Inflation volatility batters UK and EU
With global markets impacted by recent bank failures, insurance investors are anticipating disinflation trends and a potential soft landing in H2 2023.
Maya Sibulposted on Wednesday, April 19, 2023
The cycle of continuing rate hikes by central banks in North America and Europe – as well as the fallout from the Silicon Valley Bank (SVB) failure in the US – has stakeholders wondering how insurance investors will respond to turbulent markets going into the second half of 2023.
The possibility of new, unforeseen challenges is also likely, with adaptability and resilience key buzzwords for investment teams in H2 2023.
In a US context
The recent turmoil in the US banking sector has only increased the odds of a recession due to bailouts and solvency shocks more broadly. With the potential for a “soft landing” becoming less likely, the US Federal Reserve has anticipated a mild recession in the latter half of the year.
Goldman Sachs has also recently upped their recession percentage estimate from 25% to 35% in the next 12 months, citing the fact that the collapse of SVB has unignorably shaken the entire banking sector. This change comes on the heels of last month’s lowering of the estimate from 35% to 25% due to labour market strength and early signs of business improvement before the SVB failure.
Volatility, however – along with mixed recession predictions due primarily to inflation – is not new. In the 2023 Goldman Sachs Asset Management Global Insurance Survey, “Balancing with yield on the inflationary tightrope”, inflation was ranked as the top macroeconomic risk concerning investment teams at insurance organisations. It was also viewed as unavoidable – or structurally embedded in the investment landscape.
This means that whilst inflation is seen as the “top threat” to insurance investment portfolios, it is also a well-known and well-considered factor. Despite growing worries about global inflation, a recession in the US, and geopolitical tensions worldwide, the report also noted that investor risk appetite remained healthy in 2023. For example, there was increased interest in private assets and fixed income yields were attractive, the analysis said, which restored interest in the asset class.
“We are doing a much better job of monitoring portfolios. Overall, [regulators are] confident that this won't be as impactful as it has been in past [environments].”
Scott Kipper, Insurance Commissioner of the state of Nevada, recently told Insurance Investor that, whilst mildly troubling, he is hopeful that the SVB collapse is being appropriately handled by the Federal Deposit Insurance Corporation (FDIC), the Fed, and the National Association of Insurance Commissioners (NAIC). “They are monitoring the situation,” he said in reference to comparisons with 2008’s banking crisis. “We are doing a much better job of monitoring those portfolios. There's a slight concern but, overall, [regulators are] confident that this won't be as impactful as it has been in the past recessionary rates.”
Some in the industry, however, are reconsidering their market predictions from early 2023. Whilst Nicolas Malagardis, Global Macro and Market Strategist at Boston and Paris-based asset manager Natixis IM, said he initially saw a “no landing” scenario as possible – due to markets faring better than expected over the past two quarters – this was no longer his view.
Recent events, he said, had altered expectations. Rather than a “no landing” scenario, the likelihood of a “soft landing” had increased – with economic growth predicted to slow more insistently in the latter half of 2023. This indicates that disinflation trends will continue, which could mean new investment opportunities for insurers.
“Central banks are now likely to prefer erring on the side of caution with regards to monetary tightening.”
When it came to continued rate hikes, Malagardis said he was sceptical that the Fed would proceed in that direction. “Whilst much can happen [before] May’s next round of policy meetings, central banks are now likely to prefer erring on the side of caution with regards to monetary tightening,” he said. “[They] will likely pause hikes for now.”
Other have reiterated that it is difficult to predict exactly how much the likely squeeze in banks’ net interest margins will impact the real economy. "The contraction in US lending acts to further tighten financial conditions,” said Swiss Re in its March Sigma update, “Treading carefully: US banks and the risk of a credit crunch”.
The analysis said that “to bring down inflation sustainably, bank lending and financial conditions would need to both tighten steadily for a prolonged time.” It added that its research suggested that ongoing credit reductions are the equivalent of 25-to-100 basis points of policy tightening.
“This implies a US Federal Funds rate of 5.25-6% at the end of Q1, which supports our view that the Fed is likely approaching the end of its hiking cycle with one additional 25 basis point increase expected in May,” the report continued.
