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As we march into the second half of 2022, the “bread and butter” of most insurers’ asset allocation is beginning to look more promising, as we have improved our outlook for reserve-backing fixed income assets. Market worries seem to be shifting from stagflation to weaker growth, yet fed funds futures are signaling more interest-rate hikes ahead than the US Federal Reserve’s (Fed’s) already-hawkish forecast. For our part, we think slower growth and the market’s expectations will limit future spikes in rates. In the meantime, higher yields of around 4.5% in US high-quality bonds mark a departure from the return-free rate environment and offer a welcome reinvestment rate for insurers. However, we still have a moderately underweight view on surplus fixed income.
Regarding global equity markets, despite the steep sell-off through the first half of this year, we see three reasons to believe the backdrop will remain negative and warrant a moderate equity underweight for the next 6 – 12 months:
The US equity market, where valuations are still fairly high, might well be feeling “ghosted” by the Fed, with Chair Jerome Powell having all but said the central bank will not come to the market’s rescue and will be looking for the economy to pass longer-term inflation tests before taking a less hawkish stance. On the other hand, the US entered this challenging period in a strong position, with healthy household and corporate balance sheets. Elsewhere, Japan has the advantage of relatively attractive valuations. Thus, we prefer only a moderate underweight to equities and favor the US and Japan over Europe and emerging markets.
Lastly, we believe many insurers should be increasingly open to the idea of having an appropriate portfolio allocation to alternative investments, including real assets such as commodities. (In our next white paper later this year, we will explore how global insurers can seek to tap into the alternatives universe.) We remain bullish on commodities amid high and “sticky” inflation, although we have taken our view down a notch to moderately overweight. This change reflects our belief that the current cycle may put a slight damper on global demand, but that structural issues limiting supplies in energy and metals will prevail.
Three factors have made us a bit more optimistic that the 10-year US Treasury yield will find a clearing level at around 3% in the period ahead:
Within high-quality interest rates, we favor US rates and investment-grade corporates relative to European government bonds and are neutral on Japanese government bonds (JGBs). While the Fed is the most hawkish of the developed market central banks, we think markets have adequately priced in Fed policy tightening. We see potential for more rate-related pain in Europe, where the 10-year bund yield is at around 1.1%, inflation is very high at 8.1% (as of 31 May 2022), and the European Central Bank (ECB) is becoming increasingly hawkish. In Japan, inflation, at around 2.5%, is just above the central bank’s long-awaited target. Even if the bands for 10-year JGBs are widened due to concerns about higher inflation, we think the upside risk for Japanese yields remains limited.
As of 31 May 2022, US corporate bonds were offering a yield of 4.2%, so we believe many insurers should continue to “clip” steady coupons that are compounding at higher-than-median spreads. In our view, surplus fixed income assets are vulnerable to credit spread widening in a slowing economy. As of 31 May, both US high-yield corporates and emerging markets debt were trading at around their historical median spread levels (Figure 2). Finally, although we remain neutral on bank loans at their current valuations, we believe an allocation to the sector still makes sense in a rising-rate setting.
We maintain our moderate overweight view on Japanese and US equities relative to their European and emerging markets (EM) counterparts.
Japan’s equity valuations appear to be the most attractive among major developed market regions (Figure 3), while its weak currency is also a potential advantage for investors. In contrast to many of its peer nations, we believe Japan should benefit from higher inflation, given its secular backdrop of persistent deflationary pressures. In addition, broadly speaking, its market is underowned by global investors and might therefore benefit from a pickup in asset inflows going forward.
With the Bank of Japan steadfast in its pursuit of yield-curve control, even as other developed market central banks tighten monetary policy, Japan appears to have a more supportive policy mix than other regions globally. Taking this into account, along with clearer evidence of Japan’s improving corporate governance and comparatively low valuations, we expect Japanese equities to continue their year-to-date outperformance against other regions on a local-currency basis.
US equities have been particularly exposed to the recent global sell-off given the US market’s bias toward technology and expensive growth stocks, which tend to be higher duration in nature. The repricing of such stocks may not be over yet, but amid mounting global growth risks, the US market could have an edge, being relatively more defensive in nature versus other regions, especially in an environment of heightened geopolitical uncertainty. This could present some attractive entry points into the US market for insurers that are looking to add to their risk assets in the second half of the year.
Europe has higher leverage to the global cycle and a more fragile growth backdrop, in part because of China’s ongoing struggles. We maintain our moderate underweight view on European equities, as tighter financial conditions in the region should begin to hurt purchasing manager indices. The ECB has opened the door to the possibility of a June rate hike and signaled an end to quantitative easing in the third quarter of this year, as inflation concerns remain front and center. The Ukraine war continues to put pressure on Europe’s economy as these countries pivot away from Russian oil and gas.
