Many investors are sheltering in cash at the moment, taking advantage of higher rate savings accounts and money market funds, and drawing comfort from the relative safety of cash in an uncertain world. Yet, far from being safe, waiting it out in cash could come with a significant opportunity cost – that of missing out on a bond rally next year.
Karen Ward, JP Morgan Asset Management's chief market strategist in EMEA, thinks that whatever macroeconomic scenario plays out next year, cash is not the best place for clients’ savings.
“I really do understand the emotional appeal of cash,” Ward said. It is “nice and safe” and yields 5%, but “there are better things you could be doing with your money.”
“Clients are asking ‘why don’t I stay in cash until the picture is clearer?’,” Ward continued. They are holding onto cash because they are worried about a recession, but if that were to happen, central banks would cut rates and the interest on cash would be lower.
In a low growth scenario, investors should be in core bonds to benefit from capital gains when rates are cut, she explained.
Ward’s outlook for next year is cautious but if she is proved wrong, investors would be better off in equities.
If artificial intelligence fuels a boom in the US, if inflation eases because of increased productivity, if the US sustains low unemployment, and if a soft landing is achieved, then “you want to be in small-caps, or something else beaten up,” Ward said. “You’d get much more from value equities than cash.”
In an environment of stagflation (slow growth, high unemployment and inflation) alternative investments such as infrastructure would probably perform better than cash, whose value would be eroded by inflation.
Even for the more risk averse, if there is a middle scenario between stagflation and a rapid recovery, staying in cash too long could risk missing out on a bond rally.
Core fixed income usually outperforms cash significantly at the end of a hiking cycle and Ward believes rates have peaked. “If you wait for the first cut, you’ve likely missed the rally for core fixed income,” she said.
The yield curve is currently inverted meaning that yields are higher for short duration bonds than for longer duration bonds. Extending duration has an opportunity cost because it involves giving up a bit of yield.
Hugh Gimber, a global market strategist at JP Morgan Asset Management, described this cost as an insurance policy worth paying to get into longer duration bonds ahead of a rally.
Ward and Gimber think that central banks will switch from pausing to cutting more slowly than the markets expect, but once they start reducing rates, cuts will be deeper than what is currently priced in.
Ward expects at least 100 basis points of cuts, while Gimber said even that might not be enough to get the economy back on its feet.
JP Morgan Asset Management's conviction is based on the depth, not the speed, of the cutting cycle. “Bonds are very high on the Christmas wish list in my house,” Ward said.
Ultimately, whether investors expect recession, recovery or stagflation, they should consider moving out of cash. “In any state of the world, it’s hard to think that cash is the best thing,” Ward concluded. “[Be] in equities if you’re optimistic and bonds if you’re cautious.”
Regardless of the scenario, Ward expects the relationship between equities and bonds to be more volatile going forward but negative correlation to return next year.
A 60/40 portfolio split between equities and bonds has some merit, but while the bond component will protect against low growth, this portfolio would be vulnerable to a resurgence in inflation.
Therefore, Ward recommended a 10% allocation to real assets such as infrastructure, timber and transport. Core infrastructure provides a steady income stream and protection against inflation with little capital volatility.
Gimber added that infrastructure is difficult for private investors to access. Infrastructure investment trusts, for example, can use leverage so they are vulnerable to higher borrowing costs. “The cost of debt is swinging around as rates move,” he said.
Open-ended funds are not the solution either because they face the impossible task of calculating a daily valuation for very illiquid assets that cannot easily be marked to market.
As a result, Gimber said commodities and global macro hedge funds are more appropriate diversifiers for private investors because they are highly liquid.
He recommended focusing on commodities that are a source of inflation and should do well if inflation picks up, such as industrial metals. The transition to renewable energy has led to a shortage of some traditional metals where exploration has not kept pace with demand, he said.
Gimber warned against treating alternatives as a homogenous category because they behave so differently and some are more sensitive to interest rate movements than others. “You have to be much more targeted about the type of risk you’re trying to diversify against, relative to history,” he said. For instance, direct lending and private credit provide alpha and income, but not diversification against equities and bonds.