At its core, a cash-value life insurance policy consists of three components: interest rates/dividend rates, mortality costs (cost of insurance) and expense charges. And, over the last 10 years, interest rates have been at historic lows. They are often lower than the guaranteed interest rates on universal life insurance policies.
Something has to give.
Insurance companies traditionally have invested their funds in debt-related investments (mostly bonds). As insurance companies are not earning enough interest to meet the projected interest rates on universal life and other cash value life insurance policies, they have had to lower the interest rates they credit to their policy owners. On some of these older policies, the guaranteed interest rate is higher than what the companies are earning, so the insurance companies are losing money on interest rates.
What happens when insurance companies lose money? Well, they’re not charities, so they look for the money in other places. Some companies have been able to make up some of the difference by changing their investment portfolio; however, by regulation, they are restricted in what they can invest in to some degree.
Why Am I Reading About Universal Life Policies Terminating?
Keeping in mind that almost every universal life insurance policy is crediting the guaranteed minimum interest rate, the insurance companies really only have one other component they can change to continue to maintain profitability. And that’s the mortality costs, also known as the cost of insurance.
A number of companies have recently announced increases in their mortality costs, though they do not typically disclose what the actual change is (dollar amount or percentages). These companies include AXA Equitable, Banner Life, Security Life of Denver, Transamerica Life, Voya Life and William Penn Life. It is important to note that the companies are only raising mortality costs on some universal life policies, not all of them.
It is highly likely that other life insurance companies will follow, especially if there are no repercussions (regulatory, media, consumer, etc.).
Universal life insurance policies were originally promoted and designed to be transparent life insurance policies where the components were unbundled and, therefore, could be monitored. Transparency has not been the case — changes to mortality rates are not usually disclosed, — and changes in mortality rates can have a more significant impact on the performance of a universal life policy than a reduction in interest rates.
If you have a whole life policy, you may be thinking, “Well, I’m safe, I’m getting my dividends.” Dividends are tricky. Companies with whole life policies have reduced dividend scales, but this is usually not disclosed anywhere—you just receive lower dividends. On a whole life policy where your original projection was to pay premiums for X number of years, you’ll find yourself paying premiums for much longer periods without ever being told. Most people don’t realize their premium payment periods have been significantly extended.
Also, you won’t be building up the cash value that was on the original projection, so if you bought a policy using the “Missing Money concept,” “Be Your Own Banker concept” or a similar concept, you are almost certainly not going to end up where you expected. (This is setting aside the issue of whether these concepts really make sense, but that’s a topic for another newsletter/article.)
What’s This Mean for You?
If you have a cash value life insurance policy, especially one purchased more than 10 years ago, your policy has a very high chance of terminating without value. To avoid this unwanted outcome, higher premiums are needed on almost every older universal life policy (traditional universal life, variable universal life or indexed life), basically on any life insurance policy where the premiums are not fixed. And if your premium is guaranteed, such as on a whole life policy, you may be paying premiums for significantly longer than expected or will be receiving a lower cash value.
“So,” you ask, “why hasn’t my insurance company or insurance agent told me about this?” Good question. The answer could be any or all of the following: The insurance companies are not facing facts; the insurance companies would prefer to not face the issue; the insurance company does not realize the issue exists; the agent doesn’t understand the problem; or the regulatory system is not addressing it yet.
This is definitely a matter of concern because life insurance companies are not detailing the impact on premiums and the life of the policy. And companies are not required to do so; nor are they even required to notify policyholders of increases in their costs of insurance (mortality costs).
As mentioned in the interview, the only way to determine the impact of this increase in mortality costs is through an in-force illustration. An in-force illustration is a projection of future values based on current assumptions. The Insurance Literacy Institute has free “Insurance Annual Review” guides that include a form letter to request in-force illustrations in the Resources Section.
Your in-force illustration request should include a projection based on current premiums and assumptions, along with a request for the required premium to continue your policy to maturity (maximum length). The difference in premium may be significant.
What Should I do?
A couple of things to consider are your health and life expectancy as well as your current need for life insurance. Most people find they don’t have a need for permanent life insurance because they have other assets they accumulate and that replace the need for life insurance. Remember, life insurance is for protecting those who are financially dependent upon you.
If you do need your life insurance policy, consider if you can pay the higher premium that would be required to keep your policy in force to maturity, or consider if a reduced death benefit would meet your needs.
You should also take a look at the ratio of premiums to death benefit. If you’re paying in 10% of the death benefit each year in premiums, then the policy doesn’t provide you good leverage.
