Financial Market Analysis at mid year 2016 July 2016
Executive Summary Welcome to the Financial Market Analysis for insurers in Switzerland. So far, 2016 has been a challenging and rather turbulent year. The ongoing uncertainty in China s stock market as well as Britain s EU referendum have kept the markets in suspense. This report gives an overview of the developments in the Swiss market by looking at key indicators that are commonly used in the insurance business. The data used in this report is until the end of June. For this reason, we don t expect to see the full magnitude of the Brexit referendum being reflected yet. In 2016, Swiss government bond and swap yields continued to decrease. Swiss government bond yields even decreased to the unprecedented point that bonds for all maturities show negative interest rates. While the yields for Eurozone countries decreased as well, they still remain relatively high for countries like Italy and Spain. Moreover, stock markets suffered all over the world from turbulences in Chinese markets and from the uncertainty introduced by Britain s EU referendum. The overnight drop in stock markets right after the announcement of Brexit did not last as stock markets quickly recovered. The Brexit also resulted in an appreciation of the Swiss Franc, leading to immediate intervention of the Swiss National Bank. After the intervention, the Swiss Franc stabilised and is now fluctuating around an exchange rate of 1.10 against the Euro. During the same period the Swiss Consumer Price Index slightly improved after the high deflation period in 2015. In summary, the first half of 2016 was characterised by record-low bond yields; unstable and highly volatile equity markets; a stable real estate market; an improving deflation rate and a strong Swiss Franc. The Brexit vote impacted equity and bond markets, however, we anticipate that the full magnitude of the referendum still remains to be seen depending on how the British government and the European Union deal with this matter. The authors, Stefan Rechtsteiner Senior Manager Bernhard Knetsch Consultant Financial Market Analysis at mid year 2016 2
Contents Brexit 5 Regulatory Environment 6 Interest Rates 7 Equity Markets 12 Property Markets 14 Inflation 15 Exchange Rate 16 Contacts 17 Financial Market Analysis at mid year 2016 3
Brexit On 23 June 2016, the UK surprised not only most of Europe but also itself, as they voted leave on Britain s EU referendum. The results of the referendum had immediate impact on the financial markets. The British Pound had it s largest drop against the US Dollar, hitting a 30 year low and other asset prices swung wildly resulting in highly volatile markets. Markets in the UK have especially suffered and the pension deficit of UK companies grew by GBP 89bn in just one month following Britain s vote. The plunge in equities, British Pound and bond yields put more strain on schemes that were already under pressure from an ongoing low interest rate environment. The following graph depicts the plunge in equities, late in June, of four major financial services provider in the UK: The Brexit vote was as much of a shock for the EU as it was for the UK. The sharp fall in Continental European equity markets shortly after the results of the referendum testified to the depth of concern about possible knock-on effects. Financial Market Analysis at mid year 2016 4
Regulatory Environment Beginning of 2015, the European Central Bank (ECB) announced that in order to revitalise the Eurozone and to counter deflation it had decided on a EUR 60bn-a-month bond-buying programme, starting in March the same year. ECB said that it would buy more than EUR 1tn of assets, including government and private sector bonds by September 2016. Furthermore, the ECB pointed out that they would extend the programme if the attempts failed to raise Eurozone inflation to its target of just below 2%. In the beginning of 2016, it seemed that all efforts of the ECB had failed. Inflation had stalled, deflation came back and Eurozone economic growth was painfully slow. For this reason, the ECB raised the amount of bonds they buy each month under Quantitative Easing (QE) from EUR 60bn to EUR 80bn and also expanded the range of assets it will buy to include investment-grade corporate bonds. To get a thorough understanding of how Quantitative Easing affect bond yields, see the below graph. This depicts the 10-year government bond yields for Germany, France, Spain and Italy from January 2015. Since January 2015 bond yields followed a downward trend until April 2015 where yields started to increase again. In June 2015 bond yields for all four European countries started decreasing again, as we would expect from the QE. ECB QE, March 15 ECB QE, March 16 Financial Market Analysis at mid year 2016 5
