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Heading into 2023, inflation remained a key concern for insurers, with mixed views on potential regulations from central banks and what this could mean for investment returns.
There is concern in wider society about issues such as wage-price spirals and how it will affect investors and other financial institutions if 2023 sees workers continuing to bargain to catch up to inflation on hiked production costs. For insurance investors, this situation could mean even tighter monetary policy in the coming year, which would in turn usher a deeper economic downturn.
The bleak outlook comes on the heels of the UK’s recent Solvency II announcement, which – due to 60-70% risk margin reduction for life insurers and 30% reduction for general insurers – potentially frees up over £100 billion in the next ten years for productive investments.
With UK insurers now scrambling to optimise return on Solvency II capital, the question of social infrastructure gains prescience. As it becomes easier and more desirable for insurers to allocate this buffer capital elsewhere, many wonder if increased wage demands will be prioritised – or not.
Patrick Bradley, Senior Vice President of Investment Research at Brandywine Global, said that going into 2023 central banks should be concerned about the increasing unpredictability around inflation expectations, though there are some positive aspects to the situation.
“This suggests that markets are expecting somewhat higher inflation,
which could negatively affect asset prices.”
“Most measures of inflation expectations are below 3%,” he said. While this number isn’t extraordinary off the charts, it is higher than the [US Federal Reserve’s] current 2% average inflation target. “This suggests that markets are expecting somewhat higher inflation, which could negatively affect asset prices,” he added.
However, this situation might also indicate that central banks could target a higher rate of inflation going forward.
While certainty on inflation outlooks remain up in the air and a streamlined verdict does not appear likely, one of the most pressing questions is whether potential adjustments would even assure the desired average. “Some of us are doubtful,” Bradley said.
A recent report from Hargreaves Lansdown said that the Bank of England (BoE) expects inflation to “fall sharply in the next two years, with annual price increases expected to decline to 5.2% in the fourth quarter of 2023, 1.4% in the fourth quarter of 2024 and reaching 0% inflation at the end of 2025.”
With this generally gloomy outlook comes expected pain points as well as a few opportunities.
“Consumers were flush with cash and had a desire to spend
it on cars, houses, and more.”
While Russia’s war in Ukraine cemented the negative inflation outlook — particularly in Europe, which depends on Russian commodities, such as gas and oil — it also meant that long-term spending increased. “Consumers were flush with cash and had a desire to spend it on cars, on houses, and more,” said Bradley.
Despite demand, however, supply constraints were prominent, affecting automobile production with the industry experiencing semiconductor shortages and houses with lumber prices rising rapidly. “Higher interest rates and quantitative tightening will not produce one more semiconductor,” Bradley continued. “Nonetheless, we have seen some demand destruction and some loosening of supply constraints.”
A post-Covid-19 analysis from the UK’s Office for National Statistics said that “looking at longer term trends, spending on travel and accommodation as well as pubs, restaurants and fast food (including takeaways), has recovered slowly to pre-pandemic levels.”
However, the analysis went on to note that recent rises in spending are likely reflections of rising prices rather than increasing purchasing desire.
Brian Nick, Chief Investment Strategist at Nuveen, a TIAA company, said that shifting consumer preferences away from goods might lead to sharp deflation in many areas.
“The nature of the bottom is difficult to gauge at the moment, so cyclical
asset classes with high economic sensitivity could be pain points.”
“We see the global economy slowing further in 2023,” he added. “The nature of the bottom (soft landing versus recession) is difficult to gauge at the moment, so cyclical asset classes with high economic sensitivity (industrials/energy/materials in equities or lower-rated corporate bonds) could be pain points, as could private real estate in the near term as rates make deals harder and refinancings are more expensive.”
According to Nick, areas for opportunity include parts of the equity market that are interest-rate sensitive and defensive: real estate investment trusts (REITs) and higher-rate parts of the bond market, for example, such as corporates above BBB ratings.
When it comes to further regulatory action from central banks, investors are on the fence. This uncertainty could mean stalling in 2023 with fiscal plans and allocation decisions.
In the absence of stark signs of a recession — rising unemployment included — the current inflation rate doesn’t necessarily indicate that centrals banks, the US Federal Reserve in particular, will step in to ease burdens.
“As inflation rolls over and growth risks become more apparent,
different central banks will time things differently.”
Nick said that he expects tighter monetary policy in the first half of 2023, compared to looser policy in the second. “As inflation rolls over and growth risks become more apparent, different central banks will time things differently. The Fed will likely be able to keep rates high throughout 2023, but other banks may be forced to cut sooner.”
Bradley said he believes, instead, in the likelihood of smaller rate hikes, with an easing cycle being initiated in the third quarter of 2023. “Inflation has receded, but it remains too high.”
This means that in 2023 and beyond, it’s possible that central banks will consider a higher inflation target – and there are other key contributing factors as well. Because the transition to a net-zero economy has the potential to increase inflation, a 2% average rate may be difficult to meet going forward. Additionally, as workers continue to demand higher pay, a higher inflation target would move the policy rate further above the zero bound, giving central banks more room to shift monetary policy in the event of an extreme recession.
For insurance investors and for those that can stay the course, this means added opportunities in private markets – which are less liquid – despite continued uncertainty. “There may be some price adjustment still required before things become unusually attractive again (such as real assets or real estate), but we think this is a good time, generally, for investors with long-term liabilities to invest and/or rebalance,” Nick said.
