Insurance publication SNL Financial recently sat down with members of PIMCO’s Financial Institutions Group to discuss PIMCO’s latest views on global divergence, the Federal Reserve and the impact on U.S. insurers in their investment portfolio positioning. David Braun, executive vice president and head of PIMCO’s U.S. financial institutions portfolio management team, and Scott Millimet, executive vice president and head of PIMCO’s insurance company client service team, discussed the implications for U.S. insurers. This interview was initially published on the SNL Financial website in a modified form.
Q: PIMCO's outlook for 2015 predicted global growth would accelerate while inflation remains low. Is this still your view?
Braun: Yes, that is our fundamental, forward-looking view of the economy. We are at a point in time when there is significant divergence in both economic growth and monetary policy. The U.S. economy is showing solid signs of a self-sustaining recovery, an improving labor market and growth that we forecast between 2.5% and 3.0% real for 2015. The U.S. is much further along since the financial crisis than counterparts in Europe and Japan.
From a U.S. monetary policy perspective, the Federal Reserve is determining the path of normalization for its policy rates after ending quantitative easing (QE) last year; we are forecasting a rate rise later this year.
At the same time, the Bank of Japan is continuing QE and is in its second decade of a zero-interest-rate policy. The European Central Bank recently launched its QE program. And central banks in both Canada and Australia surprised markets with their own interest rate cuts largely due to the commodity sell-off but also in recognition that growth is not where they want it to be.
This backdrop has profound effects on rates and risk assets, whereby rates look fully valued at these levels. In a vacuum, you could say that rates in the U.S. are too low. But you have to recognize all the external pressures on the U.S. market.
Millimet: I would emphasize the words that Dave used in terms of “divergence.” Central banks are either moving away from uncharted territory (as with the Fed) or into uncharted territory (the ECB) or are mired in uncharted territory (the BOJ). In this environment the odds of a policy response leading to an unexpected increase in volatility are higher. In January the Swiss central bank removed the peg between the euro and the Swiss franc. While not a high-probability event, it was certainly a high-consequence event.
Q: What do you expect to happen when we get closer to the Fed raising rates, and how are you advising clients?
Braun: When we articulated our New Neutral secular outlook last year, markets were largely opposed to our view. We hypothesized that the neutral policy rate for the U.S. will likely be closer to 0% in real terms than to the 2% real neutral policy rate that prevailed before the crisis because a few things have changed in the U.S. economy.
In July 2014, the market was pricing in a level much higher than our New Neutral forecast. However, markets have since converged to PIMCO’s view. With this convergence, perhaps the Fed rate-hiking cycle will be digested in an orderly fashion, just like the ending of QE was. However, there is potential for a rise in volatility, since there is no precedent of a central bank successfully tightening policy and sustainably exiting the zero bound.
Q: What kind of investment opportunities have these conditions created for U.S. insurers?
Braun: Insurers have had an interesting ride, to say the least. In 2013, rates were at what were perceived as once-in-a-lifetime lows, and then the “taper tantrum” gave everyone a kind of stay of execution. Following that there was aggressive buying, particularly from the life and annuity insurance industry as the 10-year and 30-year Treasury rates normalized. And now we've almost come full circle. The 10-year fell back to pre-“taper tantrum” levels, and the 30-year established new lows. This has created profound challenges for the longer-duration part of the insurance industry, as well as defined benefit pension plans.
Insurers continue to look for yield by taking a little more credit risk rather than extending duration. There has been a precipitous increase in allocations to NAIC-2 bonds (the National Association of Insurance Commissioners), the BBB part of the investment universe, coming out of the NAIC-1 (A through AAA) bucket. Alternatives investments and direct lending have increased, whether they are private placements on the corporate side or commercial mortgage loans. In many of these specific cases, companies are selling liquidity to further enhance yield.
We're trying to be underweight duration because we think the market got ahead of itself and converged rapidly to the New Neutral and is not pricing in enough term premium. With the oil price drop, we felt that break-evens in the Treasury Inflation-Protected Securities (TIPS) market were pricing in inflation that was too low, so we prefer to own TIPS in lieu of nominal Treasuries.
And then on the credit side, we're very comfortable being overweight credit – select credit – based on the fundamental story of the U.S. showing signs of a self-sustaining recovery.
Q: Has it become harder to identify investment opportunities given the divergence in economic growth and central bank policies across the globe?
Braun: When policymakers and economies are diverging, it can create the risk of potholes and missteps. That's why we think it's critical for investment managers to focus not just on bottom-up security selection, but also on having a macro process to formulate a forward-looking view of the global markets, not just a view of the insurer’s own country of domicile. Second, investors should focus on active management because these are unprecedented times. The Fed’s balance sheet is $4.5 trillion and is close to coming off six or so years of being at a zero percent interest rate. There's no playbook in history that you can look at for how to navigate this, so your investment manager needs to be active and nimble.
Millimet: In the property and casualty space, where you have lower durations and shorter liabilities, companies three or four years ago went into lockdown mode. Now, the opportunity cost of a buy-and-monitor mandate or a less active mandate relative to the potential for generating alpha is much lower. Book yields are lower; reinvestment yields are dramatically lower. So allowing some higher degree of discretion on lower-duration mandates looking for alpha, as opposed to pure book yield maintenance, is something we would suggest.
Q: Is the impact of lower oil prices a positive one at the corporate level as well, especially when you consider sectors like insurance that might not be affected much by lower gas prices but that do carry significant exposure to the energy sector in their portfolios?
Millimet: From an economic perspective, lower oil prices are unambiguously a positive. It's a tax credit, if you will. On the more micro side, the high yield markets will likely feel an impact. Energy and pipelines are about 10%–15% of the BofA Merrill Lynch High-Yield Index. We certainly would be expressing caution in that specific sector.
Braun: It is likely that some insurance companies will have challenges at these oil prices given some of their energy holdings. After the financial crisis, many insurers put restrictions on how many financials they could have, thus skewing their corporate holdings to non-financials. I don't think it will be a big event for the industry, but some one-off names will likely default, and hopefully few insurers will have outsize exposures to them.
There is no doubt that more global crosscurrents are now affecting markets than we have seen in many years. We see them as creating investment opportunities.