demand in an economy that is recovering swiftly. As a result, the price of West Texas Intermediate crude oil has risen to the highest level since 2014 and is beginning to have downstream effects on inflation. Gasoline prices are up at the pump, and the Biden administration is even mulling a release of the Strategic Petroleum Reserve, even though the lasting effect on gas prices may be minimal. If the current trend continues, we could envision a scenario in which higher gas prices begin to take a toll on the consumer.
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Economic indicators

 It’s all about inflation
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Consumer sentiment and confidence readings offset each other in October as inflation remains a top concern for Americans. The University of Michigan’s sentiment index fell from 72.8 in September to 71.7, driven by higher inflation and weariness of government economic policy. Consumers anticipate inflation will rise to 4.8% over the next year, up from 4.6% a month ago and the highest since 2008. Despite higher inflation, consumers were feeling slightly more confident in October as the consumer confidence level increased 4.0 points to 113.8 according to the Conference Board’s index on consumer confidence. Looking ahead, persisting inflation could be a headwind for consumption, but it hasn’t happened yet.
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The aggregate amount spent on retail sales during the month of September was much more than market participants expected with a 0.7% increase for the month. Stronger retail sales point to the consumer’s ability to spend, despite depressed levels of consumer sentiment. Overall, 11 out of 13 categories posted gains, which indicates the economy may not be slowing as quickly as some investors expect.
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The Consumer Price Index for October surged 0.9% month-over-month (6.2% year-over-year), exceeding market expectations of 0.6% and the September print of 0.4%. The annual rate of inflation, according to the Consumer Price Index, showed that prices are rising at the fastest pace in three decades. While the headline number was buoyed by a jump in gas prices, the core index –which excludes the more volatile food and energy sectors – also increased by 0.6% month-over-month (4.6% year-over-year). Supply bottlenecks, as evidenced by the auto sector as well as the unwinding of the drag from the Delta variant on pandemic-sensitive demand, drove the increase in the core metric. More worryingly for the Fed, the shelter component showed a strong gain of 0.4%, indicating cyclical inflationary pressures continuing to build.
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The October employment report came in strong with payrolls increasing by 531k, ahead of market expectations of 450k. Upward revisions to August and September figures printed another 235k, indicating that the economy rebounded quickly from the initial Delta-wave dent. Payroll gains were pronounced in COVID-19-sensitive sectors, with leisure and hospital leading the way adding 164k. Interestingly labor force participation did not pick up despite virus fears and caregiving burdens easing. Consequently, the unemployment rate decreased from 4.8% to 4.6%. Average hourly earnings grew 0.4% from September (4.9% year-over-year). Overall, with the mix of job gains skewed toward low-wage industries, the headline figures might even understate underlying wage pressures and could accelerate from here.
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Conclusion

In conclusion, while the moderation in economic activity was more than we had expected, we still think the economy is poised for a strong rebound in the fourth quarter. Higher inflation levels will flush out a more responsive Fed as we head into next year and ultimately could bring more turbulence to the financial markets. On the other hand, the outlook in the rates market appears less certain at this juncture, but we still expect some upward pressure on interest rates across the curve as the Fed works toward making monetary policy less accommodative. Going into the end of the year, we expect more emphasis on inflation and its overall effect on the economy. 

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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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