3Q 2023 Global Fixed Income Insurance Quarterly
This paper is a product of the Global Fixed Income Currency & Commodities (GFICC) Insurance Team.
A team of our senior investors just completed the GFICC Investment Quarterly (IQ) meeting and released our views on the global fixed income markets for the next three to six months. We invite investors to read the IQ letter from Bob Michele, our Global CIO, which summarizes our thoughts on unconstrained investing.
Highlights from this quarter’s IQ:
While recession remains our base case scenario, we’ve lowered it slightly to 55%, given policymakers need time to work through years of policy stimulus. We raised the likelihood of Sub Trend Growth to 40%; our Crisis and Above Trend Growth scenarios are unchanged at 5% and 0%, respectively.
In our view, the Federal Reserve needs to see core inflation near 2% and unemployment rising toward 4% before cutting rates. While we are skeptical that inflation can return to target without a recession, given the current pace of economy cooling, recession is unlikely to start before 2024.
The main risk to our forecast is if central banks lose patience waiting for monetary policy to take hold and tighten policy well beyond market expectations.
Scenario Probabilities (%)
In this bulletin, we examine the platform’s views through our insurance lens and provide insight on how we are positioning insurance portfolios.
2Q 2023 Recap
Anyone who has been on a really long trip knows that eventually patience wears thin, triggering the dreaded question, “Are we there yet?” Investors have travelled a fair distance over the past several months and are getting similarly impatient waiting for recession to begin. The coming recession is one of the most anticipated recessions in history, with more economists calling for recession now than in the early days of the COVID-19 pandemic. While economists don’t have the most reliable track records of correctly predicting recessions before they begin, the current consensus seems reasonable given central banks have enacted one of the most aggressive rate hiking cycles since the 1970s.
Phil Jackson, long-time coach of the Chicago Bulls and Los Angeles Lakers, made famous a quote from Jacob Riis, who commented, “I go and look at a stonecutter hammering away at his rock, perhaps a hundred times without as much as a crack showing in it. Yet at the hundred and first blow, it will split in two, and I know it was not the last blow that did it, but all that had gone before.” For Phil and his championship teams, it was a reminder to continue putting in effort, even if there were no apparent results to show for it. The Fed too seems to be following a similar adage in its fight against inflation. Despite the most aggressive hiking cycle since the early 80s, and with two additional hikes currently priced in before year-end, the Fed has little to show for its efforts – core inflation has remained stubbornly high. The Fed is still not confident that its actions have tightened economic conditions sufficiently.
We believe, much like the Fed, the cumulative and lagged impacts from restrictive policy will slow inflation. We align more with Riis, however, in our belief that these policies will ultimately break the economy and push us into recession. The second quarter of 2023 was a mixed bag of economic data – a trend we often see late in a cycle. Markets wrestled with the conflicting headlines that pushed for a soft landing one day and a recession the next. One could look at any number of recession indicators and confidently say a recession was imminent, and yet corporate and consumer fundamentals showed uncanny resilience. Traditional recession indicators, such as U.S. credit conditions and the shape of the yield curve, indicate that a recession is just around the corner. Meanwhile, the labor market has been remarkedly robust in the face of tightening monetary policy. On the employment front, initial claims have ticked up modestly in the past few weeks, but the vacancy to unemployed ratio continues to sit in a range well above what is considered a balanced labor market. The housing market has also started to stabilize, and stronger-than-expected conference board data highlights the resilience in some pockets of the economy.
These conflicting data points make accurately forecasting a recession tricky and thus difficult for the Fed to move out of the hiking cycle and wait for the lagged impacts to filter into the economy. As such, we’ve left recession as our base case following the latest IQ, but believe it will likely be a 1Q 2024 phenomenon given the range of crosswinds we’ve faced and the slow pace in which tightening has been reflected in economic data.
Despite the uncertainties of when it might begin, investors are right to prepare their portfolios for a recession. Moving into longer-duration, higher-quality fixed income at this stage in the cycle is likely to provide valuable portfolio protection.
U.S. Life companies
Following the IQ, agency MBS was the best idea for the second quarter in a row given valuations are at their cheapest level since the Great Financial Crisis (GFC). This fits in well for most U.S. Life companies as they look to utilize investment income and new money to fortify their portfolios ahead of an expected downturn. There has also been a continued effort to de-risk portfolios and trim any potential downgrade candidates that could put additional pressure on unrealized losses. We spent a good portion of the quarter reviewing watchlists with clients to identify up-in-quality rotation trades that fit within their gain/loss budgets.
The speed and velocity of the hiking cycle has been immense, but the level of strength from which corporations, consumers and municipalities entered the cycle has helped push off recession well beyond what the market expected. This has given us time to trim risk and diversify our portfolios.
U.S. P&C (Property & Casualty) companies
Despite the concerns around U.S. regional banks and broader recession risk, intermediate investment-grade (IG) corporate bonds have managed to post positive excess returns YTD. First quarter earnings in the U.S. remained resilient, posting modest but still positive revenue and EBITDA growth for the trailing 12 months. In Europe, revenue and EBITDA growth are still growing at a double-digit pace; leverage has stabilized below pre-COVID-19 levels in both regions. As discussed in prior quarters, IG corporate issuers are generally well positioned for a downturn. In our base case (through 1Q 2024), we think EBITDA drawdown will be manageable; in our stress case scenarios we expect negative revenue and EBITDA growth that will be less severe than the GFC and COVID-19.
