Steve Peacher: Hi everybody, this is Steve Peacher, President of SLC Management thanks for dialing into this episode of “Three in Five.” Today I’m joined by Peter Cramer. And Peter is a senior managing director who leads our insurance asset management practice, and I wanted to talk to Peter today about the impact of interest rates and inflation on the P&C insurance companies that Peter and his team manage assets for. Peter thanks for taking a few minutes today.
Peter Cramer: Thanks for having me Steve it's great to be chatting with you.
Steve Peacher: So let's, before we get in to the perspective of P&C companies specifically, let's talk first about the big issue that everybody's talking about in the marketplace, or one of the issues, which is inflation. What are your general thoughts on why it's such a such a problem now you know, I think if anything, people have been saying that inflations been too low, borderline deflation at times, which is concerning. So it's now picked up, why is it creating such of a of an issue for investors?
Peter Cramer: Yeah, I think you kind of nailed it Steve, I think one of the interesting elements is for the better part of the last two decades we've been wanting inflation, not just here in the U.S., but I’d say globally we've been combating inflation that has been consistently below target and what I would say was you know in the early phases of the recovery from the lockdown periods, we saw a post Covid-19, that inflation was viewed relatively positively because, again, it allowed us to, as we look back over the last two decades have an inflation level that was at least approaching an average that was at or close to the targets that we're looking from central banks let's call that the ‘cute puppy dog’ phase of inflation. The problem is, we evolve that into the full grown ‘pitbull’ stage of inflation where the elements that were contributing to inflation really expanded dramatically, so I’d say previously it was more contained to a small subset of goods that were easily explained away by some of the supply chain issues we're having, you know think microprocessors or semiconductors and lumber as kind of the key poster children there. And to the extent that we were seeing it flow through to wages, it was really contained to some of the lower wage segments I’d say we're largely driven by the leisure and hospitality sector, people are really hesitant to return of that full in-person interaction. But what we saw as we get into the latter part 2021 in early ‘22 in particular was that inflation really broadened out pretty dramatically, so we saw wage gains start to rise across the spectrum and the amount of goods that were being impacted by inflation really rose dramatically as well. And then the other key factor is right and we're starting to see some resolution to supply chains, Russia invaded Ukraine and then the energy and importantly agricultural commodity space really are thrown into the chaos. You know Russia, Ukraine are both huge producers of wheat but also fertilizers that are key inputs into a lot of foodstuffs and that really drove up the inflation over a broad swath of consumer goods. And I think the damaging element there is that now the majority of average consumers consumption basket is growing faster than their wages, so we have negative real disposable income and have for the past four quarters here in the U.S. Now, I think is the real concerning part is that now inflation has been shifted from something that was a modest positive because it was again allowing us to exceed historical averages to one is now very damaging consumer spending because we're eroding consumer spending power over time.
Steve Peacher: So let's talk now about the perspective from the property and casualty insurance companies who are clients have of your teams. How, from the perspective of a P&C insurance company, how are high inflation, but also the higher interest rates that go along with that, what's the impact on their fixed income portfolios and on their business in general?
Peter Cramer: So, in a lot of ways this type of environment can be the perfect storm in a negative sense for P&C insurance companies, and the reason for that is higher inflation pushes up the liability side of the equation. So if you were to take, for example, an auto insurer in our space, the cost of repairs and replacement for their insured automobiles is increasing rapidly, particularly in this environment just given some of the shortages we've had in the auto production space. So their costs are moving up dramatically, at the same time that most of their portfolio, because again typically the majority of these companies’ portfolios invest in fixed income assets, is going to be losing value because as rates move higher again, they devalue those bonds is moving lower. So, in a lot of ways it can be a very negative scenario. The good news is that because most P&C insurance companies are able to use statutory accounting, meaning they're able to hold these bonds to maturity and not have to mark to market that volatility that we're seeing in actual prices for those bonds, the opportunity to avoid that mark to market, I think, is a big one, and what it allows for is actually the positive side, which is that reinvestment yields are now at a point where they're quite attractive. So one of the benchmarks we use to try and gauge the general reinvestment opportunities in the market is the yield on the Barclays Intermediate Aggregate index. So for the better part of the last decade that index has averaged about 2%, we're now just under 3.2% there, so for the first time in a while we're in a position where the reinvestment opportunities are actually in excess of the yields of securities that are maturing in the portfolio. So for a long time the overall book yield of P&C insurance companies has been eroded as the replacement yields have been lower than the yields that were coming off the portfolio, now we're finally positioned again, because you'll have risen and spreads have widened, where reinvestment opportunities are going to be higher than what's coming off the portfolio. So that's the silver lining to these companies is that they are able to now slowly see their investment income rise over time. It'll be a gradual process but, again, we think we've reached an inflection point in that decrease in book yield which we should start to trend higher over time.