While EM equity valuations are relatively low at this time, China faces potentially long-lasting uncertainty with respect to COVID and regulatory policy, which means the risk premium is “chunky” but a clear catalyst for a reversal in performance lacking. Other large Asian EMs are battling headwinds as well, including global cyclicality (Korea and Taiwan) and costly energy (India). High energy and food prices are likely to impact many EMs and could even raise the risk of political crises. Within EM equities, we prefer Latin America given the region’s heavy commodities exposure.
As in previous quarters, we continue to see a case for diversified global commodities exposure on the back of structural inflationary pressures stemming from underinvestment in production capacity and inventories mired at multidecade lows. Still, we have changed our view on commodities from overweight to moderately overweight to reflect weaker global demand, as the balance of macro risks shifts from stagflation to a growth slowdown.
With slowing growth likely to put downward pressure on prices, we favor industrial commodities with acute supply bottlenecks (such as aluminum) and those hit directly by curbs on Russian imports (such as oil). The oil market remains tight, although the lockdown-induced slowdown in China and the potential resulting impact on global demand have made us somewhat less bullish on oil.
While a global recession is not our base case forecast, the probability has risen to the point that it cannot be ignored. Recession is the much-feared downside scenario where tighter fiscal and monetary policies aimed at reversing stubborn inflationary trends have a high potential for policy errors on the part of global governments.
Central bank policy tightening measures are already starting to adversely impact the most interest-rate-sensitive sectors of the global economy, such as the housing market, while consumer confidence continues to weaken as well.
Meanwhile, the prolonged period of low rates and excess global liquidity has likely led to misallocations of capital in some market areas, which may be vulnerable as “air pockets” in liquidity are revealed. These could lead to unwelcome episodes, or even market failures, as in past periods of reduced liquidity. This of course could have major negative implications for global insurers, many of whom have added substantial portfolio exposure to less-liquid assets in recent years (Figure 4).
Another downside macro risk to consider is the threat of an escalating Russia/Ukraine conflict, which could force European nations into a full-on phaseout of Russian gas imports (not just oil). Finally, rising global uncertainty has begun to weigh on the corporate earnings outlook, with many company profit warnings precipitating sharp stock sell-offs, and earnings expectations have room for further downward adjustment.
A “soft-landing” economic scenario, with inflation moderating globally without significantly denting growth, is not our base case, but it is an upside risk that should not be ruled out. In the US, there are some indications of inflation potentially peaking (or at least abating), such as the inventory/sales of goods ratio appearing to have bottomed. While services inflation has been strong due to economic reopening pressures driving brisk demand, early signs of a slowdown in the housing market will likely feed through to shelter inflation.
China’s government is implementing a number of easing policies in an effort to counter a contraction in the nation’s economy, with some senior Chinese officials pushing for more steps in that direction. However, China’s “zero-COVID” stance could stymie the effective transmission of any such stimulus measures.
While the fiscal impulse is lacking in most regions globally, at least relative to COVID-era largesse, fiscal policy remains expansionary in the European Union and in the UK, where there is a long tail of prior programs and subsidies aimed at mitigating the impact of cost-of-living increases. The prospect of further fiscal easing in the second half of the year is an upside risk, particularly in China and Europe, and could partially offset the anticipated global growth slowdown.
Focus on core fixed income amid higher volatility — From a yield perspective, we think US interest rates and investment-grade corporate bonds — generally considered “core” fixed income holdings — stack up well against most risk assets right now. At current valuation levels, reserve-backing fixed income assets have the potential to dampen overall portfolio volatility and provide some degree of protection against further equity market sell-offs as the global cycle softens.
Be cautious with surplus fixed income — We think recent credit spread widening has further to go in high-yield fixed income assets if, as we expect, the global economy slows over the next 6 – 12 months. That being said, we see select opportunities in convertible bonds, structured credit, short-duration credit, and housing-related assets.
Tilt toward quality in equities — We expect the global cycle to slow, with liquidity being drained from the financial system, and therefore prefer a moderate underweight to equities and a bias toward quality as opposed to any particular market sector. We think companies with pricing power, long-term margin stability, and healthy balance sheets will be more attractive amid continued supply-chain disruptions, inflationary pressures, and market volatility.
Continue to seek inflation hedges — We have seen no signs that global commodities companies are planning to ramp up their capital spending and production. Thus, we expect a continued structural supply/demand imbalance that could keep commodity prices elevated and would argue for allocations to commodity equities, inflation-protected bonds, and some real assets.
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