- Head of Multi-Asset Strategy – Insurance
Switzerland, Institutional
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Key points
- Economic growth and corporate earnings continue to surprise on the upside, especially in the US. While valuations are on the rich side, I think fundamentals and policy support a risk-on tilt and that positive sentiment can be sustained. This adds up to what I believe may be a compelling backdrop for increasing allocations to some surplus assets, and particularly equities. Surplus fixed income fundamentals have improved, but valuations aren’t attractive enough for an overweight view.
- I have less conviction on duration and maintain a neutral view versus liabilities. The jury is still out on the timing of Fed rate cuts, but the ECB could cut rates earlier and by more given a clearer disinflation picture and weaker growth than in the US. I continue to like reserve-backing fixed income (investment-grade credit and securitized assets) thanks to positive fundamentals and technicals.
- In equities, I favor the US and Japan over Europe and emerging markets. The US is my top developed market due to the macro backdrop and confidence in AI’s potential to continue underpinning earnings growth. I have a moderately overweight view on Japan and remain skeptical we’ll see any material improvement in China considering problems in real estate and consumer confidence.
- I have moved to a neutral view on commodities. I remain biased toward higher inflation in the long term, but richer valuations in oil and gold suggest waiting for better entry points.
- Downside risks to these views include a hard landing precipitated by a spike in inflation and a Fed pivot back to tightening, or a stagflationary scenario with sticky inflation and waning growth. Upside risks include an even more benign environment than my base case, with sustained growth that’s well above trend but not inflationary.
I have banged on the proverbial drum for reserve-backing fixed income in this space for what seems like years, but is the tide finally starting to turn in favor of surplus/risk assets? The tailwinds are obvious: Growth has surprised to the upside, inflation is coming down, earnings have supported rich valuations, and financial conditions are easy. This has stoked insurers’ interest in risk assets, something we haven’t seen in some time.
Importantly, central banks are viewed as credible, having worked to tone down the market’s rate cut expectations. The repercussions of a policy error are well understood by markets in all regions: Ease too soon and risk having to reverse course and tighten more aggressively, reviving the possibility of a recession. Ease too late and risk the cumulative effects of restrictive policy tipping the economy into recession.
While this environment may seem too good to be true (and only the 1995 – 1996 period resembles it), I am hard-pressed to identify risks that could sustainably derail it over the next six months, though the US election is top of mind. But even if US political turmoil threatens the positive risk environment, central banks seem to have a “free option” to cut rates in response, given that they consider current policy to be restrictive.
Now more confident in the fundamental and technical picture, I have raised my view on global equities to moderately overweight. Were it not for rich valuations, I might have moved to an even stronger overweight view. Within equities, I favor the US and Japan over Europe and emerging markets (EM). In the US, I am loath to discount AI as a transformative technology given the earnings power demonstrated by the “Magnificent Seven.” While I have reduced my view on Japan to moderately overweight, I think there could still be another leg to the country’s economic recovery, with recent wage hikes inspiring more consumer spending. As for surplus fixed income, the fundamental picture is better, but I would need to see more attractive valuations before moving to an overweight view.
This improved view on some surplus assets doesn’t mean I am “out” on reserve-backing fixed income. In fact, I have raised my view on investment-grade credit to moderately overweight and I still see attractive pockets of opportunity in securitized assets (across CLOs/ABS). Now that markets are in line with central bank rate-cut projections for this year, I have a neutral view on duration and wouldn’t advocate for any significant bets versus liabilities. I see relative value in being long duration in European versus US government bonds; US growth is much stronger than in Europe and the disinflation trend is clearer in Europe.
Reserve fixed income: Steady as she goes
The two main policy events of the first quarter were the Federal Reserve and European Central Bank (ECB) campaigns to adjust expectations from six rate cuts to three and the Bank of Japan’s (BOJ) decision to end its negative interest rate policy. Ten-year yields in the US and Europe rose around 30 bps, much more than in Japan, where expectations exceeded the BOJ’s measured announcement.
