Monday 23rd January 2017
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The positive winds of change
Investor appetite for QBE Insurance has spiked in recent months, with the shares rallying around 15 percent since mid-November. The fact that this has occurred despite a period of subdued news flow from the company itself highlights the top-down thematics that the insurer is leveraged to, and which are swinging more in QBE’s favour.
Namely, the fact that all things being equal, the onset of rising bond yields are positive for the company’s investment income, while general inflationary pressures are also typically a tailwind for insurance premium pricing.
QBE has underperformed the broader stock-market since the global financial crisis, and it is no coincidence that this has been during a period of ultra-low interest rates, and an ongoing bull market in bonds. This dynamic has suppressed returns on the company’s investment portfolio, as it has for many insurers. This has also marked a continuation of the historic high correlation between the company’s share price and the yield on US government bonds. The winds though are set to blow more in the company’s direction in our view.
A key turning point has come with the election of Donald Trump as America’s 45th President, and who is set to be inaugurated this week. Mr Trump has made his intentions very clear as it relates to ‘Making America Great Again,’ and is set to embark on an ambitious spending program, stating; “We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals,” and “We’re going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it.”
The plan is a bold one, and fiscal spending on this scale will ultimately provide an inflationary boost. This prospect has provided equity markets with a ‘Trump bump’, while fixed income yields have risen, and bonds have been sold off.
We believe that the recent steepening of the yield curve is a sign of things to come, although the great rotation from bonds to equities is unlikely to be a linear or orderly progression. The bond market is unlikely to roll over without a fight, and a “counter reaction” is probably imminent. The global economy still has frailties, so central banks will once again be a key part of the mix, both in terms of actions and what they say.
We saw this again in December in the US when the Federal Reserve hiked the benchmark rate by the expected 25 basis points, but struck a ‘dovish’ tone. The path of rate increases this year will be relatively gradual and measured, with the fact that the greenback is at its highest levels in over a decade not lost on the Fed.
However, not even this is likely to stop the bigger primary trend which is an encroaching secular bear market in bonds and one that will likely endure for quite a few years. We envision the yields on 10 and 30 year Treasuries moving towards 4 percent in 2017. Should this play out, the re-rating in QBE Insurance should have much further to go.
This is because the onset of inflation and higher interest rates will also provide top-line impetus to QBE as the premium pricing environment becomes more favourable, and as risk gets re-priced. This also sets up in our view for an inflection point in the insurance cycle. In this scenario QBE will likely seen a material improvement in premiums written (i.e. growth) and underwriting excellence (i.e. operating margins).
QBE is currently trading on an earnings multiple for FY16 of 17 times, with this falling to 13.8 times for FY17 and 12 times for FY18. The company meanwhile offers a prospective yield for FY17 of around 4.8 percent. Supplementing this favourable pricing profile is QBE’s technical set-up, with our analysis thereof suggesting that the company’s shares should trend towards resistance (i.e. the 78.6% Fibonacci retracement) at $13.44 over the medium term horizon.
With some positive top down tailwinds finally on the horizon and QBE’s business transformation programme well progressed, we believe the company’s shares are now offering strong value over the medium term.
Greg Smith is Head of Research at investment research and funds management house Fat Prophets. To receive a recent Fat Prophets Report, CLICK HERE
Disclosure: QBE is held in the Fat Prophets Concentrated Australian Share and Income Models.
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