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Insurance Multi-Asset Outlook

Core fixed income: Stop me if you’ve heard this one before

Tim Antonelli, CAIA, CFA, FRM, SCR, Head of Multi-Asset Strategy - Insurance and Portfolio Manager
2024-07-31
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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

Key points

  • The global economy has remained resilient, shrugging off the US banking crisis and riding on positive sentiment from generative artificial intelligence (AI) and the potential for a soft landing. However, I continue to expect tighter credit conditions and restrictive policy to take a toll on the economy, and I favor reserve-backing fixed income over surplus investments at this time. 
  • My base case of recession leaves me with a slightly overweight duration stance overall and a preference for US rates in particular (excluding liability foreign exchange considerations). While I maintain an underweight view on surplus fixed income, I have a more favorable view on investment-grade corporates given declining but still-strong corporate fundamentals. 
  • Japan remains my top developed equity market. Japanese companies are benefiting from inflation, monetary policy remains easy compared with other developed markets, and shareholder activism is improving corporate governance. I have lower conviction on my China overweight given the debt overhang in the property market and consumer skittishness.
  • I retain a positive view on commodities, with a focus on copper and gold. While cyclical factors could weigh on oil and metals, I expect constrained supplies to support prices. 
  • Alternative assets could be primed for a strong second half of the year for asset owners who find strategies designed to capitalize on a segmented market.
  • Downside risks to my views include a severe credit crunch and recession in the US or Europe, and geopolitical risk involving China or Russia. Upside risks include a soft-landing scenario where central banks tighten policy sufficiently to quell inflation while not inducing a recession.
todays-sweet-spot-for-yield-mao

The global economy has been more resilient than expected, but I think recession is delayed, not defeated. In hindsight, the effects of tighter monetary policy were offset by excess savings, tight labor markets, the relative insensitivity of consumers and businesses to higher interest rates, and the breakout of generative AI. But these positives are now more than priced into equity valuations, and looking ahead, I see central banks continuing to hike rates and squeeze the economy.

Despite policymakers’ initial success at containing problems in US banking, this is a story that hasn’t fully played out. Banks face higher funding costs, larger capital requirements, and deteriorating credit conditions, including in the weak commercial real estate market. They are likely to reduce lending, the lifeline of the economy. Liquidity may be further impaired when, as part of the US debt-ceiling deal, the US Treasury issues US$1 trillion in new bonds, whose attractive yields will draw assets away from bank reserves. 

Against this backdrop, I recommend that insurers consider remaining somewhat defensive, with a preference for reserve-backed fixed income over surplus assets broadly. 

I retain my underweight view on surplus fixed income. Tighter lending standards are beginning to show up in higher bankruptcy rates, which are bound to hurt riskier credit, like high yield. Within existing mandates, it may be wise to rotate into higher-quality parts of the market (e.g., BB/B rated issuers). While corporate fundamentals appear to be deteriorating broadly, I am more sanguine on global investment-grade credit, where starting levels for fundamentals are quite strong and elevated cash balances have helped avoid the need for financing. I still see value in the securitized space, namely in collateralized loan obligations (CLOs) and asset-backed securities (ABS). I remain cautious on commercial mortgage-backed securities (CMBS), and conduit deals in particular.  

I have reduced my view on Chinese equities to “moderately overweight,” as the consumer-led recovery in China has fallen short of expectations. My view on Japanese government bonds remains at underweight. Japan’s government seems content to stand pat on yield-curve control and interest rates for now, as inflation is a net benefit to consumer wages and company margins. I also remain moderately overweight commodities, with a focus on copper and gold given supportive supply/demand dynamics. 

Fixed income: Reserve-backing assets still looking good

I continue to see central banks effectively engineering an economic slowdown, and thus retain a slightly bullish view on reserve-backing fixed income. Market expectations for policy rates shifted higher during the second quarter as the Fed and other central banks reiterated their commitment to fighting high, sticky inflation despite evidence that inflation is falling. A “pause,” which used to mean the next move would be a rate cut, is now more likely to be a “skip,” in which central banks wait to see the cumulative impact of tighter policy before resuming hikes. We’ve seen this already with the Bank of Canada and the Reserve Bank of Australia. 

