The iShares U.S. Insurance ETF (NYSEARCA:IAK) covers insurance companies in the US, and we’ve covered them in the past. However, things have changed. While in July the jury was still very much out on whether or not rate hikes will continue, economic data, in particular the jobs data, seem to be indicating the end of hikes. IAK was interesting as rates rose, but we think they are also interesting as rates plateau, in particular because of the uncertainty discount that will be evaporating in equity markets too, meaning both fixed income and equity portfolios should see some YoY benefits. The possibility of soft landing or at most a mild recession also limits the operational concerns.
IAK is a pretty simple ETF. It contains mainly P&C, but also a big chunk of L&H insurance businesses. Ultimately, they all benefit from improving demographics in the US. A reasonably solid business and economic environment, but also on the increment, they benefit massively from both fixed income rates and equity performance for their reserve portfolios.
We think that a confluence of factors continues to favour them even as rate hikes appear to be peaking, something that wasn’t clear a couple of months ago.
The first is that while rates may not be going up much more, long-term rates have come up, and a higher for longer position is likely. The current restriction on monetary policy has critically slowed down the jobs data a little, which remains absolutely strong, but relatively slow. Since some risk of unemployment is a minimal requirement for slowdowns in inflation, this has shifted the stance of a lot of members of the FOMC, and the verdict leans towards dovishness for now. Unemployment increases being a risk is important for the housing market, and in turn for rents, which has been exaggerating the inflation figures in the US, also due to the imputed system they use for rents in the consumer baskets. Also more generally, it is the key variable in the Phillips Curve (not dead) and has been the focus of market commentary for the last several months around inflation data, being more leading than the inflation data itself. Rents are the last shoe to drop to bring inflation down organically towards the 2% rate. It may not be enough, or it may not be quick enough, hence we reserve the possibility of another rate hike, but it’s very possible that it will be enough considering China’s situation and the impact that will have on commodity prices other than oil.
Higher for longer is great for fixed income portfolios. It means not too much incremental pressure on longer-term securities, while also ample possibility to roll over those securities at what might become perennially attractive rates. It also means less incremental pressure on equities – in fact, an incremental boost, as uncertainty over just the absolute rates was a big drag on the markets. These investment returns will be important. The possibility of a soft landing also helps on the operational side, but insurance should be somewhat resistant to a mild recession anyway.
IAK isn’t too cheap, with the markets likely pricing in some of the earnings benefits of the current environment and the interest rate hedges inherent to insurance companies already. The PE is 14x, offering a fair but not a phenomenal earnings yield. The downside is that the expense ratio is quite high for this ETF at 0.4%, which eats quite meaningfully into the earnings yield offered by the ETF due to the fact that it follows a rather narrow sector and theme in the markets. Insurance as a class remains interesting, but the wisest course is likely to find individual and undervalued players rather than going for an ETF.
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