- Head of Multi-Asset Strategy – Insurance
United Kingdom, Professional
Change
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
- I expect tighter credit conditions resulting from the banking industry turmoil and restrictive central bank policy to slow the global economy. Equity valuations have actually increased against this deteriorating fundamental backdrop, so I continue to believe corporate earnings and multiples are vulnerable and favor reserve-backing fixed income over surplus or risk assets.
- I believe adding to duration in this environment may be prudent and have an underweight view on surplus fixed income. I expect duration to perform well given that a US recession now seems more likely and could happen sooner than previously expected. I remain somewhat bearish on European and Japanese duration. Spread valuations are slightly better but still don’t adequately reflect a worse fundamental outlook. I still favor some securitized assets.
- Higher market stress tends to drive up correlations across surplus assets. Still, I think fundamentals are differentiated in China and Japan, both of which I favor over the US and Europe. I have relatively high confidence that China’s reopening should support a bullish stance on its equity market. Japan should benefit from China’s zero-COVID exit and from having easier policy than other developed markets.
- My commodities view remains positive, but I am now focused on gold.
I expect markets to shift from an inflationary to a “safe-haven” mindset, which I think should improve gold’s upside potential in a highly uncertain environment — recognizing, however, that a pure gold trade may be difficult for most insurers to execute. - I continue to see opportunities in alternatives but would be selective at this point in the cycle. I suggest putting a premium on manager skill and ability to source deals, while seeking diversification benefits from uncorrelated return streams and dampened volatility due to private-asset pricing.
- Downside risks to my views include a severe credit crunch and a deep recession in the US or Europe, as well as geopolitical risks involving China or Russia. Upside risks include a soft-landing scenario — where bank stresses are idiosyncratic and help to achieve the Fed’s inflation goals — and a decisive uptick in China’s fundamentals.
Themes highlighted in my 2023 insurance outlook were pulled forward during the year’s first quarter, as tighter monetary policy induced the first near-systemic fallout of this cycle. Runs on two regional US banks, as well as the forced sale of a major Swiss bank to UBS, sparked a loss of confidence in the global financial system. As of this writing, authorities had staunched the bleeding of deposits by implementing a variety of measures aimed at ensuring liquidity and protecting depositors. But with fault lines emerging as a result of higher rates, a reassessment of the investment landscape is warranted. I think the economy and markets will face their biggest test in the coming months and continue to believe that an expanded investment tool kit, a focus on downside mitigation via asset allocation, and a solutions-oriented mindset should serve insurers well for the rest of the year.
While the particulars of the bank failures may be idiosyncratic, recent events will likely lead to tighter credit conditions and reduce business and consumer activity. At the same time, the transmission effect of the US Federal Reserve’s (Fed’s) unprecedented rate hikes has yet to fully work its way through the real economy. Uncertainty will predominate as policy decisions will require judgment calls based on economic dynamics not yet entirely visible in the data. I believe a recession is now more likely and could happen sooner than I thought last quarter.
I expect volatility to remain elevated and most surplus assets to struggle. Thus, my broad asset class views remain somewhat defensive. Government bonds have rallied but I think there is further upside potential, especially in the US, given attractive yields and the likelihood that the Fed will pivot to cutting rates in the second half of 2023 amid a US recession. Credit spreads have widened but not yet to levels that reflect recessionary risks. I maintain my underweight view on surplus fixed income, especially in high-yield and bank loans, as well as a moderately underweight view on global equities, where current valuations may reflect an overly optimistic economic view. Given the risk of higher correlations across equity regions, I have adjusted my underweight view on Europe to moderately underweight and my overweight view on Japan to moderately overweight. I continue to favor Chinese and Asian equity markets that are likely to benefit from China’s reopening and lower-priced oil imports. I still have a slight overweight view on commodities but have shifted the focus from oil to gold.
The upside risk to my generally defensive view is a soft economic landing where the bank failures turn out to be isolated events, credit tightens just enough to slow demand and inflation, the Fed avoids overtightening policy, and a recession is averted. This scenario is possible but unlikely, in my view. In fact, a seemingly benign outcome like this might just sow the seeds of a more entrenched inflation problem and an even tougher challenge for global central banks.