Whilst the US is outperforming the EU and UK when it comes to maintaining economic growth in turbulent conditions, it is still far from perfect – with stakeholders now looking to the early summer months for predictions to firm up.
Continued struggle in UK and Europe
The UK economy, on the other hand, remained a mixed bag throughout the beginning of 2023. Weaknesses are evident, though there are a few green shoots of hope for improvement in late 2023 and early 2024.
In the first quarter the year, the UK just narrowly missed a full recession – with January growth in the services sector coming in at 0.5%. According to an analysis from the British Chamber of Commerce, after “no growth in Q4 2022, quarter-on-quarter GDP growth is forecast to decline in Q1 2023 by 0.3%, before flatlining again at 0.0% in Q2, followed by 0.2% in Q3 and Q4.”
“Although the economy should now avoid a technical recession, the stark reality is that businesses face a very difficult year ahead.”
Director of Policy at the British Chambers of Commerce, Alex Veitch, said that “although the economy should now avoid a technical recession, the stark reality is that businesses face a very difficult year ahead.” He added that because the government had little fiscal headroom for the Spring Budget, it would be imperative that it spend the money it did have wisely.
Fallout from the autumn mini budget U-turns and LDI crisis was still playing a major role in many of the UK’s H2 outlooks, with the goal of financial stability and a return to credibility taking centre stage. “Bearing in mind the events with UK pension funds last autumn, the likelihood of increased market volatility [in the UK] remains elevated,” said Malagardis.
He added that he saw continued signs of labour markets tightening – and felt that core inflation would stick instead of subsiding any time soon. He expected the Bank of England (BoE) to continue its rate hikes.
However, if the BoE raises rates too sharply, risks for the UK non-bank financial sector could surface – particularly for investment teams at insurers and pension funds, which would do well to keep eyes on solvency concerns moving forward. If, for example, liquidity were to tighten again in a disorderly manner, additional discord could be likely.
Inflation in the UK and the Eurozone more broadly is on the hole unlikely to subside any time soon, said Malagardis – especially if considering core inflation rates. For example, the Consumer Price Index inflation rate for all goods rose by 13.4% in the twelve months to February 2023, which was up slightly from January 2023.
On the heels of this increase, AM Best maintained its negative outlook on the UK’s non-life insurance sector. The rating agency cited macroeconomic volatility – especially inflation, high energy prices and shortages, supply chain disruptions, and a tight labour market – as a persisting detractor from performance.
In continental Europe and the wider Eurozone, inflation concerns have eased slightly. According to the Organisation for Economic Co-operation and Development (OECD), year-on-year inflation in the Eurozone – as measured by the Harmonised Index of Consumer Prices (HICP) – declined slightly to 8.5% in February 2023, which is down from 8.7% in January.
Year-on-year inflation in the Eurozone fell sharply to 6.9% in March as energy prices dropped, according to Eurostat’s flash estimate – which is down from February’s 8.5%. Food and energy was estimated to be broadly stable at 5.7%.
Some in the industry – particularly those with a long-term investment time frame – still remain hopeful.
“This should not come as a big surprise for corporates which were already cautiously managing their working capital in the second part of 2022.”
One potential plus side for the economy is that persistent labour shortages could trigger the second-round effects of inflation. This means that “wage growth could rise above pre-crisis levels on a steadily manner over time,” Malagardis said. Whilst it is difficult to assess the potential spill-over effects that recent market events may have on the real economy, an eventual slowdown in demand could have the positive impact of reducing tightness in labour markets and – therefore – on wage pressures.
Because margins reached a decade high in the fourth quarter of 2022, they could simply contract – but from a high level rather than triggering a credit crunch. “Unlike 2008, this should not come as a big surprise for corporates which were already cautiously managing their working capital in the second part of 2022,” he continued, echoing Kipper’s comments about macro positioning in the US.
If there were a slowdown, it could mean changes to investment intentions and hiring decisions. Given the quickly shifting landscape, adopting a defensive investment stance could offer investors resilience whilst they weather what might only be a temporary storm. More specifically, this could indicate a reweighting US and growth equities at the expense of Europe and value stocks.
Ultimately, when it came to fixed income, Malagardis told Insurance Investor that “US rates are attractive across the curve, and we also like curve steepeners as way to play both a pause in rate hikes and a growth slowdown.”
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