Once upon a time in a land far, far away students of economics learnt a set of rules that helped them understand the way that economies were likely to work when some central variables were tweaked.
John Maynard Keynes put his faith in the interplay of supply and demand to create market forces that led, inevitably, to market equilibrium. In the late 1970s Milton Friedman did his best to debunk this and replace it with a theory of monetarism, which put its focus squarely on money supply as the main regulator of the economy.
And that seemed to work pretty well: If a central bank increased the supply of money, the inevitable result was inflation.
So the US Federal Reserve printing $4.5tn to combat the global financial crisis between 2008 and 2014 would have led to a significant spike in inflation, right? Well, no, it didn’t.
In fact inflation remained under 1.5% for most of this time. Indeed, according to US Labor Department data of 14 July, the annual inflation rate for the 12 months ended June 2020 is 0.6%.
So, if monetarism is broken and vast increases in the money supply no longer lead to inflation, how is the typical asset manager working for an insurance company meant to make sense of asset pricing and selection?
The burning question for every asset manager is: What happened to all that money the Fed printed? Because, as many of them know, COVID-19 has prompted the Fed to delve back into its toolbox and commit to a fourth round of quantitative easing, the poetically named QE4, which is likely to see the central bank printing a further $2tn. Gulp.
Some say that the answer to the question of what happened to all that money is quite simple: Asset bubbles. Some researchers point to explosive bond price increases during the timeframe of the first phases of quantitative easing (QE1 to QE3).
A working paper called ‘Quantitative Easing and Asset Bubbles in a Stock-flow Consistent Framework’ by Cameron Haas and Tai Young-Taft studied the causal links between quantitative easing, asset overvaluation and macroeconomic performance concluded that, “Quantitative easing’s outcomes are parameter dependent, with economies less prone to consumption out of income merely being pushed forward in the schedule of rise and fall, whereas economies with greater consumption experienced minor procyclical effects. The utility of quantitative easing is thus heavily parameter dependent and not easily encapsulated in simple statements.”
In other words, it depends.
Back in January 2020, before the full impact of the current pandemic was even considered, CrossBorder Capital’s Michael Howell wrote in the FT, “If debts are not to be reneged upon, they must either be repaid or somehow refinanced. However, not only is much of the new debt taken on since the 2008 financial crisis unlikely to be paid back but, more worryingly, it is compounding ever higher. Our latest estimates suggest that world debt levels now exceed $250tn, equivalent to a whopping 320% of world gross domestic product — and roughly double the $130tn pool of global liquidity.”
He concluded, “That liquidity is already spilling around the world, with our global indices registering their sixth best year on record.”
At the end of July Moody’s said, “Asian insurers are adapting investment mixes to fit with lower-for-longer rates. Interest rates across Asian economies will stay lower for a longer period because of the disruptions caused by the coronavirus outbreak. These lower-for-longer interest rates are negative for insurers because they will lower yields on assets and challenge asset-liability duration management and solvency positions. How Asian insurers change investment mix as they prepare for these changes will determine their credit performance.”
The problem is that it will be very difficult for insurance asset managers in Asia to know which assets are already part of a bubble and which have real investment potential.
One nation that has won plaudits for its handling of the coronavirus, New Zealand, faces the same risk as many others. In a report from S&P published in early August, the agency said, “We expect the largest impact from COVID-19 for New Zealand insurers to be through investment market losses, with asset value declines. We also expect lower investment income due to the low interest rate environment continuing to affect insurers’ earnings, more recently illustrated in the first quarter of 2020.”
It seems that the ‘underwriting’ versus ‘investments’ struggle that so many insurers have grappled with over recent years will be around for some time to come.