An old adage states, “May you live in interesting times.” There is debate about where the saying originated and whether it is a curse or blessing. However, if you view this adage through the market’s lens, the financial markets are acting as if nothing interesting at all will happen in coming years. Equity valuations are at elevated levels and risk premiums (spreads) on investment grade and high yield corporate bonds are at or near historical lows. Movements in nearly all asset classes, be they currencies, fixed income or equities, exhibited subdued levels of volatility throughout 2017. In fact, the annualized year-by-year volatility on the S&P 500 was the lowest ever in 2017 at a mere 3.89%.
The question remains however: what will finally cause risk premiums to experience a sustained widening? Several potential catalysts come to mind. If U.S. Treasury bond yields move higher quickly, significant negative total returns could scare certain investors. This is important, as the ownership of domestic corporate bonds has shifted over the past decade. In 2017, approximately 50% of the U.S. corporate bond market was owned by non-U. S. investors and mutual fund/ETFs (versus 29% in 2007), which typically are more price-sensitive than insurance companies and pension funds (who buy corporate bonds for yield and are less concerned with periodic price movements). A geopolitical event, perhaps with North Korea, Russia or an unknown exogenous shock could also increase market volatility and lead to a spread widening. Inflationary pressures are slowly building and could also put some modest upward pressure on interest rates. Any upward trajectory in interest rates will likely be constrained due to the extraordinary levels of global debt, and the extraordinary amount of negative yielding bonds outside the U.S.
From an economic perspective, 2018 looks relatively promising. Global economies are showing more synchronized growth than at any time in the last ten years. Enormous global central bank accommodation and intervention is finally beginning to have a definitive impact on the world’s economies. U.S. recessionary indicators appear especially serene; the corporate bond market (tight yield spreads) looks healthy. Meanwhile, prices at the pump, while higher, currently present no issues for U.S. consumers. Washington’s recently enacted tax law is widely expected to modestly, at say 0.3% per year, boost U.S. growth over the next two years.
Unfortunately, much of this good economic news is already priced into risk assets, particularly in the U.S. The median S&P 500 stock currently trades at valuations (as measured by the Shiller P/E and Price/Sales ratios) that are higher than the last two market peaks. U.S. small cap stocks now trade at their highest level ever (using Cyclically Adjusted P/E’s). In our view, these record-setting valuations are primarily the result of historically low interest rates and less justified by expected earnings growth. And while 11th hour tax reform may extend the amazing run, how companies utilize their unexpected tax windfalls to sustain and support their earnings growth will be the key to further market upside. Stock markets in the rest of the world, while still pricey, are relatively cheaper. Japan, Europe and emerging market equities (primarily in Asia) remain as particular points of emphasis where upside return potential looms positive.
As insurers revel in the returns equity markets have blessed them with surplus growth in 2017, they must also prepare for the realities of increasing probabilities that we are in the beginning phase of a rising interest rate cycle. While on one hand it will improve investment income prospects for their fixed income portfolios, on the other hand will most certainly negatively impact their portfolio market values and liquidity.
In fact, Madison Scottsdale views this as one of the biggest risks insurers will face and be required to manage with far greater focus and precision than they have for the last 35 years of a bull market in fixed income. Rising rates will eventually begin to negatively impact insurance company portfolios as the Fed continues its great unwind of accommodative monetary policy and other monetary tools that were created during the 2008 credit crisis. Thus far, Fed increases are primarily affecting only the short end of the yield curve where their downward pressure on market values is less impactful and providing twice the investment income earning potential than existed less than a year ago. This has resulted in a flattening of the yield curve that has been mostly a function of the Federal Reserve (Fed) raising short-term interest rates three times during the year while longer-maturity bond yields didn’t move much due to low inflation and global demand for “higher yielding” bonds--with roughly 30% of global government debt in negative yield territory, the U.S. remains one of the most appealing options out there. In the end these increases on the short-end of the yield curve have presented opportunities for insurers that have been accumulating cash or overweight risk and volatility to do some Enterprise Risk rebalancing in their portfolios.
In 2018, insurers will likely continue to face an environment filled with uncertainties, volatility and concurrent risks that haven’t been experienced to this magnitude for some times. And through it all, they must be able to demonstrate with greater precision, process and documentation that from an Enterprise Risk Management perspective their risk-mitigation programs appropriately balance and monitor their investment portfolio related risks with all key aspects of their financial and operational risks within the enterprise. Insurers are being required to more clearly define and institute a Corporate Governance plan and policies, alongside their Enterprise Risk Management plan. For companies that are rated by a rating agency such as A.M. Best or file statutory statements with the NAIC, significant changes in methodology in risk-based capital measurement models to assess some of the risks that factor into an insurers risk-based capital, and overall ERM profile, are being deployed or are in the offing. Depending on how insurers have navigated and positioned their portfolios to capture yield in this historically low yield environment or leveraged surplus in their equity allocation to further grow surplus, these changes could have material impacts on their risk-based capital assessments and corresponding “adjusted capital.”
In the end, the end of a bull market in fixed income will force insurers and their investment managers to fine tune their focus and reassess their risk tolerance as the forgiving nature of bond market values “always going up” is seemingly at an end. Built-up unrealized gains stemming from the past have begun to dissipate as rising yields slowly chip away at market value, and thereby, legacy portfolio liquidity. This will make the importance of building natural liquidity in one’s portfolio more critical than ever before and require a refocused discipline of cash flow modeling and bond laddering to ensure funds are available when operational needs dictate.
The probability of 2018 experiencing as little volatility as 2017 is small when looking at the markets from a historical perspective. Few things hold true in financial markets, but two that we can count on are: markets are mean reverting and trends last until they don’t. Normally, market reversals exhibit large amounts of volatility. If the markets do become more interesting in 2018, insurers will have to decide if the old adage is a blessing or a curse.
Intended for insurance industry professional use only. Nothing contained herein is or intended to be a recommendation to buy or sell any security nor is it intended to represent the performance of any Madison product or strategy.
Although the information in this report has been obtained from sources that the Firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitute the Firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
Past performance is not a guarantee of future results. Madison Scottsdale is the insurance asset management division of Madison Investment Advisors, LLC. © January 23, 2017.