Fixed income: Investment-grade yields are the stars of the show
I have moved to a moderate overweight view on reserve-backing fixed income because I see banking troubles as a watershed episode that will slow economic growth in the US and spill over some to the rest of the globe. The defensive nature of this asset class should benefit as a result. An examination of the preliminary gross bond yields from US statutory financials as of year-end 2022 reveals a stark contrast between what was on insurers’ books then and what’s currently available in the market (Figure 1). With short-duration Treasuries recently offering 3.81% and insurers’ aggregate bond yield around 3.00% for the property & casualty (P&C) industry, it’s no surprise that most insurers find today’s yield environment appealing.
Figure 1
The Fed burnished its inflation-fighting credentials with another 25 basis points (bps) rate hike in March, despite market uneasiness, and reiterated its commitment to bringing inflation down to its 2% target. Fed Chair Jerome Powell likened tighter credit conditions resulting from the bank failures to another 25 bps hike but admitted that the extent and duration of further credit tightening are impossible to know. One reason for the uncertainty is the backward-looking nature of most data. To help gauge the severity of the economic slowdown, I am watching higher-frequency data, including weekly lending activity, deposit flows, and measures of “animal spirits.” I think the lagged effects of tighter monetary policy, the uncertain impact of tougher credit conditions, and the additional liquidity the Fed has added to the system increase the chances that the central bank may overtighten and exacerbate the slowdown.
If I am right, correlations to US rates could be higher, with other developed market government bond yields likely to follow the direction of US yields. I think US rates are most attractive and also most likely to come down. The market has flipped from pricing in “higher for longer” Fed policy rates to pricing in about 190 bps of rate cuts (from where we are now) before year-end 2024, but the one-year forwards imply little change in 10-year US Treasury yields. European government bond yields are lower and appear vulnerable to higher inflation and the rate impact of lower levels of banking stress (owing to the region’s more consistent capital regulations across large and small banks). I am least bullish on Japanese government bonds (JGBs). Although JGB yields have fallen well below the 50 bps cap, I view risks here as being asymmetric given that the Bank of Japan (BOJ) may ultimately be pressed to loosen its yield curve control amid higher-than-expected inflation.
My credit spread views remain largely unchanged: I have an underweight view on surplus fixed income and think insurers should focus on moving up in quality as the credit cycle advances (Figure 2). Spreads, while wider than they were a quarter ago, are still not near recessionary levels. I would need to see US high-yield spreads rise from the current level of about 500 bps to a range of 625 – 725 bps before I would raise my view on the market. I also maintain a preference for USD-denominated emerging market (EM) sovereign debt given its sizable weight of around 50% in investment-grade countries. The relative value trade between high-yield and EM debt has begun to work and may have further to go. Within the securitized space, I continue to see attractive opportunities in both collateralized loan obligation (CLO) and broader asset-backed securities (ABS) markets, while continuing to monitor commercial real estate (CRE) fundamentals within US regional banks.
As always, I encourage you to anchor your investments to fundamental research and consider investing at today’s still-elevated yields. To fund these trades, you might look for opportunities to sell shorter-duration, lower-legacy book yields, or explore off-balance funding mechanisms like the Federal Home Loan Bank and/or letters of credit.
Figure 2
Equities: Valuations are high, but there are opportunities outside the US
My moderately underweight view on global equities is unchanged. So far, bank strains have largely had specific effects on bank equities and credit spreads, rather than creating more generalized contagion across surplus assets. As noted, however, I believe the probability of a recession has risen and been pulled forward, with credit tightening likely to contribute to a contraction in lending as well as in corporate and consumer spending.
Valuations of about 15 times the 12-month forward P/E ratio1 for global equities and expected earnings growth in the mid-single digits over the next 12 months are still too high to suggest that a recession is the market’s base case. Valuations also appear to be misaligned with those in the bond market: Around 190 bps of rate cuts are reflected in the fed funds rate by the end of 2024, relative to where we are now. Valuation headwinds would be exacerbated if, as I expect, central banks are forced to choose between controlling inflation and combatting financial instability in an environment where inflation continues to run too hot for their comfort.
On the corporate profitability side, profit margins will likely be challenged by a still-tight labor market and now also by a slower economy. The recent jump in accruals (the difference between net income and operating cash-flow measures) also points to the risk of corporate earnings downgrades and reduced share buybacks. Recent earnings guidance from companies has turned more cautious, as shown in the S&P 500 negative-to-positive preannouncement ratios.