With spreads hovering around unchanged YTD, the IG corporate market is still not signalling recession. On a cross-sector basis, we maintain our preference for short securitized assets where appropriate as they provide higher-quality cash flows at attractive spreads that are an ideal fit for P&C accounts. For IG corporate exposure, we maintain our preference for up-in-quality issuers and recommend positioning with an underweight to spread duration. With front to intermediate IG corporate yield curves at their highest in over a decade, we appreciate the demand technical for IG bonds given elevated all-in yields. However, from a spread perspective, we think there will be more attractive entry points to add to higher beta issuers as our markets more appropriately price recession risk. Industrials screen richest in the current environment. While tighter than in the spring, large U.S. and Yankee bank issuers continue to trade at more attractive levels than at year-end. We remain comfortable with the senior bonds in larger U.S. regional banks, but are cautious about increasing exposure at this time. We continue to like utilities operating in stable regulatory environments given their stable cash flow profile and tailwind from incentives launched as part of the Inflation Reduction Act; the supply dynamics have moved spreads wider, contributing to more attractive spreads. Lastly, we will continue to be active in the primary market across sectors where new issues have been pricing with attractive concessions.
With the exception of commercial real estate risk and agency mortgages, securitized spreads recouped some of the post-SVB widening we saw in early 2Q. Continued interest rate volatility and forced sales from the FDIC portfolios have cheapened agency mortgage valuations to near their widest levels since the GFC. Current coupon mortgage Z-spreads are hovering in the 125-150 basis point range and look historically cheap to us across the broader fixed income platform. We recommend adding for P&C accounts, providing high-quality, government-guaranteed assets that should perform well on a relative basis heading into our forecasted economic contraction. Importantly, we think insurers need to be considering collateral with predictable prepayment characteristics and more stable cash flow profiles to position for future interest rate declines. As such, we are adding to marginal payup stories in specified pools and supplementing passthroughs with better convexity in the agency multifamily landscape where we can add duration at attractive spreads and all-in yields.
Elsewhere, we are monitoring and stressing portfolios for risks to parts of the commercial real estate market, where we think subsectors such as office will continue to see headwinds in the form of lower valuations and extension risk. We are still constructive on adding to the single-family rental (SFR) sector for P&C accounts with needs in the intermediate part of the curve at valuations to attractive asset classes near 150 basis points over Treasuries. Consumer credit is off the “sugar high” post-COVID-19, but balance sheets are largely still intact, and we are only seeing select pockets of marginal stress. Given new issue supply and attractive relative value, we are still advocating for portfolios to allocate to high-quality securitized credit with a bias toward investing near the top of the capital stack. For example, we see value in select auto, consumer, and equipment deals among the stronger originators/issuers. CLOs also provide for an attractive carry in this environment, but we caution insurers to think about adding further to their floating rate exposure into the latter innings of a Fed hiking cycle.
UK & European insurers
During a recent roadshow across Europe, one of the themes that emerged was concerns with liquidity and its impact on asset allocation decisions. European insurers have seen a reduction in new business, which limits the cash available for deployment. This low growth in premiums has been accompanied by lapses on traditional policies. The solvency capital requirement for lapses has increased significantly as interest rates have risen, which impacts solvency ratios negatively, eroding any benefits insurers generated due to their short duration positioning against liabilities.
Beyond SCR considerations, actual lapses have been observed in Italy, France and Luxembourg where limited penalties are in place to prevent them. In France, the lapse rate has been as high as 6-8%, compared to the historical rate of 4%, forcing some insurers to sell bonds and crystalize losses. The high-quality and liquid nature of portfolios have provided a buffer to absorb these lapses – unlike the liquidity issue that was observed in the recent U.S. regional bank crisis. Large lapses have also been observed in the high-net-worth channels, where there is greater awareness and access to alternative investment opportunities. Alternatives available to policyholders include government bonds, which have provided strong competition to insurers, particularly in the Italian and Portuguese markets where these bonds are accessible through retail channels and pay 3-3.5% fixed rates. European insurers are finding it increasingly difficult to compete with retail products due to cost structure; for example, some Portuguese products offer only a three-month lock-up period and no redemption penalty. In other markets where liabilities are longer in duration, limited lapses are being observed due to high guaranteed rates. However, the use of interest rate swaps to match long-dated liabilities is subject to margin call risk, which would also require greater scrutiny on liquidity.
Another key challenge facing insurers is book yield enhancement. Relying solely on cash flow reinvestments would only allow minimal increases (20 basis points per annum for a life portfolio), which would be further slowed down by the aforementioned liquidity pressures. We have observed numerous insurers who are rebalancing their portfolios actively; realizing losses on existing positions in order to deploy cash into higher yielding bonds. In most cases, it is possible in today’s environment to achieve an increase in book yield while recovering the loss realized over a defined time horizon. The accounting return for the current year would be similar to previous years but would increase in subsequent years once higher book yields are locked in. We would recommend using book yield enhancement exercises to add global diversification where applicable. Although the European high yield space looks attractive from a yield perspective, we would encourage our clients to wait for a more attractive entry point given spreads are not sufficiently pricing in the likelihood of recession. Other opportunities for diversification are U.S. taxable municipal bonds, which are high-quality, long-duration assets that can offer a pick-up in yield versus comparable European fixed income assets while also diversifying from a risk perspective.