After a year filled with political and economic surprises, together with a further raft of regulatory changes, insurers are now looking to the future to determine how their investment strategies need to evolve both strategically in the long-term and more tactically in the near future.
Unfortunately, there remain a number of potential obstacles for a smooth ride through 2017 and below we review some of the main issues and the potential headwinds or tailwinds that investors may face.
What next for the European Union?
Whilst the UK’s Brexit referendum is now behind us and Prime Minister Theresa May looks set to trigger Article 50 of the Lisbon Treaty in March 2017, there are a number of political events that are taking place within the European Union (EU) which could have significant consequences both for investors situated within those countries and for investors in European assets.
Britain’s planned withdrawal has created a potential fork in the road which could lead to a weakening of the EU if another significant member, such as Italy or Holland, decided to undertake similar action to Britain. More significantly, the EU would almost certainly collapse if Germany or France left. Conversely, strong results for the pro-EU parties in the German, Dutch and French 2017 elections could strengthen the Union, lead to further integration and improve stability.
In France, the National Front Leader Marine Le Pen has specifically stated her desire to remove France from the EU (in addition to the eurozone).
To illustrate the uncertain environment, as of mid-February, François Fillon, the centre-right leaning former Prime Minister, who was previously Le Pen’s most likely rival is now behind both her and the centrist candidate Emmanuel Macron. Macron is a supporter of the EU and whilst Fillon’s immigration policy shares many characteristics with the National Front’s, he does not advocate separatism. Indeed he calls on France to lead a ‘Europe of nations’ focussed on defence and security which could actually be a step towards further military integration, something the UK will no longer be able to block.
In Germany, Angela Merkel looks likely to retain her position, possibly heading the same coalition between the Christian Democratic Union (CDU), the Christian Social Union (CSU) and the Social Democrats (SDP). Should she be unsuccessful, the most likely outcome is a left-of-centre coalition including the SDP, Green Party and Left Party, all of which support mainstream, pro-European policies, resulting in short-term benefits for further EU integration.
In the Netherlands, the Freedom Party (PVV), headed by Gert Wilder, is likely to win more seats than any other. It has a right wing nationalist agenda and strongly advocates leaving the EU. However, the Dutch proportional electoral system is likely to lead to a multi-party coalition to govern the country, one that explicitly excludes the PVV.
In Italy, the comprehensive defeat (and subsequent resignation) of the then Prime Minister Matteo Renzi, in the referendum he championed on constitutional reform appears likely to lead to fresh general elections. Renzi’s Democratic Party currently has a similar level of support as the Five Star Movement (M5S), a left-wing populist movement that would like Italy to leave the EU and also supports a referendum on staying in the euro (although holding such a vote would be unconstitutional). However, the ‘No’ verdict (that the M5S supported) in the November 2016 referendum will likely make it far more difficult for the M5S to come to power. The next general election will either occur as a snap election this year or as a scheduled general election in spring 2018. Should no clear winner emerge, the vote will be repeated.
What about the United States?
In the United States (US), the new administration’s economic plans are unclear. However, protectionist policies, fiscal spending, corporate tax cuts and de-regulation were key promises on the campaign trail. The order in which they could be implemented has important implications for the directionality of markets. With unemployment reaching its lowest levels since the financial crisis and US hourly wages on the increase, the rationale for a fiscal stimulus effort is questionable, increasing the risk that inflation will be higher than expected.
The latest projections from the Federal Reserve indicate three policy rate hikes this year. Although four were predicted this time last year, this time market pricing is more in line.
How about the United Kingdom?
As the UK seeks to invoke Article 50 of the Lisbon Treaty, its aims are starting to look clearer. Prime Minister Theresa May has confirmed that retaining membership of the EU’s single market is off the table, given the government’s wish to control immigration. So too is its current customs union arrangement, although the UK will look to become an associate member of the customs union in some way or remain a signatory to some elements of it. However, there remains a large degree of uncertainty. There is a danger that the negotiations will at some point go against the UK and the potential for continuing volatility is material. This uncertainty, combined with the prospect of higher inflation from a weaker sterling and economic growth concerns over the longer-term, creates potential binary outcomes for the UK government bond market in 2017.
Investment strategy for insurers in 2017
Our approach when designing an investment strategy for insurers is to take account of both the nature of the liabilities and the regulatory capital requirements. Typically this results in a portfolio with three key components:
- A liquidity portfolio, designed to manage cash flow requirements
- A liability-matching portfolio designed to broadly or closely match all or part of a designated cohort of liabilities
- A growth portfolio, that seeks to take a deliberate mis-match with the liabilities to target higher returns
In recent years, the growth portfolio has become increasingly important in an environment of extended low interest rates. However, the greater the mis-match between this asset portfolio and the underlying liabilities, the greater balance sheet volatility that will be introduced. Further, the type and size of the mis-match will need to be monitored to ensure it remains within risk appetite over time, both from a regulatory and from an economic perspective.
In order to use the growth portfolio to take advantage of market opportunities an insurer will need to have detailed visibility of the economic environment and individual asset class markets and the ability to implement transactions to revise their exposures in a timely manner. For many insurers this hands-on approach is neither practical or desirable, which is where an actively managed absolute return fund can be of significant benefit.
Low volatility, absolute return strategies provide upside return potential whilst also aiming to protect the downside against adverse market conditions. For example, an investment strategy that can actively allocate across a wide range of strategies – such as investment grade credit, government bonds, high yield bonds, loans, emerging market debt and asset backed securities, with appropriate constraints – can take advantage of short-term market anomalies however and whenever they arise. Such a strategy can support an insurer’s investment objectives whilst remaining capital efficient and ensuring that any mis-matches with the liabilities are deliberate and fully rewarded.
Given the number and range of political events likely to take place in 2017, bouts of volatility are likely, and volatility resulting from political events frequently creates relative value opportunities between different government bond markets and relative credit opportunities across regions. Investors investing in strategies which can take both a top-down (macro) and bottom-up (issuer and security selection) focus, covering the full global fixed income universe will be well-placed to take advantage of these additional sources of value.
Heneg Parthenay, Head of Insurance, Insight Investment
Simon Richards, Head of Insurance Solutions, Insight Investment