Surrendering the policy is an option to consider, especially if there is a sizable surrender value.
Another option is selling a policy in the secondary marketplace (life settlement), though this needs to be approached carefully.
How many other companies have increased their mortality costs, and how many other policies are affected?
Whether interest rates increase and when they do so and whether insurance companies are able to start to increase their investment earnings will determine whether insurance companies will maintain or increase their cost of insurance.
The most concerning news came from Transamerica, which issued an announcement that illustrations requested by policyholders will no longer include information about the current cost of insurance rates or interest rates. Yes, that’s right. Policyholders with Transamerica will, possibly, not be able to have any idea of the premium required to fund their universal life policies. However, according to a recent report, Transamerica may have changed its mind.
The future is up to us. If we start to treat cash value life insurance as the complex investment vehicle it is and start to carefully manage it, there will be positive outcomes. If we continue with the current approach, lack of education and disclosure, more policies will terminate, and there will be significant negative consequences for policy owners and their beneficiaries.
As Iowa’s insurance commissioner, I meet with many innovators whose work affects the insurance industry. A major topic we discuss is the continual debate of innovation vs. regulatory oversight. This debate will be front and center during the Global Insurance Symposium in Des Moines when federal regulators, state regulators, industry leaders and leading innovators come together for discussions on the “right” way to bring innovation into the insurance industry.
I see three schools of thought in the debate:
Those who want nothing changed because insurance regulation has worked for more than 150 years
Those who suggest oversight by insurance regulators isn’t needed because innovations and market forces don’t require the same type of scrutiny that regulators have performed in the past
Those who feel that regulations and oversight are needed but that regulators should move quickly to keep up with emerging technological developments
Innovation is happening, and regulators realize it. No one, including regulators, can stop technological advances. Luckily, I have found that my colleagues who regulate the insurance industry desire to see innovation succeed because it will, generally, enhance the consumer experience. The focus of regulators is to enforce the laws in our states and to protect our consumers. It is that constant focus that ensures a healthy and robust market. And it is that focus that allows the market to work during an insolvency of a carrier, as Iowa witnessed recently during the liquidation of CoOportunity Health.
But wanting to work with innovators doesn’t mean insurance regulators are going to turn a blind eye to how innovations and new technologies within the industry are affecting consumers. I do not believe the fundamentals of the insurance business need to be disrupted. Innovations within an industry that is highly regulated, complex and vital to our economy and nation need to occur within the confines of our regulatory structure. Innovators who are attempting to disrupt the insurance industry outside the bounds of our regulatory structure and who are not following state regulations will likely face significant problems.
So, just as Goldilocks finally found the perfect fit at the home of the three bears, insurance regulators are working diligently to find the perfect fit of the proper regulation to protect consumers for innovations and the technology affecting the insurance industry. Regulators want the insurance business to continue to innovate and adapt to meet customer needs and expectations. Improving the customer experience through technology, quicker underwriting and increasing efficiency adds to the value of insurance for consumers. I know many smart people are working on creative projects to do these types of things and much more.
The insurance business is arguably becoming less complex because technology simplifies and evens out that complexity. Many existing insurance companies will face challenges as data continues to be harvested and as digital opportunities become more obvious. The continuous innovation in the industry is both positive and exciting.
However, insurance carriers face incredible issues, and, therefore, the regulators who supervise these firms must clearly understand the complexity of the industry and the external factors that weigh upon the industry.
A few issues industry participants must deal with:
Perpetual low interest rates that make it difficult for insurers’ investment yields to match up with liabilities;
Catastrophic storms that may wipe out an entire year’s underwriting profit in a matter of hours;
Increasing technological demands within numerous legacy systems;
International regulators working toward capital standards that may not align with the business of insurance in the U.S.
I believe regulators, insurance carriers and innovators can work together to harmonize and streamline regulations in an effort to keep up with market demands. However, the heart of insurance regulation beats to protect consumers. Compromising on financial oversight and strong consumer protections is not up for negotiation. Ensuring companies are properly licensed and producers are trained and licensed is critical, and ensuring companies maintain a strong financial position is equally critical.
Innovators who wish to bear risk for a fee or distribute products to consumers will need to comply with insurance law. Additionally, innovators looking to launch a vertical play into the industry through a creative service, model or underwriting tool need to make sure they do not run afoul of legal rules and provisions that deal with discriminatory pricing and use of data. It is a lot to absorb for an entrepreneur, but it is not impossible, and the upside may very well be worth it.
