Yesterday, former Federal Reserve Chairman Alan Greenspan gave a keynote address at the KMPG 2014 Insurance Industry Conference on why the U.S. economy – and the rest of the world, for that matter – are in such economic doldrums. He laid out 9 reasons why our economy still stinks, six years after the financial crisis of 2008-2009.
There was just one problem with it, though. Everything Greenspan said was wrong.
Well, maybe not wrong wrong. Not “2+2=5” wrong. But for all of Greenspan’s reasons for being skeptical about the future of the U.S. economy, John Kim, Vice Chairman and Chief Investment Officer from New York Life Insurance Company had a reason for why the future of our economy looks pretty bright.
Kim very graciously acknowledged Greenspan’s status and expertise, but he also noted that when it came strictly to the world of investments, he had an edge. And that informed a view that offered a counter to Greenspan’s infamously gloomy outlook.
And the audience was into it, too. Kim wasn’t just conjuring faerie tales. He had the data to suggest that all the smart money is on the United States of America, going forward.
Here are the reasons why.
1. We are at a major inflection point.
Kim started off by reminding everybody that six years ago yesterday, on September 9, 2008, Lehman Brothers declined 45 percent to 7.79 a share because a rescue deal with a Korean bank failed. Lehman’s stock was down 80 percent year-to-date, and its latest stumble caused the Dow to drop 280 points. 10-year Treasuries were trading at 3.62 percent and two-years were at 2.23 percent, numbers considered sky-high, now.
The months that followed saw the Lehman bankruptcy, AIG, Fannie Mae, Freddie Mac, Bank of America buying Merrill Lynch, JP Morgan buying Washington Mutual, Wells Fargo buying Wachovia. It was what Kim described as a “never-ending spiral of despair that resulted in the cavalry of central bank interventions, led by the Federal Reserve.” From this, we saw TARP, the AIG, Freddie and Fannie bailouts, and QE1, QE2 and QE3. From all that, Kim said, we are now at a major inflection point.
The first major sign of recovery, Kim said, is improving employment. Jobs are slowly trending back and have nearly returned to where they were pre-crisis. Unemployment rose to 10.2 percent in 2009, and in 2014, it’s declined to 6.1 percent. Yes, Kim admitted, the quality of these jobs is not that great in many cases. Yes, participating rates are the lowest in two generations. “I get all that,” Kim said, smiling. “But I suggest that from November 2009 to today, there has been a dramatic recovery in our labor picture. Europe and Japan would salivate for these improvements.”
He’s right. They would.
2. We are coming off an unbelievably good market rally.
Kim pointed out what he called “an absolutely historic performance in our risk asset classes,” as a way to underscore what has been, since the crisis, one of the most remarkable market rallies in history.
How good has it been? On April 1, 2009, the S&P 500 index value was 811. The BAML High Yield Spread was 1,712. By September 5, 2014, the S&P 500 had risen to 2,007. The BAML High Yield Spread had dropped to 393. If you had invested in both, the S&P would have given you a return of 182 percent. The BAML High Yield would have given you a total return of 136 percent. And yet, over this period of time, the average ownership of stocks declined from 65 percent in 2007 to 52 percent in 2013. This has been one of the biggest bull markets in recent history, and it seems like a whole lot of people missed it.
That’s a shame, since this 5.5-year period has performed better than any period in history for these two classes, which are the most volatile you can get your hands on. That is the kind of rally we’ve been experiencing. That is a good thing.
Now, will the market correct meaningfully, or will it stay at these levels? Like all data, Kim said, “if you torture the data long enough, it’ll confess to anything.” But he noted that based on the “Rule of 20″ and where the 10-year Treasury is today, the P/E multiple is currently below historical levels, which suggests that if the 10-year stays at 2.5-3 percent, then the market has room to increase. Chances are, those rates will go up, but not for another few years. We’re getting close to a full valuation for the equity markets, Kim pointed out, but we’re not there yet.
Translation: don’t expect a correction any time soon. The rally will continue.
3. Low interest rates are a good thing. Wait, what?
That the rate on the 10-year will stay down for the next few years is somehow a good thing for equities, yet more bad news for those who invest in bonds, like insurers. The bad news is that we can expect interest rates to stay lower for longer, Kim said. “It has been a very painful two and a half years for us, interest rates-wise.” In July 2012, the 10-Year Treasury Yield hit 1.39 percent, prompting many to fear that the U.S. was about to hit a Japan scenario, but rates have since risen to 3.05 percent before dipping back down to 2.46 percent. They might rise some more — which Greenspan suggested, but Kim remained skeptical. He sees rates staying lower for longer. But this isn’t necessarily a recipe for doom.
Keep in mind that the global economy is stalling, and stalling hard while the U.S. is, comparatively, growing nicely. We can expect around 4 percent GDP growth for the remainder of the year, while the latest IMF forecast for the world cut global GDP growth from 3.7 to 3.4. Ouch.
