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The global economy has reached a turning point as we approach the final quarter of the year.
For the first time since 2020 major central banks are cutting interest rates. The Bank of England and European Central Bank have already begun, with the Federal Reserve joining them last month.
This has profound implications for portfolios. Making well-timed adjustments in response will be key to the success of insurers’ investment teams over the next few years.
‘Higher for longer’ has been the default expectation on where interest rates would sit since a spike in inflation sent central bankers scrambling to close the monetary barn door after the horse had bolted. With inflation reaching very uncomfortable levels during 2022, few experts expected a quick return to the ultra-low rates that had become the norm post 2008 financial crisis.
Insurers’ investment teams, like most investors, will need to consider the degree to which higher for longer still applies, and what the appropriate changes to portfolio positioning look like as rates come down.
Helen Roughsedge, investment director at Fulcrum Asset Management, said the significant improvement in the inflation outlook means more cuts are certain, but it is too early to bank on rates falling back to the very low levels seen before the 2022 hiking cycle.
“With multiple interest rate cuts now priced for this year and next, the market seems to have shifted its focus from monetary policy to aggregate demand,” she said. “This is evidenced by the recent return to a negative correlation in stocks and bonds, in contrast to the strong positive correlation that typified the higher for longer environment seen over the past several years.
“When it comes to portfolio construction, this supports the use of bonds and equities as hedges against one another, a strategy that was common in the pre-Covid period,” Roughsedge continues.
“All of this being said, there are several important caveats. First, although rates are set to decline, they are sitting at multi-decade highs, with the Fed Funds rate at 5.25% - 5.5%, in contrast to a peak of 2.25% - 2.5% in the period from 2008 through 2021. As such, the prospect of ‘lower-for-longer’ also seems remote.”
Shannon Kirwin, Associate Director, Manager Research at Morningstar also noted the risk of overestimating how much the monetary policy picture has really changed.
“It’s important to always remember the difference between real and nominal yields,” she said. “Just because the nominal yields may look historically high it doesn't mean that in real inflation-adjusted terms, you're actually being compensated more than you could be in a theoretical environment where rates are a little bit lower.”
Kirwin added that the calculations investment teams make need to factor in the potential for bond valuations to rise as interest rates go down, but she also cautions that a small drop will not change things significantly.
“Liquidity is vital but there remains a significant opportunity cost
from holding excess liquidity."
“You will increasingly have the option to sell and make a make a profit via a capital gain rather than simply collecting the coupon,” she said. “But if interest rates stay near where they are currently there won’t be a huge impact on fixed income strategies.”
“While expectations for longer-term interest rates have moderated over the last year, 10-year yields are still over 4%,” said Derek Steeden, Director, Insurance Investment, at PwC. “That's a far cry from 2020 when they were near zero.
“Liquidity is vital but there remains a significant opportunity cost from holding excess liquidity. Having a clear sense of how much cash you need and in what scenarios can free up assets to earn higher yields, particularly where they can be held to maturity.”
One commonly used portfolio management approach is a barbell strategy, particularly on the fixed income side. The shift to rate cutting has implications for the relative merits of this.
The term refers to constructing a portfolio using a mix of high-risk speculative assets and very low risk assets, while largely avoiding the middle of the risk range. There are number of variations, depending on what type of investor is implementing the strategy.
For institutional investors, this manifests itself as targeting short and long duration bonds rather than those in the mid-range. The two key benefits of this are managing risk, with the shorter duration bonds counterbalancing the long side, and greater flexibility.
Having a good amount of short duration holdings means an investor is more likely to be able to get quick access to cash to pounce on new, better opportunities that emerge if rates change.
Kirwin said an alternative form of barbell is credit quality based. With this approach, an investment team targets very high-quality bonds such as Treasuries on the one side, and also has an overweight to low quality bonds such as CCC rated corporates.
"You generally don’t want a barbell unless liabilities are barbell as well."
There are limitations to a barbell strategy. There will of course be a lot of excellent investment opportunities that sit in the mid-risk range and foregoing them almost entirely may not be the best strategy for some investors, depending on their risk profile and goals.