I absolutely encourage companies looking to innovate in the insurance industry to proceed, but I urge them to do so both with the understanding of insurance law and the role of the regulator and with strong internal compliance and controls. Innovators and entrepreneurs who proceed down the right path are the most likely to have regulators excited to see them succeed.
Insurance is still a complex industry. Can and should it be made simpler? Yes. I believe that, through innovation and continued digital evolution, it will. Should the industry focus on how to continue to enhance consumer experience and put the consumer in the center of everything? Yes, and I know that is occurring within many new ideas and businesses that are beginning and evolving.
Insurance, at its core, is a business of promises. It is an industry that has passed the test of time, and I believe, through innovation and continual improvement, it will remain strong and vibrant for the next 100 years.
If you are an innovator or entrepreneur and are looking for a program to learn about how to address insurance regulatory issues within your business as well as the role of a state insurance regulator, I would again encourage you to attend our 3rd Global Insurance Symposium in Des Moines, Iowa. This is the first conference where innovation and regulatory issues truly converge. This is your opportunity to learn from state insurance regulators, the Federal Reserve, the U.S. Department of Commerce, seasoned insurance executives, start-up entrepreneurs (the second class of the Global Insurance Accelerator will have a demo day for the 2016 class), venture capital investors and leading innovative thought leaders. No other meeting has assembled a group like this.
Everyone will benefit from the unique learning experiences, and, more importantly, relationships will emerge. Register here today!
This article is an excerpt from a white paper, “Capturing Hearts, Minds and Market Share: How Connected Insurers Are Improving Customer Retention.” In addition to the material covered here, the white paper includes specific recommendations on how to improve retention.
Insurers currently operate in a challenging environment. On the financial side, premiums are stagnant and interest rates low, and many cost-cutting measures have already been enacted. On the other hand, customer empowerment is growing. Customers are finding the information and offers they need to switch providers more freely than in the past – customers whom insurers can ill afford to lose.
For many carriers, the key to preserving customer relationships still lies in personal interaction, executed through traditional distribution and service models with tied agents and brokers. For some customer sets – those who strongly favor personal interaction – this business model works well. Yet a growing segment of customers, especially those 30 years old and younger, differ in some key aspects. While they still look for help and advice, they seek personal contact in the context of a holistic, omni-channel experience; they communicate and find information whenever, wherever and however they want. And even traditional customers appreciate if their agents have broader and faster access to the information and specialists they need on a case-by-case basis.
How can insurers keep – and even expand – these diverse customer sets, old and young alike? What factors drive retention and loyalty? To explore these questions, we surveyed more than 12,000 insurance customers in 24 nations about relationships with their insurers, what they perceive as valuable and in what ways they would like to interact and obtain new services going forward.
We found that while insurers understand well how to cover risks, they often fail to engage their customers on an individual basis. Even though insurance is complex, customers want to be involved, emotionally and rationally. When insurers act on this knowledge, customer share can rise.
The churn challenge
As a rule of thumb, the cost of acquiring new customers is four times that of retaining existing ones. To grow market share, insurers need new customers. But for the balance sheet, retention has a much larger impact.
For a long time, the insurance industry did not consider this lack of trust a problem. In the highly asymmetrical pre-Internet world, there was a necessary gatekeeper to information and knowledge about risks and coverages: the insurance intermediary. For insurers, the intermediary’s trusted personal customer relationship was a guarantee of fairly reliable renewals and low customer churn – thus, keeping the most profitable customers.
The technological innovations of the digital age have altered this picture. Information asymmetry is diminishing. Although many customers still seek advice on insurance matters, the empowered digital customer does not need to rely solely on the gatekeepers of old for information. With communication being swift and ubiquitous, misinformation is quickly uncovered, leading to a steady erosion of trust, even with the personal adviser and insurer.
We have come to expect that only 43% of our survey respondents trust the insurance industry in general – a number that has stayed fairly stable since our first survey in 2007 – but only 37% trust their own insurers to a high or very high degree. Most customers are neutral, with 16% actually distrusting their providers.
As we have often seen in past studies, trust varies widely by market and culture. For example, only 12% of South Korean customers responded that they trust their insurers, compared with 26% in France, 43% in the U.S. and 51% in Mexico.
Low trust translates to high churn. Even though 93% of our respondents state that they plan to stay with their current insurers for their recently acquired coverage through 2015, almost a third came to that coverage by switching insurers. Why? Most commonly (for 41% of respondents), their old insurers couldn’t meet their changing needs (see Figure 1).
