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Allianz Investment Management LLC September 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 Delta-driven moderation is likely coming to an end, and stronger economic activity should resume in the fourth quarter

GROWTH

The rise of COVID-19 cases over the summer has manufactured lackluster economic data over the near term with both consumption and consumer sentiment taking a hit. In addition, the volatile trend in the labor market has not been advantageous to market participants looking to forecast what lies ahead for the economic recovery. Bottlenecks and supply chain issues continue to be a problem for consumers looking to spend money on goods, and this is particularly evident in the new car market as inventories are well below average. Within the backward looking data, the second reading on second quarter GDP was lifted by a tenth of a percent to 6.6%. There was nothing too notable within the report as consumer spending was revised slightly higher, but offset by a larger drawdown of inventories. While the near-term results may seem concerning, we expect this will be temporary as pandemic fears subside and consumption picks up in the fourth quarter. Overall, we are maintaining our 2021 GDP forecast at a range of 6.00% to 7.00%, but recognize that growth will eventually begin to slow as we get further into 2022.

INTEREST RATES

Long-term Treasury yields dipped briefly on rising COVID-19 cases earlier in August, but have since recovered and have been mostly range bound as technical factors continue to keep a lid on outright yield levels. Yield differentials and rising dollar reserves are driving foreign purchases of U.S. Treasuries. In addition, strong equity performance throughout the year is causing pension funds to rebalance portfolios and shift some allocations into Treasuries. Lastly, the Fed continuing to purchase $80 billion per month of Treasuries is limiting the available supply of income generating assets. However, these technical factors are unlikely to remain in place indefinitely, and the momentum for rates will eventually shift in the opposite direction. At the virtual Jackson Hole meeting, Chairman Powell alluded to the idea that the central bank was getting closer to making a decision on tapering the bond purchase program, and we expect this should alleviate some of the downward pressure on rates. Moreover, the fears surrounding the third wave of COVID-19 cases is beginning to plateau and should also spur a higher-rate environment. Ultimately, we expect the Treasury market to be more representative of the fundamental backdrop as some of the technical factors subside, and we are maintaining our year-end target for the 10-year Treasury at 1.50% to 2.00%.

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The recovery in the labor market continues to be uneven, but wage pressures continue to rise

It has been a bumpy road for the recovery in the labor market, and the August non-farm payroll report certainly provides evidence of that. After adding over one million jobs in July, the August employment report fell well short of expectations with only 235k jobs added during the month. One notable sector that showed payrolls flat-lining was the hospitality sector, which had strong gains in the previous months. While this could be related to the Delta wave, there could be some noise related to summer jobs coming to an end as the back-to-school season kicks in. The miss on the payroll number was surely disappointing and likely gave the Fed some additional time to assess the right moment for policy change. However, it is worth pointing out that average hourly earnings jumped by 0.6% during August and is sure to catch the attention of the Fed as they try to balance the prospects of higher inflation with the current state of the labor market. Perhaps labor market conditions are tighter than they appear, but we won’t get a clear picture of the labor market until later this year when many of the frictions that have caused all the noise in the data finally dissipate.

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Fed Chairman Powell sets the table for a reduction in asset purchases by year end

The speech from Chairman Powell at the virtual Jackson Hole meeting was largely in line with expectations as he left some optionality in the timing of tapering asset purchases, but made it clear to market participants that a reduction of asset purchases is highly likely before the end of the year. With inflation levels hitting multi-decade highs and no clear signal on when prices will recede, the Fed is being forced to move quicker than they would have liked to. However, Chairman Powell sent a dovish tone to market participants as he pointed out that bond tapering does not necessarily lead to rate hikes immediately after. Market participants viewed the delineation message positively as the Fed will try to keep policy rates at zero for a longer period of time. Overall, the message Powell was sending is that the Fed would like to ween the economy off the unprecedented amounts of monetary stimulus without upsetting markets, and the overly transparent process is their attempt to do so.   