Within global regions, I have the most favorable view on China equity. I would expect consumer and private-business spending to make up for the limited government policy impulse. Business sentiment is improving, and consumer surveys show higher spending intentions across most income cohorts. Overall, I believe consensus expectations for Chinese growth this year are too conservative. Meanwhile, I think China’s low correlation to other regions makes it attractive from a portfolio construction standpoint. The fact that the US dollar has not strengthened amid recent banking turmoil is also helpful for China’s and EM ex-China’s relative equity performance.
In Japan, recent data shows a catch-up in services inflation, with wage negotiations between Japanese labor and corporate management resulting in the largest negotiated wage increase in 20 years. The recent global bond rally has given the BOJ more breathing room when it comes to raising the 10-year yield cap.
In the US, I do not perceive direct risks from systemically important large-cap banks, but am focused on possible cyclical impacts if companies face tighter lending conditions. Margin normalization and historically higher valuations relative to other markets also weigh on the US. My reduced underweight view on Europe stems from recent improvements in macro conditions and the retreat in energy prices. Still, the region’s companies and economies are vulnerable to macro spillovers from tighter lending standards, which were signaled in the European Central Bank’s (ECB’s) latest survey of credit conditions. In addition, core inflation continues to surprise on the upside, putting the ECB in more of a bind with respect to the trade-off between inflation and financial stress.
Regarding equity sectors, I prefer defensive ones such as utilities and staples, as well as natural resource equities. Technology has outperformed, along with defensives, on the back of falling interest rates. However, I expect more margin normalization after companies’ overinvestment during the pandemic. Banks are likely to face headwinds from increased funding costs, reduced profitability from balance-sheet deterioration in particular areas of the economy, and potential tightening of capital requirements for regional US banks (Figure 3). That said, amid market shifts and restructuring in the banking industry, there is room for winners and losers, creating potential opportunities for active managers who can be nimble and flexible across global regions, market capitalizations, and investment styles.
Figure 3
Commodities: Taking a shine to gold
I have increased my view on gold from neutral to a modest overweight. This has less to do with inflation hedging, where gold’s recent performance has been mixed, than with gold’s potential protective characteristics amid concerns about the banking sector and recession risk. Meanwhile, positioning indicators I track suggest that the market is not presently overweight gold. Given that a direct investment play on gold could prove difficult for insurers to implement, a “quasi-play” with an asset like natural resource equities may make more sense as a way of gaining some gold exposure.
Reflecting the expectation of a more challenging global macro backdrop, I have dialed back my moderate overweight view on copper a bit and moved to a neutral view on oil. With supply and inventories still tight for both commodities, these adjustments stem from anticipation of demand destruction in the short term.
Keeping an eye on alternatives
Given a global macro picture clouded with uncertainty, much of the spotlight these days is on the portfolio diversification potential of alternative investments for insurers — and rightfully so. As such, I have continued to engage with insurance clients on which parts of the alternatives market appear to be most attractive, as well as how to best size those allocations in the context of their broader strategic asset allocation.
Coming out of 2022, a year in which public-market assets of virtually all flavors posted substantially negative returns, many insurers experienced the “denominator effect,” as their private assets’ delayed valuation markdowns left these insurers with larger-than-target portfolio allocations to such assets. This, in turn, caused many insurers to become more selective before adding a new general partner for private assets, or in some cases led insurers to shop some of those invested assets in the secondary market. I’d expect to see this trend continue for the foreseeable future, as the “lower-for-longer” interest-rate environment of recent years induced many insurers to over-allocate to illiquid assets that they may now be looking to shed (or at least not add to).
Commercial real estate
As of this writing, the CRE picture remains quite murky in the wake of the recent crisis in the banking sector. With that in mind, I am continuing to assess the potential for longer-term negative impacts on the sector that could arise from many regional US banks holding significant amounts of CRE exposure. Moreover, the multiyear “future of work” theme that began amid COVID-19 is likely to challenge the sector by continuing to pressure demand for traditional office space properties. Given these headwinds, I maintain a cautious stance on initiating new CRE allocations at this time.
Private equity
2022 saw alternative asset managers raise over US$1 trillion in assets, but due to macro uncertainty and recession fears, large stockpiles of “dry powder” still remained uninvested by the end of the year. However, history has shown that outperformance by private-equity vintages tends to occur after economic downturns, so you could look for specialized managers that have demonstrated skill over time in both deal access and research. Additionally, due in part to delayed valuation markdowns from the denominator effect (see above), private equity remains an effective accounting buffer for drawdowns versus public-equity beta. Finally, insurers should consider being active shoppers in the secondary private-equity market as well, where they may be able to add exposure to select vintages at a discount.