The pattern of increasing customer empowerment and decreasing information asymmetry is continuing. New and non-traditional entrants to the insurance market are taking advantage of the opportunities of digital technologies. For example, Google recently launched an insurance comparison site for California and other regions of the U.S. This presents a real threat to both online insurers and traditional providers – not because of the comparison option itself, but because Google has collected a huge amount of information about each individual through his or her surfing habits, thus allowing better personalization and higher-value offers.
The three dimensions of retention
What do insurers need to do to increase trust and customer retention with the intent of improving both the top and bottom lines? The findings of our survey point to three courses of action:
Know your customers better. Customer behavior is affected by experiences and underlying psychographic factors. Insurers need to know and understand customers better, not only as target groups but as individuals. Insurers also need to get their customers involved, rationally and emotionally.
Offer customer value. As overused as the term is, a strong and individualized value proposition is exactly what insurers need to provide to their customers. Value is more than price; it includes many factors, including quality, brand and transparency.
Fully engage your customers across access points. As Millennials become a significant part of the insurance market, speed and breadth of access has begun to matter much more than in the past. Insurers need to engage their customers as widely as possible, from in-person interactions at one extreme all the way to digital interaction models such as those made possible by the Internet of Things.
Customer perception and behavior
Ever since the Internet has become a viable way to shop for goods and services, much discussion has centered on the matter of price. In theory, insurance products are easy to compare, so shouldn’t the cheapest one win out?
This view assumes that, aside from the price, all else is equal. If that were true, price would indeed be the sole tie-breaker. In reality, though, all else is never equal. Insurance is a product based on trust, for which perception matters. Perception, and thus customer behavior, is shaped by the individual customer’s attitudes and experiences. Understanding a customer on an individual basis helps a carrier tailor these experiences by communicating the “right way.”
To classify our respondents according to their attitudes, we used the same psychographic segmentation as in previous studies (see Figure 2).
One size seldom fits all
Overall, our respondents stated that the three most important retention factors are price (63%), quality of service (61%) and past experience (33%) – leading back to the price as the main tie-breaker. Yet a closer look across segments paints a more diverse picture: For a demanding support-seeker, quality is by far the most important (74%), while a loyal quality-seeker bases his renewal intentions on past experience more strongly than any other group (43%).
Assuming an insurer is targeting all these customer segments, it will need a diverse set of customer communication options, as each segment requires approaches tailored to its specific preferences (see Figure 3). This figure shows the five most-used insurance search options in the three segments where we are seeing the biggest shift among Millennials, who represent future customers.
The power of emotional involvement
Our data show that appropriate communication with customers sets off a positive chain reaction. First, it increased the use of that type of interaction. Customers perceived the interaction as more positive, and ultimately this increased emotional involvement with their providers – the “heart share” of our study title. Finally, emotional involvement is strongly connected to customer loyalty, so increasing involvement from medium to high had a dramatic impact on the loyalty index (see Figure 4).
What is the right way to communicate and increase involvement? As seen in Figure 3, the answer is “It depends,” so there is no one right approach for all customers. But using current technology – specifically, social media analytics – can help insurers improve involvement.
With this tool, providers can “listen” to various online sources, understand how they are seen by customers, uncover trends and quickly tie this knowledge to specific actions. Providers can combine the findings of social media analytics with psychographic segmentation and an individual customer’s place within the segmentation; the latter gained via more traditional customer analytics. With this customer view, insurers can even go beyond the personalized knowledge their tied agents tend to have: As customer wants and needs change and they articulate it on social channels, insurers will know and can react in close to real time.
Social media analytics
Social media analytics is a set of tools that allow insurers to analyze topics and ideas that are expressed by their actual or potential customers through social media. This can be on an individual basis, or per customer group. Through social media analytics, insurers can apply predictive capabilities to determine overall or individual attitude and behavior patterns, and identify new opportunities.
This article is an excerpt from a white paper, “Capturing Hearts, Minds and Market Share: How Connected Insurers Are Improving Customer Retention.” In addition to the material covered here, the white paper includes specific recommendations on how to improve retention.
Although it may not seem like it, in the second quarter of this year the U.S. economy passed into the beginning of its seventh year of expansion. In the 158 years that the National Bureau of Economic Research (the arbiters of “official” U.S. economic cycles) has been keeping records, ours is now the fifth-longest economic cycle, at 75 months. For fun, when did the longest cycles occur, and what circumstances characterized them? Is there anything we can learn from historical perspective about what may lie ahead for the current cycle?
