Cash isn't king

On the eve of the pandemic, investors were chasing every tiny increment of additional yield. Wherever they could find it. As they had done for much of the post-global financial crisis decade.

It meant Austria could issue 100 year bonds. Companies could borrow at historically low rates with only the lightest of protections for lenders. And the landscape was littered with corporate zombies – heavily leveraged companies whose earnings barely covered interest costs, even at near zero interest rates.

Everything changed with the post-pandemic global surge in inflation.

Yet now that investors can earn rich rewards from public asset markets – including double digit yields in parts of the credit and emerging universe – they’re steering clear, clinging to cash instead. Globally investors are holding USD2.6 trillion more in money markets than they did in 2018 (see Fig. 1).

Fig. 1 - Piling into cash

Cumulative global flows into money market instruments, USDbn

True, for the first time in more than a decade, that cash is generating an attractive return – some 5.1 per cent in the US and 3.8 per cent in the euro zone. Given inflation has fallen back substantially, that’s a significant return in real terms on both sides of the Atlantic. 

But with central banks signalling that they’ll be cutting rates, money markets returns have already started to fall, and are likely to drop further – the market is pricing in three quarter-point interest rate cuts in the US this year, which would take official rates to 4.75 per cent.

Yet there’s still a reluctance to draw down holdings of money market instruments and shift capital into higher-yielding assets. In part, it could be that this excessive caution has to do with investors re-calibrating not only their risk appetites but also levels of market risk. For instance, the spike in inflation reminded investors that “risk-free” sovereign debt was anything but. Aggressive rate hikes by central banks led to historic selloffs in bond markets and bouts of extreme volatility. So in 2022, global bonds lost 31 per cent, the biggest loss the fixed income market had suffered since at least 1900.

Even the highest quality “safe haven” US Treasury bonds suffered double digit losses during that year. For investors, those will be painful memories that won’t fade quickly.

And the inversion of the yield curve – shorter maturity debt yielding more than long-dated bonds – makes cash look more attractive. Investors just aren’t being rewarded for taking on maturity risk. 

Even so, there’s potentially plenty on offer from credit and equities. Investors should be looking at assets which offer ample compensation against risks, a buffer against volatility. Right now, certain high yield credit and emerging markets offer significant protection against drawdowns (see Fig. 2). Short maturity investments avoid some of the risks of policy volatility. Overall breakeven yields – the level that yields need to rise before investors lose money – are among the highest in a decade.

And then there’s equity. 

Fig. 2 - Margin of safety

Breakeven* rates for leading credit indices

Equity market volatility has dropped even though valuations are relatively high – particularly in some sectors – and effective duration of these assets is long. Equities weathered the monetary policy tightening cycle better than bonds, to the surprise of many, because companies themselves are able to respond to changes in conditions. Corporate management can overhaul their business models and change their general approach as the economic environment shifts. It is telling that, even as corporate earnings suffered initially from rising inflation, they’ve made a rapid recovery since.

This resilience and the fact that most leading economies look set to skirt recession this year against a backdrop of falling interest rates should underpin equities and therefore investor returns.

If the past couple of years have shown anything, it’s that risk is impossible to avoid. Even money market instruments were shown to be vulnerable during the Lehman Brothers meltdown that triggered the global financial crisis of 2008. What investors need is a margin of safety, a cushion to keep them afloat through the market’s frequent rip tides. Across most risk preferences, investors would do better diversifying their portfolios across the markets’ capital structure than sitting on cash, thanks to the margin of safety on offer from current yields and spreads. Not only is cash not king, it could prove to be the joker in the pack.