High(er) interest rates for longer period
In recent years, particularly in 2022, there has been a clear break from the ‘low interest rate’ environment that dominated the first two decades of the 21st century. The trigger for this reversal appears to have been the combination of economic growth recovery and rising inflationary pressures, after the ending of the Covid-19 pandemic. To bring inflation back under control, central banks in western countries have raised interest rates to the highest levels in over 20 years, while bond yields have also risen substantially. Towards the end of 2023, bond yields decreased somewhat, but are still considerably higher than the past two decades.
Sustained volatility and reduced risk premiums
More recently, interest rates appear to have peaked but for the foreseeable future, a return to a ‘zero interest rate’ environment does not appear likely. Inflationary pressures are subsiding, but in the short term a speedy and sustained return to the 2% inflation targets of central banks, e.g. the European Central Bank (ECB) and the Federal Reserve Bank (Fed), does not appear to be forthcoming. The higher interest rate environment has proven detrimental to risk premiums and returns on relatively risky asset classes, e.g. equities and real estate.
Inflation risk vs. recession risk
At the same time, it should be noted that, while higher interest rates have been instrumental in lowering inflation risk, they have also raised the risk of a recession or ‘credit event’, e.g. the ‘almost banking crisis’ in early 2023. This might lead central banks to eventually lower interest rates again, but for now the only certainty is continued uncertainty and, therefore, heightened volatility for financial markets.
Increased geopolitical risk
Apart from the changed interest rate environment, financial markets have also been affected by heightened geopolitical risk. In early 2022, Russia’s invasion of Ukraine rocked financial markets, if only for its impact on food and fuel prices and, therefore, inflation. In late 2023, the developments in Israel and Palestine were another geopolitical shock to financial markets. Geopolitical risk, not only as a consequence of military conflict, but also of e.g. climate change and deglobalisation, is expected to remain an important factor for future economic growth and inflation, and thus for expected investment returns. In the short term, the presidential elections in the US and the rising tensions between China and Taiwan provide additional challenges.
a.s.r.’s response
In general, higher interest rates are positive for insurers, but at the same time a mixed blessing for financial markets and expected future investment returns. A sustained focus on ‘real assets’, e.g. real estate (including mortgages and infrastructure) may provide shelter in a continued high-inflation/high interest rate environment. a.s.r. actively manages its interest rate hedging in order to be prepared for sudden fluctuations.
Prolonged financial market volatility constitutes a threat to stable investment returns. Additional portfolio diversification and an increased focus on ‘illiquid assets’ and/or ’low volume/high quality assets’ may be useful in stabilising investment returns over a longer-term horizon.
a.s.r. is actively seeking opportunities to further diversify its investment portfolio, e.g. through more geographical diversification in its equity and credit portfolios. In addition, there has been a notable shift from public to private markets (e.g. private debt and structured investments) and real assets (e.g. renewables and infrastructure).