Wealth management firm Wilmington Trust recently published its 2023 outlook, Capital Markets Forecast (CMF), Inflationary Vortex. Life Risk News’ Greg Winterton spoke to Meghan Shue, Head of Investment Strategy at Wilmington Trust, about that report and their views on the outlook for the life settlement market this year.
GW: Meghan, your 2023 CMF refers to the ‘inflationary vortex’ and a paradox within that. Tell us more.
MS: This year’s Capital Markets Forecast looks at three important supply-side forces that have curiously contributed to the past decade of disinflation but are paradoxically expected to result in somewhat higher structural inflation over the medium term. Additionally, the vectors that led us into this inflationary vortex—a pandemic resurgence of demand, supply-chain stress, and an unprecedented dose of stimulus—are not the forces most critical to watch on the other side. A positive note: We are seeing compelling signs of disinflation in the pipeline and expect the headline Consumer Price Index (CPI) to decelerate to 3% by mid-2023.
GW: Inflationary pressures are having a significant impact on how institutional investors are looking at the underlying exposures in their portfolios. What’s your view on the persistence of these pressures and consequently, the impact of that on institutional investors?
MS: Persistent inflation is stemming from the three main themes in our CMF—a structurally tight labor market, China’s shifting role in the global economy, and the tenuous transition between traditional hydrocarbons and green energy. Inflation will not persist at current levels, certainly, but we also do not expect to return to the very low inflation of the post-global financial crisis era. To put it simply, we expect 3% to be the new 2%.
This means monetary policy will skew slightly more restrictive, which provides a better environment for the diversified investor. We believe the diversified stock/bond portfolio should do much better in 2023 than it did in 2022, and equity investors also may likely be rewarded by diversifying across sectors and industries. For institutional investors with income needs, a higher-inflation, higher-rate environment could make it easier to achieve those income goals without reaching into riskier investments.
GW: Moving onto the life settlement market more specifically. Fund managers in the space regularly tout the fact that the drivers of returns are fundamentally uncorrelated to broader financial markets, and thus offer not only diversification benefits but something resembling a hedge. Do you think the current macroeconomic climate will be something of a tailwind for this industry?
MS: It’s difficult to tell. As mentioned, we believe a diversified stock/bond portfolio should do better this year than it did in 2022; we don’t see both asset classes losing money simultaneously like they did in 2022, which would provide the fuel for the argument to allocate to lower-correlation products like life settlements, although they are not reflected in our client portfolios. Keep in mind this is a smaller space, and most of the funds in the life settlement space are long-dated, private equity style funds, so for those funds that are closed, investors can’t get in. You don’t rotate in and out of life settlements like you do in public equities and bonds. They’re a longer-term allocation designed to provide diversification – I think demand for life settlements, and other “alternative credit” products, is not as tied to the prevailing macroeconomic environment as is demand for more liquid asset classes; the main challenge for the life settlement market is selling itself against other alternative credit-style products.
GW: Wilmington Trust itself is a participant in the life settlement market providing trust and agency services to investment managers. Which are one or two market and economic trends you’ve observed in the past year or so, and how do you expect them to unfold in the year to come and beyond?
MS: The main feedback from the capital markets insurance team is that deal activity in the secondary market has rebounded somewhat in 2022 after falling off in 2021. That means we’ve been busier, which is good news for us, of course, as a service provider to fund managers in the space. But again, it’s hard to predict how persistent this trend might be. According to our capital markets insurance team, for deal flow to remain elevated in the secondary market, more policies need to come to market, so the intermediaries in the space need to either expand the range of policy sizes they bring to the market, or find a way to source more policies in the existing buy-box. That obviously feeds into the industry’s tertiary market as well.
GW: Finally, Meghan, back to global markets. Your CMF says that there will be a mild recession in 2023. What’s driving that forecast, and what’s the investor to do about it?
MS: Despite our expectation for a rapid deceleration in inflation, we do not think it will be fast enough to avoid a mild recession in 2023. The anticipated stickiness of inflation, coupled with a determination from the Fed to keep policy restrictive until inflation has been totally eradicated, will likely result in a 5.0% or slightly higher fed funds rate. We expect this to curtail consumer activity and business capex, leading to a recession with two quarters of contraction of 1.0%–1.5% annualized. Job losses are likely to occur but, given the structural tightness of the labor market, are unlikely to be significant. Corporate cash balances, consumer balance sheets, and bank health mean the economy is starting from a relatively good place. At this time, we see no areas of excessively valued capital stock that would need to be worked off and therefore prolong the economic recovery. The labor market is structurally tight, so an increase in the unemployment rate would likely be consistent with a mild recession—likely already largely partially priced into markets after last year’s correction, in our view. This suggests the market will begin to recover in 2023, with potential to deliver better—and in our view, positive—returns for equities.
On the fixed income front, our inflation expectations suggest a more constructive backdrop for both yield-seeking and diversified investors and we are overweight investment-grade securities. In our view, a higher interest rate environment should return the advantage to the diversified investor. A 10-year Treasury yield of 4% is likely approaching the highs of this cycle, and we believe the pain for bond investors is largely behind us. Current yields finally give fixed income investors decent coupon and present a reasonable alternative to riskier assets. The linchpin of our overarching strategy is diversification—across asset classes, factors, and sectors—and it will likely be even more helpful for risk-adjusted returns than it was in the years of ultra-low rates and highly accommodative monetary policy.
Internationally, while we have held a slight underweight to international developed equities since Q4 2022 in light of the Russia/Ukraine war, energy concerns, and recession risks, we are neutral on emerging markets (EM), and advise investors to resist calls to divest from this space. In particular, we believe EM equity investors will need to recalibrate their approach to investing in Chinese equities, which comprise roughly one-third of the EM equity index.
Meghan Shue is Head of Investment Strategy at Wilmington Trust
