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For much of the year, bad news for the economy was good news for markets. More slack in the US labor market, for instance, was cheered by risk assets as a sign that growth and inflation were moderating and the Fed might achieve a soft landing. Now the other side of this relationship is playing out: A stronger-than-expected economy has pushed the expected terminal interest rate higher for longer, causing stocks to struggle. Meanwhile, still-tight labor markets and rising commodity prices indicate ongoing inflation pressures, at a time when businesses and consumers have yet to fully absorb the impact of higher rates. This could mean a third phase of the narrative, where a weaker economy spells bad news for markets (Figure 1).
Figure 1
What’s my view? While it has taken longer than expected, I think higher rates will hurt the global economy and that a slightly cautious investment stance is still warranted. I’m also tracking a number of risks still unfolding as of this writing, including a potential US government shutdown, the spike in oil prices, and the strong US dollar. That said, I am more sanguine about the resilience of the US economy given several positives I had underestimated: the increase in household net worth from gains in stocks and real estate; low pandemic-era interest rates locked in by consumers and businesses; and plenty of liquidity.
On balance, I still expect risk assets to underperform reserve-backing fixed income, given high valuations for the former and the lagged but looming impact of restrictive monetary policy. However, I have reduced my underweight views on global equities and credit spreads and am quite close to neutral across active weights overall. My highest-conviction views are in Japan: Equities there have finally begun to embrace economic and corporate governance improvements, while slow-drip monetary tightening has left real rates in negative territory and expensive relative to other regions. Among spread sectors, I prefer investment-grade credit, and collateralized loan obligations (CLOs) and asset-backed securities (ABS) within the securitized market. I remain moderately overweight commodities, with a focus on copper and gold.
A number of factors drove government bond yields around 50 bps higher in the second quarter. First, longer-maturity real yields rose as markets embraced the Fed’s mantra of “higher for longer,” which translated into expectations of a higher fed funds rate for a longer period. Second, the term premium — which compensates investors for adding duration — widened to reflect greater long-term inflation uncertainty and rising US public debt (which, among other things, prompted Fitch to downgrade US government debt in August). Meanwhile, the Bank of Japan (BOJ) took the first step toward tightening monetary policy by relaxing its yield curve control and allowing 10-year government bond yields to rise to around 50 bps. While this does not seem particularly dramatic on its own, 0% rates in Japan anchored rates in other regions to some extent.
So, are rates likely to go even higher? Growing evidence that the US economy is getting pinched by higher rates suggests that the Fed is at a restrictive enough stance to slow the economy. European growth has notched down and looks recessionary. Therefore, I think US and EU insurers could consider lengthening their portfolios and closing asset/liability management gaps within those two markets. The risk to that view is that the US term premium widens further, either in response to the Fed losing credibility in its inflation fight or because markets demand a larger term premium for being a creditor to a highly indebted government.
As noted, the global economy has been surprisingly resilient and inflation has come down quickly, particularly in the US, leaving me with less conviction around the severity of a potential recession and credit downturn. Still, we remain in the late stages of the credit cycle, with compressed valuations, tightening credit conditions, and some weakening in corporate balance sheets and cash levels, albeit from very high levels (Figure 2). Despite the risks being somewhat skewed to the downside, spreads may remain range-bound for some time in the absence of a clear catalyst for widening — an environment in which I expect credit income to dominate returns. This will continue to be embraced by insurers who are capturing greater than 6% all-in yields for broad investment-grade indices. Within the securitized space, I continue to like CLOs but think there have been select opportunities to reduce CLO exposure in favor of credit, given where we are in the cycle. In terms of traditional ABS, I think commercial-backed securities look marginally more attractive than consumer-backed securities.
Figure 2
The surplus fixed income picture could get more challenging in the near term — spread levels are not pricing in a traditional recession on a look-back basis, so valuations aren’t providing much of a cushion. As mentioned previously, I think insurers with existing allocations to bank loans, high-yield bonds, and emerging market debt may want to look to go up in quality within those mandates and favor BBB (within EMD), BB, and B issuers, all else equal. I also think insurers should consider maintaining dry powder, as there may be opportunities to add exposure on weakness in light of the more positive starting point for yields, which are typically a strong determinant of long-term returns.
I have raised my view on global equities to moderately underweight but maintain a defensive tilt. I think the lower interest-rate sensitivity of consumers and businesses, and the overall strength of the consumer, make a US hard landing less likely. However, I still believe the distribution of risks for the global economy, and even the US, is skewed to the downside. While the effects of tighter policy are playing out with more of a lag than in the past, there will eventually be a monetary overhang, which implies lower equity valuations and downgrades in earnings expectations.
I think the fiscal impulse that has propped up the private sector will in time become a drag on growth in the US and Europe as they consolidate fiscally — although the impact may be less noticeable in Europe, where fiscal stimulus has not been fully deployed on the ground. I also expect higher inflation risk globally as the path to further disinflation becomes more fraught. A worsening growth/inflation mix will chip away at margins. Meanwhile, global equity valuations are still expensive, in absolute terms and relative to cash. I observe more regional divergence, with the US and Japan outperforming Europe cyclically, and valuations similarly disparate.
