- Head of Multi-Asset Strategy – Insurance
United Kingdom, Institutional
Change
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Key points
- I think the Fed’s rate cut validates a risk-on tilt and a boost for surplus assets amid decent growth and decelerating inflation. That said, I opted for a moderate rather than full overweight view on global equities given that markets anticipated the Fed’s move, growth is slower, and geopolitical risks loom.
- Reserve-backing fixed income priced in the Fed’s rate cut well in advance. Thus, I have moved to a neutral view on duration. Investment-grade and high-quality high-yield bonds provide attractive income potential, with peak defaults behind us, and positive technicals, including strong demand and minimal net supply. Pockets of securitized assets still look attractive, even at the AAA tranches. I think insurers should have a plan to lock in current yields ahead of rate normalization over the next one to two years.
- I still expect the equity rally to broaden beyond the mega-cap tech names, helped by the Fed’s “commitment” to preserving growth. This should be a boost for areas of the equity market that have long been insurer favorites, including high-dividend-paying and value names.
- Gold appears positioned to continue its meteoric rise amid lower US real rates, continued central bank and retail buying, and geopolitical risk.
- Insurers should be mindful of the potential implications of the US election for private equity and position accordingly.
- Downside risks to my views include US election-related volatility, broader turmoil in the Middle East, and a spike in inflation that would dim hopes of Fed easing. Upside risks include a strong upward turn in the global cycle and a weaker dollar. Meaningful fiscal stimulus from China could also translate to upside risk for emerging markets.
My long-held view that the Fed would wait until inflation stayed down persistently before cutting rates ended up playing out in September, although the 50 basis point (bp) cut was larger than I expected. Bottom line: This left a recession looking much less likely. Fed Chair Jerome Powell assured markets that the size of the cut did not suggest concern about the US labor market but instead represented a risk-management measure to ensure the Fed does not fall behind in its full employment mandate and a “strong start” toward pushing policy rates back to neutral. Essentially, the Fed was cutting from a position of strength.
Looking ahead, I am focused on balancing the prospects for growth, inflation, policy implementation, and lofty valuations against the market volatility that tends to occur leading up to presidential elections. Over the course of the fourth quarter, I believe the market will follow the data and the US election will present only modest drawdown risk. While the presidential race was very close as of this writing, raising the specter of lawsuits and social unrest, my base case is a peaceful transfer of power and divided government, which would avoid the most extreme policies espoused by the candidates.
All in all, I am moderately pro-risk heading into the fourth quarter, largely in line with last quarter. And if my political forecast is correct, election-induced volatility could even be an opportunity to add risk. Of course, it is critical to be mindful of alternative outcomes, as well as other externalities such as the Middle East conflict, and I’m advocating for selectively adding risk, not a large push.
Asset class overview
With another 150 bps of rate cuts projected by the Fed through year-end 2025, I expect equities to outperform fixed income. Taking a lesson from history, after the Fed’s first rate cut in past easing cycles, global equities have performed well when there was no recession (left chart in Figure 1). Fixed income has performed slightly better in a recessionary environment (right chart).
Within equities, I continue to expect a broadening of performance across regions and market caps. I still see value in Japan, followed by the US — although the headwinds from valuations in the US need to be noted. After August’s mini-crisis, precipitated in part by the Bank of Japan’s (BOJ’s) interest-rate hike, yen carry trades have been flushed out and the BOJ is likely to pursue a measured pace of tightening.
I’m less positive on Europe, which has an uninspiring earnings outlook and is exposed to China, which still faces problems in the property market and other challenges. While China’s recent stimulus announcements are a positive development, it will take time to determine whether they go far enough to change the market’s longer-term trajectory. Beyond China, I’m neutral on emerging market (EM) equities, where valuations are relatively inexpensive but a clear inflection in global growth is still needed.
Figure 1
Given the rally of nearly 80 bps in 10-year US Treasuries leading up to the Fed’s rate cut, I’ve moved to a neutral view on duration and advise against taking any major tactical bets versus liabilities or benchmarks. I continue to think insurers should skew toward higher-rated parts of the high-yield market, as there has been some extreme bifurcation between the spreads of higher- and lower-quality issues, reflecting distress in CCC bonds. While Fed easing will provide some relief, it won’t change distressed situations overnight. Thus, I’m still expecting relatively modest contributions from spread tightening, with the bulk of the return potential coming from coupon income.
The commodity space remains mixed, with gold and oil looking most attractive. Gold should benefit from continued central bank demand and lower US real rates, among other factors. And there may be upside pricing pressure for oil amid fading recession risks, overstated worries about oversupply, geopolitical volatility, and the potential to earn carry.