The first cycle longer than the current, by only five months, is the 1938-1945 U.S. economic expansion cycle. Of course, this was the immediate post-Depression recovery cycle. What preceded this cycle, from 1933-1937, was the bulk of FDR’s New Deal spending program, a program that certainly rebuilt confidence and paved the way for a U.S. manufacturing boom as war on European and Japanese lands destroyed their respective manufacturing capabilities for a time. More than anything, the war-related destruction of the industrial base of Japan and Europe was the growth accelerant of the post-Depression U.S. economy.
In historically sequential order, the U.S. economy grew for 106 months between 1961 and 1970. What two occurrences surrounded this economic expansion that were unique in the clarity of hindsight? A quick diversion. In 1946, the first bank credit card was issued by the Bank of Brooklyn, called the “Charge-It” card. Much like American Express today, the balance needed to be paid in full monthly. We saw the same thing when the Diners Club Card became popular in the 1950s. But in 1958, both American Express and Bank of America issued credit cards to their customers broadly. We witnessed the beginning of the modern day credit culture in the U.S. economic and financial system. A support to the follow-on 1961-1970 economic expansion? Without question.
Once again in the 1960s, the influence of a major war on the U.S. economy was also apparent. Lyndon Johnson’s “guns and butter” program increased federal spending meaningfully, elongating the U.S. expansion of the time.
The remaining two extended historical U.S. economic cycles of magnitude (1982-1990, at 92 months, and 1991-2001, at 120 months) both occurred under the longest bull market cycle for bonds in our lifetime. Of course, a bull market for bonds means interest rates are declining. In November 1982, the 10-year Treasury sported a yield of 10.5%. By November 2001, that number was 4.3%. Declining interest rates from the early 1980s to the present constitute one of the greatest bond bull markets in U.S. history. The “credit cycle” spawned by two decades of continually lower interest rates very much underpinned these elongated growth cycles. The question being, at the generational lows in interest rates that we now see, will this bull run be repeated?
So fast-forward to today. What has been present in the current cycle that is anomalistic? Pretty simple. Never in any U.S. economic cycle has federal debt doubled, but it has in the current cycle. Never before has the Federal Reserve “printed” more than $3.5 trillion and injected it into U.S. financial markets, until the last seven years. Collectively, the U.S. economy and financial markets were treated to more than $11 trillion of additional stimulus, a number that totals more than 70% of current annual U.S. GDP. No wonder the current economic cycle is pushing historical extremes in terms of longevity. But what lies ahead?
As we know, the U.S. Fed has stopped printing money. Maybe not so coincidentally, in recent months macroeconomic indicators have softened noticeably. This is happening across the globe, not just in the U.S. As we look forward, what we believe most important to U.S. economic outcomes is what happens outside of the U.S. proper.
Specifically, China is a key watch point. It is the second-largest economy in the world and is undergoing not only economic slowing, but the very beginning of the free floating of its currency, as we discussed last month. This is causing the relative value of its currency to decline against global currencies. This means China can “buy less” of what the global economy has to sell. For the emerging market countries, China is their largest trading partner. If China slows, they slow. The largest export market for Europe is not the U.S., it’s China. As China slows, the Euro economy will feel it. For the U.S., China is also important in being an end market for many companies, crossing industries from Caterpillar to Apple.
In the 2003-2007 cycle, it was the U.S. economy that transmitted weakness to the greater global economy. In the current cycle, it’s exactly the opposite. It is weakness from outside the U.S. that is our greatest economic watch point as we move on to the end of the year. You may remember in past editions we have mentioned the Atlanta FED GDP Now model as being quite the good indicator of macroeconomic U.S. tone. For the third quarter, the model recently dropped from 1.7% estimated growth to 0.9%. Why? Weakness in net exports. Is weakness in the non-U.S. global economy the real reason the Fed did not raise interest rates in September?
As you are fully aware, the Fed again declined to raise interest rates at its meeting last month, making it now 60 Fed meetings in a row since 2009 that the Fed has passed on raising rates. Over the 2009-to-present cycle, the financial markets have responded very positively in post-Fed meeting environments where the Fed has either voted to print money (aka “Quantitative Easing”) or voted to keep short-term interest rates near zero. Not this time. Markets swooned with the again seemingly positive news of no rate increases. Very much something completely different in terms of market behavior in the current cycle. Why?
