Protect and thrive
Category: Asia, Hong Kong, Global
By Daniel Shane and David Macfarlane
Analysis of GSAM insurance survey and insurance investment trends
Chief investment officers (CIOs) and other senior executives from some of Asia-Pacific’s top insurance players gathered in Hong Kong in July for a roundtable, hosted by Goldman Sachs Asset Management (GSAM) and Asia Asset Management.
The objective of the event was two-fold, with the first half of the afternoon luncheon dedicated to discussing GSAM’s recent survey of the global insurance market, entitled Risk On… Reluctantly, while the second half provided an insight on current investing trends and themes.
The findings of the survey were presented on the day by New York-based John Melvin, global CIO of GSAM’s insurance unit, and indicated that insurers, both worldwide and regionally, were seeking to increase their allocations to riskier and alternative assets amid a lower yield environment from traditional asset classes.
GSAM’s research indicated that many CIOs believed that the investment climate was becoming more challenging, with key risks including credit and equity market volatility, tepid US economic growth, the end of relaxed monetary policy, and economic shock in China. “Key takeaways from the survey were that it’s a difficult investment environment and it’s become harder to invest for insurance companies’ balance sheets over the last year,” Mr. Melvin told attendees.
The GSAM survey, published in May 2014, canvassed the opinions of a diverse landscape of 233 insurance CIOs and CFOs, with more than one-fifth of respondents from Asia-Pacific. “The survey was very consistent with what we’ve seen in prior years; the change is that we’ve actually seen more take-up from our Asian clients in responding to the survey,” Mr. Melvin continued. “There’s a pretty active Asian interest in what’s actually happening in their peer group.”
One of the first questions posed by the survey was “Where do you expect the ten-year US treasury yield will be at year-end 2014?”. The 57% of insurance CIOs forecasted a rate of more than 3.0% but less than 3.5%. Just under a third anticipated that the ten-year yield would be higher than 2.5% but shy of 3.0%.
Min Lei, chief investments officer at Sun Life Hong Kong, asked Mr. Melvin what were the factors driving current low yields (2.5%-2.6%) on ten-year US treasury notes, which are not favourable for insurance companies.
Mr. Melvin highlighted reasons including technical positioning in the market, demand from overseas buyers, and the limited supply of longer-dated treasuries, as well as the expectation the Federal Reserve may not be as aggressive in tightening policy as previously thought.
A vote on the day showed that most CIOs at the luncheon expected rates to end the year in the 2.5-3.0% range. The research’s findings strongly indicated that across the board there was acceptance that the US Federal Reserve would increase rates as it tapers its asset-purchasing programme, but that there was minimal concern over a possible sharp rise in yields. A gradual rise in yields would likely benefit Asia’s life insurers.
“We are a little bit more bullish on growth than many of the market participants, so we would expect [Federal Reserve Chairwoman Janet Yellen] to be earlier on this,” Mr. Melvin explained. “However, there’s relatively clear communication from the Fed that indicates they’re going to wait and take their time.”
The day’s discussion then moved on to what insurance CIOs perceive to be the greatest macroeconomic risk to their investment portfolio. Credit and equity market volatility was ranked as first choice in this regard by 19% of respondents; followed by slower-than-expected US growth; acceleration of monetary tightening; and economic shock in emerging markets and China, which were all at 15%.
“Credit and equity market volatility was the highest, and what you and all of your peers were saying was that you think we’re at very low levels of volatility, but a spike in volatility is going to pose some significant risk to valuations in both debt and equity markets, which is something to be concerned with,” Mr. Melvin told attendees. “It makes sense when you think about life insurance in particular, where they’re heavily weighted towards long-dated credit, which is very susceptible to spread movements.”
One delegate, Matt Vincent, regional investment manager at Zurich Insurance Group Hong Kong, put it to the roundtable that if volatility is at an all-time low, what does this mean for how insurers allocate?
Responding to this point, Mr. Melvin noted: “That’s the multibillion dollar question. Some of the takeaways from this survey are that insurance companies are willing to sell liquidity and own volatility. They’re comfortable taking on risks, going into the equity market, and taking on private debt, infrastructure debt and other things that are outside the traditional scope of liquid assets. Those are all trades that you’d consider to be consistent with an environment that you’d think is going to be stable, and not one that you’d think is going to have increasing volatility.”
Mr. Melvin and other delegates then moved on to address the question of how China handles a slower pace of economic growth, and its implications. Jonas Von Oldenskiöld, director at Swiss Reinsurance Company, said that he believed a sputtering China should be higher up on the list of risks as the present administration has a challenging, but not impossible, task to restructure its economy and markets while cushioning the present slowdown. He noted that the secondary effects of a slowdown in the country’s property market, is still not fully understood by the market.
GSAM’s Mr. Melvin agreed with this point to an extent, adding: “They have to take some pain somewhere. It’s just a matter of how they distribute that throughout their system. I think the benefit of the Chinese system is that it can sufficiently implement specific policies without disruption.”