Hedge funds
Hedge funds are a space that most insurers have shied away from in recent years. Lagging returns versus public-market assets, fears around headline risk, and often-stiff fees have been the main reasons why. Now, however, I believe many insurers should once again consider adding an appropriate portfolio allocation to hedge funds. The hallmark traits of some flavors of hedge funds include diversified return streams vis-à-vis public assets, the ability to act tactically and opportunistically, and volatility-management potential — all of which may be valuable features in a world of market dislocations like today’s. For example, even on a risk capital-adjusted basis, insurers might benefit from investing in macro hedge funds.
Private placements
With public-market all-in yields perched at such lofty levels, I do not think now is the right time to be purely “reaching for yield.” Instead, insurers could seek private credit managers who can access bespoke deals that are offering incremental spread versus syndicated deals. Private placement spreads tend to follow their public-market counterparts, albeit with a lag. This has been most pronounced in credit market sectors where large spread changes are occurring because private placement assets typically maintain wider spreads for longer, even as public spreads are tightening. Of course, the inverse is also true in that it takes longer for private spreads to “catch up” when they’re widening from tighter levels. In my view, managers who can originate their own deals are usually better positioned to capture strong relative value versus publics, regardless of the rate environment. Many insurers have made structural allocations to this asset class as part of their reserve-backing investments and have thus moved beyond mere tactical investing (Figure 4).
Figure 4
Risks
As noted, banking stresses could help central banks achieve their desired soft landing, but I assign a low probability to this upside risk. If a recession is avoided, the recent surge in central bank liquidity (e.g., via banks’ use of US lending facilities) could find its way into asset valuations.
A faster-than-expected pickup in Chinese economic activity, especially if it has broader spillover effects, remains a potential source of upside risk for the global economy.
In terms of downside risks, tight financial conditions and fragile sentiment could lead to further turmoil in the financial sector or other vulnerable areas, such as commercial real estate. A full-blown default cycle like that experienced during the global financial crisis is another risk and is not currently priced into credit markets. While market participants have been attuned to the risk of further escalation in the Russia/Ukraine conflict, more dramatic developments could ensue, including a higher risk of nuclear deployment. In addition, relations between the US and China remain on a downward trajectory and could get even worse over Taiwan or other issues.
Investment implications
Amid a weakening global economy, focus on quality — Developed economies’ resilience will be tested as restrictive monetary policy and credit tightening work their way through the system. I think the focus should remain on quality in developed market equities, as valuations have become richer and earnings expectations seem optimistic given my recessionary base case. I favor quality companies that can withstand ongoing inflationary and balance-sheet pressures, as well as those in more value-oriented sectors like energy and materials.
Bond yields look relatively attractive — I think reserve-backing fixed income could offer decent income, along with some capital appreciation and diversification. US government bond yields have the most room to rally, followed by Europe and then Japan. I favor high-quality fixed income given that spreads in growth fixed income are still not compensating investors for recession risk. Parts of the securitized market also look attractive, namely CLOs and ABS. Consider putting incremental cash flows to work at current market yields, without taking undue risk, of course.
My conviction on China remains strong — I have a full overweight view on China, whose reopening should release pent-up demand for services in particular. I expect some positive spillover from China’s recovery to other parts of Asia, but I also think higher interest-rate costs and exposure to a slowing global economy will pose challenges for many non-Asian emerging markets.
I expect equity correlations to increase — Regional differences may be less pronounced in a period of higher volatility. I expect European equities to feel the effects of the US banking issues, while Japanese equities could be more insulated given the country’s now-less deflationary mindset, cheaper valuations, and proximity to China’s recovery.
Alternatives are playing a growing role — Insurers are no exception to this trend and, indeed, have increasingly warmed to the portfolio diversification potential and other possible benefits of alternatives — and not just within their surplus assets. Particularly in recent months, many conversations with insurance clients have centered on which segments of the alternatives market to consider investing in and how those allocations might fit into their overall investment strategy.
Financial stability may be the priority over inflation — I continue to believe inflation will be structurally higher, but I think the market’s near-term focus will be on credit tightening and its disinflationary effects. Within commodities, I favor gold during this period of uncertainty and maintain a slight overweight view on industrial metals, especially copper given an improving outlook for China. I also think TIPS breakeven rates are likely to narrow as inflation potentially cools.
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1Based on the MSCI ACWI Index as of 30 March 2023.
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