2Q 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:
Recession remains our base case, at 60% probability, with central banks saying they will fight inflation aggressively. We lowered Crisis to 5% and raised Sub Trend Growth to 35%, acknowledging the global economy’s resilience.
The fastest monetary tightening since 1981 is hitting some parts of the economy but its wider impact is being cushioned by strong corporate financials, the catch-up in activity after the pandemic, China’s reopening and, most of all, still-abundant savings sloshing around from excessive pandemic-era stimulus.
The Federal Reserve hiked by 25bps last week, bringing the terminal rate to a 4.75%-5.00% target where it will likely peak. After a tumultuous few weeks following stress in the banking sector and softer Fed-speak, the market has now priced in cuts later this year, but will this last hike and credit tightening be enough to fight the stubbornly high inflation we’ve been experiencing?
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.
1Q 2023 recap
Central banks continued to hike rates considerably over the last quarter in an effort to bring down stubbornly high inflation. Over the last year, the Federal Reserve increased its benchmark policy rate by 475 basis points (bps). Despite this, economic data is indicating that a recession may not be imminent and the road back to target inflation could be longer than previously hoped. The global economy has remained resilient in the face of higher rates, largely because many consumers and businesses refinanced when interest rates were low. Investors have reassessed their expectations for both the peak in interest rates and the subsequent pace of rate cuts.
Implied overnight interest rate & number of hikes / cuts priced for upcoming Fed meetings (as of 30th January 2023)
Implied overnight interest rate & number of hikes / cuts priced for upcoming Fed meetings (as of 30th March 2023)
This historically aggressive pace of hiking, combined with holding a greater amount of securities vs. loans, has placed the U.S. regional banking system under significant strain and has contributed to the demise of three banks as 2Q 2023 commences. The Fed could justify a pause in its rate-hiking cycle, citing financial stability concerns; however, inflation remains an issue. The latest print shows that inflation was 6% year-on-year in February, with components such as shelter, transportation services and food prices driving much of the increase. The Core Consumer Price Index (CPI) ticked up to 0.5% month-on-month, exceeding expectations that it would remain unchanged at 0.4%. The possibility of sticky inflation poses a challenge for the Fed, which will have to carefully weigh the need for financial market stability against continued inflationary pressure. Looking beyond March, the latest bout of market volatility means the Fed will likely reconsider its hiking cycle for its May and June meetings to assess the strain on the banking system. We expect this will lead to a lower terminal rate for the fed funds rate than previously expected.
European economic data has held up surprisingly well despite the European Central Bank’s (ECB) continued rate hiking. A warmer-than-expected winter and elevated gas storage leading to lower gas prices as well as resilient economic data have contributed to the improved sentiment. However, inflation may remain sticky for longer, indicating that the ECB’s work could be far from finished. The market’s optimism has run contrary to corporate fundamentals. The ECB hiked 50bps and is still guiding toward further hikes; similar to the Fed, it is requiring further evidence of tighter credit conditions before pausing.
U.S. Life companies
We started 2023 with lingering uncertainty about recession, but slightly more hope a soft landing might still be possible after receiving a string of strong data surprises to start the year. It seemed like recession may be pushed back to 2024, and in accordance with this, the Fed happily continued its hiking cycle. In early March, sentiment turned on a dime and the potential for a hard landing became much more real. The downfall of Silicon Valley Bank and Signature Bank and the following tumult that arose in the banking sector has been front and center for U.S. Life companies. Market volatility has been at an all-time high in recent weeks as concerns about the banking sector and the risk of contagion have spread rapidly.
Following the IQ, some our best ideas included EM, short securitized and agency MBS. Now, U.S. Life companies are most concerned with trimming out the risk in their portfolios rather than proactively seeking out these opportunities. Facing a domino effect of downgrades in their portfolios, U.S. Life companies have been focused on identifying the real weaknesses within their portfolios. We believe the banking sector will recover and that this isn’t indicative of a larger crisis. Still, we view this event as the beginning of the end to this cycle. At our IQ, the room went back and forth trying to figure out what the smoking gun was – the market can’t be that strong after all the hikes we’ve had, could it? Fast-forward 24 hours from the meeting, and we started to see the cracks in the banking sector. We expect there will be more to follow.