I maintain an overweight view on Japanese equities. While the market is no longer cheap, positive economic momentum has fed through to higher margins and earnings growth. The BOJ’s decision to add flexibility to its yield curve control policy in July has not challenged the market’s outperformance, partly because the yen has continued to weaken against the US dollar. In addition, Japanese equities continue to show good market breadth.
I have an underweight view on US and European equities relative to Japan. I have upgraded my US market view slightly, taking into account the resilience of the economy and companies’ exposure to AI trends. But US valuations seem priced for perfection, making them vulnerable to a downgrade in growth expectations sparked by the resumption of student loan repayments, auto worker strikes, or any number of other catalysts. Corporate balance sheets still look solid, although I see some signs of weakening in net margins and interest coverage.
European valuations are attractive and I have more conviction that the European Central Bank has reached the end of its hiking path as the economy has cooled. However, weak earnings momentum and downward adjustments in profitability — in what I believe to be a stagflationary base case — leave me downbeat on equity market prospects. I also see cracks emerging in the services sector, a negative sign for the labor market and consumer resilience.
I have downgraded my China view to neutral, as I have been too optimistic on the potential for a cyclical uplift as well as on structural issues holding back sentiment and investors’ willingness to engage. I am tracking a raft of recent policy measures and signs of cyclical green shoots suggesting we may be at peak pessimism, but also note that there are fewer signs of a turnaround in consumer sentiment or the property cycle. The case for emerging markets ex-China is also finely balanced, with domestic monetary policy easing juxtaposed against a strong US dollar and inflation risks from food and oil.
Regarding sectors, I am positive on financials and negative on materials. I expect financials to be supported by strong corporate fundamentals as well as continued positive sentiment, while I expect the materials sector to struggle given weaker return on equity and higher return volatility.
I’ve previously acknowledged the difficulties insurers have had historically when considering an allocation to commodities, but moving forward, I believe this asset class needs to be strongly considered by insurers of all types. Not only have we seen commodities perform well in 2022 and 2023 year to date, but we have also seen the negative impact inflation has had on claims/underwriting with insurers through the first half of 2023. Generally speaking, insurers are positioned best for periods of rising or falling growth and falling inflation (Figure 3). Very rarely are insurers invested in assets with the potential to outperform in times of rising inflation or stagflation. As cycles become shorter and more volatile, I think having coverage across all economic regimes will be essential.
I continue to have a moderately overweight view on commodities, driven by positive views on copper and gold. In the copper market, I expect favorable long-term supply dynamics and robust demand spurred by spending on the global energy transition. While I continue to monitor the challenging macro environment in China and its impact on copper demand, there have been signs of sustained demand strength, particularly from the housing market.
Figure 3
Gold prices have remained stable in recent quarters, defying the typical correlation with higher real yields, which indicates underlying strength. I think gold is a reasonably priced hedge in the context of increased stagflation risk, as well as the potential for geopolitical shocks. Concurrently, central bank purchases in Asia persist as a source of positive demand.
I remain neutral on oil, which has been rallying in recent months with support from a bullish supply backdrop and an improving demand outlook. With the price near year-to-date highs and continued demand risks from a potential global economic slowdown, I prefer to stay on the sidelines and wait for opportunities to engage with the market.
I am certainly not suggesting that insurers consider an outsized allocation to commodities or to assets with quasi-betas to inflation, but for those who agree that we are facing sustained levels of higher inflation for longer, I think an appropriately sized allocation could make good sense.
Infrastructure has long been considered an asset class that felt custom tailored to an insurer’s business model, give the long duration, stable income potential, and lower risk capital charges. Now, the recent increases in policy support for infrastructure from a number of large economies (e.g., the Inflation Reduction Act in the US) have sparked renewed interest in growing these assets as a share of insurers’ total investments.
Core infrastructure has been the sweet spot for insurers. Not only do the underlying index-linked revenues offer the potential for inflation protection, but the asset class may offer a way to achieve commitments to investing in renewables or the energy transition. However, those attractive traits were counterbalanced by what investors perceived to be expensive valuations of legacy deals, as well as an insufficient pipeline of deals prior to this year. Those concerns may be fading, as Preqin noted in a recent report that dry powder in unlisted North American infrastructure funds fell by more than 12% during the first half of 2023.1 While there is a legitimate concern that “higher for longer” inflation will negatively impact the purchasing power of the infrastructure industry, the prospect of more deal volume, particularly in the energy space, which has accounted for the majority of deals since the beginning of 2022, has put infrastructure back in the spotlight for insurers looking at 2024 investment strategy.
