hero july market commentary

Allianz Investment Management LLC August Market Update


Market outlook: Stimulus has supported the initial phase of the road to recovery, but the fiscal stalemate in Washington puts the economic recovery at a crossroads


Reflecting back, it seems like it was ages ago when most of the U.S. economy was in full lock down to mitigate the risk of the spreading COVID pandemic, but the reality is that it was also only a few months ago when the economy experienced the sharpest decline since 1947. Looking at the initial numbers for the second quarter, GDP shrank 9.5% from 1Q to 2Q, which equates to a 32.9% annualized decline. Due to the lockdowns, personal consumption decreased 34.6% in 2Q and household spending for services slid 43.5% in 2Q. In addition, the contraction was broad-based in investments with business investment falling 27%, while residential investment dropped 38.7%. Although small, the fiscal stimulus spending did contribute to a 2.7% rise in government spending that offset some of the decline in growth. Fortunately, the worst appears to be behind us, and we are looking for a strong rebound in third quarter growth within the neighborhood of 20% to 30% as the economy continues to normalize. However, while we think the economy is well on the road to recovery, we suspect there will be some bumps along the way. As some of the fiscal measures put in place begin to wear off, the need for additional fiscal stimulus only increases. At the end of the day, the speed of the recovery rests in the hands of politicians as they wrangle over the details in the next round of fiscal stimulus spending.



Rates grinded their way lower throughout the month of July as the Fed’s purchases of U.S. Treasuries and safe-haven buying pushed the 10-year Treasury yield to a new all-time low.  Interest rates have remained in a very tight trading range since April, and recent comments from Fed officials indicate that they are in no hurry to change the rate picture until there is more certainty around the path of the virus. Additionally, the number of confirmed COVID-19 cases increased across the country in July, and that weighed on interest rates. Looking forward, the pace of the recovery is likely to be determined by the path of the virus and until we have more clarity on how that plays out, we expect interest rates to remain anchored. Lastly, we have a major U.S. election this fall where the only certainty at this point is that the event will likely provoke more volatility in the markets, which could ultimately weigh on rates as investors look for cover in safe assets like U.S. Treasuries.


The dislocation between markets and the real economy explained

As the S&P 500 drifts closer to a new all-time high, many market participants are trying to square up this phenomenon with the gloomy economic outlook and level of uncertainty regarding the virus. For starters, there has been a massive amount of both fiscal and monetary stimulus pumped into the economy that has set the backdrop for higher stock prices. In addition, markets are forward looking and typically reflect what investors expect six to twelve months ahead. Second, we are almost through earnings season and many companies have reported a positive earnings surprise that indicates expectations were very low to begin with. Lastly, economic data has also surprised to the upside, and in particular, we have seen a strong V-shaped recovery in retail sales. Some of that strength is coming through online sales and is one of the reasons the technology sector has performed so well.  On the other hand, it appears we are nearing an inflection point in the market, as the path forward looks less certain. Fiscal stimulus that supported the economy during the first half of the year is wearing off, and it is unclear whether Congress will be able to provide more fiscal support, but for now markets continue to price that another stimulus package is a done deal.

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The Federal Reserve: maintaining the status quo

The transition from a liquidity provider to keep markets functioning to an enabler of policy accommodation appears to be the current objective of the Fed. Given the gloomy tone from the committee in past meetings, we did not expect much progress on guidance in light of the surge in virus cases over the summer. We suspect that Fed officials did discuss a framework in which to think about removing some accommodation, but the current economic backdrop affords them the ability to remain ambiguous. The pace of the recovery may have slowed in recent months as virus cases have surged across the country and the Fed appears to be in no hurry to change the status quo. The committee reiterated their dovish policy stance and the need to maintain accommodation until it’s clear the economy has recovered from the economic fallout caused by the pandemic. Regarding asset purchases, the Fed appears to remain on course until the path of economic recovery becomes more certain. Ultimately, the Fed does not intend to upset the applecart until some certainty has been instilled in the economic outlook and progress made towards price stability and full employment.


Signs of fiscal stimulus wearing off are starting to show up in the employment numbers

With the margin of error fairly wide going into the release of July’s employment report, it was anyone’s guess as to how the data would look. However, most market participants were certain that job creation was unlikely to be as robust as the previous two months given the increased virus cases across the country and the slowdown of the reopening process. The economy added 1.763 million payrolls for the month of July, and the weaker data should be a stark reminder to investors that the recent strength in equity prices is not always reflective of what is happening in the real economy. In addition, today’s payroll data should remind lawmakers that we are not quite out of the woods yet when it comes to dealing with the damage the pandemic has caused on the economy. While July’s jobs data was somewhat better than expected, we still think Congress needs to pass further fiscal stimulus to fuel the economy on the road to recovery.


