2024 should mark the beginning of the end for reforms to Solvency II. Having fired the starting gun in February 20191, almost four years later the Commission, European Parliament and European Council are negotiating the final contours of the reform package. Although leaders are aiming to conclude the negotiations by the end of the year, there is a realistic prospect of continuing into Q1 2024.
The European institutions are currently seeking to close the gaps on both technical differences of detail as well as areas of political contention. Topics still under negotiation include the extent of sustainability disclosures, long-term guarantees and EIOPA’s role in cross-border supervision.
Once negotiations on the Directive are complete, work will begin almost immediately to amend the more detailed Delegated Regulation which underpins the Directive. Initial work on a draft Delegated Act began in 2022 and we expect the Commission to publish the draft text as soon as a trilogue deal is reached.
The draft is expected to support the key changes made to the Solvency II Directive – as well as potential further areas of reform, such as to the volatility adjustment, matching adjustment and the extrapolation of long-term interest rates.2
Alongside reform of the Solvency II Directive, the European institutions are also negotiating on the final form of a new Insurance Recovery and Resolution Directive (IRRD) which aims to provide a set of resolution tools if (re)insurers are failing or likely to fail. As with Solvency II, the institutions are aiming to complete negotiations by the end of the year, but there is also a possibility that they drag into Q1 2024.
Despite their expected finalisation in 2024, changes to Solvency II are not expected to come into force until mid-2025. In the meantime, a new European Parliament will be elected in June, and a new set of commissioners appointed to lead the European Commission. As such, all eyes will be on the new Commission in H2 2024 to understand to what extent insurance will feature in their policy priorities for the next legislative mandate 2024-2029.
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We expect a “bumpy landing” for the US and the Eurozone to go from a slowdown into a contraction. Both scenarios imply a favourable backdrop for fixed income, especially higher quality assets, as central banks should be at or near the peak of their hiking cycles.
Current market pricing suggests easing rates on both sides of the Atlantic in Q2-Q3. The decent is relatively gradual, with the ECB deposit rate finding a new range around 2.75%. Hedging costs for USD issues are likely to remain in the 1.4-1.6% area.
Source: Bloomberg, October 2023
There are a couple of drivers for softer conditions in Europe: first, the monetary transmission mechanism is more efficient than in the US, so rate hikes have been swiftly passed on to households and firms.
Second, the supply shock effects of the Russia-Ukraine conflict are now abating; we can see that the contribution of energy (in blue) to headline inflation has turned from strongly positive to negative in recent months.
Source: Macrobond, October 2023
Absent another flare-up in this conflict, or an expansion of the one in the Middle East, at the current trajectory we should see the headline rate fall back within the target range by year-end.
In the US, the credit cycle shows signs of maturing. Leverage has trended higher while margins, interest coverage, and revenue growth have fallen. We expect that corporates will prioritize debt paydowns to control borrowing expenses and defend balance sheets. Downgrade activity escalated in 2023, albeit from a low base, and upgrades still outweigh downgrades.
The European cycle is further ahead with credit events picking up among weaker rating categories. We expect these to continue rising in 2024 given more challenging refinancing conditions. We have seen an uptick in disappointments during the Q3 2023 earnings season, but we still view these as idiosyncratic rather than systemic.
Overall fundamentals are still reasonable, however. Euro Stoxx 600 leverage is close to record lows and earnings margins are still elevated. We are expecting interest cover to deteriorate gradually, but this is not an immediate concern given well-spread maturity profiles.
We think spreads on investment grade look reasonable given the macro environment and corporate fundamentals. Euro and Sterling issues are trading substantially outside of their long-term medians while US ones are slightly inside – likely due to the stronger growth dynamics in the US.
Source: Bloomberg, October 2023. An investment cannot be made in an index.
As always, the spread levels for an overall index conceal wide variations therein – and there are many relative value opportunities for investors who can pick and choose securities with a global viewpoint.
In the current risk-averse environment, European insurers are naturally over-allocating to high quality bonds which exhibit much better spread than during the last decade and which could withstand a potential recession. Besides their median duration mismatch narrowed to around -5 years, as the duration of liabilities decreased more than that of assets.
Amongst the driving factors of this asset allocation change, we can count the increasing need of liquidity notably in Italy and the denominator effect impacting private assets.
Private assets perfectly played their role of shock absorbers over recent years but their relative importance in the balance sheet increased and neared the liquidity risk limits. Though the denominator effect slowed down the allocation to private assets over the last 18 months.
We expect a repricing of the private assets at year-end and a stabilization of the liabilities’ cost which will leave more room for diversification in 2024.
Source: Invesco. Data as of 30/09/2023.
Public markets, Fixed income remains the story of the year.
On the private markets side, we over allocate to debt over equity to cushion the volatility and refinancing risk and benefit from opportunities which are a good fit for insurers’ risk appetite & ALM: low LTVs and strong covenants.
The focus on diversification and the increasing appetite for inflation linked assets will probably attract new investors in the real estate debt space since higher interest rates have resulted in an attractive entry point thanks to repricing. Besides reduced bank lending creates a compelling opportunity for alternative real estate lenders.
Private Credit quality has also improved since 2022 via lender-friendly documentations and lower leverage profiles notably on the middle market side. Considering loans offer some of the best yields in fixed income despite their senior secured status, we believe their low correlation with traditional asset classes of the insurance balance sheet make them an attractive way to reinforce asset allocation in 2024.
As we head into 2024, the market consensus is generally that interest rates have peaked – which is exciting news for bond investors. We explore the implications across a broad range of fixed income asset classes.
Investing through market corrections has historically driven outperformance for real estate investors. We believe this will continue into 2024.
It’ll be a challenging backdrop for equities in 2024. From an investment perspective, company fundamentals are likely to become more important. Read our investment outlook for more.
Invesco Investment Solutions develops CMAs that provide long-term estimates for the behavior of major asset classes globally. The team is dedicated to designing outcome-oriented, multi-asset portfolios that meet the specific goals of investors. The assumptions, which are based on a 10-year investment time horizon, are intended to guide these strategic asset class allocations. We also utilize 5-year CMAs to give a half cycle view. For each selected asset class, we develop assumptions for estimated return, estimated standard deviation of return (volatility), and estimated correlation with other asset classes. For additional details regarding the methodology used to develop these estimates, please see our white paper Capital Market Assumptions: A building block methodology.
This information is not intended as a recommendation to invest in a specific asset class or strategy, or as a promise of future performance. These asset class assumptions are passive, and do not consider the impact of active management. Given the complex risk-reward trade-offs involved, we encourage you to consider your judgment and quantitative approaches in setting strategic allocations to asset classes and strategies. This material is not intended to provide, and should not be relied on for tax advice.
References to future returns are not promises or estimates of actual returns a client portfolio may achieve. Assumptions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell securities. Forecasts of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. Estimated returns can be conditional on economic scenarios. In the event a particular scenario comes to pass, actual returns could be significantly higher or lower than these estimates.
Indices are unmanaged and used for illustrative purposes only. They are not intended to be indicative of the performance of any strategy. It is not possible to invest directly in an index.
The CMAs included are based on Invesco’s return expectations for the asset classes shown. The indices referenced are included as proxies for the asset classes and have been selected because they are well known and are easily recognisable by investors. The inclusion of these indices is not linked to the promotion of any investment products or services.
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Data as at 31 October 2023, unless otherwise stated.
Views and opinions are based on current market conditions and are subject to change.
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