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?)