Allianz Investment Management commentary for the month of January 2017.
Key Points
- Unsurprisingly, the Fed unanimously raised policy rates to a range of 0.50% to 0.75%.
- However, market participants were somewhat surprised by the hawkish tone of the Fed as the committee now projects three rate hikesin 2017 versus two hikes previously.
- The new regime comprised of pro-growth, pro-business policy setters taking over Washington D.C. has ignited the “animal spirits” of the US economy.
- Looking ahead, the new regime certainly has some work to do in 2017 as expectations are notably high.
- Critical to our outlook and investment thesis for 2017 will be the first 100 days Trump is in office as this will likely set the tone for the administration and their agendas.
Outlook
GROWTH: The third and final reading for third quarter GDP was revised upward to 3.5% from the second revision of 3.2%. Driving the results were personal consumption which was revised up to 3.0% from 2.8%. This coincided with strong retail and auto sales witnessed earlier in September. Strong consumption results were the product of rising wages and a tighter labor market, creating a strong fundamental backdrop for US households. Going into 2017 growth is starting off on a solid footing as the economic backdrop in the US remains favorable. While it’s true some policy uncertainty will exist under the President elect’s agenda, the prospects for higher inflation and growth are apparent. We expect much of the growth pick-up to occur during the second half of the year as Trump’s policies become more concrete. Consequently, we think growth will pick up gradually within a target range of 2.25% to 2.75%.
INTEREST RATES: It appears rates have taken a breather following the rapid increase that occurred following the election. Policy uncertainty will be one of the biggest headwinds to our outlook for rising rates. We expect much attention to be focused on Capitol Hill as tax reform gets underway. The Fed is expected to raise policy rates three times in 2017 and push expectations of the terminal rate higher. Inflation is expected to exceed the Fed’s target of 2.0% by year end. However, due to tight labor markets and a strong consumer, the risk is inflation continues to move up while the Fed remains dovish. Given the current backdrop and the prospects for fiscal stimulus our base case for our 10 year Treasury yield target in 2017 is 2.50% to 3.00% with risk tilting to the upside.
Allianz Investment Management – December 2016 Recap & Macro Themes
Looking back, 2016 can largely be characterized as the culmination of financial repression as overly gloomy sentiment and fears about global risks from dovish central bankers weighed heavily on growth and interest rates. As a result, the benchmark 10 year Treasury spent most of the year below 2% and created a challenging environment for investors in search of income. That being said, the landscape fundamentally changed with the result of the US election. The new regime of pro-growth, pro-business policy setters taking over Washington D.C. has ignited the “animal spirits” of the US economy pushing household confidence to the highest level since 2001. Within this context we remain cautious until details of Trump’s policies are more tangible.
The market’s response to the US election has been undoubtedly favorable as the prospects appear to be outweighing any negative consequences. However, it is important to note the improvement in the economic backdrop in recent weeks. Most notably a turnaround in the manufacturing sector is being noticed. The Institute of Supply Management’s Purchasing Managers Index (PMI) ended 2016 on a positive note with December’s reading coming in at 54.7 percent. The increase reflects the fourth week of consecutive growth in the manufacturing sector and the 91st consecutive week of overall economic growth. It also provides further evidence that the manufacturing sector is starting to turn around. New orders, growth in production, and increased prices were key catalysts behind December’s reading.
Also helping to push rates higher in December was the surprise change to the median “dots” in the Fed’s Summary of Economic Projections released at the December FOMC meeting. Not surprisingly and for the first and only time in 2016 the Fed unanimously raised rates to a range of 0.50% to 0.75%. The rate hike marks only the second increase since 2008 when rates were cut to almost zero. Although unexpected, the Fed’s decision did not provide additional clarity to the timing of further increases. While the market had already priced in a 25 basis point rate hike at the December meeting, market participants were somewhat surprised by the hawkish tone that was portrayed as the Fed now expects three rate hikes in 2017 compared to only two in the previous assessment. Perhaps most notable was the fact that this was the first time that the Fed has raised its long-term projections for Fed funds.
