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2022 was a bad year for equities due to the rising interest rates. A few equity industries managed nevertheless to post a positive total return: the commodities related energy industries; and metals & mining; and …. insurance. Insurance is an industry that benefits from higher and rising rates. We expect interest rates (and inflation) to be higher for longer and we expect the same for the SPDR S&P Insurance ETF (NYSEARCA:IE).
2022 in review
The best performing equity sector ETF was the Energy Select Sector SPDR Fund (XLE).
Figure 1: Total return chart (Yahoo! Finance, Author)
When we look at a bit more in detail to the equity industry ETFs, we see that the commodities-related ETFs like the SPDR S&P Oil & Gas Equipment & Services ETF (XES), the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), and SPDR S&P Metals & Mining ETF (XME) managed to post a positive total return in 2022.
Figure 2: Total return chart (Yahoo! Finance, Author)
And there is a fourth industry ETF that booked a positive return: the SPDR S&P Insurance ETF.
Insurance and rising rates
Insurance companies dispose of a pool of money called “the float.” They first collect insurance premiums, and the payout to policyholders comes later. The time in between, insurance companies invest this float. The higher the interest rates, the higher the investment results.
Figure 3: Asset correlations (Portfolio Visualizer)
KIE is negatively correlated to both short and long term treasury bond exchange-traded funds (“ETFs”) (and hence positively correlated to both short and long term interest rates).
Figure 4: Correlations (Portfolio Visualizer)
Higher for longer
Research Affiliates recently investigated how quickly inflation returns back to an acceptable level once it crossed certain thresholds. They make a difference between cresting inflation and accelerating inflation. Cresting inflation crosses the 4% level, but doesn’t reach the 6% inflation level. Accelerating inflation does cross the 6% level. The historical record is like this:
- If inflation is cresting, inflation levels revert by half in about a year.
- If inflation is accelerating, 6% inflation reverts to 3% in a median of about seven years. Above 8%, reverting to 3% usually takes 6 to 20 years, with a median of over 10 years.
Figure 5: Years for inflation to fall by 50% (Research Affiliates)
If it takes longer for inflation to return to the FED’s 2% target, interest rates will have to remain higher for longer. The FED added another 50 bps to the fed funds rate in December. What comes next? Based on futures markets, there is a 68% chance that the FED will hike with 25bps at the next FOMC-meeting in February. There is a 61% chance for an additional 25bps rate hike in March. This would bring the FED rate to a range of 475 to 500 bps. This meeting would mean the end of the rate hikes, according to the futures markets. The FOMC-meeting in May would leave the FED rate unchanged. For the FOMC meeting in June, the odds are more or less fifty/fifty between an additional 25 bps rate hike and a status quo.
Figure 6: June 2023 target rate probabilities (CME Group)
A rate hike in June would bring the terminal rate to a range between 500 and 525 bps, and this is the level the FED expects for the 2023 year end, according to the FOMC dot plot. The FED expects that rates will fall to 4% in 2024. In the dot plot below, created by CME Group, the red dots indicate where the futures markets expect the FED rate to be. At the end of 2025, the futures market banks on a FED rate above 3.5%, while the members of the FOMC count on a rate slightly above 3%.
Figure 7: FOMC dot plot (CME Group)
If rates stay indeed higher for longer, this is good news for the insurance industry.
WHERE
Our favorite insurance ETF is the SPDR S&P Insurance ETF. KIE has an expense ratio 0.35% and invests in the sub-industries: Insurance Brokers, Life & Health Insurance, Multi-Line Insurance, Property & Casualty Insurance, and Reinsurance.
Figure 8: Sector weightings (SPDR)
The fund’s benchmark uses a modified equal weighted index.
Figure 9: Top holdings (SPDR)
This equal weighting leads to a less-concentrated portfolio with a tilt away from large caps. The Morningstar style box places KIE in the midcap value category.
Figure 10: Style box (Morningstar)
This category was the best performing style box in 2022!
Figure 11: Total return chart (Yahoo! Finance, Author)
KIE has a P/E of only 13 (versus 17 for the S&P 500), while the expected earnings growth is higher. KIE has a P/B of 1.80 (versus 3.6 for the S&P 500). The 30-day SEC yield is 1.37% (versus 1.6% for the S&P 500).
Figure 12: Valuation (SPDR)
Together with the SPDR S&P Oil & Gas Equipment & Services ETF, KIE is the only equity industry ETF in a clear long-term uptrend.
Figure 13: Trends (Yahoo! Finance, Author)
Figure 14 gives an overview of the evolution of both the short and long term trend over the past years.
Figure 14: Total return chart (Yahoo! Finance, Author)
Conclusion
High and rising interest rates are beneficial for insurance companies. We expect interest rates (and inflation) to remain higher for longer. High interest rates should be a tailwind for SPDR S&P Insurance ETF, one of the few equity industry ETFs that merits a buy-rating.
