A big bang or a pop?

 

In November last year, Chancellor Jeremy Hunt proposed an overhaul of the insurance industry Solvency II rules. These require life assurance companies to hold a sizeable ‘buffer’ of assets on their balance sheets and dictates where they can invest these reserves.

Should the overhaul go ahead given the current lack of confidence in global financial institutions?

The Solvency II rules were introduced by the EU to make financial institutions safer after the 2008 financial crash. The life assurance industry is regulated by the Bank of England’s Prudential Regulation authority (PRA). The PRA has previously stated it is determined to ensure any easing of the regulatory burden does not create a risk to policy holders or to the stability of companies. It has also warned against an overhaul of the solvency rules that ‘materially decapitalises the insurance sector.’

The Bank of England has warned, the annual risk of a failure will rise from 0.5% to 0.6%, if the changes are implemented, with a “relative increase in the probability of failure of around 20%”.

The government only pushed ahead with the reforms of the solvency rules following Brexit and after a protracted discussion between the Treasury and the PRA. Many believed the implementation of the rules could drag on for years, but some life assurance companies are already examining potential investment opportunities. These include infrastructure, including wind farms, social housing, care homes and university campuses. Some sector analysts estimate that over £100bn could be released for investment in these asset-backed projects. Previously, life assurance companies had to invest in government and corporate bonds. Traditionally these were viewed as highly-liquid and lower risk investments for solvency purposes, but the increase in interest rates from a record low base – led to 2022 being an ‘annus horribilis’ for bond investors.      

Freeing up financial institutions to be able to invest in infrastructure as the UK seeks to transition to net-zero and boost its renewables industry, is a positive move. Unfortunately, since November we have seen another banking crisis and while not on the scale of 2008, the latest crisis of confidence will no doubt be making the Bank of England and PRA nervous about lowering the asset liquidity buffers of institutions. At a time of increased national borrowing, sustaining lower gilts yields also sounds attractive.

Government bond yields have also risen from record lows and are now relatively more attractive to investors. The crazy days of negative bond yields seems a lifetime ago, when in fact it was only 3-years.  While bond yields remain well behind double-digit inflation, this is expected to drop sharply as the year progresses. For the first time in a decade, gilts could offer a real return, above inflation, by the end of 2023. Nonetheless, life assurance companies will no doubt welcome the opportunity to improve returns and diversify their assets beyond bonds and into alternatives.

What have we been watching? 

A measure of calm returned to markets as some of the debris from the recent banking crisis started to be cleared but much uncertainty remains. In the US, most of the remains of Silicon Valley Bank (SVB) is to be acquired by First Citizens Bank. With HSBC having swept up SVB’s UK arm and UBS acquiring Credit Suisse will this be enough to end the crisis of confidence in the bank sector or will markets continue to play whack-a -mole by finding the next vulnerable player? Bank of England governor Andrew Bailey said ‘we have to be very vigilant’ as markets are ‘trying to find points of weakness at the moment.’

Investors are likely to continue to keep watching movements in bank credit default swap for signs of stress – this is how confidence in Deutsche Bank collapsed very quickly. Markets will also want to see firm action from central banks. A leading Federal Reserve (Fed) official has already confirmed that the collapse of SVB was a ‘textbook case of mismanagement’ -so what does this say about the Fed’s oversight of the bank?  Indeed, SVB was not one of the 34 US banks stress tested by the Fed last year! The flight to safety in the US has continued with Goldman Sachs, JP Morgan, and Fidelity the biggest winners, with their US money market funds -largely invested in short-term US treasuries -taking in over $286bn in March so far – that is not a vote of confidence in the US banking system.

Putin announced that Russia will be storing tactical nuclear weapons in Belarus, in yet another clear message to the West that he has no intention of backing down. Elsewhere, China warned it was ‘resolutely opposed’ to any meeting between Taiwan’s president and the US House speaker.

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In the UK, grocery price inflation is estimated to have hit a record 17.5% in the four-weeks to mid-March. Meanwhile, UK house prices fell by over 3% in march -the fastest annual fall since 2009.

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In Europe, Spain saw a big fall in headline inflation from 6% to 3.1% while Germany saw a drop from 9.3% to 7.8%. However, core inflation is proving stickier at 7.5% in Spain.

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The US March PCE (personal consumer expenditure) – the Fed’s preferred gauge of inflation came in on the low side of expectations at 4.6%. US interest rate futures continue to indicate that markets see the end of the interest hiking cycle as over with rates falling from 5% to 4.5% by the end of 2023.

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China ‘s manufacturing activity slowed in March although February had hit a ten-year high after factories returned to work after lockdown. However, service and construction activity surged to a 12-month high.  

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Brent oil remained rallied to $85 as OPEC+ unexpectedly announced a 1 million barrel a day cut in production from May in response to recent price weakness following the banking crisis.     

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Finally, it is not just the UK that has problems delivering prestigious infrastructure projects such as HS2. Two leading Spanish transport officials have resigned over a botched order for new commuter trains that cost nearly £230m. Spain’s northern rail network has tunnels under the mountainous landscape that do not match standard modern tunnel dimensions. Unfortunately, the new trains that have been built are too big to fit in the tunnels! Meanwhile, the UK government remains unwilling to confirm where in London HS2 will terminate – Old Oak Common or Euston station? What a shambles!

 

Read Last Week’s Alpha Bites – The race to net-zero

 

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Alpha Portfolio Management is a trading name of R C Brown Investment Management PLC which is authorised and regulated by the Financial Conduct Authority.