Within alternatives, regulatory shifts stemming from the US election outcome and insurance oversight updates could have implications for the relative near-term attractiveness of private equity and the long-term attractiveness of esoteric structures that insurers have gravitated toward in recent years. It will be imperative to follow these changes closely heading into the new year.
Reserve fixed income: Don’t let the good yields pass you by
Central banks around the world are in easing mode and China’s recent cut in the reserve requirement ratio adds to the list. Of course, there are exceptions. The BOJ is normalizing rates higher and variations in growth and inflation are causing some central banks, such as the Bank of England (BOE) and European Central Bank (ECB), to move at a more measured pace. However, I think the Fed’s strong 50 bp cut signals a commitment to sustaining US growth that will support the global economy as well.
That said, my long duration view has moved to neutral and at this point there are no strong regional relative value views. As in past easing cycles, markets anticipated the first Fed rate cut, with the US 10-year yield declining almost 80 bps prior to the September FOMC meeting. From here, the 10-year yield should remain rangebound around 3.25% – 4.25%, with the front end of the yield curve likely to experience more downward pressure than the long end. In fact, the 10-year yield actually rose after the Fed’s announcement. In addition, markets have priced in substantial additional easing. This includes cumulative cuts of around 180 bps by the Fed, 135 bps by the BOE, and 170 bps by the ECB over the next 12 months — all of which are more than the central banks’ own projections. And, as we have seen over the last few years, the Fed is not beholden to market expectations when it comes to the timing or pacing of interest-rate decisions.
The focus from here will be on real growth. Higher jobless claims could signal a weaker employment and growth picture. On the other hand, lower inflation and looser financial conditions amid buoyant markets are helping sentiment, leading to tentative signs of improved activity. Ultimately, the Fed will need to guide policy to the unobservable neutral rate — the rate that neither restricts nor accelerates growth — and estimates there are in a wide range. The Fed’s long-term terminal rate gives us a clue. It is at 2.9%, around 200 bps from the current policy rate. That is quite a bit higher than what was considered neutral in the past and might be lower if the cycle weakens more than expected or even higher if inflation turns out to be structurally higher amid deglobalization, a shrinking labor force, increased government spending, and mounting costs related to the energy transition.
Overall, it’s a strikingly similar story to previous quarters, only this time the Fed has actually moved. While global central banks continue to ease, inflation moderates, and growth is on a good trajectory, the macro backdrop remains favorable for credit overall. Company balance sheets have stabilized and remain healthy, supported by a positive earnings season. We are past the peak in high-yield credit default rates, and more accommodative capital markets have made it easier for companies to refinance and term out liabilities, decreasing the impact of the maturity wall. This supply has been well absorbed by strong demand, as institutional investors lock in an attractive all-in yield.
Spreads will likely remain rangebound in this environment. As a result, income should primarily drive returns over the next year, with limited opportunity for spread tightening. This aligns with the philosophy and process of our insurance-focused portfolio managers, who believe income is the most reliable driver of total return over the long term.
From a sector perspective, I still see value in collateralized loan obligations (CLOs) and non-agency residential mortgage-backed securities (RMBS), though they are slightly less compelling based on current valuations. The much-maligned commercial mortgage-backed securities (CMBS) picture has improved on the margin, as I’m seeing slightly better fundamentals and supportive technicals (this will be worth following closely in a world where lower rates make the underlying business models more profitable). Taxable municipals’ spread levels remain tight on an absolute basis, but I think their relative value versus corporate credit is fair. Couple that with strong fundamentals and taxable municipals look attractive, in my view — if investors are able to source supply. Finally, in the tax-exempt space, valuations are still poor for the majority of the curve.
I once again encourage insurers to consider “locking in” current yields (see Figure 2) within their reserve-backing portfolios, to create the potential for a large gap versus normalized rates in the future. I think this is also a prime time to consider a structural allocation to investment-grade private placements, as it can take a bit of time to ramp up exposure, which will come primarily through new issuance.
Figure 2
Surplus fixed income: Skew toward quality
For insurers who seek income and are less total-return leaning, high yield may continue to offer attractive carry and remain well supported by the healthy macro and fundamental backdrop. Just be aware of limited lift from spread tightening.
While the overall backdrop for credit is solid, there are still some risks. For example, the recent decrease in yields is beneficial for some companies looking to refinance, but low-quality companies need to see additional interest-rate cuts to avoid costly refinancing rates. This means some distress remains in the riskiest part of the high-yield market, but I expect it will dissipate as rate cuts materialize, which could provide spread tightening potential in a positive macro environment.
Regionally, I am neutral, closing my preference for European high yield over EM high yield. I see a smaller return differential between the markets, with elevated risks around French fiscal policy and a potential tailwind for EM assets from forthcoming Fed cuts.