Interest Rates Switzerland Government bonds are a material asset position on the balance sheets of insurance companies. Therefore, it is worth having a closer look at the yield curve for government bonds. The downward trend of Swiss government bonds has continued and reached a new record low. Swiss government bonds show highly negative yields which are below -100 bps for maturities between one and four years. Although the situation of negative yields is not new, a negative yield for all maturities is unprecedented. This increases the pressure, in particular on Swiss life insurers, since interest rates are one of the major drivers of income for their annuity and saving products. Swiss swap rates showed a development similar to government bonds in 2016 so far: a new record low has been reached for all maturities. If we compare the government bond yields with the swap rates, we see that the spread increased slightly for all maturities greater than one. Financial Market Analysis at mid year 2016 6
Interest Rates Eurozone government bonds To gain insight into the current government bond situation in the Eurozone, we examined the yield curves of four major European economies: Germany, France, Spain 1 and Italy. We can observe the same downward trend as for the Swiss government bonds compared to December 2015. The yields of Spanish and Italian government bonds decreased slightly over all maturities to about 1.2% for 10 year maturity. However, German and French government bonds decreased even more dramatically compared to Italy and Spain, and now show negative yields for maturities up to 15 and eight years, respectively. 1 The spot yield of one year government bonds for Spain was not available. Financial Market Analysis at mid year 2016 7
Interest Rates Eurozone corporate bonds For corporate bond markets, we analysed the EUR credit spread history for 10-year corporate bonds rated AA, A and BBB compared to the EUR swap yields 1. The decreasing trend for the spreads over the last few years came to a halt in 2015. In the beginning of 2016, credit spreads for BBB rated bonds reached their highest value since early 2014 followed by a quick downswing. In June 2016, credit spreads have widened compared to the end of 2015. The BBB spread is now significantly higher compared to the spreads for AA and A. 1 A similar analysis for the Swiss market was not possible because of insufficient market depth. Financial Market Analysis at mid year 2016 8
Interest Rates Swaption implied volatility Swaptions are options that allow the buyer to enter into an underlying swap. These options are more directly related to interest rates than other derivatives and can be used as an indicator of interest rate volatilities. Below, we use a 10 year into 10 year at-the-money (ATM) swaption, which is usually the longest option and swap term readily available in the market. This is one of the most important volatilities used to calculate the Time Value of Financial Options and Guarantees (TVFOG) in (life) insurance portfolios. In the previous editions of this report we have looked at Black implied volatilities. However, Black volatilities are not a good measure of interest rate volatility when yields are low. In particular, Black volatility is not defined when interest rates are too low, which is mainly due to the setup of the formula and the assumptions used to derive the volatility. Given the current interest rate environment, we are displaying the normal volatility rather than the Black volatility as this provides a more stable basis 1. Looking at normal volatilities, we observe a slightly increasing volatility since the end of 2015. June 14 Sep. 14 Dec. 14 Mar. 15 June 15 Sep. 15 Dec. 15 Mar. 16 June 16 71.7 72.4 71.6 71.5 72.2 75.5 74.6 75.2 76.0 1 The article "Hidden complexities provides more information http://www.theactuary.com/features/2016/05/hidden-complexities/ Financial Market Analysis at mid year 2016 9
Interest Rates Group pension business (BVG saving process) In group pensions business, the technical interest rate of the BVG (Bundesgesetz über die berufliche Alters-, Hinterlassenen- und Invalidenvorsorge) savings process is determined by the Swiss government as the outcome of a political process. The Swiss Federal Council (Bundesrat) is in charge of setting the BVG rate. Although they act independently, they are guided on the opinion of the BVG committee. For valuation and risk modelling purposes, insurance companies need to forecast the BVG rate, which is difficult to predict due to its political nature. The Swiss Solvency Test SST suggested taking 70% of the 7- year average of 7-year par government yields to give a reasonable estimate for the BVG rate for different economic scenarios. In January 2016, the BVG rate was reduced to 1.25% from 1.75%. The spread between the BVG rate and the 70-7-7 rule still remains high, indicating that further adjustments need to be made in the future in order to lift the pressure on Swiss life insurers by low interest rates. Source: Swiss National Bank (SNB), Deloitte Financial Market Analysis at mid year 2016 10
