Market Update (11/2017) Allianz Investment Management LLC November 2017 Market Update Key Points Equities rallied to fresh all-time highs as the prospects for tax reform continued to move forward. Jay Powell has been officially nominated to be the next Fed chair, replacing Janet Yellen. This should be welcomed by investors as his views represent the status quo and a smooth transition. The theme of policy accommodation removal continues as the European Central Bank reduced asset purchases by 50% and the Bank of England raised rates for the first time in 10 years. Economic data was generally positive throughout the month, but potential distortions caused by the recent hurricanes have some market participants worried about the noise in the data. Growth in the U.S. remains above trend with the advance reading for 3Q at 3.0%. This is the second consecutive quarter with growth at or above 3%. Outlook GROWTH: The recent upward trend in growth appears to be unbroken despite the potential for weather-related disruptions. The advance reading on third-quarter GDP indicated that disruptions from the recent hurricanes had less of an effect on overall economic growth. Consensus estimates were looking for a 2.5% increase in third-quarter GDP while the Bureau of Economic Analysis reported annualized growth for the third quarter at 3.0%. One factor that could be contributing to the upside surprise in growth is the strength of the global economy as this is the first period since 2010 that we have had synchronized growth across domestic economies. Overall, recent economic data, in conjunction with potential fiscal stimulus, leads us to believe that growth should remain above trend and toward the top end of our range in the coming quarters. 2017 OUTLOOK FOR GROWTH EXPECTATION Real GDP (growth) 2.00% - 2.50% INTEREST RATES: Interest rates jumped in October to the highest level since March as the progression on tax reform combined with headlines on the Fed chair nomination pushed the 10-year Treasury above 2.40%. That said, rates have settled in around 2.30% in recent weeks as Jay Powell, a more predictable Fed chair nominee, was selected by President Trump. In addition, the overly dovish forward guidance from the ECB could be attributed to the significant curve flattening we have witnessed in recent weeks. The spread between 2-year Treasuries and 10-year Treasuries dropped 15 basis points since October to the lowest level since the recession. Interestingly, bond markets continue to discount little inflation risk on the long end of the curve, but this is something we ll pay closer attention to as signs of rising prices are lurking around the corner. On balance, the prospect for interest rates is still higher as the economic backdrop, even without tax reform, should put upward pressure on Treasury yields. FORECAST PERIOD 10-YEAR TREASURY YIELD 12 months 2.25% -2.75% M-5334 Page 1 of 5
October 2017 Recap & Macro Themes Much of the attention was focused on a game of musical Fed chairs, as rumors around the potential nominees for the next Fed chair and their potential impact on markets dominated headlines during the end of October. With that said, the official nomination of Jay Powell for Fed chair by President Trump should be viewed as a welcome event by markets as this choice is seen as a more predictable path for future monetary policy. A smooth transition of the chair position is exactly what this economy needs, and Janet Yellen appears to have committed to that in her latest statement. However, while Powell has similar views to Janet Yellen, it s important to note his background is less academic than his predecessor. In light of this, the decision process for policy change may derive from other influences as the composition of the Fed continues to change. On balance, we do expect the Fed to continue the process of removing policy accommodation, but pace of change remains a question. In addition, equities quietly staged another rally to reach fresh all-time highs as the prospects for tax reform moved forward. A Congressional budget was passed and the House GOP has released the details of the tax bill with a notable 20% corporate tax rate, as well as a host of other details aimed at simplifying the tax system in the U.S. Despite the long road ahead, equities continue to price at a higher probability than the bond market that tax reform gets done. Nonetheless, in our view the economic backdrop in the U.S., combined with synchronized global growth, should continue to lift interest rates regardless of whether tax reform is completed. Throughout the month there has been mounting upward pressure on interest rates, with the benchmark 10-year Treasury breaking through 2.40% for the first time since March. We suspect some of the yield increase is the result of a larger theme at play, which is the unwind of policy accommodation by central banks. The Fed is well along in its path of removal and started the process of shrinking its balance sheet in October. At the same time, other central banks are beginning to move in that direction. In fact, Mario Draghi, president of the ECB, announced plans to taper their bond buying program by 50%, down to EUR 30 billion per month until September of 2018. This is seen as yet another sign that global policy accommodation has peaked. Across the pond, the Bank of England raised policy rates for the first time in 10 years to 0.50% as growth and inflation forecasts warranted an increase. Looking ahead there will be much attention on the speed of policy accommodation removal from central banks and with a new Fed chair taking the driver