Mar 29

The Times, They are a Changing


“Come gather round people wherever you roam
And admit that the waters around you have grown
And accept it that soon you’ll be drenched to the bone
If your time to you is worth saving
Then you’d better start swimming or you’ll sink like a stone
For the times, they are a changing”

Bob Dylan was singing about the Vietnam War, but his words could easily paint a picture of today’s investment marketplace.  Those changes are all around us – increasingly more dynamic.  But, like the frog that doesn’t move as the stove temperature gradually rises and ultimately gets burned, insurers may be the victim of their own inertia.  Here are a few major changes that I think may be worth discussing:

1 – Consider the deleveraging of the world economy:  We’ve written about this in our Insurer Investment Strategies newsletter, so I won’t go into details.  However, it is clear that investor appetite for risk is slowly undergoing a change.  Where we looked to a flight from quality, we are starting to see the beginnings of a flight to quality.  It is still early days, as my British friends would say, but risk expectations are changing as we speak.  Every day, a new group of homeowners in the US get a notice of higher payments due to higher short term rates.  This can only put pressure on US consumers (as well as mortgage default rates and residential realty prices), who have done more than their share to keep the global economic turbine running.  This is expected to continue for the next 2-3 years, unless short rates drop to historic lows as seen earlier in this decade.

2 – Consider the reorganizing of the investment industry:  I’ll discuss the good, bad and ugly of hedge funds, and their penchant for marketing ‘double speak’ that would make George Orwell proud, at another time.  However, it is undeniable that hedge funds have significantly reshaped the landscape of the investment industry…and they will continue to do so.  Not to better understand how hedge funds may or may not make sense for your company, is akin to closing your eyes to other newer investments — many of which you now have in your company’s portfolio.  For example, look at the portfolio ten years ago, and you will probably not see a Commercial Mortgage Backed Security (CMBS).  Today, it is highly likely that you will find several of them provdiing quite competitive yields in the portfolio today.  And, we can apply this to many other asset classes over the past fifty years or so.

Perhaps more importantly, hedge funds have begun a ‘brain drain’ from more traditional investment management shops.  It does take a certain personality type to move from the comfort of a traditional shop to a hedge fund, and not everyone will take the leap.  Many personal and unique factors keep employment moves under control.  However, higher pay does have a way of drawing a subset of those that might consider themselves ’the best and brightest’.  What does that say about your current portfolio and its management by a traditional investment management firm?

3 – Derivatives continue their infiltration into nearly all investment types and strategies.  However, on their own, derivatives have traditionally been a very tough ‘sell’ to insurer Boards.  The credit derivatives market , according to some sources, now totals a notional amount in excess of world GDP…and it’s all over the counter business.  What does that say for the stability, accuracy and volatility of credit risk imbedded in practically all insurer portfolios?

4 – Globalization continues to drive investment flows – both due to trading of goods and services and due to trading in financial instruments.  No longer can we look solely at the US yield curve in determining the impact of interest rates on the economy.  We now have to review a global yield curve, where short rates are quite short in Japan versus higher long rates elsewhere — and, thus, the ‘carry trade’ was born.

Meanwhile, the PBoC (People’s Bank of China) has decided to diversify from safe fixed income investments into those with credit and convexity risk and now, probably, into equity oriented securities.  That’s a lot of US$ currency reserves for investment somewhere into US$ securities, mergers/acquistions or real assets.

According to Mr. Dylan, we better start swimming or we’ll sink like a stone.  Your company must ask how these changes are impacting not only current investments, but how your company can take advantage of these changes to improve the investment process in advance of their likely impacts.

As for my comments, I remain chastened by this verse:

“Come writers and critics who prophesize with your pens
And keep your eyes open, the chance won’t come again
And don’t speak too soon, the wheel’s still in spin
And there’s no telling who that it’s naming
Oh the loser will be later to win
For the times, they are a changing”