Equities: You may want to be ready to buy when the market panics
I have a moderately overweight view on equities, unchanged from last quarter. I think insurers should look past near-term volatility and focus on longer-term return potential, while also considering opportunities to add when the market overreacts to headlines. I remain confident in the fundamental resilience of companies and the global economy. With the low risk of an economic hard landing and inflation largely in control, developed market companies appear well positioned to achieve robust earnings growth. Following the recent rate cuts by the Fed and the People’s Bank of China, most central banks should loosen monetary policy over the next 12 months.
All of these factors should support equity valuations, though there are potential headwinds to consider. In particular, while I think markets can deliver on earnings expectations, negative earnings surprises from the Magnificent Seven are a top risk to equity markets in the near term. That said, I continue to expect an improvement in earnings growth outside of the large-cap tech sector, which will be reflected in price action. I’ve seen early signs of broadening at a stock and sector level, as shown in Figure 3. This would be welcome news for insurers who have a tendency to invest in the higher-dividend-paying, value-oriented portions of the equity market (due in part to accounting and volatility considerations).
Figure 3
The potential for volatility driven by the US election over the next few months keeps me from moving to a stronger overweight view on global equities. With the election still looking like a coin-flip, I’d prefer to allow some room to lean further into equities at more favorable entry points. As cash rates become less attractive, I’d consider looking for market dips to buy.
Overall, I’m neutral on US equities, mostly out of prudence as the market made new highs following the Fed’s September rate cut and appears expensive based on traditional valuation metrics. However, when adjusted for declining interest rates and long-term earnings growth potential, the US index appears closer to fair value. Earnings are supported by an expansion in margins, with the growth in productivity well outpacing that in unit labor costs and pointing to improving competitiveness.
With valuations of Japanese equities looking more favorable following the August volatility, I’ve moved to a moderately overweight view on them after a hiatus earlier in the year. Much of the volatility was driven by technical dynamics linked to positioning and the carry trade, rather than fundamental weakness. The structural case for Japanese equities, including an improving macro backdrop, corporate reforms, and increased cash return through buybacks, also remains largely intact. There is room for further re-rating here, with expected returns evenly balanced between valuation expansion and earnings growth components.
In China, recent stimulus is a step in the right direction for liquidity and sentiment. However, I need to see more policy detail to determine whether this marks a long-lasting turning point in sentiment and valuations or just short-lived market exuberance. In the meantime, weak private sector confidence, worsening property market dynamics, and intensifying deflationary risks make me cautious about the outlook.
I have also turned more negative on European equities relative to other markets. The outlook for earnings is lackluster — with the exception of more domestically oriented sectors such as banks and utilities, the region’s equities remain quite dependent on an inflection in the global cycle.
Within sectors, I’m most positive on financials, followed by consumer discretionary, utilities, and IT. I have an underweight view on materials, staples, and communication services. These relative sector preferences add up to a balanced cyclical view, and my long-IT versus short-communication-services view neutralizes an outright Magnificent Seven bet.
My bottom line: Insurers may want to be ready to jump on sell-offs and look for parts of the equity market with room to run as the market leadership broadens.
Commodities: Focused on gold and oil in a volatile world
I still have a moderately overweight view on commodities, driven by positive views on gold and oil — both of which may be effective diversifiers amid elevated geopolitical risk.
I believe gold prices can continue to be supported in 2025 as central banks cut policy rates, which is typically associated with more demand for gold. Central bank buying of gold remains strong, and we are now seeing increased retail demand in China and India, spurred by tax incentives. Some insurance regulatory regimes are even considering reducing capital charges for purchases of gold, increasing the potential demand globally.
Recent price declines and a positive roll yield, which reflects the lower cost of longer-dated futures, warrant a constructive stance on oil. However, this optimism is tempered somewhat by the possibility that additional supply could come into the market and weigh on prices.
Alternative(s) views
Election results could matter more for private equity
As I mentioned, the US election will likely drive short-term volatility but could have a largely benign long-term impact on asset prices (e.g., in the case of divided government). However, I do see some potential implications for the relative attractiveness of private equity.
Private equity has been a focus of the Biden administration. Deal making has come under scrutiny from the FTC, including private equity involvement in health care services. This has been one factor in the reduced deal flow in recent years, along with elevated interest rates and the macro backdrop. Meanwhile, the SEC has taken steps to increase access to information about private equity fees and performance. And the DOL has sought to limit private equity exposure for retirement assets. Some of these changes are being challenged in court but could move forward or even be strengthened depending on the election results.
Private equity is also an increasingly large part of the sustainability story. It has proved fertile ground for investments in clean energy, transition technology, and resilience and adaptation disruption. I would expect policies under a Harris administration to keep things moving in that direction. On the other hand, a Trump administration would likely deprioritize future investment in those areas, potentially undermining new business ventures.