With that as a background, global yield arbitrage all plays to our favor. If you are a German investor, Kim said, and you are comparing a 2.5 percent yield on a U.S. 10-year versus 1.0 percent on a german one, or a 2.2 percent return on a Spanish one, then putting your money in the U.S. Treasury market becomes a no-brainer.
China, Japan and OPEC, for example, are all doubling down on U.S. Treasury bonds, Kim said. They now hold more than $2.7 trillion in U.S. Treasuries. Why? Because despite everything, the U.S. market is still the “deepest, most liquid place to hold cash,” Kim said. At present, some 35 percent of our total treasury debt load is held by foreigners, which is up from 31 percent from 2011. The Chinese government is increasing its purchase of U.S. Treasuries at the fastest pace on record since it began buying our Treasuries 30 years ago. When China, Japan and OPEC are all placing their long-term bets on America’s future, that’s a good sign.
4. Hardship breeds strength.
The “still low environment,” as Kim put it, is also a good thing because it is, quite simply, forcing insurers to get better at their business. Unable to rely on yield from their investments, insurers have no choice but to turn to operations for profit. Insurers are now forced to consider product changes, revisit their premiums and fee schedules, monitor growth in markets (and consider whether it is time to exit them), and other features. This is a kind of evolutionary pressure not entirely unlike what insurers underwent during the prolonged soft market of the 1990s, and ultimately, it makes for a harder, faster, better and stronger insurance industry.
Companies are having to take a sharper look at risk management on their investment side. They must embrace enterprise risk management and engage in tighter interest rate and cash flow hedging. Kim cited an NAIC figure that of the total swaps on the books for insurers, some 75 percent of that swap activity is noted for interest rate hedging purposes. This is a very positive sign, Kim said.
Operating efficiency is also improving across the industry as companies are embracing transformations of their operating models. This is happening more at public companies (driven by shareholder expectations) rather than mutuals, Kim said, but everyone is thinking about how to streamline their operations and manage their unit cost structures. The three elements of operational model changes to keep an eye on are process & technology (can the day-to-day operations be made more efficient through technology?), work structure (can the company delayer its own hierarchy?) and organizational effectiveness (should the company revisit its internal roles, responsibilities, governance and talent?)
These are all worthy issues to face head-on. Ideally, every insurer should do this all the time, but we all know that when times are fat and insurers can get by on their investments, complacency can set in. That might work during peacetime, but now it’s war, and it’s time to get lean and mean. Your competitors are already doing it, and when you do too, Kim implied, you’ll be a better company for it. This is all a good thing.
5. Alternative investments have earned a place at the table.
With interest rates so low, many insurers are embracing alternative investments. “It’s clear that we’re pushing the envelope in terms of adding yield, whether we’re going into higher-yield bonds, or CMBS, emerging market, debt, or commercial mortgage loans,” Kim said. Some insurers have already gotten into this space faster, but the entire industry needs to move to alternatives if they want their investment side to come back to life.
And indeed, it seems like more have than haven’t. “The entire universe of investors have gone alternative,” Kim said, noting that since 2005, traditional investment assets have grown at a compound annual growth rate of 5.4 percent. Alternatives, on the other hand, have grown at an annual rate of 10.7 percent.
Private debt, private equity funds of funds, private equity single funds, REITs, infrastructure, mezzanine debt, hedge fund of funds, commodities, hedge funds (single manager) are all expected to increase.
“This is powerful, but very dangerous,” Kim warned. “If you do not have the capabilities to analyze this, you could do very poorly.” He noted that New York LIfe, given its size and sophistication, does as good a job with alternative investments as anybody, but they don’t engage in a lot of common alternatives, such as single-manager hedge funds, because they view them as too risky.
That said, alternatives are here to stay, and they provide insurers with a strong avenue for yield, provided that they are engaged with a sober approach and a firm sense of risk management. Now is not the time to take a Wild West approach to alternatives. In fact, it’s probably never the time to take a Wild West approach to alternatives.
6. The U.S. middle class remains a largely untapped opportunity, especially for insurers.
Since the global financial crisis, Kim said, the recovery has really only been beneficial for the wealthy. From 2009-2011, for example, the average net worth per household for the top 7 percent of all households increased by 28 percent, from $2.5 million to $3.2 million. Conversely, the change in average net worth for the bottom 93 percent decreased 4 percent, from $139,896 to $133,817. Kim was pretty straightforward about it: “This has been one mother of a gift” that the central banks bestowed upon the world’s wealthy, and the social impact of this, in the long-term, will be profound. But, Kim stresses, from a financial and economic perspective, this might not be the worst thing in the world.