Another attendee, Chuck Scully, regional chief investments officer, Metropolitan Life Insurance Company of Hong Kong, added at this point that he believed any sharp acceleration in the tightening of global monetary policy was a risk, due to high leverage in the region.
Mr. Melvin then addressed some of the survey’s findings in regard to how asset allocations were evolving among insurers, as well as their expectations for returns. Of the respondents, 26% expected private equity to provide the greatest return; followed by US equities at 17%; European equities at 13%; emerging market equities at 8%; and real estate equity at 6%.
“I think you’re seeing a continuation of this positive investment outlook for these risky assets, with certainly a less positive outlook for credit assets, but not necessarily negative,” Mr. Melvin told those present. “The assets that are likely to perform the least are cash and government bonds, implying that riskier assets are actually about to outperform.”
When it came to asset classes that insurers said they were seeking to raise their exposure to over the coming 12 months, private equity again came out on top, Mr. Melvin pointed out.
Overall, alternatives were an obvious theme, with 33% of those that took part saying they were seeking to raise their exposure to private equity over the next 12 months; followed by infrastructure debt at 29%; and real estate equity at 28%.
Tuan Lam, head of North Asia at GSAM, noted that despite high PE ratios in developed public equity markets recently spilling over to private equity, there were other reasons why the latter market was alluring to insurance CIOs. “I think what might be underlying that number there, are clients saying: ‘OK, we recognise that the prices for acquisitions are a little bit high, but perhaps the other two drivers of returns will be there for us.’ The two being: earnings growth continuing for the next four to five years, and cheap leverage.”
The other class of alternative investments that has been gaining recent interest among Asian institutions is infrastructure debt. This was reflected in the survey’s findings, which showed that 30% of Asian respondents were seeking to raise their exposure to these assets. Mr. Melvin told delegates that the reasons for this included one, because infrastructure debt lends diversification to a corporate and sovereign credit rich portfolio; and two, because these are long-dated, illiquid assets that offer spread.
However, he warned that there was a perception that infrastructure credit was a deep market, and that commercial banks had stepped away from this space. Mr. Melvin pointed out that this was not necessarily the case.
“Banks haven’t been stepping back anywhere near to the extent that people thought. The amount of capital that is willing to meet demand for borrowing is way in excess of what the demand is. It’s clearly a borrowers’ market at this point. Any kind of value we would have seen from a spread standpoint has essentially dissipated in comparison to relative public market corporate debt,” he said.
According to the GSAM survey, 24% of Asian insurers will also seek to raise their allocations to real estate, another alternative asset class. Juliet Siette, who runs the Insurance Asset Management business for GSAM in Asia commented that “there is already growing evidence of this taking place in the region”.
“As a result of changing legislation in Taiwan, we anticipate seeing a lot more interest in direct investments in real estate. The Financial Supervisory Commission has listed a number of countries that insurers can invest in, and as they widen that list of countries, we expect insurers to invest in more than just Paris, New York and London,” Ms. Siette explained.
Ms. Siette continued that interest in the US property market had been resurgent on the back of strong economic and construction data, while Japanese real estate was also finding its way into more insurance portfolios. “There has been a lot of interest from global insurers in private real estate in Japan, because it is a way of diversifying. The interest in buying property is driven by the rent cycle, and positive expectations regarding the Tokyo Olympics,” she explained.
With that, the discussion turned to some of the other overriding themes and trends presently covering the global investment landscape.
The second session of the roundtable kicked off with the moderator for the day, Tan Lee Hock, Asia Asset Management’s publisher and founder, asking Mr. Melvin for his take on emerging markets debt.
Mr. Melvin explained that “with emerging markets corporate debt, and even with sovereign debt, we are not seeing institutional investors and insurance company clients pull back from these markets.”
There were significant withdrawals out of retail funds, but institutions had been building up their allocations and essentially they just stopped building. “New entrants that were considering going into the market held off, but we’ve now seen a significant pick-up this year of pent up demand from people that were planning on funding last year who held off coming back into that market as spreads started to retrace,” said Mr. Melvin.
There are a number of reasons why clients look at emerging markets debt. “I would say eight out of ten insurers that we work with would be focused on the corporate market as opposed to the sovereign market,” he noted.
Mr. Melvin said he sees a very small number of insurers focused on local currency markets, predominantly because it’s a big component of currency strategy. According to him, that will change over time but operationally it’s very difficult to put a 30-country, local-currency strategy in place into an investment portfolio, “The operational challenges of setting up accounts in each of these countries, accounting for them and dealing with all the effects of derivatives that are to be utilized in a local currency portfolio are too complex for the value-add that most insurers think they’ll get for a moderate allocation to the strategy,” he said. “Many insurers will tend to do so in fund form and deal with the capital implications of running a fund.”