Equity markets Indexes In the beginning of 2016, world wide stock markets suffered from turbulences in Chinese markets, leading to an abrupt depreciation at the beginning of the year. In contrast to the US, Swiss and European stock markets have not yet fully recovered and remained volatile during the half yearly-period. The ongoing volatility in Swiss and European stock markets was most likely driven by the Brexit vote in June 2016. The immediate negative impact following the result of the referendum end of June did not last as markets recovered quickly. SNB SNB CHF/EUR Chinese stock markets Debt crises Brexit Debt crises Chinese stock China markets, Deloitte Analysis Financial Market Analysis at mid year 2016 11
Equity markets Volatility The SIX Volatility Index on the SMI (VSMI) aims to provide a tradable index that reflects the volatility of the Swiss market. In contrast to previous years, 2015 displayed extremely high volatility not seen since the end of 2011 where markets were extremely volatile due to the ongoing Eurozone debt crisis and the prospect of a slowing global economy. In the first half of 2016, market volatility remains on a high level. During this period, China's economic slowdown, as well as Britain s EU referendum in June 2016, have caused major concerns for the markets. Eurozone Debt crises CHF/EUR rate Chinese stock markets Brexit Source: SIX Swiss Exchange, Deloitte Analysis Financial Market Analysis at mid year 2016 12
Property Markets Real estate is a key component in the portfolios of many Swiss insurers. As a measure of the Swiss real estate market, we refer to the IAZI Investment Real Estate Performance index. This index takes into account the net cash flows and annual change in value of the underlying properties. Compared to the previous observations, the index is stable and only slightly increasing. June 14 Sep. 14 Dec. 14 Mar. 15 June 15 Sep. 15 Dec. 15 Mar. 16 331.0 343.7 346.2 349.3 351.7 354.7 357.6 362.2 Financial Market Analysis at mid year 2016 13
Inflation The development of price inflation is of particular interest for insurers, as it is linked to expenses as well as Property & Casualty (P&C) claims. The Swiss Consumer Price Index (CPI) measures the private households' consumption in Switzerland. Inflation hit a new record low during September 2015, which was mostly driven by the removal of the flooring policy in the EUR/CHF exchange rate. Inflation is increasing again and according to the Swiss National Bank (SNB) this is mainly due to raising oil prices. However, the CPI still remains negative at -40 bps. In its monetary policy assessment dated 16 June 2016, the SNB forecasts a value of -40 bps for 2016 and +30 bps for 2017 1. Source: Swiss Federal Statistical Office, Swiss National Bank (SNB) 1 More details can be found in the press release of the SNB from June 2016: "https://www.snb.ch/en/mmr/reference/pre_20160616/source/pre_20160616.en.pdf Financial Market Analysis at mid year 2016 14
Exchange Markets The graph below depicts the development of three major currencies (Euro, British Pound and US Dollar) against the Swiss Franc since June 2013. Following the sudden appreciation of the Swiss Franc at the beginning of 2015, due to the abandonment of the floor on the EUR/CHF rate, the EUR/CHF exchange rate went up to 1.05 in June 2015 and after that just below 1.1. In the beginning of 2016, the exchange rate reached the mark of 1.1 for the first time after the sudden appreciation. Due to the outcome of the Brexit vote in June 2016, the Swiss Franc strengthened again which led to immediate interventions by the SNB. The intervention of the SNB stabilised the EUR/CHF exchange rate, which is now fluctuating around 1.1. It is expected that the SNB will continue to intervene if the Swiss Franc strengthens again. Following the removal of the floor on the EUR/CHF rate, the USD/CHF rate shows the same upward trend as the EUR/CHF rate and is now fluctuating just below parity. The removal of the floor on the EUR/CHF rate has also had a strong impact on the GBP/CHF exchange rate. Right after the appreciation, the Swiss Franc weakened during 2015 and reached its old mark of 1.55 against the British Pound in December 2015. Shortly after this mark was reached, the GBP/CHF rate started moving downward followed by a sudden depreciation as soon as the result of the referendum was announced. Financial Market Analysis at mid year 2016 15
Contacts Dr. Philipp Keller Partner phkeller@deloitte.ch +41 58 279 6290 Stefan Rechtsteiner Senior Manager srechtsteiner@deloitte.ch +41 58 279 6796 Bernhard Knetsch Consultant bknetsch@deloitte.ch +41 58 279 6945 Dr. Michael Grampp Chief Economist & Head of Research mgrampp@deloitte.ch +41 58 279 6817 Financial Market Analysis at mid year 2016 16
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