Inversion

When most investors are de-risking their portfolios and deleveraging their positions, the “Oracle of Omaha”, decided to buy insurer Alleghany for USD 11.6 billion. It is common knowledge that Warren Buffett invests only in quality businesses that have straightforward economic models and are capable of generating robust earnings. The insurance business is not the simplest one. So, what does Buffett see in this insurance company?  

Nothing but doubt remains. There are times in life when it is hard to ignore your own fears. Most investors are following the trend, but in the deepest corners of their minds, they try to cope with rampant fear.  

Buffett does not believe in feelings, he trusts information. He understood Goldman’s role in the post-credit crunch era and he took a profit from it. Buffett is not a novice in the insurance industry, Berkshire having already vested interests in several insurers.

Last week marked significant changes in the Treasury yield curve. The two years Treasury note yield spiked significantly in March, topping the benchmark for the ten-year note. Thus, a portion of the yield curve is inverted, indicating that short term yield includes a premium compared to long-term yield. Such an inversion signals a foreseeable recession, thereby leading to an increased demand for long-term notes.  

The Oracle made his computations and reached a conclusion. Hyperinflation and the inverted yield curve will appreciate the embedded value of insurance companies. Thus, the overall value of an insurance company’s surplus reserves should increase, due to a relative depreciation of its contingent claims. In a nutshell, if there is inflation, the insurance claim would have a lower real value. It is nothing more than a simple assets/liabilities projection showing that an insurer will generate realised profit just from the changing geometry of the interest rates environments.

In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money. Warren Buffett, Berkshire Hathaway CEO

Market overview

The US private sector added 426,000 payrolls in March of 2022, the lowest figure since September 2021 and significantly below the market expectation.  Nevertheless, the US labour market is in an optimistic mode, the unemployment rate settling at 3.6% compared to 3.8% in February and going towards pre-pandemic levels.

The macroeconomic indicators are green, but investors are reluctant to inject more liquidity into the stock market. Despite the low volatility recorded over the past few days, the Dow Jones ended at the same level as last week. Crude oil passed below USD 100, amid President Biden announcing a historic oil reserve release.

Focus:

AIG

While many traditional institutions are struggling to cope with the new wave of sanctions and structural mutations in the financial industry, AIG, one of America’s leading insurance companies, seems to have a positive outlook.

Investors are welcoming AIG’s latest strategic move consisting of the separation of Life & Retirement operations. AIG sold this division in November 2021 to Blackstone, which took over the management of  USD 50 billion worth of invested assets. Fitch Rating, the leading credit rating agency reaffirmed AIG ratings and revised upward the outlook of property/casualty insurance subsidiaries.

The foreseeable inflation and the inversion in the interest rates curve may play a decisive role in the calculator of AIG’s embedded value, the market anticipating positive value for shareholders.

Commodities:

Carbon

We are at the dawn of a new era marked by a redistribution of global energy resources. The European Union is betting on green energy and reducing its dependence on fossil. Therefore, the price of European carbon dioxide pollution allowances, the world's leading carbon market, had exponential growth over the past years. Nevertheless, the war in Ukraine undermined Europe's plan for a swift energetic transition.  

The carbon price dropped dramatically amid the Russian invasion which underlined that European countries still rely massively on fossil and in the short term even dirty sources such as coal are on the table to balance the dependence on Kremlin’s gas.  

This temporary market collapse signals that the European countries are unprepared for significant inflation in energy prices and high carbon prices would be an extra burden for European consumers.

Commodities:

Wheat

Ukraine and Russia supply almost half of the world's wheat necessities. The percentage is even higher in some regions such as Northern Africa and the Middle East. Wheat prices climbed to unforeseen levels in the early days of the Russian invasion but had a steep descent in March. While the wheat supply has obviously not increased overnight the market dynamic shows that the global commodities supply chain may be able to self-adjust.  Needless to say that the likelihood of seeing wheat prices at pre-pandemic or pre-war levels is modest.

Investors have historically considered soft commodities as a diversification tool, but in the current hyperinflationary environment, they may become a core investment vehicle.

Market outlook

The Dow Jones Index ended the week above 34,800 marking no significant move over the past week. After the initial turmoil triggered by the war between Ukraine and Russia, the market calmed down and showed signs of stability.

Bitcoin ended the week above USD 46,000, moving back into a coupling mode with the other markets. The leading cryptocurrency showed resilience amid a critical situation.

The Gold ounce ended the week on a negative note, below USD 1,930, amid technical sales and an overall bearish path in commodities prices. However, the foreseeable commodities crisis and the inflationary context are good arguments for a rally in gold prices.