Given everything we’ve experienced since the IQ, U.S. Life companies have been focused on re-allocating their portfolios to high-quality assets like government bonds and money market mutual funds. These have become popular assets among many investors, with U.S. and European government bond funds and ETFs having received over $18bn of inflows a month to date (as of 3/21/23).
Despite the end of the hiking cycle, we can assume that the degree of tightening due to more stringent lending conditions that we should see in the market will be equivalent to about 25-50bps of hikes, and given that, we expect recession is on the horizon. We have believed that credit spreads needed to widen significantly for months now in order to adequately price in recession, and going into 2Q23 we expect that this will come to fruition.
U.S. P&C (Property & Casualty) companies
After starting 2023 with a rally, Intermediate Investment Grade (IG) corporate bonds’ excess returns turned negative entering the last week of March. Fourth quarter earnings continued their trend lower in revenue and EBITDA growth but remain above historical averages. While we view the recent bank failures as idiosyncratic events, we appreciate that it shows central bank tightening is starting to bite, which will have a larger drag on the broader economy and corporate earnings more so than anticipated just a month ago. That said, corporate balance sheets and liquidity remain adequately positioned heading into recession, which we expect will make any rating downgrades manageable.
On a cross-sector basis, we maintain our preference for high-quality, short securitized assets where appropriate. For IG corporate exposure, we favor adding to higher-quality duration and limiting exposure to higher beta sectors and credits in the Industrial complex at current levels. We think there will be more attractive entry points as our markets more appropriately price recession risk. We still like large U.S. and Yankee bank issuers, which we continue to view as well capitalized and trading at more attractive levels than at year-end. While we remain comfortable with larger U.S. regional banks, we are cautious about increasing exposure at this time. We also like Utilities operating in stable regulatory environments given their stable cash flow profiles and tailwinds from incentives launched as part of the Inflation Reduction Act. Lastly, we will continue to be active in the primary market where new issues have been pricing with attractive concessions.
In the most recent re-pricing of risk assets, interest rate volatility took another leg higher in March despite a seemingly clearer path on the trajectory of future rate hikes. Risk assets and Treasury yields moved in a volatile fashion as investors debated implications of instability in the banking sector. As we think about the securitized debt market in a forecasted economic downturn, we advocate for P&C portfolios to move up in quality and take advantage of spread widening up the capital stack, where we feel structures well insulate insurers even if we see continued fundamental weakening.
Consumer fundamentals continued to normalize to start the year, with pockets of stress starting to become evident, but recent data suggests that the stressed lower income cohort is not expanding broadly across other consumers. The deepest areas of subprime borrowers (<550 FICO scores, for example) and select areas of the marketplace consumer unsecured lending space give us pause, but we generally feel comfortable in more upper-tier originators, underwriters and sponsors that have the business models to weather the storm. We look to be a liquidity provider into volatility and find high-quality securitized, such as Consumer ABS, to have attractive spreads at short break-evens.
Another area of the securitized credit market we’ve been monitoring closely is the commercial real estate market. Cap rates have only started to increase, transaction volumes have fallen significantly and liquidity in the market remains challenged. Specifically, we see fundamentals within the office space as something to watch over the near to intermediate term. In addition, banks that were recently the primary lenders to the CRE market will likely make a material move tighter in lending as we progress over the next 12 months. We are not outright adding CRE exposure to portfolios at this juncture given the asymmetric risk profile to the downside; in our view, we look for wider spreads in the CMBS market.