In the world of government debt, the market’s repricing makes US government bonds more attractive than European and Japanese government bonds. The Fed’s tightening campaign should benefit longer US maturities, which longer-duration insurers and pension funds continue to acquire. Europe is still earlier in the hiking process and inflation is higher than in the US. As noted, I believe any tightening in Japan will be gradual.

Meanwhile, we are at the late stage of the credit cycle, characterized by an inverted yield curve, tighter credit conditions, and deteriorating fundamentals. Historically, these conditions have been reliable indicators of negative excess returns relative to government bonds over the following six to 12 months. Year to date, US bankruptcies have exceeded levels of any comparable period since 2010 (Figure 1). I think high-yield spreads should be at least 140 basis points (bps) wider than the current +430 bps spread, given the risks described earlier. I expect investment-grade credit to outperform high yield in this environment, yet high-yield spreads tightened during the second quarter while investment-grade spreads were relatively unchanged. Taking this into account along with the strong starting level of investment-grade fundamentals, I have raised my view on global investment-grade credit. Given that we have seen a relative decrease in below-investment-grade bond allocations by US insurers over the last year (Figure 2), the rotation into the investment-grade space, even with surplus dollars, has remained a strong risk-adjusted return trade. 

ABS and CLOs remain among my best ideas within the securitized space, and as noted, I remain cautious on conduit CMBS deals as a result of their exposure to pure office-space properties. My view on municipal bonds (both taxable and tax-exempt) remains unchanged quarter over quarter, although I think there is value to be found at the long end of the tax-exempt curve. Finally, I prefer emerging markets hard-currency debt over global high-yield corporate bonds, with more risk priced into the former. The EMD asset class also skews to higher credit quality, consistent with my overall preference for investment-grade bonds over high yield.

Figure 1
private-biotech-innovation-amid-disruption-fig1
Figure 2
todays-sweet-spot-for-yield-fig2

Equities: What to expect from the second half of 2023

I am slightly more cautious in my global equity view, moving from moderately underweight to underweight. Equity markets have gained ground this year despite the rise in real yields and conflicting signals from manufacturing and services activity indicators. While we’ve seen some cyclical disinflation, tight labor markets and robust consumption in many regions suggest there is still insufficient slack in the system to move core inflation sustainably back to target. Consequently, I expect the emphasis on tighter monetary policy to remain in place, further slowing the economy.

This makes it hard to rationalize the equity market’s gains year to date, all of which derive from forward multiple expansion rather than an increase in earnings-growth expectations (Figure 3). Similarly, the growth segment of the market has outperformed the value segment, despite the negative historical relationship between the growth factor’s relative performance and rising rates.

Figure 3
todays-sweet-spot-for-yield-fig3

Optimism about AI’s potential has helped drive gains in a relatively limited group of large-cap stocks, especially in the US. On the sentiment front, the recent run is likely overextended, driven by more bullish institutional positioning. There is certainly potential for AI to fuel a boom in the economy and in markets, but this is likely to play out over several years and be a complex process, allowing for productivity gains but also varied forms of disruption. What’s more, ascribing the right earnings forecast and valuation multiple to account for significant technological revolutions is hard, if not impossible. While I would not chase the rally in tech, I would seek balance in exposure to value versus growth in the near term. 

Earnings breadth has been mixed across regions, but globally has moved into positive territory. I see this as grounds for some optimism, but my base case is that macro deterioration will weigh on earnings expectations.  

China’s performance this year has come as a significant disappointment. The recovery has been uneven, with the goods sector still weak but services also stalling a few months after the post-COVID reopening. Structural issues, including in the housing market and local government financing, are holding the recovery back. Policymakers have confirmed the need for “more forceful” stimulus measures, but it isn’t clear whether the timing and magnitude of their efforts will suffice. That said, I think depressed valuations and positioning signal deeper pessimism than is warranted, and while I have tempered my own optimism, I am still comfortable with a moderate overweight view.