If you don’t look at it in terms of 7 percent vs 93 percent, but instead look at distribution of wealth in quintiles, there are lot of insurance sales opportunities in the 2nd and 3rd quintiles, which make up the middle class and upper middle class, respectively. The top quintile is already well served by banks, wealth advisors, mutual fund industry, and the like. And the industry should continue to serve that market, Kim said. But what New York Life likes are those 2nd and 3rd quintiles. There are a lot of boomers in those who are turning 65 at a rate of 10,000 a day, and who will retire at that rate for the next 20 years. This is a retirement tsunami, Kim said, and these people are desperately shifting to treasuries, bonds and various forms of annuity products and other conservative investment products that insurers do a better job of constructing and offering than anyone else.
So the wealth gap means more opportunity for selling to the middle class. Don’t give up on them.
7. The global middle class is exploding, and the U.S. is there to sell to it.
The opportunity of selling to the middle class is especially true if you look outside of the United States, Eurozone and Japan. “In many respects, the core fabric of our middle class going away is offset by the global growth of the middle class in China, India, Malaysia, and Korea,” Kim said. “In Asia, these people are going from the novelty of three meals a day to buying designer bags for the wealthy.” There is a once-in-a-lifetime growth in the middle class around the world, driven by a shift in the share of world GDP. By 2018, 54 percent of the world’s GDP will come from the so-called “developing economies.”
Concurrently, the world’s population is increasingly urban. There are already more people living in cities than in rural areas across the world, and by 2050, some two-thirds of the world’s population, buoyed by a huge middle class, will be concentrated in cities. This is a huge set-up for insurers in general and U.S. insurers in particular, which are uniquely well suited for serving both middle-class clients and urban clients. In fact, this might be a market development “perfect storm” the likes of which the modern insurance industry has never seen before.
8. Foreign oil? What foreign oil?
Getting back to points of strength on the U.S. economy, Kim spoke on the narrowing gap between U.S. energy consumption and production. Citing information from BP — “not the most credible source these days,” Kim joked, in reference to BP’s recent ruling of gross negligence in the Gulf oil spill — increasing domestic production could make the U.S. energy independent by 2030. But to back that up, Kim cited more conservative numbers from the Energy Information Administration that also suggested the gap between consumption and production would get very narrow by 2030.
Compare this to 2005, Kim said, when we imported 30 percent of our energy consumed on a daily basis. That is a huge improvement, especially in Texas.
Case in point: some 20 percent of new construction in the largest central business districts in this country is currently happening in Houston alone. Now, Texas has seen more than its share of boom and bust cycles, Kim noted, but in our chase for energy, Texas is having a boom that extends well beyond oil and gas. Other large economies in the region are benefitting as well. Most folks with an “East Coast mentality” don’t appreciate that, Kim said, but it’s a big deal, and its a big reason why the indicators in the U.S. are pointing up.
9. The U.S. has a huge new natural resource: Big Data.
200+ million hours of video uploaded to YouTube each day. 81 billion “likes” on Facebook last month. Nearly 5,000 text messages per month … from the average teenager. 15 billion tweets last month. The advent of “SoLoMo” — Social, Local Mobile. We are awash in data, and all of that data is coming from us – info or content that some 3 billion human users are volunteering.
But this is all just the beginning. There is an information supernova just getting underway as the Internet of Things — an increasingly vast array of personal items and technology that exchange and upload information on those who use it, such as GPS info, purchasing info, medical info — gets established. At the same time Kim gave his address, Tim Cook and his colleagues at Apple were unveiling the Apple Watch, Apple’s first wearable computing device. Given Apple’s ability to change behaviors in ways we never thought possible, Kim said, the watch could be a game-changer like the iPad, and deliver a new magnitude of ergonomic and health diagnostic information. “Remember September 9, 2014 not for what John Kim said, but for what Tim Cook said,” Kim noted.
We are at a point where we can quantify the positive impact of Big Data, Kim said, noting that as we realize some $300–$600 billion in annual cost savings and productivity gains from Big Data, the U.S. economy is building fresh GDP equivalent to about +1.5 to +3 percent … all from Big Data. The Economist noted that data is new big natural resource, analogous to what steam was in the 18th century, what electricity was in the 19th century and what hydrocarbons were in the 20th century.
And the U.S. is driving it.
The big postscript to this is that not everybody is making the most of it just yet. Insurers are well behind the curve when it comes to implementing a digital strategy. In a world where there are currently five exobytes of information on the Internet (Google an exobyte to see how big it is), some 30 percent of insurance companies are doing nothing with it. Another 43 percent are trying to understand it. That means that three-quarters of the insurance industry are trying to figure out what to do with Big Data.
The truth is, few in the insurance industry have really used Big Data to their advantage — whether it’s because of constrained IT budgets or simply a lack of focus or understanding. Maybe 7 percent of insurers have a well understood digital strategy. Maybe 3 percent have fully integrated a digital strategy into daily operations. But the upside here is that when it comes to Big Data, Kim said, because so few insurers have harnessed data to their competitive advantage in a meaningful way, especially in life insurance, the only way to go is up.
“It’s like playing hockey in Costa Rica,” Kim said. “We’re all pretty good, considering the standards.”