Now that these events have unfolded and volatility has dropped, I am happy to sit with a neutral overall duration to our benchmarks until we see a better entry point to extend. One exception is our view that European rates could rally earlier and more than US rates. The premise here is that while European growth may be improving, it is from a near-recessionary base. This is because European growth is bifurcated between the north and south, with the latter being more service-oriented than Germany, the largest European economy. Long the powerhouse of Europe, Germany is now the laggard as it deals with structural challenges from weak manufacturing, high wages, and competition from China. In addition, now that energy prices have come down, inflation is on a clearer downward trajectory. I think the bar for the ECB to cut rates is lower than for the Fed, with US inflation being stickier.
I changed my view on Japanese government bonds from underweight to neutral. The BOJ not only ended negative interest rates, but also its yield curve control and ETF and REIT purchase programs. While these changes were dramatic in direction, the ultimate impact seems mild at this juncture given the leeway the BOJ gave itself to manage the shift to prevent rates from spiking higher. As a result, yields actually fell after the news.
In a world of easing credit conditions, expected policy rate cuts, lower inflation pressure, and solid growth, I raised my view on investment-grade credit to moderately overweight. With yields lower across credit markets, companies have been coming to market to issue new debt and refinance existing debt. This supply has been met by a supportive demand backdrop, as investors seek to lock in yields ahead of rate cuts.
Within the securitized asset universe, I acknowledge that valuations are making the subsectors slightly less compelling, but overall I still see opportunities within CLOs (AA rated, in particular), non-agency RMBS, and commercial ABS. Finally, while municipal bond fundamentals are generally strong, absolute valuations remain tight, with tax-exempt municipal bonds inside of 10 years particularly rich.
Surplus fixed income: Is the juice finally worth the squeeze?
There are signs we are at or near a peak in default rates in high-yield markets, which has historically been associated with flat or tightening spread levels. I am keeping a close eye on distress ratios, which are typically a lead on default rates and have been coming down in recent months (Figure 1). Given that spreads are already tight versus history, I don’t think there is much room for further tightening and instead anticipate spreads will remain range-bound this year. In this environment, I expect income to be the primary return driver for credit investors, which makes me more constructive on high-yield fixed income compared with where we have been in the last few quarters.
Figure 1
That said, we continue to believe there are risks for credit in 2024, with the market priced for a benign environment. The recent decrease in yields is beneficial for companies looking to refinance, but current yields are higher than the weighted coupons, so some businesses may still struggle with refinancing.
From a regional perspective, I have a slight preference for European high yield over US high yield. On valuation, Europe is where there is still a bit of premium left and the potential for some tightening in spreads. I am also turning more constructive on the European macro outlook, which, as noted earlier, may give central banks the latitude to cut interest rates sooner than the Fed.
Equities: Things are looking up
I have increased my view on global equities from neutral to moderately overweight. Economic growth is firming up, with the US leading the way but global laggards also improving. New orders suggest global manufacturing activity is picking up to join already healthy services activity. With global equity valuations relatively high, I would expect earnings expansion and upward revisions of EPS growth to be the main drivers of performance. I would turn more bullish on further evidence the economic expansion and the equity rally are broadening out.
I have reduced my long-standing overweight view on Japan to a moderately overweight view. I am still positive on the path of structural reforms, which give further runway for a re-rating. Moreover, strong wage hikes driven by union agreements are likely to boost inflation further, especially on the services side. This is a positive for domestic consumption, which has lagged the recovery. It is noteworthy that company profits have been resilient in the face of rising wages so far. However, my outlook on both inflation and short-term rates is above consensus following the recent policy move away from negative interest rates and a cap on Japanese government bond yields. As a result, a stronger Japanese yen is a risk, as EPS is very sensitive to moves in the currency given the export orientation of the market.