In Japan, positive momentum has reinforced my overweight view. Japanese companies have been able to maintain their pricing power amid rising inflation. Meanwhile, the Bank of Japan (BOJ) has taken a gradualist approach to its revision of yield-curve control, leaving overall policy very reflationary. Structural tailwinds remain in place, including improved corporate governance and increased corporate investment in productivity enhancements. On the flip side, the market has rerated significantly, to the point where some valuation measures (e.g., price-to-book ratios) have risen to median levels from compellingly cheap levels earlier this year. 

I maintain an underweight view on the US market, where I see downside risks for lofty valuations and earnings expectations. Europe faces headwinds of its own, including weaker leading indicators of activity, hawkish commentary from the European Central Bank (ECB), and the weaker-than-expected recovery in China. 

Regarding sectors, I favor industrials over financials. Despite the competent handling of US regional banking failures by policymakers, tighter regulations and capital requirements will have consequences for US banks’ profitability and valuations. I have neutralized my relative view on value versus growth over the quarter, but my longer-term view is that value factors will outperform in an environment where inflation and interest rates will likely be higher than in the last cycle.

Commodities: Should insurers take a longer look?

As I have acknowledged many times before, insurance companies seldom play in this space for a variety of reasons. However, those who subscribe to the theory that the next few decades will be marked by more mini-cycles, more volatility, and higher structural inflation may want to consider tactically adding exposure when it makes sense. To that end, I maintain a moderately overweight view on copper and gold. My positive view on copper balances very favorable long-term supply dynamics with expectations of lower demand from China’s reopening. Gold has retreated recently as banking and debt-ceiling risks have ebbed, but I think the precious metal should be a medium-term beneficiary of higher stagflationary risks, as well as the potential for geopolitical deterioration or de-dollarization. Meanwhile, my positioning indicators on gold are not stretched and there has been increased gold buying by Asian central banks, which usually buy on dips. 

My view on oil remains neutral, as OPEC supply discipline has to be set against expectations of demand loss in a recession. I am also watching the impact of Russian oil, amid some supply leakage into world markets and fast-moving events related to the war. 

Alternatives

Commercial real estate: Searching for value (add)

Concern about the commercial real estate (CRE) space remains elevated, and the market reflects it. For example, in the first quarter of this year, New York City saw CRE sales of US$2.2 billion, a nearly 60% decrease versus trailing four-quarter average sales, and down over 50% from the fourth quarter of 2022.1 This projects to be the slowest year for CRE sales since the 2008 financial crisis. That said, CRE strategies with the potential to capitalize on a changing market, or even thrive because of it, continue to find favor with insurance investors. Value-added real estate strategies grew 29% in AUM over the course of 2022, according to Preqin, which notes the increase is likely the result of these strategies’ ability to invest in projects that focus on repositioning old office space to fit the new hybrid work model. Typically, value-add strategies focus on downside risk mitigation and target properties with stable income profiles — a combination that may suit insurers well and make a case for a rotation from core real estate strategies into value-add strategies. 

Private equity: Don’t overlook the secondary market

In the previous Insurance Multi-asset Outlook, I discussed the interest some insurers with significant private and illiquid allocations were showing in changing their investment strategy after public market assets sold off drastically in 2022, thereby making the private allocations too large on a relative basis (the “denominator effect”). A popular way to reduce exposure for the largest holders of private assets was utilizing the secondary market. This market has experienced substantial growth in recent years, with US$100 billion in transaction volume in 2022 alone.2 Not only is the secondary market being used for liquidity purposes, it is also being used by asset owners to actively manage illiquid assets, allowing them to be more nimble and, in some cases, invest with hard-to-access general partners offering continuation funds for desirable strategies. 

Midsize insurers who are in the early days of adding to a private allocation may want to consider supplementing primary transactions with potentially discounted exposure in the secondary market. As Figure 4 shows, markdowns in the secondary market, particularly in times of public market sell-offs, could make the entry point attractive. And while this has been done largely in the private equity space, the entirety of the private asset class now has some element of a secondary market.