seat in 2018, investors will be curious to see what limits he is willing to test. Regarding the Fed, most investors appeared to be looking beyond the November 1 FOMC meeting before it even occurred, as there was no expectation for policy change and the economic outlook had not deviated since the previous meeting. The Fed did acknowledge the start of balance sheet run-off, but beyond that there was not much new information. Despite faltering signs of inflation recently, the probability of a rate hike remains above 80%. Janet Yellen s Fed has maintained a consistent view that downward inflationary pressures are transitory and the continued reduction of labor market slack will eventually lift inflation, which requires a very gradual lift to policy rates. The November Fed statement appeared to be a continuation of this view, but bear in mind the next Fed chair will be influenced by a new cast of characters, with the potential of four governorships to fill if Janet Yellen decides to retire after her position as Fed chair ends in February of next year. The amount of turnover at the Fed is highly unusual and the composition of the Fed will be something to pay close attention to in the coming months, as this will partially impact the pace of policy accommodation removal. Elsewhere, there was less attention placed on economic data throughout the month as the potential distortion from the hurricanes has introduced some noise into the data. Regarding the employment report, the payback in distorted payroll data from the previous month was evident as the Bureau of Labor Statistics reported the U.S. economy added 261K jobs during the month of October. In addition, September s data was revised upward to 18K from a previous reading of -33K. Solid payroll additions of 24K in the manufacturing sector are likely reflective of elevated ISM data we have seen recently. However, the wage picture was somewhat disappointing with average hourly earnings coming in flat for the month, but it s likely there was some distortion in the data. Overall, the unemployment rate dropped to 4.1%, indicating the continuation of a tightening labor market. This provides a difficult backdrop for the incoming Fed chair when determining the pace to remove policy accommodation. Page 2 of 5
Market Indicators (figure a) figure a It is starting to sound like a broken record talking about equity markets reaching higher highs, and the pattern continued in October as the S&P once again climbed to a new high of 2,582. Driving the positive momentum is a combination of a low rate environment and large advances in the technology sector. With policy normalization in full swing, the high probability of a December rate hike, and tax reform discussions already underway, there is potential for some downward pressure in the equity market as we close out 2017. While there was much reflection on the 30th anniversary of the 1987 stock market crash, equity volatility is nowhere to be found, as the average level reached in October was only 10.1. Given the commemoration of the crash, October had historically been the most volatile month of the year, but that doesn t seem to be the case this year. Treasury yields climbed to their highest level since March of this year as the Fed officially began the process of unwinding its massive balance sheet position. Simultaneously, hawkish commentary from the Fed during their October meeting put upward pressure on rates, as the possibility of a December rate hike became even more likely. Oil prices climbed to nearly $55 per barrel in October, a positive change of 5.75% over the month. The increase comes as a result of falling inventory in response to the ongoing discussions around the OPEC production cuts. Economic Indicators (figure b) Consumer confidence rebounded in October following a slight dip in September, as both the Conference Board s index of consumer confidence and the University of Michigan s sentiment Index reached multi-year highs. Given record-breaking returns from stocks, a strong labor market, positive outlook for business conditions, and strength in the housing market, it is not surprising that consumers are so optimistic about the economy and their financial positions. This confidence should flow through to economic growth in the coming months as consumers will be more likely to spend, given their optimistic views of the near and longer term. Page 3 of 5
Economic Indicators (continued) The advance reading on third-quarter GDP indicated that weather disruptions from the recent hurricanes had less of an effect on overall economic growth, as the Bureau of Economic Analysis reported annualized growth of 3.0%. While the entirety of the report was quite strong, some notable weakness stuck out within the structural and residential investment categories. Despite the pockets of weakness, which were likely weather-related, growth in the U.S. economy appears to be on a solid footing. figure b While the headline figure for consumer price inflation surged by 0.5% in September, core inflation data was more subdued as core goods prices continued to be under pressure. Rising gasoline prices due to Hurricane Harvey caused the spike in headline inflation, where autos, apparel, and medical care prices weighed on core inflation. Despite the core-inflation miss, we do not think it was big enough to derail the Fed from moving forward with a rate hike in December, with the only exception being materially weaker inflation prints in October and November. Jobless claims have settled to their pre-hurricane level following a large spike in September. More specifically, in