Jack Meskunas, executive director of investments at Oppenheimer, shares his views on how captive insurers can manage their assets and investments effectively
For as long as I have been managing money — since 1989 — and as long as I have been doing it for captive insurance companies — since 1991 — there is one common thread that has driven valuations in both the stock and bond markets, and that is the actions of the Federal Reserve, both observed and anticipated.
Captive insurance companies generally invest primarily in bonds and other fixed income investments, and secondarily in equities, either through funds or alternative investment structures.
As such, it is of the utmost importance for captive owners and managers to understand the main factors that affect stock and bond valuations. Understanding how values are derived — and what moves them — allows captives to anticipate how the value of their investment portfolios might change in the near and intermediate term.
There has not been a period of time I can remember where the monetary policy moves at the Fed have had a more direct effect on the markets than the last four years. Let us revisit what happened and how the Fed was the driving force behind the moves.
If we think back to the 2020 pandemic and the subsequent market recovery at the end of 2020 and through 2021, we saw several interesting actions from the Fed as well as the Federal Government — namely fiscal and monetary policy changes that were both outsized and drastic (in hindsight, certainly).
To counter the forced shutdown of the US and global economies, governments wrote trillion-dollar cheques directly to businesses and consumers alike. At the same time, the Fed cut the overnight interest rate to zero. While these actions preserved numerous jobs for the future, they also overheated the economy by giving consumers a significant amount of disposable income at a time when the availability of goods for purchase was at an all-time low, due to businesses closing and being unable to produce the goods these consumers desired. Think about the dramatic increases in the prices of cars, computers, etc.
While the Fed was late to start raising rates in spite of obvious inflation — recall them saying that inflation at that time was only transitory — they dove in and raised rates 11 times in a row. While the overall level of rates now is not historically high (that occurred in the early 1980s), the Fed has never raised rates so quickly from zero to 5.25-5.5 per cent in the short span of 15 months.
As a direct result of this rapid rise in rates, virtually everything else dropped in value. In 2022, the S&P 500 index declined about 20 per cent by the end of the year, and the NASDAQ was down over 33 per cent. In the same time period, the value of bonds fell between 10 and 15 per cent. Almost every other asset class saw double-digits declines, as the markets tried to calculate what would become the ‘new normal’ values in this higher interest rate environment.
While most people have a solid understanding of why bonds decline in value when interest rates increase, the effect on stock valuations might be less well known.
If, in the ‘zero rate environment’ prior to March 2022, a bond was priced to yield two per cent and is now yielding seven per cent because rates are 500 basis points higher, the price of a 10-year bond would decline over 20 per cent. In the summer of 2020, for example, when there was a ‘flight to quality’ and rates were zero for the Fed Funds rate, the US Treasury issued 10-year bonds yielding 0.625 per cent.
Today, the bond trades at 80 cents on the dollar and yields 4.25 per cent. That represents a 20 per cent decrease in value.
Higher rates also negatively affect stock valuations. The reasons might be slightly less obvious, but since most corporations rely to some extent on borrowed money, the rapid increase in borrowing costs due to higher rates depresses corporate earnings and future earning potential.
Additionally, high-growth companies are generally bigger borrowers and are more adversely affected than ‘cash cows’, who rely less on borrowings. In fact, the fastest growing companies declined an average of 62 per cent in 2022 due to the change in rates.
The ‘competition’ between stocks and bonds also influences corporate valuations. As bond yields increase, corporate earnings are expected to decline or stagnate, and therefore companies are unlikely to raise dividends, or even cut them. Bonds look relatively more attractive than stocks, exacerbating the decline in share prices.
Asset valuations had suffered damage by the end of 2022, but the Fed was far from done. They continued to raise rates until June 2023, but the market started to recover, and 2023 turned out to be a very good year, with the S&P 500 appreciating over 24 per cent and the NASDAQ climbing over 40 per cent.
Why would the markets recover even in the face of rising rates in early 2023, and rates unchanged for the balance of 2023?
This is due to the expectation of future rate movements. In 2022, once the Fed started raising rates, all they talked about were more increases to come. By the summer of 2023, inflation looked to have peaked, and the Fed started talking about a ‘pause’ in rates. The DOT Plot — the Fed governor’s own estimation of the direction and level of rates in the future — went from looking ‘flattish’, to looking decidedly lower over the next three years.
Captives must revisit their portfolios and analyse how their investments will perform in a falling interest rate environment as the Fed moves to cut rates later in 2024, 2025, and beyond. The types of companies captives own and the bonds in their portfolios need to be re-rated for multiple factors, including their sensitivity to interest rates, a slowing economy, and even a potential change in government policies. This rating and analysis must be reviewed on a consistent basis to ensure that the portfolio is providing the best possible rates of return with the minimal amount of volatility.