Figure 4
todays-sweet-spot-for-yield-fig4

Hedge funds: Is now the time to consider macro strategies? 

The equity run during the first half of the year and better-than-expected fundamental macro data were not conducive to strong returns in the macro strategy space. That said, central banks are on a very different footing as we enter the second half of the year, as noted earlier. The US may be at the end of its hikes, while the European Union and the UK have much work to do. This dispersion in interest-rate policy may be one of the best tailwinds for traditional macro strategies, and we could see a return of outperformance more in line with 2022. While long/short strategies finished the first half of the year in the black, they trailed broad equity indices, which were driven by gains in growth and technology. However, having risk-managed diversifiers in an investment lineup could prove useful if the ever-looming recession finally arrives.   

Private placements: More than meets the eye?

At some point, private placement fixed income may no longer be labeled an “alternative” asset for insurers. Both long- and short-duration underwriters are increasingly considering private placements as an extension of traditional core fixed income (while recognizing there may be different risks to consider). As we head into the second half of the year, some hallmarks of the asset class, beyond the prospects of an illiquidity premium (Figure 5), could become more attractive. For example, our private credit team has noted several potential benefits: 

  • The low correlation to traditional asset classes in times of market stress  
  • Bespoke deals that may offer strong covenants and therefore more downside protection (perhaps ahead of a recession)
  • The advantages of the floating-rate part of the market in a rising- or elevated-rate environment
Figure 5
todays-sweet-spot-for-yield-fig4

Risks 

Upside risks to my views include the possibility that central banks slow the economy enough to moderate inflation without crushing labor markets and consumption, leading to a soft landing. We could also see long-lasting liquidity and cash buffers create an even longer lag between rate hikes and an economic slowdown, delaying the recession beyond my 12-month horizon. I’m also watching the possibility that China's economy reaccelerates, with global spillover effects, and that the narrow rally in equity markets broadens out and becomes more durable.

Among the downside risks are a deeper recession as a result of financial accidents (e.g., a broadening of the banking crisis); a civil war in Russia or existential threats to Putin’s leadership, leading to military escalation and the prospect of unconventional warfare; and a petering out of China’s recovery, with consumption stalling alongside weakening industrial activity.

Investment implications 

Investment-grade bond yields look relatively attractive — Consider continuing to add to reserve-backing fixed income allocations, which could potentially offer decent income, diversification, and capital appreciation. I favor high-quality fixed income given that spreads in surplus fixed income are not compensating investors for recession risk.  

Stick with quality equities — Restrictive monetary policy has taken longer than expected to work through the system but will still weaken growth and pressure earnings. I think the focus should remain on quality in developed market equities as valuations have become pricier amid optimism over generative AI. I favor companies that can withstand inflationary and balance-sheet pressures and, from a sector perspective, prefer industrials over financials. I wouldn’t chase the rally in AI from here and I’m neutral on US tech. 

Japan stands out amid developed market equities — Valuations have increased as flows move to this neglected market. However, I maintain that Japanese equities have more room to run, with markets finally engaging with improved corporate governance and capital return to shareholders. China’s recovery has disappointed, but current pricing reflects more pessimism than warranted, in my opinion.  

Seek niche opportunities in alts — Look for segments of the alternatives and private universe that may capitalize on market dislocations or structural shifts. Consider sourcing new vintages with proven managers who can access the best deals, but also supplement the exposure via forced sales in the secondary markets, as asset owners look to bring their allocations into alignment with long-term objectives. 

Prepare for a wide set of possible outcomes — Markets have shrugged off various risks, including in banking, credit conditions, inflation, and geopolitics, but uncertainty still reigns. Insurers should take a fresh look at commodities, in which I favor gold in the face of stagflationary risk, geopolitical deterioration, or de-dollarization. I think copper will play a large role in the energy transition but faces severe supply constraints.

1Source: Bisnow.com, 10 April 2023 | 2Source: Jefferies-Global Secondary Market Review, January 2023

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