We knew 2024 would be marked by a seemingly unprecedented number of global elections, with 64 countries and the European Union (EU) all facing potential changes, representing more than half of the world population. And as of July 1, more than one billion people had already voted, per Time. With the increase in political uncertainty can come a corresponding bout of market volatility, in particular within surplus assets. That being said, political noise has been largely offset by supportive economic fundamentals. It’s a fool’s errand to predict election outcomes, so I continue to anchor my outlook to a view that the fundamental backdrop of decent growth, moderating inflation, and credible monetary policy has staying power and is bullish for surplus assets despite high valuations. I recognize that growth is slowing and there is a bit more slack in the labor market. And while services inflation remains sticky, and specifically shelter in the US, the path forward is pointing downward. These factors leave the Federal Reserve in a position to ease eventually, which should be supportive of bond and equity markets alike. All this lines up for what may be a promising summer break for insurance CIOs (or a winter break for those in the southern hemisphere!).
Drilling down into some specifics, the success of France’s right wing in the EU elections and President Macron’s announcement of a snap election spooked bond markets last month. Populist-driven spending proposals by the National Rally party on top of a French budget deficit of 5.5% of GDP drove the spread between French and German 10-year bond yields to its widest level since early 2017, when French fiscal concerns also arose. However, I don’t see this growing into a systemic issue for a couple of reasons. First, I don’t see an EU breakup as a risk, although its fiscal rules and institutional setup face challenges. Second, as we saw in the UK in 2022, Greece in 2015, and France in 2017, markets can impose discipline on politicians when fiscal policies are deemed profligate. Even if a crisis were to ensue, the European Central Bank (ECB) would likely be a buyer of last resort at some level of risk premia spike. I’ll be watching for politically induced market disruptions elsewhere too, but I don’t think they’ll be sustained enough to influence my 12-month view. Ultimately, a divided US Congress could curb spending, while the UK election was largely a non-event for markets and may even yield a better outlook. Bottom line, it’s too early to be shifting positioning in anticipation of any political outcome.
Reserve fixed income continues to be the sweet spot for insurers, and not to sound like a broken record, but I think locking in all-in yields at these levels should be a focal point for the second half of 2024. I’ve been cautioning clients to avoid recency bias and think about a world in which interest rates normalize; in my view, it calls for seeking out every incremental basis point of yield, being proactive now, and reaping the benefits later.
From a duration perspective, slowing growth, declining inflation, and eventual central bank easing may provide an opportunity to add duration across insurers’ reserve-backing fixed income, or to tighten the gap toward the liability profile for those running at a short posture.
Turning to surplus assets, the income in high-yield bonds continues to be impressive, but the potential for spread tightening remains limited. However, I continue to see future upside in equities broadly, given the positive fundamental backdrop. Finally, for insurers who have commodities in their opportunity set, I have a moderately overweight view on oil given OPEC’s desire to keep the market tight and oil futures’ positive carry.
Reserve fixed income: Regional divergence is the name of the game
Disparate factors popped up over the second quarter to drive moves in government bonds in developed markets. In the US and Germany, central bank easing is on the horizon and bond yields have rallied. Both of those government bond markets got a boost from their safe-haven status relative to France, where the spread to Germany rose in response to the political shift to the far right. Other “weak links” in southern Europe also saw spreads rise. In Japan, yields moved higher as the Bank of Japan’s (BOJ’s) measured policy appeared out of sync with rising inflation and a weak yen.
For insurers who have been questioning when to extend duration, my view is that central bank easing will be the primary driver of rates over the next 12 months, and that may provide an entry point to tighten up duration gaps and add some duration. In the US, I’ve seen more evidence that growth is softening (albeit from strong levels), including in manufacturing, consumption, and employment, and that inflation is decelerating. I think this is paving the path for the Fed to cut rates at least once this year following the ECB’s first rate cut in June. I also think the BOJ will remain patient given the recent negative GDP print and I would note that the high carry makes shorting Japan duration expensive.
The big question is on term premia and the extent to which France’s deficit concerns could ensnare a wider set of countries with similar issues. The US could face its own debt problems, of course, given that both presidential candidates share a predilection to spend beyond their means. However, the US dollar’s reserve status is likely to tip flows toward US Treasuries in a eurozone crisis scenario. My view is that the environment is ripe for disruption but that markets will force politicians away from extreme policies. Either way, I expect higher rate volatility to persist and think investors need to be quite tactical to capture opportunities.
Within investment-grade credit, I think income-focused insurers should still embrace the all-in yields, while those who skew toward total return will need to be aware of a more carry-focused environment versus potential spread tightening from here. Against the backdrop of solid economic growth, receding inflation, impending interest-rate cuts, declining default rates, and all-in yields twice as high as they were in 2021, credit looks attractive. Tight credit spreads give me pause, but with strong demand for bonds and weak supply, I believe credit is an attractive place to generate income with limited potential for spread widening.
I think securitized assets across the CLO, ABS, and non-agency RMBS space remain attractive even at rich valuations, but I am cautious about CMBS given potential pain from office properties in the future.
Surplus fixed income: Hope on the horizon
While I acknowledge moderate stress in issuers at the lower end of the quality spectrum, indicating that the “higher for longer” rate regime is creating headwinds for some companies, the rate cuts already arriving in some regions and imminent in others should provide relief to some of the riskiest names. In turn, this should take a bite out of the left-tail risk spreads, which haven’t compensated insurers for months.
In addition, technicals continue to be supportive of price levels, as the supply and demand dynamics remain favorable. Demand for corporate bonds has been very strong, as investors seek to lock in attractive yields ahead of a rate-cutting cycle. But the size of the high-yield market (the supply of bonds available to and held by investors) has been shrinking as many companies graduate back to investment grade after being downgraded in recent years. Strong company balance sheets, robust refinancing year to date, and a limited M&A pipeline suggest supply may continue to be overwhelmed by demand going forward (Figure 1).