October jobless claims fell 22K to their lowest level since 1973 at 222K. The significant decline was most likely attributable to employees who had previously been impacted by the hurricanes returning to work. Jobless claims are a volatile number, so we expect the levels to bounce around while still remaining at post-crisis lows. After falling in mid-october, the U.S. dollar index rebounded and ended the month 1.06% higher. Buoying the dollar was progression of U.S. tax reform by the House, as well as overall confidence in the global market. We expect the dollar to have some volatility through the end of the year as tax reform details are likely to change. The ISM surveys for both manufacturing and nonmanufacturing had mixed but still robust results for October. The manufacturing reading declined from September s reading of 60.8 to 58.7 in October and failed to meet expectations of 59.5. Despite this downward shift, the results for manufacturing still remain strong. Nonmanufacturing, on the other hand, beat estimates, coming in at 60.1 - the highest reading since 2005. Both surveys reflected the pickup in economic activity, which we expect to flow positively into GDP. Page 4 of 5
EVENT Previous Survey Actual Next ISM Manufacturing Index 60.8 59.5 58.7 December 1 (Friday) GDP Annualized 3.1% 2.6% 3.0% November 29 (Wednesday) Unemployment rate 4.2% 4.2% 4.1% December 8 (Friday) Retail sales -0.2% 1.7% 1.6% November 15 (Wednesday) Consumer Price Index (YoY) 1.9% 2.3% 2.2% November 14 (Tuesday) U. Mich. Consumer Sentiment 101.1 100.7 100.7 November 22 (Wednesday) Home Price Index (MoM) 0.35% 0.40% 0.45% November 28 (Tuesday) Definitions Table Columns Previous Observation as of the end of the prior month Survey Economist survey prediction for current month s observation Actual Actual observation as of the end of the current month Next Date of next period s observation ISM Manufacturing Index Based on a survey from the Institute for Supply Management, this index indicates a positive growth in the manufacturing sector when the figure is above 50 and a contraction of the sector when it is below 50. An increase in the figure indicates either slowing contraction or accelerating growth. The index represents underlying figures in employment, inventories, new orders, production levels, and deliveries. (Source: Bloomberg) Unemployment Rate Based on a monthly survey of households, the unemployment rate is one of many figures in the Current Population Survey that move markets by indicating what portion of the population is at work or looking for work, what they are getting paid, and how many hours they work. The unemployment rate is the percentage of workers unable to find work who are actively seeking a job. The survey is conducted by the Bureau of Labor Statistics. Retail Sales Retail sales measure the total amount of purchases by consumers in stores that sell merchandise, food, and other services to end consumers. This measure is a large indication of trends in consumer spending, which moves markets because consumer spending accounts for over 2 / 3 of U.S. economic output. Data is compiled by the U.S. Bureau of the Census. Consumer Price Index (CPI) The Consumer Price Index measures the prices of a fixed basket of goods that reflect an average consumer s cost of living. CPI is a popular indicator of inflation, driving prices on U.S. inflation-linked bonds and used to adjust tax brackets and Social Security payments. CPI is compiled by the Bureau of Labor Statistics monthly. Home Price Index The S&P Case-Shiller Home Price Index we track is the seasonallyadjusted average price of residential homes in 20 major cities in the U.S. Data is published with a 2-month lag (numbers available in March reflect price changes from January). Housing prices affect consumer wealth and consumers ability to borrow and spend, which affects U.S. economic growth. Gross Domestic Product (GDP) Gross domestic product is the sum of all goods and services produced in the economy. It is one of the most comprehensive benchmarks for economic performance. Real GDP measures economic productivity adjusted for inflation, which measures growth that is not due to goods getting more expensive. GDP is published by the Bureau of Economic Analysis. University of Michigan Consumer Sentiment Index The index is derived from surveys of 500 households by the University of Michigan on consumer finances and attitudes regarding the economy. The index is set to 100 as of 1966, reached a high of 107.3 in June of 1999 and a low of 56.4 in June of 2008. High consumer confidence levels lead to robust consumer spending, whereas low consumer confidence levels lead consumers to pull back on spending. The views expressed above reflect the views of Allianz Investment Management LLC, as of 11/2017. These views may change as 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. Allianz Life Insurance Company of New York is also a wholly owned subsidiary of Allianz Life Insurance Company of North America. Products are issued by Allianz Life Insurance Company of North America, 5701 Golden Hills Drive, Minneapolis, MN 55416-1297. www.allianzlife.com. In New York, products are issued by Allianz Life Insurance Company of New York, 28 Liberty Street, 38 th Floor, New York, NY 10005-1422. www.allianzlife.com/new-york. Variable products are distributed by their affiliate, Allianz Life Financial Services, LLC, member FINRA, 5701 Golden Hills Drive, Minneapolis, MN 55416-1297. Only Allianz Life Insurance Company of New York is authorized to offer annuities and life insurance in the state of New York. Page 5 of 5