Low interest: the new reality
How does the current financial crisis differ from past recessions, and how are events affecting the investment landscape?
What sets this recession apart from the 11 other downturns we have seen since World War 2 is that this is a demand-side, as opposed to a supplyside, recession. A standard recession is driven by a supply-side inventory correction, where inventories are overbuilt over time and necessary cutbacks have to be made. Monetary policy is good at resolving such supply-side recessions, but not so good when it comes to demand-side downturns.
This time around we are seeing deleveraging among consumers, corporations and governments. Conventional monetary policy that entails cutting rates to help spur demand isn’t working as well because the US Federal Reserve is struggling to prevent a liquidity trap, where liquidity is trapped behind unwilling lenders, while demand for debt among corporations and consumers is limited. The fundamental issue that the Fed is struggling with is the deleveraging of the wider economy.
If you examine household debt growth, for example, for the last 60 years household debt grew even during recessions. This is the first recession since the Great Depression that household debt growth was actually negative. It has been below zero since 2008 and is starting to get close to zero, but the key point is that consumers are not looking to take on more debt to fund consumption, and that is a huge change compared to previous recessions.
Leveraging and deleveraging cycles tend to run a lot longer than inventory cycles, and we have spent the last 50 years—particularly the last 10 or 15—leveraging up. Household debt service levels increased dramatically in recent years and as a result we are now going through a significant deleveraging process. Between 1994 and 2008 household debt service ratios rose as households levered up and took out home equity. There were multiple contributors to this: the Fed holding loose monetary policy in the early 2000s and government setting out milestones to the banks for loans to lower income and credit quality borrowers, which resulted in the real estate bubble, being the two most prominent drivers.
Since then regulatory measures such as the Dodd-Frank Act and Basel III have made clear to the banks that they need to delever and build a stronger capital base. The banks in the US have been mandated to take on less leverage and risk, and underwriting standards are now far tighter than they used to be. Part of the deleveraging process has been regulation; the other part has been consumer confidence and unemployment.
Consumers and corporations have done a really good job deleveraging their balance sheets. Both have come down dramatically in recent months. The next step, however, is forced deleveraging by governments globally. This is already in train in Europe, with markets forcing governments there to deal with their debt levels and get their government deficits under control. At some point the US government will have to deal with its fiscal deficit and that is likely to result in tax rates going up and entitlements being cut. We are not forecasting dire growth and there is not an expectation that the US economy will enter into a double-dip recession, but we believe that growth will be between 2 percent and 3 percent for the next few years—more moderate, but more sustainable.
What do you expect will happen to interest rates, and how will this affect the portfolios of captives?
Conventional wisdom has been that interest rates have nowhere to go but up, particularly given what people are calling unprecedentedly low interest rates. The people who are saying this however are not going far enough back in history or considering examples globally. Between 1934 and 1950 the Fed held the discount rate at or below 1.5 percent for about 18 years. Interest rates can, and do, stay low for some time—particularly when the Fed is trying to get out of a demand-side liquidity trap. Japan has found itself in a similar position for some years now and that deleveraging process has proven to be slow and painful for the Japanese economy.
In the US, the Fed has made an open-ended commitment to quantitative easing in an attempt to resolve the crisis. In terms of the latest Quantative Easing 3 measures undertaken by the government, it has made a commitment to buy $40 billion of US mortgages on a monthly basis for as long as it takes to get the economy back to sustainable growth levels, and has committed to keeping interest rates low until at least 2015. Our view is that rates will probably stay low for much longer than the market is currently expecting.
Over a short period of time rising interest rates can be bad for a captive portfolio. With bond prices and yields being inversely related, should they rise this would result in somewhat negative returns. However, if you think about most captive portfolios, their primary objectives are preservation of capital and asset-liability matching. If you then consider that liabilities are generally on the short side—between one and five years— a gradually rising rate environment would enable captives to reinvest those cash flows that run off at higher interest rates. Gradual rate increases over the medium-term can, therefore, be a good thing.
"Asset-backed securities and mortgage-backed securities can help diversify the portfolio and bring excess return and better yield, but captives need to consider whether such asset classes are appropriate to their portfolios."
We are watching closely for when rates will finally turn. We think the Fed will go through several stages of telegraphing that it is shifting to a ‘not easing’ status, before it hikes rates. Congress in the US needs to work through the fiscal cliff before that happens, but it is our belief that this will be resolved. There will be a lot of political bluster surrounding that, but it will get done. It will again depend on how the economy develops and we will be watching retail sales, consumer demand, unemployment, wage inflation and housing for indicators of likely directions.
Before the Fed raises interest rates, it will signal a ‘not easing’ type regime. The options it has available to do that include putting an end to Operation Twist, which is a programme via which the Fed is currently selling shorter-term securities in its portfolio and buying longer-term securities to keep long-term interest rates low. It could shorten the duration of the US Treasury portfolio, meaning ‘untwist’ by selling longer-term securities allowing longer-term interest rates to rise.
Additionally it could end the reinvestment of portfolio cash flows in agency mortgage backed securities, and finally begin selling its holdings of mortgages and US treasuries. It is doubtful that the Fed will do more than a couple of these things in a single meeting, unless there is a sudden bout of inflation, but it should be clear to the market that changes are afoot long before an official increase in the Federal Funds Target Rate.
What other elements should a captive insurer consider at this time when assessing its investment portfolio?
Other long-term strategies that should be considered are the overall asset allocation picture and return expectations. Beyond preservation of capital, a captive’s objective should be to maximise returns within what it determines to be an acceptable level of risk. Considering the entire asset allocation and the captive’s return expectations it is important to have a well diversified portfolio with the right allocation to stocks as well as bonds, to get the appropriate placement on the efficient frontier.
Captives should continually revisit their investment policies in order to ensure that policy is aligned with investment goals. For example, does the policy on maturity limitations truly reflect its objectives and its liabilities? The inclusion or omission of certain market sectors also needs to make sense. Asset-backed securities and mortgage-backed securities can help diversify the portfolio and bring excess return and better yield, but captives need to consider whether such asset classes are appropriate to their portfolios. Credit quality also plays its part and captives need to consider the kind of quality versus yield available in the marketplace. Of course, all of this must be assessed within the context of the captive’s governing guidelines, including, for example, any restrictions that would impact letter of credit rates, Regulation 114 trust investment policies, domicile regulations or restrictions applied at the parent level. A good investment manager will not only understand this and build the portfolio in the context of the regulatory network of each captive, it will advocate for the client to the governing entities if it feels that reasonable and fair adjustments should be made to the captive’s policies.
Ed Goard is chief investment officer, fixed income at Munder Capital. He can be contacted at: egoard@munder.com
