4Q 2022 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:
Inflation remains the key concern as central banks across developed markets have been intervening by hiking aggressively over the last quarter. It is yet to be seen when tighter financial conditions will start to cool down economies substantially. Volatility will remain high for the foreseeable future.
Recession is now our base case scenario at 50%, given central banks’ hawkish attitude toward controlling inflation. We increased the probability of Crisis to 15% while lowering the likelihood of Sub Trend Growth to 30% and that of Above Trend Growth to 5%. The base case is not in line with what markets are currently pricing.
Following the 75 basis points (bps) hike during the September FOMC meeting, we expect the Federal Reserve (Fed) to raise the fed funds rate by another 125bps by year-end and bring the rate to a range of at least 4.75%–5% in 2023. The primary risk to our forecasts is severe stagflation. If central banks have to exceed market expectations to control inflation, the ultimate recession may be deeper, and asset prices may fall further.
In this bulletin, we examine these views through our insurance lens and provide insight on how we are positioning insurance portfolios.
3Q 2022 recap
It seems like a long time ago that the market perceived inflation as transitory. The big questions investors are pondering are whether inflation is of cyclical or structural nature, the implication on rates and what’s going to happen to growth as a result of monetary policy intervention. While global central banks have made it clear that tackling inflation is their main objective, we are seeing early signs of a divergence between regions.
Despite inflation sitting at decade-high levels, headline inflation may potentially start to ease in the United States. A reduction in supply chain pressures has led to declining goods prices. The region also benefits from being self-sufficient in covering its energy consumption needs, which stands in contrast to Europe and Asia. In the same breath, core inflation remains high, which can partially be explained by the fact that more cyclical components like energy and food prices are not only affecting headline inflation numbers, but also having an impact on more structural components. The Fed continues to reinforce the view that inflation is much too high, that they are attentive to upside risks and that they want to get inflation back to 2%. Tightening financial conditions in order to reach this goal, the Fed has been on a path of hiking interest rates by 75bps consecutively since its June meeting. It has been reinforced that “the FOMC is resolved to bring inflation down and will keep at it until the job is done.”
In the eurozone, inflation continued to rise over the quarter both on a headline and core basis – with the August print sitting at its highest since the creation of the single currency. Inflation is not expected to peak until December at above 10%. Following a wave of hawkish European Central Bank (ECB) rhetoric, we saw an unprecedented 75bps hike in September, which moved rates on the continent into positive territory. Simultaneously, risks for the region emanate from energy prices – driven by the Russia/Ukraine conflict – for which the narrative could potentially change overnight. While gas prices have fallen slightly, they are still around 15x higher than 2020 prices. The Russian tactic of strategic ambiguity in gas supply will further feed fears that recession is all but certain in Europe. We are expecting fiscal policy to ramp up significantly to protect households and businesses. The key news over the next few weeks will be the extent of this stimulus. We anticipate governments will continue to try to offset 50%-75% of this gas shock.
Similar to the eurozone, the energy crisis has also had a significant impact on the UK as the country’s inflation has been rising both on a headline and core basis over the quarter. The Bank of England (BoE) reacted with a 50bps hike in September. The bank’s forecast is very negative with 5 quarters of contraction from 4Q 2022 onwards. Despite this outlook, it has been highlighted that the bank is “in response to more persistent inflationary pressures, despite a significant deterioration in its economic growth forecast and the fact that the cost of living crisis will disproportionately affect more vulnerable parts of the population.” We have seen massive movements in the UK market following the government’s budget announcement as a response to the cost-of-living crisis on September 23. Investors are questioning contradicting dynamics with a central bank that continues to raise interest rates and tries to implement quantitative tightening measures on the one hand, and a government that effectively tries to minimize the hit on growth and shield consumers on the other. The government is now in a tight spot as borrowing costs have increased and markets question the credibility of these actions. Simultaneously, the bank needs to reconfirm its commitment to tackling inflation to prevent a further decline in Sterling.
Moving away from rates toward the investment-grade (IG) credit space, we continue to see a widening in spreads across the U.S., EUR and UK markets. Interest rate volatility is one of the primary drivers for this widening – with the MOVE index being highly correlated with spreads throughout the year. Compared to previous economic downturns, fundamentals remain robust and corporates are entering this period from a point of strength. At the same time, earnings are likely to start rolling over in 3Q or 4Q. We anticipate that both in the United States and Europe recession risks are not fully priced as of now and further increases in spreads are yet to come. We favor the high-quality, shorter-dated part of the market offering a cushion against rising rates.
While the timing and extent of an economic downturn and its implications for different sectors remain uncertain, the direction of travel is clear: rates are moving higher and spreads are moving wider as we approach the end of the year. Considering volatile conditions and elevated recessionary risks, we are eager to ensure that our portfolios are set to weather the storm. We remain rooted in the tenets of our investment process: pairing the diligent evaluation of the macroeconomic landscape together with rigorous bottom-up security analysis and stress testing, resulting in portfolios that are built to mirror a fortress balance sheet.
