Recent market turmoil and muted economic growth should be sufficient encouragement for U.S. and European fiscal policymakers to move forward more aggressively in addressing the debt side of their respective balance sheets. Unfortunately, recent history has shown that what politicians should do and what they end up doing are rarely the same. In our opinion, weak economic fundamentals and an uncertain policy environment should serve as a wake-up call to U.S. investors of all stripes to increasingly look to specific foreign markets to seek returns as well as manage downside portfolio risks. We also believe that income-oriented insurance companies should seek to take advantage of whatever regulatory and guideline freedoms they have in an attempt to find potential yield cushions and total return alternatives to traditional strategies.
Many U.S.-based insurance companies are limited by statute on the percentage of their fixed income portfolios that can be invested in non-domestic issuers. This carries over to direct foreign currency exposure as well. Those insurers with offshore operations and more investment discretion should consider a broader global opportunity set. Where restrictive guidelines are self-imposed, such as for surplus portfolios, guideline liberalization may be worth contemplating. A look at some of the fundamentals of the U.S. and European economies may reveal deeper and more systemic problems than many have perceived. In both regions, there appears to be little likelihood of an appreciable economic recovery over the cyclical horizon, and the implications for investment strategies could be significant.
Backdrop – Poor Investment Options in the U.S. and Core Europe
In early August, Washington brought the U.S. to the brink of potential default before agreeing to a stopgap measure of spending cuts and increasing the debt limit. The difficult decisions were handed off to a Congressional “super committee” focused on cutting $1.2 trillion from the budget over the next 10 years. Political wrangling is a symptom of the problem – not the problem itself. With gross debt forecast to reach $16.5 trillion (nearing 100% of GDP) by the end of this year and projected to double to twice annual GDP by 2037 under the Congressional Budget Office’s alternative fiscal scenario (see Charts 1 and 2), it is discouraging that U.S. policymakers are struggling to agree on the exact amount of de minimis cuts. The super committee is due to present its recommendation by November 23; if Congress fails to approve its recommendation by December 23, automatic spending cuts of $1.2 trillion will be enacted. (We suggest keeping plenty of antacids nearby come Thanksgiving.) Given this backdrop, it should not have come as a shock to markets when S&P downgraded the U.S.’s long-term credit rating on August 5.
The U.S. economy is likely to be impacted by the accelerating debt crisis in Euroland. There, the European Central Bank (ECB) and its primary backstop, Germany’s Bundesbank, are being pressured by debt markets to go “all in” to address the solvency crisis of the continent’s periphery before it spreads to the core. Thus far, cyclical solutions aimed at providing stopgap liquidity to the most indebted countries have proven largely ineffective. One alternative to going “all in” would be to jettison one or more of the peripherals from the European Union (E.U.), thereby allowing them to compete through currency depreciation. Never mind that no one has presented a credible plan for how a country would exit the Union, the bigger question remains how, when, or even if they would repay their European banking creditors. In effect, the only viable European solution may be for the ECB to go “all in,” supported by Germany ballooning its balance sheet and thus acting as underwriter to Europe’s periphery. No other similarly sized, similarly healthy balance sheets exist.
What the U.S. and the peripheral (and some core) European countries have in common are sovereign balance sheets in severe disrepair. As a result, both economic regions are faced with rapidly deleveraging private and public sectors (possibly with the exception of Germany). With such contraction in aggregate expenditures (see Chart 3), the potential downside effect on traditional investment returns may be significant and long-lasting.
We believe it is more than just the state of the balance sheets that is a burden to investors; it is the lack of secular, globally oriented solutions proposed by policymakers. Charts 4 and 5 below are emblematic of what ails the U.S. economy: The labor force is thought to be structurally ill-equipped to compete in a deleveraging global economy where the cost of labor is too expensive and where technology continues to replace workers.
Investment Options Outside the U.S. and Euroland
So, what are an investor’s options? Strong sovereign balance sheets are generally associated with the policy flexibility needed to sustain or stimulate economic growth, combat inflation and otherwise ward off the enemies of strong investment returns. These balance sheets exist primarily in countries that had strong financial conditions prior to the financial crisis. While much investor focus recently has been within the developing/emerging world, we believe there are opportunities in the developed world as well, including Canada and Australia. Interestingly, interest rates in these two countries remain high vs. those of the U.S. Post-crisis, central banks in these countries had the flexibility to respond to strong growth and commodity-induced inflation with rate hikes. Should global growth wane, which seems to be the case, these two countries have room to guide rates lower, a move that could provide investors with the potential for capital gains. This is the type of policy flexibility that can help sustain corporate profits while accommodating credit and equity markets.
Since the financial crisis, the focus of many portfolio diversification efforts has been to target the emerging markets. As Chart 6 shows, this reflects the shift in global growth away from the developed to the developing world. We consider this a secular trend, with growth initially being propelled by exports to the developed economies and eventually becoming more diversified via domestic consumption. Within the emerging markets sphere it is important to consider not only the country of exposure but to separate the currency decision from the bond decision. In cases where only U.S. dollar, or external, debt is the focus, the country and yield curve decisions tend to dominate. When local currency-denominated debt is allowable by guideline, we believe the decision should equally weight the bond and currency exposure decision. In some cases, exposure to the bond is desirable but the local currency may be hedged back to U.S. dollars. One example could be Brazil, where shorter maturity bonds are currently very attractive (offering almost 6% real yields and 13% nominal yields) but the currency, having appreciated over 220% since 2002, is much less so. On the other hand, when we look at countries in the Asian bloc where inflation may be a concern, exposure to the currencies that may appreciate with the Chinese yuan, but not to the bonds, may be an attractive strategy. Finally, there are emerging countries such as Mexico where both the bond and the currency may be attractive at certain points in time.
Many U.S. insurance portfolios may have only marginal exposures to emerging market bonds – particularly in locally denominated currencies. Bond yields on many favored emerging economies remain three to four times those of comparable U.S. Treasuries, with locally denominated issuance in some cases recently benefiting from appreciating currencies, albeit currency rates can fluctuate. These asset classes can offer compelling total return possibilities. For example, higher yields on offshore investments such as emerging markets might help meet the interest rate floors embedded in specific life insurance policies and annuity products. While recognizing the past historical volatility associated with emerging markets, one could argue that the events we have been experiencing are unprecedented and the uncertainty that comes with investing in this new rising asset class may pale when compared with the known, volatile investment environments in the U.S. and Euroland.
For domestic insurers, direct diversification to emerging markets may represent challenges due to statutes, the imposition of capital charges, etc. However, we believe opportunities exist in both dollar-denominated issuers of select EM countries and local currency bonds. Diversification away from the troubled U.S. and core European economies may exist in both the bonds and currency of Canada – a country often exempted from statutory non-dollar restrictions. Australia presents similar opportunities, but investments may carry regulatory hurdles or capital charges. Even in cases where direct investment in non-U.S. issuers faces high hurdles, investing in U.S. companies that derive a substantial portion of their profits offshore is still considered diversification.
So, in uncertain times like these, we feel investors – including insurance companies – must look to economic fundamentals and understand that until the U.S. and Euroland come up with secular solutions to secular economic problems, it may be an intelligent and logical decision to consider diversifying globally. Higher capital charges that may be incurred for investments in specific emerging market bonds may be worthwhile considering the potential alternatives. In our opinion, defaults in developed country bonds are more likely than ever – in which case realized losses could far exceed any capital requirements. Failing to re-evaluate one’s home bias may mean losing much more, including purchasing power and the ability to accumulate sufficient wealth to meet long-term liabilities.