We need to think about the possibility that investors are now seeing the Fed, and really global central bankers, as to a large degree trapped. Trapped in the web of intended and unintended consequences of their actions. As we have argued for the past year, the Fed’s greatest single risk is being caught at the zero bound (0% interest rates) when the next U.S./global recession hits. With declining global growth evident as of late, this is a heightened concern, and that specific risk is growing. Is this what the markets are worried about?
It’s a very good bet that the Fed is worried about and reacting to the recent economic slowing in China along with Chinese currency weakness relative to the U.S. dollar. Not only are many large U.S. multi-national companies meaningful exporters to China, but a rising dollar relative to the Chinese renminbi is about the last thing these global behemoths want to see. As the dollar rises, all else being equal, it makes U.S. goods “more expensive” in the global marketplace. A poster child for this problem is Caterpillar. Just a few weeks ago, it reported its 33rd straight month of declining world sales. After releasing that report, it announced that 10,000 would be laid off in the next few years.
As we have explained in past writings, if the Fed raises interest rates, it would be the only central bank on Earth to do so. Academically, rising interest rates support a higher currency relative to those countries not raising rates. So the question becomes, if the Fed raises rates will it actually further hurt U.S. economic growth prospects globally by sparking a higher dollar? The folks at Caterpillar may already have the answer.
Finally, we should all be aware that debt burdens globally remain very high. Governments globally have borrowed, and continue to borrow, profusely in the current cycle. U.S. federal debt has more than doubled since 2009, and, again, we will hit yet a U.S. government debt ceiling in December. Do you really think the politicians will actually cap runaway debt growth? We’ll answer as soon as we stop laughing. As interest rates ultimately trend up, so will the continuing interest costs of debt-burdened governments globally. The Fed is more than fully aware of this fact.
In conjunction with all of this wonderful news, as we have addressed in prior writings, another pressing issue is the level of dollar-denominated debt that exists outside of the U.S.. As the Fed lowered rates to near zero in 2008, many emerging market countries took advantage of low borrowing costs by borrowing in U.S. dollars. As the dollar now climbs against the respective currencies of these non-dollar entities, their debt burdens grow in absolute terms in tandem with the rise in the dollar. Message being? As the Fed raises rates, it increases the debt burden of all non-U.S. entities that have borrowed in dollars. It is estimated that an additional $7 trillion in new dollar-denominated debt has been borrowed by non-U.S. entities in the last seven years. Fed decisions now affect global borrowers, not just those in the U.S.. So did the Fed pass on raising rates in September out of concern for the U.S. economy, or issues specific to global borrowers and the slowing international economies? For investors, has the Fed introduced a heightened level of uncertainty in their decision-making?
Prior to the recent September Fed meeting, Fed members had been leading investors to believe the process of increasing interest rates in the U.S. was to begin. So in one very real sense, the decision to pass left the investment world confused. Investors covet certainty. Hence a bit of financial market turbulence in the aftermath of the decision. Is the Fed worried about the U.S. economy? The global economy? The impact of a rate decision on relative currency values? Is the Fed worried about the emerging economies and their very high level of dollar-denominated debt? Because Fed members never clearly answer any of these questions, they have now left investors confused and concerned.
What this tells us is that, from a behavioral standpoint, the days of expecting a positive Pavlovian financial market response to the supposedly good news of a U.S. Fed refusing to raise interest rates are over. Keeping rates near zero is no longer good enough to support a positive market sentiment. In contrast, a Fed further refusing to raise interest rates is a concern. Let’s face it, there is no easy way out for global central bankers in the aftermath of their unprecedented money printing and interest rate suppression experiment. This, we believe, is exactly what the markets are now trying to discount.
The U.S. Stock Market
We are all fully aware that increased price volatility has characterized the U.S. stock market for the last few months. It should be no surprise as the U.S. equity market had gone close to 4 years without having experienced even a 10% correction, the third-longest period in market history. In one sense, it’s simply time, but we believe the key question for equity investors right now is whether the recent noticeable slowing in global economic trajectory ultimately results in recession. Why is this important? According to the playbook of historical experience, stock market corrections that occur in non-recessionary environments tend to be shorter and less violent than corrections that take place within the context of actual economic recession. Corrections in non-recessionary environments have been on average contained to the 10-20% range. Corrective stock price periods associated with recession have been worse, many associated with 30-40% price declines known as bear markets.