The private credit asset class has yet to feel a major financial shock, given that the majority of growth occurred post the global financial crisis (GFC). However, as we continue to inch toward a macro environment that may be marked by a slowing economy/recession, sustained inflation, and increased defaults, being in the correct part of the private market will become more important. Direct lending, in particular, could begin to lose some of its shine for insurers, due to reduced fee income paid to investors as a result of fewer restructurings or originations of the loans, coupled with a more challenging environment for securing leverage. On top of all that, we are seeing a noticeable reduction in the illiquidity risk premia attributed to middle market direct lending. Cliffwater estimated the premium at 1.27% as of 30 June 2023, one of the lowest figures since 2016. Similar to my views on the surplus fixed income asset classes, I think insurers should look to go up in credit quality, focus on lender protections, and avoid frothier parts of the private credit market.
For insurers with a healthy surplus who can stomach market volatility in exchange for seeking mid-teen income returns, CLO equity may be worth a closer look. Yes, the asset class generally comes with volatility levels akin to traditional public equity (e.g., near 20%), but there are a few key attributes that could potentially make CLO equity more attractive than direct lending on the margin. First, CLOs as an asset class are more battle tested, with more managers having navigated multiple market stresses (including through the GFC, the debt crisis in Greece, oil shocks, and COVID). Since the early 2000s, only about 10% of all CLO equity tranches have had a realized negative IRR, and only 2% have had a realized negative IRR of less than -10%.2 These long-term performance statistics demonstrate the resilience of the asset class, in my view.
In addition, the two strongest vintages in terms of performance were 2007 and 2020, times of extreme market volatility. CLOs also have significant long convexity, which has enhanced returns over time. Not only has CLO equity provided excess income over middle market direct lending in every year since 2013 (Figure 4), but the forward returns on a three- and five-year basis after large market shocks outperformed distressed debt and middle market lending, sometimes significantly.3 For those with existing direct lending allocations, CLO equity may be a potentially compelling complement at this point in the cycle (again, assuming the prospect of elevated market volatility can be tolerated).
Figure 4
Upside risks include a “Goldilocks” scenario for the US economy, in which growth remains at or above trend and inflation continues to move toward target, as well as a soft landing where growth is below trend but unemployment doesn’t spike. For Europe and China, positive outcomes would include a reacceleration in growth, with developed market central banks abstaining from further rate hikes or beginning to move toward rate cuts. In addition, further advances in AI or announcements pertaining to the technology could impact mega-cap valuations, with a disproportionate impact on equity markets.
Downside risks include a scenario in which overtightening of monetary policy or renewed financial stress shocks a prospectively weaker US economy into a hard landing. In addition, a bank or property crisis in China could create a negative skew for global growth. Finally, escalating tensions in Ukraine, the Middle East, or with respect to US/China relations could have profound negative implications for markets.
Seek better relative value in fixed income — With the spike in US and European yields and more pronounced economic slowing in Europe, I see a clearer case for US and European government bonds over Japanese government bonds. Within credit, I favor investment grade given that spreads in surplus fixed income are not compensating investors for recession risk. I also think securitized assets (CLOs, ABS) remain attractive.
Consider sticking with quality equities — While we’ve seen signs of economic resilience, restrictive monetary policy is starting to have the desired effect and I see weaker growth ahead pressuring earnings. Across sectors, I favor companies with robust balance sheets and a greater ability to navigate cyclical pressures. I recognize the potential of AI to impact a range of sectors and companies but wouldn’t chase the rally in tech more broadly from here.
Look at the current and longer-term case for Japanese equities — Japanese equities have outperformed other regions year to date, and I think the market’s unique combination of an improving economy and better corporate governance give it a long runway for further gains. Exporters continue to benefit from a weaker yen.
Seek to weatherproof your portfolio across regimes — A worsening growth/inflation mix would pressure margins and credit fundamentals. I think expanding one’s investable asset class universe could be critical. I favor gold in the face of stagflationary risk, geopolitical deterioration, or de-dollarization. I also think copper is a potentially good inflation play given its large role in the energy transition but constrained supply. Investors should be alert to opportunities to reload risk if markets reprice.
Be selective within alternatives — The alternative asset landscape continues to evolve rapidly. I think insurers should look for potential inflation hedges within core infrastructure and monitor the declining liquidity risk premia in direct lending. Finally, insurers may want to consider CLO equity as a diversifier versus traditional surplus asset exposure and middle market direct lending, as it has shown the potential for outperformance in times of market stress.
1Source: Preqin, “Dry powder drop points to North America infrastructure investment revival,” 13 June 2023 | 2Sources: BofA Global Research, PriceServe, Intex. Data from 1 January 2003 through 30 June 2023. Data captures realized returns on over 1,000 BSL CLO equity tranches during the period. Outstanding deals are excluded from the data. For illustrative purposes only. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. | 3Based on historical analysis of CLO equity total returns relative to equity and bond markets during periods of heightened volatility, including the global financial crisis, Greek government debt crisis, and 2015 oil sell-off. Further information on sources available upon request. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
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