- Head of Multi-Asset Strategy – Insurance
United Kingdom, Professional
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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Key Points
- From an economic and market perspective, the conflict in Ukraine may warrant some sectoral shifts toward defensive assets; however, we continue to prefer an overweight to equities relative to bonds due to higher inflation, a strong labor market, improving consumer spending, and more accommodative policy.
- Within equities, we prefer the US and Japan relative to European and emerging markets (EM). Europe is likely to suffer the brunt of war-induced energy price hikes. We also favor developed markets over EM given China’s recent sluggish growth.
- We are most bullish on commodities, with inflation likely to be “stickier” than the market expects. We favor energy and think a gold allocation is worth considering in light of geopolitical concerns and the risk of a deteriorating growth/inflation trade-off.
- Within fixed income, we remain moderately bearish on government bond yields and credit spreads amid the continued strong inflation headwind.
- Downside risks include a surge in inflation that forces faster-than-expected central bank tightening and an escalation in the Russia/Ukraine conflict. Upside risks include a “Goldilocks” scenario (just the right amount of monetary tightening) that extends the current cycle and positive policy surprises out of China.
In our 2022 Insurance Outlook, we highlighted persistent inflation and rising interest rates as critical factors for insurers investing in the new year. It’s safe to say these themes are now front and center in a major way. Market complications are piling up early in 2022 and weighing on equity and bond returns. The year began with higher-than-expected inflation (the US CPI hit 7.9% in February) and the US Federal Reserve’s (Fed’s) firm response to it (signaling a first rate hike in March, which the Fed delivered). Then it took another sharp turn with Russia’s invasion of Ukraine — creating a massive and distressing humanitarian crisis, while adding another layer of market complexity given Russia’s role as a global supplier of commodities (notably oil).
So where to from here? To state the obvious, we have no idea how the war in Ukraine will unfold and can only assess the likelihood of various scenarios. We think markets will continue to grapple with the trade-offs between inflation and growth and likely central bank responses. We remain convinced that inflation will prove higher and “stickier” than widely expected. The war in Ukraine and sanctions on Russia only bolster this view, given the likelihood of additional supply-chain disruptions and shortages in agricultural, metal, and energy commodities. Higher energy prices could also weigh on global economic growth.
Given our current inflation outlook, we are most bullish on commodities at this time, including gold. We continue to favor a moderate overweight to global equities despite the somewhat worse fundamental backdrop. Why? As of this writing, we believe consumer spending should remain resilient given the accumulation of savings and higher nominal wages, while many companies should continue to benefit from relatively strong economic growth, especially with COVID restrictions being eased or lifted across much of the globe. In addition, bearish investor sentiment is at an extreme. Finally, with geopolitical risk running high, global central banks are apt to be cautious in removing liquidity and fiscal spending likely to increase in some countries, which would benefit risk assets. The market has largely “backed off” from its earlier expectation of six Fed rate hikes this year; we suspect that even the reduced rate-hike expectations may still be too high (Figure 1).
Figure 1
In fixed income, we continue to see potential downside for total returns in the coming months. Looking at developed market government bonds, we think Japan’s central bank is the least likely to hike interest rates. We have turned marginally more negative on credit risk of late. With spreads being wider, credit returns could be vulnerable to higher government bond yields should investors choose to shed duration. Within credit markets, we continue to prefer floating-rate structures (like bank loans) but favor an underweight to credit overall.
Higher rates a challenge for governments and spreads
It’s been a tough year so far for fixed income, with yields generally rising (the US 10-year Treasury hit 2% at one point in response to the 7.5% January CPI print) and credit spreads widening. Amid stiff headwinds from inflation and Fed policy, on a relative basis across all assets, we currently have an underweight view on both reserve backing and surplus fixed income (see “Our multi-asset views” table). However, most insurers and other liability-driven investors don’t have the luxury (or desire) to make a large rotation out of fixed income, so finding and acting on pockets of opportunity will be critical in the months to come.
To that end, there has been some improvement in fixed income valuations. Year to date, credit spreads have widened by 30 to 200 basis points (bps), depending on the market sector. Valuations are near their historical median for investment-grade corporates and wider than average for emerging markets debt (EMD), while still on the rich side for high-yield bonds (as measured from the inception of each index). But even with arguably more attractive valuations and lower default risk, we don’t see much of a case for longer-duration credit, given the threat of duration “shedding” in government bonds and credit at a time of rising rates. Figure 2 shows that the correlations of US Treasury yields with high-yield spreads have turned positive recently, an atypical relationship that augurs poorly for spreads should rates rise. By not extending duration, an insurer can consider reinvesting cash flows into a growing rate curve.
Figure 2
Global equities: Favoring Japan and the US
We think Japanese equities look attractive, with stronger monetary and fiscal policy tailwinds than any other market and relatively cheap valuations. What’s more, the Japanese yen could prove to be a safe-haven “hedge” currency in a risk-off environment. In addition, Japan has long been stuck in a deflationary spiral and should therefore benefit to some degree from higher global inflation.
As you may recall, we made similar arguments for European equities last quarter. However, European inflation has now reached higher (and less helpful) levels, its equities are expensive across a variety of metrics, and the region stands to suffer acutely from the Russian invasion of Ukraine. That’s because Europe is heavily reliant on Russian energy (gas and oil), with European energy prices having already skyrocketed even prior to the invasion (Figure 3).