Market indicators

Despite the rising number of virus cases, market sentiment remained positive and risk assets continued their upward trajectory

Equities were able to shrug off the negative news surrounding increased virus cases, as fiscal stimulus hopes and strong earnings from the technology sector were able to push the S&P 500® Index closer to a new record high. Big tech was the shining star as the Nasdaq-100® Index rose to an all-time high in anticipation of strong profit reports. Additionally, the low rate environment created by the Fed has enticed investors to shift into stocks as dividends continue to look to be an attractive alternative. Going forward, we see a tremendous amount of uncertainty surrounding the path of the virus and the upcoming election that could be a challenging headwind for risk assets.


Market volatility, measured by the CBOE’s VIX Index, declined throughout July, but the overall level remains above pre-pandemic levels. The index declined just over 23% in July as positive sentiment towards risk assets improved throughout the month. Despite overall levels of market volatility subsiding recently, we suspect there will be ample opportunity for increased volatility in the coming months as the economy continues to battle the fallout from the pandemic and jitters prior to the upcoming U.S. elections.


Treasury yields have been anchored by Fed policy including bond purchases from the Fed that have led to a flatter yield curve. Throughout the month of July, rates continued to drift lower on Fed purchases and concerns over the increase in virus cases. The Fed has indicated they are in no hurry to raise interest rates, and they have purposely been vague on forward guidance until there is more clarity on the path of the virus. Some market participants have expressed concern that rising inflation will cause real yields to become too negative, but the Fed appears unconcerned with rising inflation when the unemployment rate is at 10%. On balance, we expect rates to remain range bound on the long end until the economy normalizes and growth moves back to potential. In addition, we do not expect the Fed to raise rates any time soon.


Price action in West Texas Intermediate (WTI) crude oil was muted throughout most of July as investors weighed the speed of the global economic recovery with the tapering of supply cuts from OPEC producers. WTI crude oil ended the month slightly above $40 per barrel, and the price is likely to hold around that level until there is further evidence of a pickup in global growth.


Economic indicators

Survey based measures of economic activity improved, but the pace of hiring slowed

Survey based indicators, such as the ISM Manufacturing and ISM Non-Manufacturing data, both surprised to the upside this month, increasing to 54.2 and 58.1 respectively. Within the Manufacturing sector data, the new orders and production components drove the uptick while the rebound in employment has been slow to materialize. Turning to the Non-Manufacturing sector, the employment component continues to lag but gains from the business activity, and new order components were more than enough to offset the pullback in employment. Overall, upticks in both sectors suggest that recovery is taking place from a production and output perspective but continues to lag from the employment perspective.


Retail sales for June came in better than expected at 7.5% versus estimates of 5%. The gain was primarily driven from purchases at clothing stores, which was up 105.1% and electronic store sales which increased by 37.4%. The second consecutive month of strong retails sales has brought the dollar amount of retail sales back to the level we had seen before the pandemic began. Ultimately, while the rebound in consumption is a welcomed sign following the shutdowns, we are cautiously optimistic on June’s uptick given the resurgence of virus cases in the United States combined with declining consumer sentiment readings in recent weeks.


Nonfarm payroll employment rose by 1.76 million in July beating market expectations of 1.5 million, though falling behind the increases of 4.8 million in June and 2.7 million in May.  At the sector level, employment in leisure and hospitality increased by 592k and accounted for about one-third of the gain in total nonfarm employment. The breadth of job gains was solid, with government, retail trade, professional and business services, and health care adding a notable number of jobs, while only a few sectors shed jobs in July. Overall, the number of unemployed persons fell by 1.4 million to 16.3 million, and the unemployment rate declined by 0.9% to 10.2%.  Overall, employment is still 12.9 million below its February level; roughly, only 40% of the job losses suffered in March and April have been recovered.

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The economy appears to be continuing along the road to recovery, but the month of July has shown us there will likely be some speed bumps along the way. The uptick of virus cases across the U.S. has proven to be challenging and led to some fits and starts in the reopening process. The Fed has reiterated their support for the markets, but Congress appears less motivated to complete another round of fiscal stimulus as the stalemate continues in Washington. Risk assets remain supported for now, but we have an election around the corner that is likely to bring additional volatility given the stakes are high and the outcome is uncertain. Looking ahead, we suspect the path of the virus will continue to affect the speed at which the economy recovers, and investors will have to navigate the obstacles left behind in the path of the global pandemic.


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