Late August often provides a useful vantage point for reflection on the year so far, which enables us to fine tune our expectations for what is to come in the coming months ahead. As we write, the US and European yield curves have rebased to levels previously seen in January of this year, apparently erasing the expectation changes discounted in the previous seven months. This seems somewhat unfair, as the global macro picture appears clearer than it was in January.
Opportunities for Insurance Investors
For insurance investors, the present market appears generous with its offering and thus we expect to be busy for the remainder of the year. We note an uptick in available yields across a variety of asset classes which presents opportunities for strategic asset allocation. For example, current UK gilt yields continue to support the bulk annuity theme. While spreads remain low relative to historic ranges, we see this reflecting a convergence in risk between higher quality private sector balance sheets and a more challenged public sector balance sheet. As a result, we see carry at the heart of the conversation for insurance investors.
If there is a common theme to the opportunity presented by the market currently, it is that credit’s income pickup appears well placed relative to sovereign – especially at the shorter end. In investment grade credit markets, issuers’ fundamental quality remains robust, commonly helped by a lengthening in average life. In sovereign markets, the short end of both the US and Euro government curves offer appealing yields, while longer duration maturities appear better anchored. In Europe, we think longer dated sovereign bonds may offer a better opportunity as long dated corporate spreads are quite tight.
Medium-Term Market Opportunities and Macro Themes
At present, the market is well positioned to provide opportunity in the medium term. We see a series of macro themes playing out to insurer advantage in coming months. In our view, the key drivers of fixed income return are well positioned to provide attractive return drivers.
First, 2024 has seen a notable cooling in global inflation, creating policy space for a response. Whether we consider US, UK or European inflation as our chosen indicator, we see evidence of economic cooling. Of those three, the US has shown the most vigour, which has challenged the US Federal Reserve’s (Fed) policymakers; back in January, the market expected 5 Fed cuts in 2024, while today’s expectations look for the Fed to begin cutting in September. The Bank of England saw sufficient room to begin its cutting cycle in August, with the Governor casting the deciding vote against the Bank’s chief economist. In Europe, the ECB continued to hold, with market expectations of a cut growing.
Second, cooling inflation is a function of moderating growth. Our second global investment quarterly concluded that sub trend growth remained our base case expectation – and so it has proven. While the US economy remains robust, there is evidence that the effects of Fed policy are being felt. In Asia, China’s economic growth has been challenged by a more complex export picture. Japan’s decision in the quarter to exit Quantitative Easing (QE) – the last of the Central Banks to do so – was enough to provoke investor concerns around tightening financial conditions.
Third, central banks preparing to cut rates suggest that we have entered the late stage of the global economic cycle. US equity returns seem to support this view: the rally in US equities has seen market leadership thin to a short list of names. Remove these, and US equity returns look more pedestrian.
Opportunities in a Changing Landscape
Further, the most recent earnings season has shown more positive earnings surprises from defensives than cyclicals, suggesting that Corporate America is also seeing the changes in the boardroom. European and UK shares offer more attractive multiples than their US peers, balanced against less impressive earnings growth. In our view, a slowing in global growth can provide support for fixed income returns, to the advantage of longer-term asset holders.
Lastly, concerns in one area can create opportunities in others. A slowing of the US economy has led to speculation that the dollar may soften. This may lead to rallies in assets elsewhere: for example in emerging markets, where we note that local central banks moved ahead of the Fed on inflation and are now cutting earlier to protect local growth. A softening dollar may make support the case for local currency assets in less complex economies. EM assets tend to offer attractive returns when the US economy is reaccelerating and when Chinese growth rates are positive. When both themes are in place, the space can surprise positively.
Author: Giles Bedford, Senior Investment Specialist, EMEA Insurance
