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Inflation, rates, and volatility. In today’s risk-laden environment, the best defense is a good offense. Here are our latest multi-asset views for insurers, including the mounting need to balance defensive portfolio strategies with continued income and return generation.
The equity rally in July and August seems like a distant memory, with market optimism having been wiped out by higher inflation readings, more central bank tightening, another natural gas supply shock, continued weakness in China, and corporate earnings warnings. In addition, divergent monetary and fiscal policies — highlighted by the UK’s initially conflicting signals on these fronts — are driving market volatility and dislocations. On balance, we see tighter monetary policy and the risk of lower corporate earnings and multiples weighing on surplus assets over the next few months. But in this environment, the risk/return profile of assets can change dramatically, and we are on the lookout for prices being driven down by factors other than fundamentals. Among the signals we will be watching to assess whether it’s time to add risk: Is the market pricing in a severe global recession, and is the economy sufficiently weak or inflation sufficiently contained to trigger a pause in US Federal Reserve (Fed) tightening?
The dynamism of this situation highlights the need for insurers to move quickly and streamline governance and oversight to capture upside potential in the face of large market dislocations. This is not a “set it and forget it” environment for surplus assets, nor will it be in 2023.
From a fixed income perspective, we were early in calling a shift in market sentiment from stagflation fears to weaker growth worries last quarter. However, we continue to think weaker growth is coming and with it, stabilizing bond yields. Here too we are differentiating more between US and European markets, with the Fed ahead of the European Central Bank (ECB) in its inflation fight (Figure 1). Within our overall-neutral view on global rates, we favor being long US rates and short European rates.
Elevated interest rates have allowed many insurance clients to increase their book yields, either by letting lower-yielding exposures roll off, or by strategically selling select positions that don’t expose them to significant realized losses due to duration moves. At today’s attractive current yields (Figure 2), insurers can continue to bolster the income-producing and reserve-backing portions of their investment portfolios. While current spreads may not appear overly cheap versus history, in the investment-grade part of the market, the income potential still looks compelling.
In line with last quarter, and consistent with our quality bias, we have maintained our underweight view on surplus fixed income. Credit spreads do not, in our view, adequately compensate investors for the elevated risk of recession. However, as markets begin to price in these risks, spreads could widen to levels that may provide favorable entry points for longer-term, buy-and-hold insurance investors. Being able to act tactically, and in relatively short order, will likely be essential in the coming months.
Turning to the equity markets, our regional views have changed somewhat, as higher inflation is being met with asynchronous central bank, economic cycle, and market reactions. Within our moderately underweight view on global equities, we continue to prefer the US and Japan and are more negative on European equities. The US is supported by still-healthy consumer spending and balance-sheet strength, while a European recession due to the energy supply shock seems inevitable.
We are moderately bullish on commodities but now prefer energy over metals, which could remain weak given China’s ailing property market and a weakening global cycle.
We think the bond markets are ahead of the equity markets in terms of being priced for the Fed’s forecast peak fed funds rate (Figure 1). The Fed’s median forecasts of 3% average inflation (based on the Personal Consumption Expenditures Index) and a terminal fed funds rate of 4.6% in 2023 imply a positive real rate of over 1.5%, which we would consider restrictive in real terms (which, of course, is the Fed’s policy goal). Yields near 4% on US 10-year Treasuries and the Fed’s clear willingness to sacrifice growth make us confident that US government bond valuations are attractive. The key question is whether the Fed’s terminal rate needs to go even higher to bring inflation down.
In Europe, we have become more cautious on the interest-rates market. Our global macro team has a higher-than-consensus view on European inflation and ECB rate hikes and is below consensus on GDP in the region, suggesting a more stagflationary environment than in the US. Fiscal spending is high and still rising, which could heat up consumer demand even as the ECB is trying to dampen it.
While we think current spreads in surplus fixed income are not wide enough to compensate for higher defaults in the event of a recession, the all-in yields of more than 9% in the high-yield space may be attractive to investors seeking income and as an alternative to equities. We also see select opportunities in short-end credit, given low dollar prices and positive carry, and in structured credit, where vintage non-agency residential housing assets may be well-insulated from losses by the equity built up in these structures.
Broadly speaking, we continue to prefer US and Japanese equities over Europe and EMs. Geopolitical tensions and the energy crisis remain overhangs on Europe, with the almost-complete shutdown of Russian gas making a recession there the most likely scenario. Valuations, earnings expectations, and investor positioning reflect a more pessimistic outlook (Europe is cheapest among developed market equities), but they could have further to fall to reach recessionary levels.
While European Union (EU) and UK measures aimed at supporting households, relaxing fiscal rules, and limiting energy prices will help, much more policy tightening is likely needed in Europe. Entrenched inflationary pressures mean that the ECB and the Bank of England (BOE) will need to continue to hike rates, even into a recession. In the UK, expansionary fiscal policy has exacerbated the twin-deficit problem and stoked fears of a balance of payments crisis.
European energy supply should remain constrained until at least 2025 – 2026, when meaningful new sources of gas will come to market. Over the short to medium term, this is likely to leave European energy prices at multiples of US prices (Figure 3), leading to the risk of energy rationing and a potential loss of relative production and competitiveness. This is reflected in a weaker euro, which has partly offset tighter financial conditions and supported European equity outperformance in local currency terms. Eventually, however, the burden of adjusting to weaker fundamentals may shift from the currency to the equities themselves.
