“Buffett evolved an idiosyncratic strategy for his insurance operations that emphasized profitable underwriting and float generation over growth in premium revenue.” -William Thorndike, Jr. in The Outsiders
The quote above from The Outsiders addresses the fact that Buffett concluded certain environments provided better opportunities to write insurance than others. Generating insurance float has become an integral source of Berkshire funding, but they certainly haven’t adopted a “float growth at all costs” mentality…
Thorndike goes onto write that Berkshire had “a propensity to write extraordinarily large amounts of business when prices were attractive.” Judging when prices are “attractive” is of course the big question. Some would call it a “macro” decision. There’s nothing wrong with a little macro for all now and then (but of course we’re biased).
Wall Street wants to see linear “premium growth” from insurers and linear “credit growth” from lenders which creates euphoria and cycles. Driven by Wall Street’s request, many CEOs elect for the “social proof” associated with adopting the same practices as their industry counterparts. Buffett calls this force the “institutional imperative.”
Back to the Global Macro Market…
We referenced this Berkshire insurance snippet in a conversation this week as an analogy to simplify the insurance markets that we study and sequence. One interesting trend we’re following right now in the “insurance market” space has developed at the sector level in Real-Estate REITs and other rate-sensitivities.
Long-term interest rates have done a whole lot of nothing this summer (the yield spread of 10yr yield – 2yr yield is at a new YTD low of 22bps this morning). The beating down of “rate breakout” euphoria has been at least one factor that has shaped the consensus view of future volatility in exposures that key off the rate curve.
To be more explicit with the insurance analogy, the cost to hedge for 6-months forward hit all-time lows this week in this diverse basket that keys off rates and the curve:
- Munis (ETF: MUB)
- REITs (ETFs: VNQ, RWR)
- Real-Estate (ETF: XLRE)
- Russell 2000 (RTY; ETF: IWM, IWN)
On one hand, prospectively rotating into REITs specifically fits our macro playbook heading into the quarter (and STILL does). #HaveRatesPeaked is one of our Q3 "Macro Themes," and when we rolled out the deck on 6/28, REITs (VNQ is one vehicle) were smack dab in the middle of our investment conclusions page. On the other hand, the sector has had quite a run over the last 3 months, particularly if you care about volatility-adjusted performance.
We know this point which is highly important for studying insurance markets: future expectations are typically performance-chasing. The recent past is often extrapolated into the future.
We’ve seen that sequence in a sector like REITs (VNQ) and need to parse out this short-term shift in sentiment with our fundamentally-driven macro views on growth, inflation, and rates into year-end which would still firmly support our call. Here are a few thoughts from our morning derivatives market commentary – skip to the “Takeaway” if you want to bypass the granularity:
Consensus View on REITs (VNQ): When looking at sector dispersion among S&P 500 sectors we look at the Vanguard Real-Estate REIT ETF (VNQ) in place of the SPDR Real Estate ETF (XLRE). VNQ has more history and deeper markets…
VNQ is a +474bps total return outperformer against SPY in the last 3 months, and relative performance has been particularly good on a volatility adjusted basis which is an important complement to last price in our process. Not surprisingly, an extended period of good performance on declining volatility will eventually move market expectations:
- Dispersion: VNQ has the deepest IVOL DISCOUNTS to the SPY benchmark on both a relative (Z-Score) and absolute (% Discount) basis.
- IVOL DISCOUNTS: IVOL DISCOUNTS are by far deepest of any S&P 500 sector on both a relative and absolute basis across the term structure (-17% currently on a one-month window)
- L-T Hedging Costs: It’s never been cheaper to hedge the sector at-the-money for 3 & 6 months.
- IVOL Extraction: IVOL usually trades +25-40% above SPY depending on the contract expiry. Right now it trades below SPY IVOL and the discount to the SPY bench grows the farther out you move on the term structure. This dynamic is multi-duration.
Keith commented on this set-up yesterday in his top 3 things note which summarizes the multi-duration nature of our views:
“SECTORS – after bounces we tend to see some serious complacency in futures/options pricing – while I like the Long REITS (VNQ and XLRE) position, I don’t like chasing it up here with an implied volatility DISCOUNT of -23% for the XLRE (vs. 30-day realized volatility); Industrials (XLI) and Russell Growth (IWO) are also signaling complacency with DISCOUNTS of -11% and -1%, respectively.”
Takeaway: As of now, the market agrees with our prospective call on the sector and rates through a VOLATILITY lens (just one arm of the process), and it’s driven by the same theme we’ve hit on of late – interest rate volatility expectations. Whether or not this is a signal that there could be room for a wash-out near-term, our #HaveRatesPeaked theme for Q3 remains our intermediate and longer-term bias.
Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now:
UST 10yr Yield 2.80-2.94% (bearish)
SPX 2811-2872 (bullish)
VIX 10.33-16.32 (neutral)
RUT 1 (bullish)
NASDAQ 7 (bullish)
Utilities (XLU) 52.66-54.85 (bullish)
REITS (VNQ) 82.06-84.69 (bullish)
Industrials (XLI) 74.09-77.67 (bearish)
Nikkei 210 (bearish)
DAX 12006-12586 (bearish)
USD 94.90-97.15 (bullish)
EUR/USD 1.12-1.16 (bearish)
YEN 110.08-111.75 (bearish)
GBP/USD 1.26-1.29 (bearish)
Oil (WTI) 64.22-68.05 (bearish)
Nat Gas 2.85-3.01 (bullish)
Gold 1170-1217 (bearish)
Copper 2.55-2.75 (bearish)
Corn 3.67-3.84 (bearish)
Good Luck Out There Today,
Ben Ryan
Macro Analyst