Steve Peacher: When you think about the different sectors in the fixed income market that P&C insurance should be thinking about today what comes to mind?
Peter Cramer: I think there's a couple areas that are really worth considering here. and I’d say that the backdrop for this is one where we do think we're heading into a more challenging environment for the U.S. economy, just because the Feds very dramatic commitment to curtailing growth in the pursuit of lower inflation. In that type of environment we think it's preferable to be looking for ways to move up in the capital structure and up in ratings. So a couple areas that we think really are worth evaluating now are in the structured products areas. So we like AAA and AA rated asset backs and CMBS. We like the structural protection that those securities offer, so essentially by having people lower in the capital stack they're available to absorb losses, you get the added protection against any potential loss that you would see in the in the underlying collateral pool which, for most of what we're investing in in the aspect space is going to be credit card receivables or auto loans. We also like the CLO space, s, in addition to having a significant subordination, so typically 30, 35% at the AAA level, you also get the benefit of those assets being floating rate. So to the extent that we see short term rates moving higher as the Fed is hiking rates, you get the added protection of that coupon resetting higher, which you think is a real key advantage in this environment. The other area that I think has really become more interest recently is tax exempt municipals. So for a long time that space had really been one that wasn't economically viable for most insurance companies, just because post tax reform the tax adjusted yielding in the municipals was significantly lower than what you could find the taxable space. Because municipal said had really a historically week first quarter of 2022, and those ratios have now become attractive again to the point where we think it's an area that's worth starting to consider increasing allocations to after having seen those allocations dwindle over the last four years. We also like the fundamentals in the municipal space, so if we are heading into an economic slowdown municipals tend to be a space that performs a bit better. They are still coming off the tremendously strong period in terms of the surpluses they’ve been able to generate because of the huge tax windfall seen with the increased economic activity, as well as just the dramatic increase in property values that awards them the opportunity to implement the additional property tax if they need to increase revenue, so we like both the fundamentals and the relative value of that space as well.
Steve Peacher: You know I think your comments highlight the fact that for markets you go through these long periods where the backdrop is fairly stable and then all of a sudden you get a big change. And I think we're seeing that right now, we just had a huge change from an inflation standpoint, we’ve seen a huge move in rates and I think that can be unsettling for a lot of investors, but actually I think your comments point out that it can also be a great opportunity too, to look at sectors that may have been out of favor or to do things in a portfolio that you couldn't have done before, and I, you know I know that's how you try to look at it for our clients. Let me end with a personal question, you know we had a chance to have dinner recently, we were talking about a big upcoming trip you've got in Paris with your family soon and I know that’s a big trip you're looking forward to, so I want to ask you what are the one or two things that you're really looking forward to as part of that trip?
Peter Cramer: France has always had a special place in my heart, when I was 10 years old my folks at the opportunity to take a sabbatical and go live in South of France for six months, so I had the opportunity to go to a small local school there, we had about 25 kids spanning five grade levels in that school. It was really an incredible experience for both my brother and I to learn to speak the language. So I’m really excited about taking my daughter now, and she just turned 11, over to Paris to be able to really immerse her in the French language, she had been taking French since she was about three and a half, she did a French immersion school when she was younger, so seeing her really blossom and develop in terms of her language skills is something I’m really excited about seeing. I also can't lie, I’m very excited about the food in France, I’m planning on gaining about 15 pounds in croissants and wine weight while I’m there.
Steve Peacher: So you’ve working out in advance, that’s good.
Peter Cramer: Exactly.
Steve Peacher: Pretty neat that your daughter has had that background, and then will be able to make even more out of this trip, I mean her language skills will just been incredible coming out of this. Well, listen thank thanks Peter for those comments they’re very timely and thanks everybody for listening to this episode of “Three in Five.”
Peter Cramer: Thank you, Steve.
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