Risks to our outlook
Downside risks to our views include the threat of a severe recession in the US, which could come about because either: 1) the Fed is unsuccessful at re-anchoring inflation; or 2) financial conditions tighten excessively. A severe recession is also a downside risk in Europe, where it would most likely be precipitated by a prolonged energy crisis and associated cuts in industrial production.
Other downside risks include extreme currency volatility (e.g., markets punishing the currencies of regions with expansive fiscal spending and too-loose monetary policy) and more dramatic developments in the Russia/ Ukraine conflict, including a higher risk of nuclear deployment by Russia. Upside risks include a “soft-landing” economic scenario, where the Fed tightens policy just enough, and significant policy intervention in China. On a more micro level, corporations may be able to maintain pricing power, thus preserving profit margins and sustaining earnings growth over a 12-month period at higher levels than consensus currently expects. An upside risk to our equity underweights (whether overall or regional) is that valuations, especially in Europe and EMs, may have adjusted to more than fully reflect lower earnings and other headwinds.
Investment implications for insurers
Continue to source opportunities within reserve-backing fixed income allocations — High-quality fixed income looks more competitive versus equities from a yield perspective and could offer upside and diversification once a slowing cycle gains traction. We continue to see opportunities in structured credit and short-duration corporate credit.
Approach surplus-credit investments with caution — Credit spreads do not look particularly attractive right now, given the higher risk of recession. However, be ready to act accordingly if spreads widen out closer to recessionary highs.
Tilt toward quality — Synchronized central bank tightening is likely to slow the global cycle. We think the focus should be on companies with pricing power, long-term profit margin stability, and healthy balance sheets, given their potential to fare relatively well amid cost pressures and market volatility. Company fundamentals in the energy and materials sectors appear attractive, thanks to capital discipline, reasonable multiples, strong cash flows, and well-behaved credit spreads.
Prepare for regional divergence — While many central banks are tightening policy at the same time, we expect individual economies and markets to respond differently. For example, European equities and rates appear more vulnerable to drawdowns than their US counterparts. Currency exposures bear watching in the period ahead, as we could well see more cases of a country’s fiscal and monetary policies working at cross purposes — like the one that recently sent UK government bond yields soaring — which could create market dislocations and investment opportunities.
Continue to seek inflation protection — While demand destruction is a headwind for commodities, a continued supply/demand imbalance could push oil prices higher, as could potential output cuts signaled by OPEC. We think TIPS “breakeven” inflation rates remain attractive, as do some real assets and other alternative investment strategies with high beta to inflation. (To learn more, please see my September 2022 white paper “The road less traveled: An insurer’s path to investing in alternatives.”)