Aside from reiterating their continued plan to gradually raise rates as well as positive economic and market data we experienced in the latter half of 2016, the Federal Open Market Committee (FOMC) added little additional insight with the exception that some uncertainty was a common theme felt by Committee members. The next FOMC meeting takes place from January 31st to February 1st. We are hopeful that the outcomes will provide additional information around fiscal policy and offer some hint towards timing of the next rate hike, however, given that Trump’s transition into the White House does not occur until the end of January we expect sizable insight will not actually occur until a later date when the Fed has obtained a better picture of Trump, his policies, and ultimate impacts.
Looking ahead, the new regime certainly has some work to do in 2017 as expectations are notably high. Critical to our outlook and investment thesis for 2017 will be the first 100 days Trump is in office as this will likely set the tone for the administration and their agendas. Priorities for Republican lawmakers will be focused on budget reconciliation and tax reform during the first half of the year. In our view tax reform, which would be the most significant driver of growth, will be the largest hurdle given the amount of involvedness in such an undertaking. Regardless of the outcome we expect volatility to pick up as investors begin to price in policy outcomes in an environment where policy uncertainty exists.
Market Indicators (figure a)
- One of the biggest factors that will affect equity markets in 2017 will be corporate tax reform. Some of the potential changes appear to be priced in already, but tax reform is a huge undertaking and details are not quite known. In this context, Financials and industrials may become more favorable in environment with steep yield curves, less regulation, infrastructure investing. Given the potential for tax reform, companies with high tax rates could benefit. Overall, we expect modest returns on the broad indices, but sector specific returns could be outperform in the changing environment.
- Volatility, as measured by the VIX index, traded near a historical low during the month of December. The index dropped 15 percent over the month and was near two year lows. The index is signaling that investors are relatively confident with the current level of equity prices. That said, volatility should start to pick up as Trump’s agendas start to formulate this year.
- Yields on the 10 year Treasury reached a post election high of 2.64% in mid-December as solid economic data and the prospects for increased inflation helped buoy rates. However, yields have drifted lower in the last few weeks as technical factors have weighed in.
- Oil prices were up 20% during the month of December as OPEC as well as non-OPEC oil producing countries came to an agreement on coordinated production cuts. Prices have since come in as some questions surrounding compliance to the cuts by some OPEC nations has come up. In addition, US rig counts have been steadily rising which could curtail any efforts by OPEC to balance the supply.
Economic Indicators (figure b)
- Consumer confidence measured by the Conference Board’s Index of consumer confidence rose to the highest level in 15 years as American households remain optimistic about the outlook for the economy. The confidence index rose to 113.7 from 109.4 in November while the expectations index rose to 105.5, the highest level in 13 years. The level of optimism indicates that consumer spending should remain solid as we move into the first quarter.
- Growth for the US economy was revised higher in the third estimate for Q3 GDP. The Bureau of Economic Analysis (BEA) now estimates Q3 GDP to be 3.5% compared to the previous reading of 3.2%. Driving the results were personal consumption which was revised up to 3.0% from 2.8%. This coincided with strong retail and auto sales witnessed earlier in September.
- CPI data failed to surprise to the upside in November, but nonetheless consumer prices were up a solid 0.2% on a monthly basis. Headline CPI rose by a tenth of a percent to 1.7% on a year-over-year basis as the energy price gains continue to close the gap between headline and core consumer prices. Core inflation was flat on a yearly basis at 2.1%, but medical services rose for the first time in three months contributing to the 0.2% monthly gain in core CPI. Overall, the trend for inflation is pointing upward and it appears the Fed shares this view as they increased their forecast for rate hikes in 2017.
- Initial jobless claims for the last week in December fell to 235k only 2k off the 43 year low indicating the resilience in the labor market. Despite coming in slightly lower than expectations of 175k December’s addition of 156k payrolls ended the year strongly and contributed to the sixth consecutive year that job gains reached a level above 2 million.
- The U.S. dollar index rose to the highest level since 2003 at the end of December as the demand for dollars continued to pick up. With the possibility of more rate hikes in 2017, we expect USD strength will likely persist.
- Survey based measures of economic activity such as the ISM manufacturing and ISM non-manufacturing index indicate solid positive momentum in the US economy. New orders and prices paid components are rising substantially. As a result we have reflected this in the outlook for growth in 2017. The bottom line is, the US election results have created a reflationary environment and previously depressed sectors of the economy like manufacturing are receiving a benefit.
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