Figure 3
US equities look moderately attractive to us, given a still robust US economic cycle and its relative safety from global concerns like weak growth in China and the Russia/Ukraine conflict. US corporate fundamentals are quite strong overall, while a ratcheting back of Fed policy tightening expectations should help ease pressure on rate-sensitive growth sectors. Some EM equities outside of China may be worth exploring, as China’s economic growth shows few signs of improvement, while Russia now reminds many investors of the perils of autocratic government decision making. Within EM equities, we generally favor commodity exporters (such as Brazil) that stand to benefit from higher commodity prices.
Inflation: Likely higher for longer
Our bullish view on commodities is supported by structural supply shortages across many commodities, which our firm’s commodity specialists expect to persist for several quarters, if not years. Global demand for commodities should remain strong and bottleneck pressures acute. The war in Ukraine is another, more cyclical reason to consider investing in commodities, as Russia (oil, gas, and metals) and Ukraine (wheat) are both large commodity exporters. We also continue to see gold as a potentially attractive inflation hedge, given today’s heightened geopolitical concerns and the very real risk that inflation expectations could “de-anchor.”
In terms of portfolio implementation of these ideas, asset allocators may want to consider adding commodities exposure through futures contracts, energy companies, and/or miners. We believe the focus should be on companies that have clear long-term environmental, social, and governance (ESG) plans and have begun to reduce their carbon footprints and to transition their businesses more toward renewable energy. Multi-asset investment strategies that target an array of inflation-sensitive assets and are designed to manage inflation’s aggregate volatility may also make sense moving ahead.
As we have discussed before, insurance balance-sheet volatility related to commodities investments can be difficult for many insurers to stomach, in which case other areas of the invested asset market with the potential for positive beta to inflation and/or to rising interest rates may be more suitable. These include assets like convertible bonds, collateralized loan obligations (CLOs), floating-rate bank loans, and real estate investment trusts (REITs). REITs, in particular, can offer a liquid complement to the increasingly large amounts of private real estate exposure the insurance industry has acquired in recent years. In fact, public real estate has witnessed a shift in correlations from the public equity markets to being more correlated with the private real estate space (Figure 4).
Figure 4
Risks to our outlook
We are reasonably optimistic that world central banks can approximate a “soft landing” for the global economy, even if the growth/inflation trade-off worsens somewhat. Despite some reductions in our market expectations, we think global markets generally remain priced for substantial policy tightening and that most central banks are unlikely to surprise on the hawkish side. However, if inflation proves “stickier” or goes higher than we expect — perhaps because supply-chain bottlenecks don’t ease as anticipated — then central banks may be forced to tighten more aggressively, potentially causing risk assets to falter.
One potential driver of more persistent inflation is the risk of a drawn-out conflict in Ukraine that inflicts greater-than-expected disruptions on the energy, metals, and wheat markets. If Russian President Vladmir Putin’s ultimate goal is to occupy all of Ukraine, then we fear the conflict will become a bloody stalemate of urban warfare with even greater economic costs in the form of reduced business and consumer confidence, higher and more stubborn inflation, and perhaps lower growth for the rest of the world.
On the upside, if Russia chooses to retreat or to only occupy parts of eastern and southern Ukraine, then risk assets may rally strongly. Any news that suggests the potential to avoid interruptions in trade with Russia would also help markets, as would any increases in European fiscal support. Turning to China, the country’s opaque system is difficult at best to analyze, but an upside policy surprise is not out of the question and worth watching for. Finally, in terms of the COVID pandemic, we appear to be on the cusp of a more “normal” summer season in the northern hemisphere and a broad recovery in the services sector, although the risk of yet another COVID variant cannot be ruled out.
Investment implications
Prepare for rising rates — We continue to favor shortening duration in fixed income, given our expectation for higher longer-term yields and wider credit spreads. Where appropriate, investors might consider pursuing fixed income opportunities that can increase return potential without adding undue duration risk (e.g., convertibles, bank loans, CLOs).
Stay the course with equities — Given ongoing geopolitical uncertainty, we expect to see risk premiums in the global equity and credit markets, particularly in Europe and EMs. However, given the asset repricing we’ve already seen, the likelihood of less hawkish developed market central banks, and extremely bearish investor sentiment, we expect global equities to outperform bonds over a 12-month horizon. Again, we generally prefer Japanese and US equities.
Inflation risks: Higher for longer — Shortages of some commodities and supply-chain disruptions stemming from the Russia/Ukraine situation could drive commodity prices even higher. Allocators may thus want to consider adding greater exposure to commodities, the asset class that has historically been the most sensitive to higher inflation. We think Treasury Inflation-Protected Securities (TIPS) are likely to outperform US Treasuries in the period ahead. Higher yields and inflation should support value stocks, but on the other hand, weaker economic growth would favor growth stocks. Tapping into the inflation protection that may be available in some areas of the REITs market could be an attractive strategy as a liquid complement to an insurer’s private real estate portfolio.
Consider defensive assets — US equities, unhedged Japanese equities, and gold are likely to hold up relatively well should global growth weaken amid geopolitical uncertainty. In addition, high-quality government bonds may regain some of their portfolio diversification role during bouts of turmoil. Within equities, we think the focus should be on quality: Domestically oriented firms, service companies, and profitable businesses with growth potential may be more insulated from geopolitics. Greater military spending by Europe is likely and may warrant a closer look at defense stocks (though ESG considerations could limit such allocations).
Active management may play a role — In an environment of increased market volatility, higher dispersion of returns, and likely worse liquidity, active investment managers have the opportunity to distinguish between “winners” and “losers” and can seek to take advantage of price dislocations that may not be justified by underlying fundamentals at both the country and individual company levels.
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