While monetary policy in EMs, and China in particular, is turning incrementally less restrictive, headwinds to profitability and China’s regulatory uncertainty and real estate crisis still add up to a challenging outlook. Aside from some commodity exporters, which obviously benefit from higher commodity prices, EMs are hampered by higher prices and constrained food and energy supplies. Geopolitical tensions and the eventual realignment of supply chains are added risks.
The hawkish Fed and strong US dollar are weighing on risk appetites broadly, especially in EMs. We will look for evidence of a potential reversal in the dollar (e.g., perhaps because other global central banks are becoming more hawkish relative to the Fed) and a more forceful policy turn in China before revisiting our moderately underweight view on EMs.
Given our concerns about Europe and EMs, and about global equities overall, our preference for US equities is a relative one. Higher valuations and earnings expectations in the US reflect more optimism about its outlook versus the rest of the world, which we think is justified given the strong US labor market, its resilient corporate fundamentals, and its higher degree of energy independence. US inflation expectations are also more contained. There are signs of cooling in goods prices, while a turn in US home prices could signal that broader shelter prices will peak in coming months. If we see a global recession, cyclical stocks will underperform, which also supports the US on a relative basis.
Japanese equities could benefit from favorable valuations and a weak currency. Despite acute pressure on the yen and some concerns about upside risks to inflation, the Bank of Japan (BOJ) remains committed to yield-curve control, instead leaning into direct currency intervention to defend the yen. Even if the BOJ were to tweak its yield-curve control approach, the policy mix would still be more supportive than in other regions when combined with likely fiscal expansion. If Japan can create the right kind of demand-driven inflation, especially via wage growth and employment of younger cohorts, it can accelerate nominal economic growth.
Our favored global sectors are energy, where supply/demand tailwinds remain strong, and materials. Company fundamentals appear attractive in both sectors, thanks to capital discipline, reasonable multiples, strong cash flows, and well-behaved credit spreads. Both sectors can generate dividend income, which may become even more attractive on an after-tax basis in the US (i.e., using dividend-received deductions), or under IFRS 9 accounting rules where applicable. Across sectors, we prefer companies with pricing power, long-term profit margin stability, and healthy balance sheets, given their potential to fare relatively well in the face of cost pressures and market volatility.
We have a moderately overweight view on global commodities. We continue to see opportunities in the energy complex, given structural supply challenges that have helped drive roll yields into positive territory (“backwardation”). However, we have shifted our view on industrial metals to neutral: We think demand erosion from a slowing global cycle will outweigh the benefits of supply bottlenecks, meaning that short-term pressure on industrial metals prices is likely going forward. Gold faces a mixed picture, as the balance of risks shifts from a stagflationary scenario toward a growth-slowdown one. As a result, we have a moderately underweight view.
To learn more about how insurers might benefit from having appropriate allocations to commodities and other alternative investments, please see my September 2022 white paper “The road less traveled: An insurer’s path to investing in alternatives.”)
Downside risks to our views include the threat of a severe recession in the US, which could come about because either: 1) the Fed is unsuccessful at re-anchoring inflation; or 2) financial conditions tighten excessively. A severe recession is also a downside risk in Europe, where it would most likely be precipitated by a prolonged energy crisis and associated cuts in industrial production.
Other downside risks include extreme currency volatility (e.g., markets punishing the currencies of regions with expansive fiscal spending and too-loose monetary policy) and more dramatic developments in the Russia/ Ukraine conflict, including a higher risk of nuclear deployment by Russia. Upside risks include a “soft-landing” economic scenario, where the Fed tightens policy just enough, and significant policy intervention in China. On a more micro level, corporations may be able to maintain pricing power, thus preserving profit margins and sustaining earnings growth over a 12-month period at higher levels than consensus currently expects. An upside risk to our equity underweights (whether overall or regional) is that valuations, especially in Europe and EMs, may have adjusted to more than fully reflect lower earnings and other headwinds.
Continue to source opportunities within reserve-backing fixed income allocations — High-quality fixed income looks more competitive versus equities from a yield perspective and could offer upside and diversification once a slowing cycle gains traction. We continue to see opportunities in structured credit and short-duration corporate credit.
Approach surplus-credit investments with caution — Credit spreads do not look particularly attractive right now, given the higher risk of recession. However, be ready to act accordingly if spreads widen out closer to recessionary highs.
Tilt toward quality — Synchronized central bank tightening is likely to slow the global cycle. We think the focus should be on companies with pricing power, long-term profit margin stability, and healthy balance sheets, given their potential to fare relatively well amid cost pressures and market volatility. Company fundamentals in the energy and materials sectors appear attractive, thanks to capital discipline, reasonable multiples, strong cash flows, and well-behaved credit spreads.
Prepare for regional divergence — While many central banks are tightening policy at the same time, we expect individual economies and markets to respond differently. For example, European equities and rates appear more vulnerable to drawdowns than their US counterparts. Currency exposures bear watching in the period ahead, as we could well see more cases of a country’s fiscal and monetary policies working at cross purposes — like the one that recently sent UK government bond yields soaring — which could create market dislocations and investment opportunities.
Continue to seek inflation protection — While demand destruction is a headwind for commodities, a continued supply/demand imbalance could push oil prices higher, as could potential output cuts signaled by OPEC. We think TIPS “breakeven” inflation rates remain attractive, as do some real assets and other alternative investment strategies with high beta to inflation. (To learn more, please see my September 2022 white paper “The road less traveled: An insurer’s path to investing in alternatives.”)
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