U.S. Life companies
After almost 40 years of absence, high inflation has returned to global financial markets with a vengeance. While not welcomed by central banks and total return investors, the current environment is offering achievable yields not seen for over a decade. The rise in market yields year-to-date has been astronomical, even in historical context. Yields look great across the curve and credit spectrum, from short securitized to long corporate credit. Having temporarily been put out of their long misery in search for yield, Life insurers in particular are now faced with the question of where to put their cash to work.
Credit curves are flat – particularly from 10yr out to 30yr – and most of the Treasury curve is inverted, providing very little marginal yield compensation for extending out. From a total return perspective, we favor investing in short, high-quality instruments to preserve capital and hide out until market conditions become more favorable. For a life insurance CIO, however, relative value considerations need to be put into the context of a much longer timeline: premium from life insurance policies comes in fairly consistently and cash needs to be put to work each month, irrespective of economic conditions since mortality risk is uncorrelated to market risk. A life insurer’s bread and butter is built on consistent high income over the lifetime of a policy. New money yields are attractive across the curve and 30yr BBB all-in yields have not been above 6% in over a decade, providing a window to lock in attractive yields that can be passed on to policy pricing.
The elephant in the room is the potential for elevated downgrades and impairments as we enter a shallow (or severe) recession. Within BBBs, we favor mid- to high-BBB defensive, non-cyclical credits. We still feel comfortable with corporate fundamentals, recognizing however that they likely already peaked earlier this year. Revenue and EBITDA growth was still positive YoY in the second quarter at 12% and 9%, respectively, for the median IG industrial company, though should slow meaningfully in 4Q22 and 2023. Compared to last quarter, financial leverage has flat lined, if not slightly increased, which is intentional as companies divert their free cash flow to share buybacks, capex and dividends. Margins also continue to compress – though our concerns center on consumer-focused sectors such as auto, retail and consumer goods where operating margins are already at or below their 20-year averages. The banking sector, meanwhile, has benefited from lessons learned from the Global Financial Crisis, resulting in higher regulatory capital ratios, stronger balance sheets and less cyclical earnings profiles.
Unfortunately, this yield environment may prove to be fleeting: restrictive financial conditions might provide higher yields now, but are almost always followed by recessions, whence central banks turn toward accommodative monetary policies and rate cuts. Timing any sort of pivot is a very challenging endeavor. While credit spreads should continue moving wider, 10yr and 30yr Treasuries are already trading within our intermediate-term forecast ranges. As a result, we favor balancing short amortizing, high-quality cash flows with longer maturity purchases to harvest today’s achievable yields. At the center of our investment philosophy is rigorous fundamental credit due diligence, which will ensure our client portfolios have the stability to weather whatever hurricane passes over.
U.S. P&C companies
Intermediate IG corporate bonds have posted positive 3Q excess returns going into the last week of September, as spreads have tightened from recent wides set in early July. Second quarter earnings fell from elevated levels and operating leverage has turned negative as revenue growth exceeded EBITDA growth, but both remain elevated historically. We maintain the view that IG fundamentals are robust enough to handle the recession we are anticipating. Companies have continued to spend down elevated excess cash levels on buybacks, dividends, capex and M&A, which suggests executives currently view recession risks as manageable. For the moment, the technical backdrop has improved as IG outflows slowed, then reversed into summer on the back of higher all-in yields. September’s underwhelming new issue calendar has further helped maintain spreads amidst elevated volatility in the rate and equity markets.
We continue to maintain our preference for short securitized where appropriate. However, for insurers that are limited in their ability to participate in securitized assets, we think front-end A-rated corporate bonds provide attractive up-in-quality yield. While fundamentals remain intact, our view is that spreads do not adequately reflect recession risk. That said, yields for the intermediate IG index are at levels not seen in over a decade, even after adjusting for duration. This provides opportunities in the intermediate part of the curve to improve book income, either outright or on swap (to the extent losses can be realized). We prefer issuers that demonstrate fiscal discipline, as they are more likely to maintain ratings. U.S. and Yankee banks continue to offer attractive carry, which we think will persist. We also like utilities and certain REIT sectors that are more insulated from stress outside of the United States and have the ability to more effectively pass on rising costs to consumers.
As the U.S. economy approaches a salient juncture, we look to our individual security selection and depth of our securitized credit research team to lend to borrowers that could comfortably survive an inflation-led downturn. Fundamentals across residential housing, commercial real estate and consumer credit are adjusting to higher rates, funding costs and Fed tightening. Similarly, the Fed recently doubled the pace of its quantitative tightening (QT) program in September, putting further pressure on overall liquidity in risk assets. Production coupon agency mortgages, affected by lack of Fed buying and decade-highs in interest rate volatility, sit at their widest levels since 2011 (excluding briefly during COVID-19). We are cognizant of negative convexity risks, but P&C companies looking for diversification away from corporate credit risk should take comfort in these valuations and risk-adjusted income levels. Additionally, agency mortgages can help provide for an enhanced liquidity profile for insurers in the event of a materialization of our base case for a downturn in the economy.