Mr. Melvin then moved on to discuss the other two emerging market strategies, which are external corporates and external sovereigns.
“With external corporates, the big benefit is a fairly substantial yield advantage – meaning emerging markets corporates versus US corporates investment grade only spread differential; it widened earlier towards the end of 2013 into 2014 when we saw a substantial retracement,” he pointed out. “We don’t expect a major compression there but you’re getting a lot of credit spread for an investment grade corporate bond strategy.”
With an emerging markets external corporate bond strategy, Mr. Melvin said the reality is one would consider it to be an Asia investment grade, an Eastern European investment grade or a Latin American investment grade portfolio, rather than just as an emerging markets strategy. “A global investor will think of this as an emerging markets strategy across all these markets but it’s very reasonable for a Hong Kong investor to say ‘we have an Asia investment grade portfolio and we’re generating returns that are significantly out-yielding US investment grade credits’”, he added. “It depends on where your perspective is and how you think about emerging markets.”
When the audience was asked if they had invested in this asset class, 70% of them said yes.
Mr. Melvin revealed GSAM still views emerging markets debt as an area where there’s continued demand from insurance clients, which he said is a good sign.
“We have a number of clients who have gone down the path of external sovereigns and are ultimately transitioning to a blended corporate and sovereign mandate, or have both mandates on their platform. The credit spread is the real driver,” he added.
He went on to say that the volatility of emerging market corporates is fairly comparable to high yield. “So when you think about it, you have better credit metrics, but you have the volatility of a high-yield asset class – and that’s the challenge you face as an investor.”
He continued: “Having better credit metrics makes a solid case for emerging markets corporates. You’re getting substantially lower leverage from emerging markets issuers than you are in the US for the same rating category.”
Mr. Melvin added that GSAM tends to stay in the investment grade space because “you can mitigate the risks by staying in investment grade.”
Mr. Melvin shared a sound bite given to him by one of his colleagues, who recently had lunch with former Federal Reserve Chairman Ben Bernanke who had commented that markets seem to be very complacent about interest rates given the fact that volatility is at historic lows, yet where Fed policy and the outcome of that policy will be highly uncertain.
“Hearing this from Mr. Bernanke and others of similar stature is concerning because we have this low vol environment,” said Mr. Melvin. “I think that part of it is that there’s a real hesitancy for anyone to give up spread and start selling assets and moving to a risk-off position until they see something tangible. Most market participants feel we’re in a carry environment where spreads are able to stay and hold at current levels for a prolonged period of time until we see a significant change in the Fed – and we actually believe that too.”
Mr. Melvin continued, “If you think about credit fundamentals, they are really strong. Credit fundamentals are supportive but valuations are at post-financial-crisis highs,” he observed. “Earnings growth sit in the mid-to-high single digits for companies. There is very little prospect of defaults rearing their ugly heads within the next two years. With every day that goes by, we see continued refinancing in the high-yield market, of companies pushing out their funding requirements for another two years. It’s not until mid to late 2016 that we see any material need for refinancing in the US credit markets.”
However, he went on to say that in late-2016, when we’re at a period of much higher levels of interest rates and companies won’t be able to cost-effectively refinance, there could be a downturn in the credit cycle. “It’s inevitable and it’s just a matter of when,” he warned. “For now, there’s no catalyst from a credit risk standpoint that we think will be likely to drive credit spreads wider. The risk is what’s going on at the Fed – are we going to see a spike in rates, and increase in volatility that will have a performance impact on credit? When you start hearing a lot of people in key positions voicing their concerns about how low volatility is, it gives the sense that maybe the Fed is not guiding markets along a stable path; maybe they’re just holding that accelerator down and telling people to keep risk on until the last possible minute.”
On markets, Mr. Melvin said he sees continued strength in the US, but pointed out that Europe is still slow, with inflation remaining low – but he did note that aggressive central bank policies were starting to come into play in the continent. On China, he said things are much better today than they were six months ago in terms of the market’s perspective – the data is better – but he did wonder if China could be holding a big surprise in the waiting.
“We’re continuing to see clients looking at exposure in risk assets in high yield and equities,” he revealed. “Most firms are comfortable holding their positions, and knowing if we have a period of high volatility they can ride through given that the default outlook isn’t imminent – and they’re willing to do that.”
“There is a hesitancy to be aggressively adding to higher risk positions, particularly to high yield – I think there’s a belief that high yield is overdone, which is reflected in the survey numbers. We have a slightly different view; we think that high yield actually has a little more room than investment grade, but if we were to take on risk we would probably prefer to take it in the high-yield market rather than in the investment grade market.”
In the current environment with historically low levels of volatility and tight spreads where liquidity is widely available, Mr. Melvin asked, “why would you be willing to sell liquidity?” He explained that “now’s the time when you hold your liquidity and wait until we go through a tightening cycle where liquidity is being pulled out of the market and you’re able to step in and provide it – that’s where insurance balance sheets can really benefit in the markets.”