We can see exactly this in the following graph. We are looking at the Dow Jones Global Index. This is a composite of the top 350 companies on planet Earth. If the fortunes of these companies do not represent and reflect the rhythm of the global economy, we do not know what does. The blue bars marked in the chart are the periods covering the last two U.S. recessions, which were accompanied by downturns in major developed economies globally. As we’ve stated many a time, economies globally are more linked than ever before. We live in an interdependent global world. Let’s have a closer look.
If we turn the clock back to late 1997, an emerging markets currency crisis caused a 10%-plus correction in global stock prices but no recession. The markets continued higher after that correction. In late 1998, the blowup at Long Term Capital Management (a hedge fund management firm implosion that caused a $3.6 billion bailout among 16 financial institutions under the supervision of the Fed) really shook the global markets, causing a 20% price correction, but no recession, as the markets continued higher into the early 2000 peak. From the peak of stock prices in early 2000 to the first quarter of 2001, prices corrected just more than 20% but then declined yet another 20% that year as the U.S. did indeed enter recession. The ultimate peak to trough price decline into the 2003 bottom registered 50%, quite the bear market. Again, this correction was accompanied by recession.
The experience from 2003 to early 2008 is similar. We saw 10% corrections in 2004 and 2006, neither of which were accompanied by recession. The markets continued higher after these two corrective interludes. Late 2007 into the first quarter of 2008 witnessed just shy of a 20% correction, but being accompanied by recession meant the peak-to-trough price decline of 2007-2009 totaled considerably more than 50%.
We again see similar activity in the current environment. In 2010, we saw a 10% correction and no recession. In 2011, we experienced a 20% correction. Scary, but no recession meant higher stock prices were to come.
So we now find ourselves at yet another of these corrective junctures, and the key question remains unanswered. Will this corrective period for stock prices be accompanied by recession? We believe this question needs to be answered from the standpoint of the global economy, not the U.S. economy singularly. For now, the jury is out, but we know evidence of economic slowing outside of the U.S. is gathering force.
As you may be aware, another U.S. quarterly earnings reporting season is upon us. Although the earnings results themselves will be important, what will be most meaningful is guidance regarding 2016, as markets look ahead, not backward. We’ll especially be interested in what the major multinationals have to say about their respective outlooks, as this will be a key factor in assessing where markets may be moving from here.
Unless you have been living on a desert island, you are aware that Greece is in the midst of trying to resolve its financial difficulties with European authorities. This is just the latest round in a financial drama that has been playing out for a number of years now. Up to this point, the solution by both euro authorities and Greek leaders has been to delay any type of financial resolution. And that is the exact prescription handed down just a few weeks ago as Greece approached a February month-end debt payment of a magnitude it could not meet. Greece has been given another four months to come up with some type of restructuring plan. At this point, we’ve simply stopped counting how many times euro authorities have kicked the Greek can down the road.
Why all the drama regarding Greece? Greece represents only about 2% of Eurozone GDP. Who cares whether Greece is part of the euro? The Greek economy simply isn’t a big enough piece of the entire euro economy to really matter, is it?
The fact is that the key problems in the Greek drama have very little to do with the Greek economy specifically. The issues illuminate the specific flaw in the euro as a currency and the fact that the euro authorities are very much hoping to protect the European banking system. The reason we need to pay attention is that the ultimate resolution of these issues will have an impact on our investment decision making.
A key characteristic of the euro, which was formed in 1998, is that there is no one overall guarantor of euro area government debt. Think about the U.S. If the U.S. borrows money to fund building bridges in five states, the U.S. government (via the taxpayer) is the guarantor of the debt; it is not the individual debt of the five states involved. Yes, individual U.S. states can take on state-specific debt, but states cannot print money, as can large governments, so there are limiting factors. In Japan, the Japanese government guarantees yen-based government debt. In the U.S., the federal government guarantees U.S. dollar-based government debt. In Europe, there is no one singular “European government debt” guarantor of essentially euro currency government debt. The individual countries are their own guarantors.
The Eurozone has the only common currency on planet Earth without a singular guarantor of government debt. All the euro area governments essentially guarantee their own debt, yet have a common currency and interest rate structure. No other currency arrangement like this exists in today’s global economy. Many have called this the key flaw in the design of the euro. Many believe the euro as a currency cannot survive this arrangement. For now, the jury is out on the question of euro viability, but that question is playing out in country-specific dramas, such as Greece is now facing.
