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Allianz Investment Management LLC September Market Update

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Market Outlook: Can see the light through the trees, but not out of the woods yet

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There is no doubt the economic recovery is well underway and despite the pace of the recovery proving to be faster than what we witnessed in 2009, several economic indicators in August suggest some caution as we head into the final quarter of 2020. The strong fiscal support that helped the economy quickly get back on its feet looks to be wearing out. From an economic standpoint, third quarter GDP will likely be the highest growth rate on record, but not enough for annualized GDP to be positive for the year. Retail sales data for July has shown that consumer appetite for spending has slowed. In addition, consumer confidence, measured by the Conference Board, fell to a 6-year low of 84.8. Some of this can be attributed to the spike in virus cases over the summer, but the elevated unemployment rate and the stalemate in Washington D.C. over the next round of fiscal stimulus is likely taking a toll. We are not saying the recovery is over by any means, but signs of exhaustion are something to pay attention to in the coming months.

 

INTEREST RATES

The interest rate environment remains subdued as Treasury yields continue to trade in a narrow range. For now, the Fed has pledged to keep policy rates near zero for the near future and they reiterated that the virus, and how quickly an acceptable vaccine can be deployed, would influence the path of the economic recovery. More importantly, the Fed used their annual Jackson Hole meeting to crystalize the framework and strategy for inflation. They chose to adopt the widely anticipated Average Inflation Targeting (AIT) strategy in which they will now allow inflation measures to drift above the 2% target. While the announcement bears little effect on interest rates today with inflation measures running below 2%, we could witness some additional steepening of the yield curve once the economy has reached full recovery and inflation moves back toward the target. All in all, the impetus for rates to rise significantly from current levels is marginal for now as lingering uncertainties surrounding the virus, the speed of the economic recovery, and the election remain.

High-flying technology stocks have been taken down to a more comfortable cruising altitude

Despite slowing economic indicators, the stock market was on a tear during the month of August with the Nasdaq-100 and the S&P 500 indices gaining 7.01% and 11.05% respectively. In fact, the Nasdaq-100 was up over 70% from the March low through August 31. The accelerated adoption of digital processes with less human interaction, which was brought on by the pandemic, has driven technology stocks to their elevated levels. However, valuations became quite lofty in August as stock prices got ahead of themselves and eventually, investors began to take note. The catalyst for the sell-off in technology names could be attributed to the progress made towards a COVID-19 vaccine as the so-called “work-from-home” trade started to unwind. The price declines in technology shares has led the Nasdaq-100 Index to sell off as much as 9% from the peak on September 2. Overall, the healthy correction seemed overdue as investors rotated out of the high-flying technology shares in favor of value sectors that have been hurt the most by the pandemic.

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The Federal Reserve goes all-in to move the needle upward on inflation

The Fed decided to use the annual Jackson Hole meeting to lay out their new monetary policy framework and strategy. Within the framework, the Fed described the long-awaited change to their view on inflation. Instead of a 2% cap on the inflation target, the Fed is moving to Average Inflation Targeting (AIT). This means they will allow inflation to run significantly above the 2% target “to achieve inflation that averages 2 percent over time.”  Additionally, the Fed has indicated that the unemployment rate will bear less relevance on policy decisions when the economy is near full employment. What this effectively means is that the Fed will no longer proactively raise rates if the unemployment rate is low. They will specifically focus on inflation data as a guide to tighten monetary policy. At the end of the day, the Fed appears to be going all-in on attempting to move the needle upward on inflation after decades of trying to suppress it. As a result, we could see an ever-steepening yield curve in the coming years as the ceiling on the inflation target has been removed.

The rebound in inflation has occurred faster than many market participants expected, including the Fed

Consumer prices bounced back significantly in July and August as both headline and core CPI came in well above expectations. Headline CPI rose by 0.6% in July and 0.4% in August, with food and energy prices being significant contributors. The annualized figure now stands at 1.3%, but well below any level the Fed will be concerned about. Core CPI also rose by 0.6% in July and 0.4% in August and was driven by the rebound in motor vehicle prices, airfares, and hotel prices. The sharp increase in core prices over the last few months has lifted core CPI to 1.7% on an annualized basis and was likely not something the Fed was expecting. As we approach pre-pandemic levels in core inflation, it will be interesting to see the Fed’s reaction function following the newly adopted average inflation targeting strategy. We suspect this could be a driving theme for Treasury yields in the coming years as the economy normalizes and the pandemic ends.

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Market indicators

Signs of slowing upward trajectory are emerging as some indicators are stalling out
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Equities had a fantastic month during August with the monthly gains on the S&P 500 being the strongest in over three decades. However, the exuberance appears to have met a roadblock as lofty valuations are squared up against the risks on the near-term horizon. First, we have yet to see Congress make any meaningful progress on another round of stimulus, which is weighing on risk assets. In addition, the U.S. election is just around the corner and the expectation for volatile markets is almost certain given the uncertainty and the potential for a contested result. Overall, the upside for equities will be diminished until further clarity presents itself on key topics such as the election, fiscal stimulus, and a vaccine.