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Market indicators

Noticeable undercurrents were felt from the Delta wave of the virus, but the volatility proved to be short-lived
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The performance of the S&P 500 in August marked the seventh straight month of gains for the index and another series of record highs as second quarter profitability was strong and the low-rate environment continued to favor riskier assets. The S&P 500 Index rose by 2.90% during August and was the third best month this calendar year. For the second quarter of 2021, 87% of companies reported a positive earnings-per-share surprise and revenue surprise. The index is up just over 20% for the year, but the 12-month forward P/E ratio is higher than the 5-year average, which indicates that investors believe there is more room for strong earnings in the near term.
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Market volatility remained elevated during the month of August as heightened concerns around COVID-19 cases, tensions in Afghanistan, and the potential reduction of monetary stimulus lifted volatility in markets. From a monthly low on August 13, the Cboe VIX Index increased by over 50% as investors became more wary of stock market levels against the incoming headlines. The elevated concerns coincide with the drop in consumer sentiment for the month as a normally quiet August trading month quickly turned on a dime.
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After briefly hitting a near-term low of 1.12% in August, the 10-year Treasury yield drifted upward to end the month close to 1.30%. Technical factors continue to weigh on long-term rate levels while the front-end remains anchored by the Fed. The combination of foreign purchases, fears around rising COVID-19 cases, pension buying, and the general lack of income producing assets have all weighed on rates. We suspect these technical factors holding down rates will eventually subside and rate levels will eventually represent the fundamental picture of the economy.
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Oil prices struggled to find footing in August as production increases from the Organization of the Petroleum Exporting Countries (OPEC) combined with increasing COVID-19 concerns drove West Texas Intermediate crude oil to the lowest price level since last May. Overall, OPEC production increased to 27.1 million barrels in August, but production levels still remain below pre-pandemic levels. Despite the recent decline of prices in August, fundamentals remain supportive for oil prices at current levels.
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Economic indicators

A summer lull took full effect in August as some economic data ran into a soft patch
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The University of Michigan Consumer Sentiment Index dropped to the lowest level since 2011 as rising inflation and slower wage growth began to weigh on consumers’ attitudes. The final reading for August came in at 70.3 and was well below the 81.2 reading in July. The abrupt change in sentiment could be concerning as we near the important holiday spending season, but more importantly, it’s a sign that inflation concerns are beginning to bubble up as consumers are starting to take notice.  
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Additional signs of slowing consumption were felt in the latest data on Retail sales for July. The headline number surprisingly decreased 1.1% month-over-month on the back of a 3.9% drop in auto sales and 3.1% drop in online sales. However, the weakness was partially offset by a 2.4% rise in gasoline prices and a continued recovery in spending at restaurants which rose by 1.7%. The control group sales, which exclude more volatile items such as auto, gas, and building materials, declined by 1.0%. The hit to real incomes from fading fiscal support and surging consumer prices are the most likely culprits. With the Delta variant driving a plunge in consumer sentiment, retail spending is bound to remain under pressure.
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Core CPI has moderated in July, going from 4.5% to 4.3%, with some of the re-opening categories, like airfares and used vehicles, moderating from the previous month. However, it would be premature to think that inflation has peaked. Despite the re-opening categories cooling, other factors could derail the Fed's "transitory" view. One that has not fully played out is the demand for labor in a tight labor market that pushes wages up faster than we saw in the previous cycle. This will allow companies to have more flexibility in passing along costs that they otherwise would not have been able to do in the past. Lastly, with robust demand in the housing market, we have seen prices go up dramatically in the last year, and rents will eventually catch up to that. Higher costs for shelter will eventually be reflected, and this sticky inflation could be the mechanism that transfers temporary inflation into something more permanent.
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Non-farm payrolls in August came in at 235k, well below market consensus of 733k. The main disappointment came from employment in the leisure and hospitality sector, which stayed flat after strong gains in previous months. This suggests the Delta variant may be scaring off consumers despite few re-imposed restrictions. People also seem to be reluctant to rejoin the labor force, which increased only by 190k despite the majority of supplemental unemployment benefits having expired or being close to expiring. The unemployment rate nudged down from 5.4% to 5.2%. On another note, average hourly earnings increased by 4.3% YoY, indicating still elevated labor shortages. The combination of wage pressures and slow employment growth puts the Fed in an awkward position as they attempt to balance the state of the labor market against upward inflation in their decision to taper bond purchases.
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Conclusion

As the third wave of the pandemic looks to be maturing, investors are beginning to look down the road to see what obstacles are ahead. There is still a considerable amount of uncertainty ahead as the Fed hasn’t fully laid out their plans for tapering bond purchases. Additionally, inflationary pressures are lasting longer than most market participants expected as supply chain issues and bottlenecks persist. Lastly, many companies have started to delay their full back-to-office plans until next year. However, we suspect consumption should pick up in the fourth quarter as risks associated to the third wave of the virus dissipate and inventories for consumption build back up. Overall, we think that the soft patch of economic data late this summer is not the beginning of a broader slowdown for the economy, but we do recognize there are some challenging headwinds ahead.

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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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