I have turned more positive on the US, where both earnings and the economy show resilience and the AI theme seems likely to continue boosting the market’s relative prospects. While valuations of the Magnificent Seven stocks remain higher than the broad market, the companies have delivered on earnings, so their valuations have actually come down in recent months despite strong price gains (Figure 2). Recent dispersion within the Magnificent Seven (with Tesla and Apple underperforming for idiosyncratic reasons) has also left more opportunities for active managers, though I would still like to see increased breadth across the US market. Meanwhile, in an environment of resilient growth, equities have delinked from rate expectations: The market is now expecting only three rate cuts in 2024, down from nearly seven, but equities have shrugged it off. I think this dynamic can continue.
Figure 2
I have moved my view on European equities from underweight to neutral. There are signs that economic momentum has bottomed out and the disinflation trend is more reliable than in the US, giving the ECB more of a clear path to cut rates. Earnings have been more lackluster, with earnings revisions the worst among the major regions I monitor. A turn in earnings momentum and/or breadth would give me more confidence to turn positive on this inexpensive market.
I have moderately underweight views on China and EM ex-China. China’s headwinds are more structural, with factors such as internal deleveraging and geopolitical uncertainty limiting the potential for the market to outperform over a 12-month horizon. The policy response remains tepid or reactive as the government is unwilling to deploy the full policy toolbox to stem deflation, all of which has left private-sector confidence suppressed.
EM ex-China is a more positive story, with robust macro momentum in India and other parts of Asia and structural reform in South Korea. The AI ramp-up’s impact on semiconductor demand should be positive for the region. I need stronger conviction on the global cyclical expansion and a meaningful decline in the US dollar before I can move away from an underweight view here, which is more tactical than that on China.
At the sector level, I have an overweight view on energy, financials, and consumer discretionary, and an underweight view on health care, industrials, and materials. Consumer discretionary is my largest overweight view, with interest rates and macro fundamentals now supportive (e.g., real disposable incomes are rising) and valuations providing a tailwind. The materials sector is our largest underweight view, with sentiment, trend, and valuations all serving as headwinds.
Commodities: Has gold lost its shine?
Based on my outlook for gold and oil, I have moved from an overweight view on commodities to a neutral view. Gold has been a strong performer in recent months, but I see limited potential for further price appreciation. Central banks and other investors have been building gold allocations this year after weak sentiment in 2023, and more recent gains have been driven by an expectation of lower real yields later in 2024. With heightened geopolitical risks priced in, I think a lot of the positive case has already played out.
One of the main drivers of my positive view on oil in recent quarters has been an expectation of constrained supply from OPEC. While this expectation hasn’t changed, growth in non-OPEC supply from the US and Latin America is weighing on my outlook. I believe geopolitical risk in the Middle East limits the downside risk to oil prices somewhat, but overall I am less constructive than I have been.
Commercial real estate: Pockets of concern, but not yet a systemic issue
To borrow an expression from sports, we are still in the “early innings” of the commercial real estate (CRE) story, but so far the large US insurers appear to have been relatively insulated from major negative credit events.
While data from Fitch Ratings suggests the US life insurance industry has material exposure to CRE and the losses that are forecast in CRE for the coming years are not insignificant (office property in particular), I think insurer credit ratings are unlikely to be impacted given their portfolio skew toward the higher-quality parts of the CRE market (e.g., 90% of total exposure is in the top two risk weightings per the NAIC’s risk-based capital calculations1). There is still more potential bad news to come, given the higher capitalization rates and lower occupancy that office properties have experienced post-pandemic, but insurers seem prepared to weather the storm and have been increasing their mortgage loss reserves accordingly (Figure 3).
Figure 3
I should note that exposure to CRE is largely a US phenomenon. The 17 largest US life insurers have an average of 16% of invested assets in commercial mortgage loans, while their European counterparts have only 4%.1
Secondary markets: Rapid growth and a potentially useful tool for insurers
As illiquid assets continue to grow as a share of insurers’ invested assets, so does the need for a tool to adjust exposure, increase diversification, and source liquidity in the event of an idiosyncratic cash need. With its rapid growth, the private secondary market appears poised to continue to help fill this need.
According to Jefferies, secondary market deal volume climbed to $112 billion in 2023, led by a $4 billion increase in limited partner (LP) trading.2 This was the second-largest volume since 2017, trailing only the $132 billion total in 2021. The dominant theme for these LP sales was the need for liquidity, and I think that trend will continue.