All that said, I don’t expect a material reversal in private equity growth. It is a nimble market that should be able to adapt to regulatory twists and turns and continue to grow meaningfully in coming years. Preqin estimates a nearly 13% annual growth rate in global private equity from 2023 to 2029 (Figure 4).
Figure 4
Substance over form: In the weeds of PBBD
US insurers have been hyper focused on ensuring that their fixed income assets meet the definition set by the National Association of Insurance Commissioners in its Principles-Based Bond Definition (PBBD) project, and the NAIC continues to provide additional detail as the implementation date (1 January 2025) nears. I believe the vast majority of insurers’ fixed income holdings will meet the definition and continue to be filed on their Schedule D (bond) financial statements. The intent of the initiative, per the NAIC, was to properly identify assets that were misrepresented as bonds due to “increased innovation in investment portfolios” (i.e., esoteric structures that have a bond wrapper but underlying exposure to equities, alternatives, or derivatives).
One area insurers, and especially life insurers, have been allocating to considerably in recent years is principal-protected notes and structured notes. The NAIC has provided guidance that neither can be filed as bonds, noting that:
- Principal-protected notes fail the PBBD because the underlying interest varies depending on the performance of non-bond variables and typically does not include credit enhancement. These notes should be listed on Schedule BA, according to the NAIC.
- Structured notes fail the PBBD because the contractual amount to be paid at maturity is at risk for reasons other than the failure of the borrower to pay the principal amount due. These notes should be considered a derivative and captured in SSAP 86 – derivatives, according to the NAIC.
It is important to note that even if a bond moves to Schedule BA from Schedule D, it doesn’t automatically mean a significantly higher capital charge, as the Schedule BA reporting will bifurcate those with SVO ratings from those without. At Wellington, we are performing extensive reviews across asset types to make sure we can provide information before year’s end about how we think securities should be treated by our insurance clients.
Finally, while the PBBD is a US issue, our non-US insurance clients under IFRS 9 have had to undergo a similar exercise around the Solely Payment of Principal and Interest test (SPPI test) that requires insurers to determine whether bond-like assets are truly performing as bonds and not as other asset types. I’d encourage multinational insurers with a foot in each region to look for synergies across existing processes, as the insurance world is collectively moving to the same place under the two changes.
Risks to my views
Downside risks to my views include a reacceleration in core inflation, leading central banks to push back against the current implied path for interest rates, and downside surprises in the earnings of mega-cap stocks. I am also monitoring the Middle East conflict — if it continues to escalate, it risks pushing up oil prices, leading to supply chain frictions and increasing macro uncertainty.
Upside risks to my views include an upward inflection in the global growth cycle together with a weaker US dollar. This scenario would lead to a catchup for global laggards and stronger gains for surplus assets (within emerging markets in particular). Another upside risk would be a scenario in which central banks cut rates faster than currently priced in if inflation declines more than expected. A final upside risk worth mentioning is a stronger-than-expected third-quarter earnings season, with expanding margins demonstrating productivity improvements.
Investment implications
Avoid recency bias and consider locking in current yields now — Despite tight spreads, I continue to like credit for the carry, strong supply/demand technicals, and declining default rates. Pockets of securitized assets continue to have the best relative value, in my view, and investment-grade private placements should be considered for structural long-term allocations, regardless of the insurer’s line of business. Don’t forget that yields were at historic lows only a few years ago.
Consider sticking with global equity exposure — With the Fed having launched the easing cycle with a strong start, I am more confident in a soft landing characterized by moderating growth and lower inflation. I think allocators should consider a risk-on tilt despite expensive valuations and political noise as I expect positive fundamentals and monetary policy to support earnings.
Expect further broadening in the equity rally — I see upside potential in Japanese equities given that improved corporate governance should benefit earnings and that strong earnings expectations are already priced into the US market. US equities should see improved earnings prospects for areas outside of the US mega-cap tech stocks, which could benefit value, small cap, and some cyclicals. Among sectors, I favor financials, IT, utilities, and consumer discretionary over materials, staples, and communications.
Consider a small allocation to commodities — I see upside to gold and oil prices over the coming year. Oil could benefit from receding recession fears and low inventories. Geopolitics, retail demand in China and India, central bank buying, and lower real rates could support further appreciation in gold.
Examine the impact of politics and regulation on your alts — Both private equity and esoteric security structures may experience changes in relative attractiveness for insurers in the new year, depending on the election outcome. Follow political proposals closely to understand how each party’s priorities could impact private equity and monitor evolving insurance regulations as they pertain to alternative asset structures, liquidity risk, and capital charges.
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