Areas of focus in our client conversations
Recent discussions with our insurance clients have centred upon key risks in markets, rich valuations, the stage of the credit cycle and the beginning of the end of the key supportive technical of QE. As long-term providers of ‘patient capital’, insurance investors are keen on looking beyond the immediate short-term and trying to determine what risks and rewards are in store.
Central banks around the world are starting to dial down their accommodative policy mix and we are in the early stages of the end of one of the most extraordinary monetary policy experiments. Our expectation is for the Federal Reserve to announce and start their balance sheet unwind in September, for the ECB to reduce the scale of bond purchases in 2018 and for the Bank of Japan to continue its stealth taper while focusing on yield curve control. The central banks are doing this against a backdrop of coordinated global growth, although inflation remains stubbornly subdued globally. This expected $1tn reduction in yearly G4 central bank purchases is a potential source of market volatility and raises a number of questions:
At current yields of 4.21% the long dated USD credit market is still around 50bps below the average yields of the last five years and around 1.30% below the average yields of the last ten years. We are also eight years into the current credit cycle and, as cycles typically last 8-10 years, there are concerns around when and how this will end. Our bottom up analysis suggests stable corporate fundamentals with current earnings remaining supportive. However, leverage metrics remain elevated in the investment grade sector and valuations are approaching or are at their pre-crisis tights. Two of my colleagues will analyze the credit markets from a longer-term perspective in a future blog post, but the key message here is that we are in the latter stages of the current cycle and that warrants caution when looking beyond the next 6-12 months.
Investors are especially concerned about a turn in credit markets in the context of the changes in fixed income market liquidity, which we have discussed in a previous blog post. China continues to remain a longer-term risk but has not been a focus of recent discussions. Aggressive spending has stabilized growth at around 6.5%, but has also increased existing imbalances.
Finally, political risk also continues to be a key discussion topic – whether it’s President Trump’s team and policy measures, Brexit, elections in Germany and Italy and other geopolitical risk such as North Korea. All of this means that while we are constructive on fixed income spread sectors in the near to medium term, a number of factors (QE unwind, credit cycle, market liquidity) worry us in the longer-term.
What does this mean for insurance company investment strategies?
Increased market volatility, rising yields and widening in credit spreads present both a challenge and an opportunity to insurance companies. It is vital that insurers know and are comfortable with the risks in their portfolios, have stress tested their portfolios and have, importantly, quantified the impact of market volatility on key metrics such as earnings, investment income and regulatory capital. In our experience, insurers across Europe have been taking on increasing amounts of liquidity, credit and macro risk, and extending beyond their core fixed income competencies in search of more attractive yield opportunities. We have seen an increase in allocation to sectors such as private credit, infrastructure loans and real estate loans. They have also increased their corporate exposures, invested in high yield, and taken on more macro risk by investing outside their domestic markets in emerging markets and USD denominated instruments.
For the public fixed income and equity markets, insurers have been investing in these asset classes for a very long time and there is a lot of historical data available to help them calibrate the impact of a risk-off environment. This is not the case for a number of investment strategies such as private credit, where the amount of historical data available in Europe is limited and insurers have only been major investors in the recent benign credit environment. If yields and credit spreads increase over the longer-term we expect insurers to tilt back towards more of a core fixed income allocation while still continuing to be invested in some of the extended sectors. As an example of this, we heard anecdotal evidence of French insurance companies adding to their French government bond exposures when yields on the 10 year OAT reached 1% before the French elections this year.
Insurance companies should continue to build and manage diversified fixed income portfolios, incorporating a global opportunity set for their investment portfolio. Insurers need to be nimble and may benefit from a flexible approach to investing in global markets, with the resources to intelligently construct portfolios and to actively manage positions through economic cycles and turbulent markets.
Data based on Bank of America Merrill Lynch 10+ Year US Corporate Index as of 23rd August 2017. Source: Bloomberg
Please see our blog post Why Bond Market Liquidity is back on the investor worry list – and what to do about it