From an asset class perspective, leveraged buyout private equity continues to make up the lion’s share of transaction activity (72% of volume), but pricing climbed 400 bps in 2023 (Figure 4). Real estate and venture pricing levels remained flat in 2023, reflecting more challenging environments for investors.
Given the growth in the secondary market and the increase in the number of buyers and sellers, it seems reasonable to expect 2024 to be another banner year in terms of transaction volume. I think insurers should consider using the secondary market to increase diversification across vintage years and fund strategies; invest in hard-to-access fund managers; source liquidity where current assets may be overweight versus strategic targets; or increase exposure at a faster clip (compared with relying solely on new vintage funds).
Figure 4
CLO equity: Residual tranche risk capital charges in the spotlight
The NAIC continues to focus on assessing a new risk charge for residual tranche exposures held by US insurers. The year-end 2023 charge was 30% for life insurers (consistent with common stock) and is expected to increase to 45% by year-end 2024. This development has not been embraced by the industry at large, and the American Academy of Actuaries is exploring other options through a three-pronged project on behalf of the NAIC that will include:
- Assessing shared attributes of residual tranche exposure to understand whether a small number of variables drive the majority of tail risk, and then creating a risk charge based on those variables
- Re-underwriting credit-rating-provider methodologies to ensure the NAIC is comfortable with how credit ratings are utilized (currently they feed directly into filing-exempt asset risk charges)
- Undertaking a review of research conducted by Oliver Wyman that calculated residual tranche risk charges based on a 30-deal sample size across different asset-type cohorts; this analysis found that the residual tranches performed better than common stock in each scenario, and therefore likely deserve a lower charge (Figure 5)
I discuss these developments in greater detail in my latest Insurance Quick Take, but insurers in all lines of business should continue to monitor this closely, as the relative attractiveness of the asset class could change materially.
Figure 5
Risks
Downside risks include a scenario in which core inflation reaccelerates or spikes, leading central banks to push back against aggressive rate-cut expectations or even to resume hiking. Another possibility is that the lagged impact of tighter monetary policy causes financial accidents in commercial real estate or other more vulnerable areas or leads to a recession. We could also see the Middle East conflict broaden, pushing up oil prices and increasing macro uncertainty. Finally, there is the potential for US political turmoil precipitated by the lead-up to a fraught election period.
Upside risks include an even more benign environment (versus my base case) in which the loosening in financial conditions lifts growth above trend and disinflation resumes. Other upside possibilities include a scenario in which equity market gains become more broad-based and therefore more durable and a resolution to the conflicts in the Middle East and/or Ukraine.
Investment implications
Don’t get aggressive with duration, but consider overweighting investment-grade credit — Developed market rates are fairly priced in my view. However, I see potential opportunity in some divergence between the ECB and the Fed, with the ECB likely to cut rates sooner. Credit spreads could stay tight for a while given the positive fundamental backdrop, lower anticipated defaults, and strong institutional demand. This may be a time to clip the coupon and enjoy the income.
Don’t forget about equities, which aren’t just a Magnificent Seven story — The improving global economic environment should support valuations and continued earnings expansion, despite more measured rate-cut expectations. I see signs of the rally broadening beyond the Magnificent Seven, which could benefit some market segments that have lagged, such as value and small cap. Regionally, I favor the US and Japan but have also lifted my view on Europe. Among sectors, I favor energy, financials, and consumer discretionary.
Benign expectations could be disrupted — While I favor a risk-on tilt, I am concerned about volatility later in the year stemming from the stark policy differences between the US presidential candidates and the market implications. Heightened geopolitical tensions could also induce higher volatility.
Monitor your alts — Keep a watchful eye on looming CRE stress, have a plan to access secondary markets to fine-tune your allocations, and follow the NAIC’s residual tranche risk charges closely.
1Source: Fitch Ratings. Based on CM1 and CM2 ratings categories as of year-end 2023. | 2Source: Jefferies Global Secondary Market Review, January 2024.
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