The global economy has been more resilient than expected, but I think recession is delayed, not defeated. In hindsight, the effects of tighter monetary policy were offset by excess savings, tight labor markets, the relative insensitivity of consumers and businesses to higher interest rates, and the breakout of generative AI. But these positives are now more than priced into equity valuations, and looking ahead, I see central banks continuing to hike rates and squeeze the economy.
Despite policymakers’ initial success at containing problems in US banking, this is a story that hasn’t fully played out. Banks face higher funding costs, larger capital requirements, and deteriorating credit conditions, including in the weak commercial real estate market. They are likely to reduce lending, the lifeline of the economy. Liquidity may be further impaired when, as part of the US debt-ceiling deal, the US Treasury issues US$1 trillion in new bonds, whose attractive yields will draw assets away from bank reserves.
Against this backdrop, I recommend that insurers consider remaining somewhat defensive, with a preference for reserve-backed fixed income over surplus assets broadly.
I retain my underweight view on surplus fixed income. Tighter lending standards are beginning to show up in higher bankruptcy rates, which are bound to hurt riskier credit, like high yield. Within existing mandates, it may be wise to rotate into higher-quality parts of the market (e.g., BB/B rated issuers). While corporate fundamentals appear to be deteriorating broadly, I am more sanguine on global investment-grade credit, where starting levels for fundamentals are quite strong and elevated cash balances have helped avoid the need for financing. I still see value in the securitized space, namely in collateralized loan obligations (CLOs) and asset-backed securities (ABS). I remain cautious on commercial mortgage-backed securities (CMBS), and conduit deals in particular.
I have reduced my view on Chinese equities to “moderately overweight,” as the consumer-led recovery in China has fallen short of expectations. My view on Japanese government bonds remains at underweight. Japan’s government seems content to stand pat on yield-curve control and interest rates for now, as inflation is a net benefit to consumer wages and company margins. I also remain moderately overweight commodities, with a focus on copper and gold given supportive supply/demand dynamics.
Fixed income: Reserve-backing assets still looking good
I continue to see central banks effectively engineering an economic slowdown, and thus retain a slightly bullish view on reserve-backing fixed income. Market expectations for policy rates shifted higher during the second quarter as the Fed and other central banks reiterated their commitment to fighting high, sticky inflation despite evidence that inflation is falling. A “pause,” which used to mean the next move would be a rate cut, is now more likely to be a “skip,” in which central banks wait to see the cumulative impact of tighter policy before resuming hikes. We’ve seen this already with the Bank of Canada and the Reserve Bank of Australia.
In the world of government debt, the market’s repricing makes US government bonds more attractive than European and Japanese government bonds. The Fed’s tightening campaign should benefit longer US maturities, which longer-duration insurers and pension funds continue to acquire. Europe is still earlier in the hiking process and inflation is higher than in the US. As noted, I believe any tightening in Japan will be gradual.
Meanwhile, we are at the late stage of the credit cycle, characterized by an inverted yield curve, tighter credit conditions, and deteriorating fundamentals. Historically, these conditions have been reliable indicators of negative excess returns relative to government bonds over the following six to 12 months. Year to date, US bankruptcies have exceeded levels of any comparable period since 2010 (Figure 1). I think high-yield spreads should be at least 140 basis points (bps) wider than the current +430 bps spread, given the risks described earlier. I expect investment-grade credit to outperform high yield in this environment, yet high-yield spreads tightened during the second quarter while investment-grade spreads were relatively unchanged. Taking this into account along with the strong starting level of investment-grade fundamentals, I have raised my view on global investment-grade credit. Given that we have seen a relative decrease in below-investment-grade bond allocations by US insurers over the last year (Figure 2), the rotation into the investment-grade space, even with surplus dollars, has remained a strong risk-adjusted return trade.
ABS and CLOs remain among my best ideas within the securitized space, and as noted, I remain cautious on conduit CMBS deals as a result of their exposure to pure office-space properties. My view on municipal bonds (both taxable and tax-exempt) remains unchanged quarter over quarter, although I think there is value to be found at the long end of the tax-exempt curve. Finally, I prefer emerging markets hard-currency debt over global high-yield corporate bonds, with more risk priced into the former. The EMD asset class also skews to higher credit quality, consistent with my overall preference for investment-grade bonds over high yield.