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There has been an interesting anomaly regarding market volatility that market participants have witnessed in recent weeks. Despite the S&P 500 Index making new highs, the CBOE Volatility Index (VIX) has remained elevated and near the mid-20 level. This signals that investors perceive the market to be more volatile one month forward, which can be attributed to the lofty levels that the broad stock indexes achieved. In addition, VIX futures for October are even more elevated as investors continue to expect the upcoming election to be a significant driver of equity volatility.

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Treasury yields continue to be range bound as the tug of war between virus uncertainty and additional supply is driving the ebbs and flows in the Treasury market. Indeed, we have seen the macro backdrop improve over the past four months, but there is some uncertainty around the speed of the recovery from here. The Fed is really keeping a lid on rates as Treasury purchases remain at $80 billion per month. On the flip side, inflation has been rebounding faster than expected which has led to some moderate steepening of the yield curve. On balance, we do not expect Treasury yields to break out of the narrow trading range until we see a widely adopted vaccine and some meaningful improvement in the economy, both of which are not likely to occur until 2021.

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The grind higher in West Texas Intermediate (WTI) crude oil prices appears to be hitting a wall as the combination of China purchases slowing and OPEC adding production caused prices to peak close to $44 per barrel. In August, WTI crude oil gained 5.81%, but fundamentals and a slowing economic outlook have already led prices to decline by over 12% in September. In general, prices have been following the macro backdrop in sync, and the sooner that picture starts to improve again, the quicker we will see oil prices stabilize.

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Economic indicators

The fiscally charged economic recovery has begun to lose steam and more stimulus may be necessary
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The ISM Manufacturing index continued its climb in August, rising to 56 from 54.2 in July. Within the data, new orders increased to the highest level since 2004 while the employment index remains weak. ISM Services Index came in mostly as expected at 56.9. Muted employment and supply chain constraints are becoming more evident in the services sector as inventory levels decline and order backlogs edge higher. Overall, both the manufacturing and services sectors appear to be rebounding since the COVID-19 shutdowns, but employment and supply chain implications will be important to watch going forward, especially as we get closer to the election.

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Posting a modest growth of 1.2% from June (vs 2.1% expected), July retail sales suggest that the recovery has lost steam.  Retail auto sales dropped by 1.2% month over month, affecting the headline figure. Excluding autos, retail sales rose by a stronger 1.9%, ahead of expectations of 1.3%. Consumer spending was positive in 9 out of 13 categories with electronics and appliances registering the strongest growth followed by gas stations and clothing. It is worth mentioning that restaurants posted a 5.0% gain month over month despite the new restrictions on bars and indoor dining announced by several states. Looking ahead, the expiry of additional Federal unemployment benefits at the end of July and uncertainty over future finances could influence consumer spending in August.

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On the margin, the employment report for August looked better than expected as the economy added 1.37 million jobs. However, looking into the details, 238k of those job additions were only temporary government jobs, and the overall pace of hiring appears to be slowing. The unemployment rate dropped to 8.4%, but only about half of the jobs lost since the pandemic started have been recovered. When looking at more high-frequency labor market data, such as initial jobless claims and business survey data from the ISM, we are not seeing a lot of evidence that the labor market will return to pre-pandemic levels any time soon. Some of the jobs lost early on in the pandemic may become permanent, and it could take some time for structural shifts of labor to play out. While the most recent employment report showed some improvement, there are signs that the recovery in the labor market is moving toward the point of exhaustion. This, in turn, should signal to lawmakers that another round of fiscal stimulus may be needed to keep the current pace of the economic recovery going.

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In conclusion, the economic recovery remains intact, and we can see the light through the trees, but we are not quite out of the woods yet. High-flying market indicators have begun to stall out as the pace of the recovery appears to have slowed and investors recognize the near-term risks on the horizon, like the upcoming U.S. election. Progress on a vaccine has been quite positive over the last month, but it could be some time before a widely adopted vaccine is available. Markets will be looking for additional fiscal support to help push the economy back to pre-pandemic levels, but it appears as if we will not see any progress on that front until after the election. For now, we expect the economy to continue along the road to recovery, but the speed will be dialed back given the current backdrop.

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List of definitions

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The views expressed above reflect the views of Allianz Investment Management LLC as of 09/2020. These views may change as the market or other conditions change. This report is not intended and should not be used to provide financial advice and does not address or account for an individual's circumstances. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Allianz Investment Management LLC is a registered investment adviser that is a wholly owned subsidiary of Allianz Life Insurance Company of North America.