One last key point in the euro currency evolution. As the euro was formed, the European Central Bank essentially began setting interest rate policy for all European countries. The bank’s decisions, much like those of the Fed in the U.S., affected interest rates across the Eurozone economies. Profligate borrowers such as Greece enjoyed low interest rates right alongside fiscally prudent countries like Germany. There is no interest rate differentiation for profligate or prudent individual government borrowers in Europe. Moreover, the borrowing and spending of profligate countries such as Greece, Italy, Spain, Portugal, Ireland and, yes, even France, for years benefited the export economies of countries such as Germany — the more these countries borrowed, the better the Germany economy performed.
This set of circumstances almost seemed virtuous over the first decade of the euro’s existence. It is now that the chickens have come home to roost, Greece being just the opening act of a balance sheet drama that is far from over. Even if we assume the Greek debt problem can be fixed, without a single guarantor of euro government debt going forward the flaw in the currency remains. Conceptually, there is only one country in Europe strong enough to back euro area debt, and that’s Germany. Germany’s continuing answer to potentially being a guarantor of the debt of Greece and other Euro area Governments? Nein. We do not expect that answer to change any time soon.
You’ll remember that over the last half year, at least, we have been highlighting the importance of relative currency movements in investment outcomes in our commentaries. The problematic dynamics of the euro has not been lost on our thinking or actions, nor will it be looking ahead.
The current debt problems in Greece also reflect another major issue inside the Eurozone financial sector. Major European banks are meaningful holders of country-specific government debt. Euro area banks have been accounting for the investments at cost basis on their books, as opposed to marking these assets to market value. In early February, Lazard suggested that Greece needs a 50% reduction in its debt load to be financially viable. Germany and the European Central Bank (ECB) want 100% repayment. You can clearly see the tension and just who is being protected. If Greece were to negotiate a 50% reduction in debt, any investor (including banks) holding the debt would have to write off 50% of the value of the investment. At the outset of this commentary, we asked, why is Greece so important when it is only 2% of Eurozone GDP? Is it really Greece the European authorities want to protect, or is it the European banking system?
Greece is a Petri dish. If Greece receives debt forgiveness, the risk to the Eurozone is that Italy, Spain, Portugal, etc. could be right behind it in requesting equal treatment. The Eurozone banking system could afford to take the equity hit in a Greek government debt write-down. But it could not collectively handle Greece, Italy, Spain and other debt write-downs without financial ramifications.
The problem is meaningful. There exist nine countries on planet Earth where debt relative to GDP exceeds 300%. Seven of these are European (the other two are Japan and Singapore):
Debt as % of GDP
IRELAND 390 %
As we look at the broad macro landscape and the reality of the issues truly facing the Eurozone in its entirety, what does another four months of forestalling Greek debt payments solve? Absolutely nothing.
How is the Greek drama/tragedy important to our investment strategy and implementation? As we have been discussing for some time now, relative global currency movements are key in influencing investment outcomes. Investment assets priced in ascending currencies will be beneficiaries of global capital seeking both return and principal safety. The reverse is also true. While the Greek debt crisis has resurfaced over the last six months, so, too, has the euro lost 15% of its value relative to the dollar. Dollar-denominated assets were strong performers last year as a result.
The second important issue to investment outcomes, as we have also discussed many a time, is the importance of capital flows, whether they be global or domestic. What has happened in Europe since the Greek debt crisis has resurfaced is instructive. The following combo chart shows us the leading 350 European stock index in the top clip of the chart and the German-only stock market in the bottom.
Broadly, euro area equities have not yet attained the highs seen in 2014. But German stocks are close to 15% ahead of their 2014 highs. Why? Germany is seen as the most fiscally prudent and financially strong of the euro members. What we are seeing is capital gravitating toward the perception of safety that is Germany, relative to the euro area as a whole. This is the type of capital flow analysis that is so important in the current environment.
The headline media portray the Greek problem as just another country living beyond its means and unable to repay the debts it has accumulated. But the real issues involved are so much more meaningful. They cut to the core of euro viability as a currency and stability in the broad euro banking system. The Greek problem’s resurfacing in the last six months has necessarily pressured the euro as a currency and triggered an internal move of equity capital from the broad euro equity markets to individual countries perceived as strong, such as Germany. This is exactly the theme we have been discussing for months. Global capital is seeking refuge from currency debasement and principal safety in the financial markets of countries with strong balance sheets. For now, the weight and movement of global capital remains an important element of our analytical framework.
Watching outcomes ahead for Greece within the context of the greater Eurozone will be important. Greece truly is a Petri dish for what may be to come for greater Europe. Outcomes will affect the euro as a currency, the reality of the Greek economy, the perceived integrity of the European banking system and both domestic and global euro-driven capital flows. For now, Greece is the word.