Within Agency Mortgages, 2023 private market supply is forecasted to be significantly below 2022 levels, but marginal buyers such as money managers will control clearing levels given the absence of the Federal Reserve and most banks. Fundamentally, prepayments continue to be slow with borrowers largely out of the money. Mortgage rates are hovering north of 6%, and convexity in production coupons is likely to be poor given elevated loan balances. We continue to favor marginal convexity stories in specified pools at lower payups in the belly of the coupon stack. In lieu of tighter trading low coupons (2s and 2.5s), we recommend P&C insurers seeking stability of cashflows to add high-quality similar duration Agency CMBS at positive convexity and wider spreads.
UK & European insurers
Buying high-quality duration in the front end of yield curves was the top idea coming out of our meeting. Two-year U.S. Treasuries at 5%, and fed fund futures at 5.625%, are pricing in a lot of further tightening and creating considerable carry for short-maturity securities. Adding IG corporates and securitized credit can bring front-end yields up to 6%-7%, a level where it would be very hard to generate a negative return over the balance of the year. Emerging market (EM) debt also garnered a lot of interest. Aggressive EM central bank tightening starting in early 2021 has been impressive, and there are now very high real yields to be had in those markets. Further, a peaking U.S. dollar would add a nice FX tailwind to local EM debt.
European insurance companies have clearly benefited from the higher interest rate environment, with better solvency and improved financial results for life insurers. However, the downside of higher rates is most insurers are sitting on sizeable unrealized losses in their fixed income portfolios. In the banking sector, we’ve seen deposit flight from low or non-interest bearing accounts in search of more yield as rates have risen. The insurance equivalent risk is lapse risk. How will this have an impact on the insurance sector?
Our insurance research analyst recently met a number of insurance companies at an industry conference where most suggested that they had seen no trend changes in lapse rates. Unlike in the banking sector, where deposit transfers are quick and easy, there are various hurdles in place that prevent a large increase in insurance policy lapses. These include various penalties such as surrender fees and the loss of bonuses at a policy’s maturity. Other things to note include loss of protection/coverage and, most importantly, insurance policies are considered to be long term in nature. Despite these, we will continue to monitor lapse risk. Insurers also hold liquidity buffers to cover stress scenarios, including a potential increase in surrenders, and have undrawn emergency liquidity facilities. Under Solvency II and equivalent capital regimes, insurers must also hold sufficient capital against lapse risk to cover losses (including investment losses) in a 1-in-200 year event. In our view, the resulting long-duration liabilities make the relevance of unrealized losses on hold-to-maturity assets much less relevant to insurers. Moreover, insurers are typically cash rich as they receive premiums before paying claims, which also limits a need to sell assets.
Insurers’ balance sheet fundamentals are currently robust with higher asset quality in investment portfolios, which are well place to withstand an impending slowdown in economic growth.
Similar to other insurers, Asian insurers have been focused on adjusting their portfolios to de-risk from certain issuers in the banking sector, notably the regional banking sector, and re-allocate elsewhere when possible. Liquidity has proven to be challenging, but we have supported realizing some losses to exit these positions where appropriate and possible. In particular, we’ve spent time digging into the held-to-maturity portfolios, where sales are more difficult to approve, and identified a short list of credits that we feel warrant more flexibility to trade. Working with our clients ahead of any future market uncertainty will help protect against downside returns.
Aside from the efforts to de-risk, we are now moving toward the stance in positioning end-of-cycle trades. The last two weeks appear to have signaled a regime shift in central banks. While most central banks still hiked at their March meetings, we expect them to tread cautiously going froward as credit conditions tighten even further and more cracks in the economy emerge. With the regime shift, markets have begun to price in recession and abandon the hope of a soft landing. As mentioned earlier, we believe this is just the beginning of a series of events that will drive us into recession. In preparation, we will continue to stress test and monitor portfolios with the assumption that volatility will persist and more economic weaknesses will arise. Having expected recession as our base case for the second quarter in a row, we feel our portfolios are well equipped to withstand the volatility that lies ahead.