For insurers and pension funds, the need to balance assets and liabilities can be a particular sticking point when considering a barbell approach.
“I’d say you generally don’t want a barbell unless liabilities are barbell as well,” said Henry Heathfield, an Equity Analyst covering the insurance sector at Morningstar. “Assets need to match liabilities, that’s number one. In the short-term a fall in rates is probably going to hurt insurers with the greatest duration mismatch on the liability side.”
Steeden notes that 'barbell' is not a phrase used much by insurers he works with as they generally frame things in terms of matching assets to liabilities.
“Insurers matching liabilities will always be predominantly fixed income investors, with an appetite for investment-grade tradable assets,” he said. From this core, smaller allocations to alternative assets offer the prospect of higher returns, required by a combination of their term, illiquidity, equity component, complexity or specialism in sourcing amongst others.
“While the risks can be modelled, assets may need to be sold when least expected, some assets can be subject to additional risk over time, such as changes to government policy, and changes in corporate strategy can leave ‘stranded assets’ or realised mark-to-market losses if the risks are not thoroughly understood.
“It is also important to be aware of the tendency of models to overlook ‘middle ground’ assets, that though they may not offer the maximum return nor maximum liquidity, can be readily incorporated while additional work is undertaken on new asset classes.”
With monetary policy pivots of the nature, we are starting to see now coming along only once in several years at most, investment teams have a relatively unfamiliar task ahead of them as they seek out money making opportunities for 2025 and beyond.
“Navigating a more uncertain policy landscape will be a key challenge for investors over the medium term,” said Roughsedge. “On the domestic front, most developed market economies are facing public debt ratios that are at their post-war highs and continuing to run structural budget deficits.
“With mounting demands in the areas of healthcare, defence and green investment, this issue is unlikely to resolve itself any time soon. This raises the prospect of higher state intervention in the economy, in the form of taxation, spending and regulation, with an associated increase in investor uncertainty.”
Roughsedge said her firm has positioned its absolute return strategies for a US economy ‘soft landing’ by targeting both bonds and equities, with the aim of taking advantage of the recent shift back towards negative correlation between the assets.
She continued to see potential for further gains in US tech stocks, while within healthcare and pharmaceuticals anti-obesity drug makers remain a good place to be invested in her view.
"Clearly as rates come down bond values rise,” said Heathfield. “This will mean a temporary uplift in bond returns. However, yields will be lower long term. The opportunities are probably that financing will be cheaper and so for anything long term that needs financing, that is likely to be a benefit. We’re probably talking infrastructure projects and real estate development.
"With fixed income fund managers that we speak to
there is optimism developing."
“I imagine those projects will start to look more appealing and more will start up again. Those projects are generally good for long term insurers because they match their long-term liabilities,” he said. “Plus, insurers can generally get an uptick in return from the illiquidity premium. That has to be balanced though with the need for liquidity should policyholders cease making contributions and look for a capital return.”
On the fixed income side specifically, Kirwin sees a likely increase in divergence between government bond rates as notable. With rates coming down on slightly different trajectories across the world an uptick in the number of relative value plays available could emerge, she explained.
“With fixed income fund managers that we speak to there is optimism developing that there is going to be more opportunity to start generating more meaningful alpha.”
Other said firms have gained valuable experience investing in a wider range of asset classes in recent years, which could help. “For some that may be as simple as moving from sterling credit to global, or a wider appetite to retain bonds downgraded to high yield, for others it will be widening the number of asset managers to invest in a fuller mix of private debt and real assets,” said Steeden.
The UK Pensions market, for example, is larger than the UK investment grade corporate bond market, he said, and wider asset classes will be needed for many years to come if the demand for investment grade assets eligible to back pension and insurance liabilities is to be satisfied.
“With higher corporate financing costs expected to be here to stay, it is no less vital to ensure you have the expertise, systems and processes in place to identify, measure, manage, monitor, control and report the associated risks, especially where outsourced to third parties," he said.
