Canadian life insurance stocks have been on a tear: Manulife Financial Corp., Sun Life Financial Inc., and Industrial Alliance Insurance and Financial Services Inc. have all jumped by 30 per cent or more since the start of 2012, while Great-West Lifeco Inc. is the laggard with a robust 26 per cent return. But as insurers prepare to report fourth-quarter earnings next month, investors should beware: There is a growing amount of speculation built into their stock prices about the future direction of long-term interest rates. If interest rates don't start rising quickly, Canadian insurers could be in for a big correction.
Low interest rates are the enemy of life insurance companies: they hurt sales, increase liabilities, and reduce investment returns and profits. When interest rates stay low for a long time – as they have been – they lead to lower returns from fixed-income investments, prompting big charges, reduced book values and weaker stock market valuations for insurance stocks.
Not surprisingly, insurance companies and their investors have been thirsting for a return to higher long-term interest rates. And indeed, the 10-year U.S. interest rate has bounced back since hitting an all-time low of 1.4 per cent in late July of 2012, skittering up to 1.8 per cent. But while Canadian insurance stocks have tended to move in step with the U.S. and Canadian 10-year rate, something different happened in the latter part of 2012 – they started galloping ahead, to the point where there is now a sizable gap when you compare interest rates to stock valuations , National Bank Financial analyst Peter Routledge pointed out in a report last week.
"We are thus faced with an unusual fact pattern: Canadian life insurance valuations are foreshadowing a rise in long-term bond yields (usually the reverse is true), perhaps leading some investors to ask whether a virtuous cycle of steadily rising interest rates and stock prices has begun," Mr. Routledge wrote.
That's a daring bet to make, and some investors have bet the other way, heavily shorting the shares of Canadian life insurers. As Mr. Routledge points out, central banks in Canada and the U.S. have kept interest rates low to stimulate economic growth, but what growth has resulted has been anemic. There are growing fears the U.S. and Canada are in for a sustained era of weak growth and mangy job creation, which central bankers have been slow to fully acknowledge. Interest rates, in other words, may not rise, and if they do, not to enough of an extent to ease pressure on the balance sheets of insurance companies, prolonging their pain.
Insurance stocks are still a good bet when economic times improve, and Canadian insurers have taken steps to shield their balance sheets from further degradation in the existing economic climate. Manulife stock in particular should benefit handsomely when both equity markets and long-term interest rates in the U.S. improve, Mr. Routledge says. But the more cautious case suggests hard times could await optimistic investors in the medium term.