Consumer credit – coming off a “sugar high” of unprecedented fiscal stimulus and monetary easing – is largely normalized to pre-pandemic levels. Revolving credit balances, delinquencies and loss rates have all seen upticks in recent months, but debt burdens seem manageable for the consumer as a whole. Despite only marginal signs of stress in the deepest FICO buckets of auto loan borrowers and some borrowers in the consumer unsecured space, lenders have tightened their credit boxes since the start of the year to mitigate risks of a deteriorating macro environment. Spreads generally are not fully reflecting recession risk premiums in securitized credit, but pricing appears attractive when looking across competing asset classes. We think it makes sense for P&C insurers to hide out in short-dated, high-quality securitized cash flows, cushioning general account asset values amid our outlook for a continued tighter central bank policy response. Specifically, short duration securitized assets such as automobile ABS from top-tier sponsors provide P&C insurers naturally amortizing cash flows with limited downward ratings migration – in our view – at all-in yield levels not seen since the Great Financial Crisis. We believe creating well-diversified securitized subsector allocations provides for a meaningful complement to overall fixed income allocations.
UK & European insurers
During the quarter, three key trends have affected European insurance portfolios and allocations:
Turnover and SAA “freeze”: The incessant rise in yield levels and rate volatility has unnerved our accounting-sensitive clients, as large unrealized losses have started to emerge in insurance balance sheets. UK Motor, Lloyd’s market and P&C insurers (exposed to the most vulnerable 2-year part of the curve) were the most affected. In order to reduce P&L volatility, and to avoid crystalizing losses, our clients have increasingly “frozen” current asset allocations, reducing portfolio turnover budgets, while significantly curtailing management discretion around trading activity. In partnership with our derivatives team, we have created an accounting-friendly forward-purchase-agreement framework that can help insurers unlock assets and take advantage of the higher re-investment yields available in the market;
The end of negative rates: In Continental Europe, life insurers have historically had to move out along the curve in order to avoid negative yields. The ECB aggressive monetary moves changed this paradigm: 2-year German Bunds currently yield almost 2% compared to -0.73% in March. Moreover, the rise in yields was mostly caused by an increase in risk-free rates, as opposed to credit spreads. This trend created an investment opportunity to increase book yields without adding too much duration risk by investing in short-dated, high-quality, investment-grade corporates. This part of the market presents an historically high yield, combined with a robust “breakeven” cushion against further rate hikes (e.g. corporate bond investments would be able to sustain a further 180bps European rate rise before registering a capital loss);
Capital and liquidity shifts in credit markets: The heightened volatility in the government bond space and announced QT programs by the ECB and BoE reverberated in wider bid-ask spreads in both investment-grade and high yield allocations. This, combined with a peaking rating cycle, increased the importance of investing in the right issuers so as to avoid being forced sellers in a lower-liquidity world, while maintaining solvency capital intact. With this in mind, we have developed a rating forecasting framework to help identify the SCR effect of ratings migration across portfolios and inform insurance client decisions in buy-and-maintain portfolios.
In the face of sticky inflation and a strong labor market, the Fed has been forced to hike rates at an unprecedented pace. Some early signs suggest its efforts are working and inflation is rolling over, but it’s abundantly clear more work is to be done. This, however, leaves market participants in unknown territory – on the one hand, the Fed has only hiked rates once into a recession, on the other hand, it has never paused with a negative real fed funds rate. Combine these crosswinds with an unprecedented withdrawal of liquidity, and it’s no wonder markets have been volatile these past few months. The probability of a soft landing dims with each new inflation print, and as such, recession weighs ever heavier on investor sentiment. Consequently, there has been a marked shift in focus from yield maximization to capital preservation amongst our clients.
This past quarter we spent time drilling down into the individual credits across the platform, remaining stringent with our watchlists and trimming positions that appeared less fundamentally sound. The rapid rise in Treasury yields and credit spreads has enabled clients to meet yield objectives with higher-quality, shorter-duration securities.
In addition to trimming low hanging fruit, we’ve moved our clients shorter in duration. Either by keeping cash at elevated levels or investing at the front end of the curve, reducing interest rate and spread duration is key to capital preservation. The rise in front-end rates has allowed us to move down the curve without sacrificing book yield, in turn improving liquidity and protecting total return. Demand for floating rate instruments – specifically AAA-and AA-rated CLOs – remains elevated too, given the aggressive pace of hikes from the Fed. In short, we’ve moved defensive without having to sacrifice yield – a rare but welcomed occurrence.
Our base case is that the pending recession will be fairly muted given strong private sector balance sheets, the broad strength of the consumer and the interest coverage ratios we see in credit markets. Still, we remain grounded in the tenants of our investment process and cognizant that as lenders of our clients’ funds, downside protection is the key to long-term outperformance.