Should investors rethink their dash to cash?

Investors have piled into cash and cash-like instruments since the start of 2022. In fact, more than $5.6 trillion is sitting in US money market assets today, up $1 trillion from a year ago.¹

On the surface, this makes sense when you consider how much higher cash rates are today coupled with still an uncertain macro outlook. So, it’s hard to argue that investors shouldn’t have a bit more in cash, but our conversations with global clients and what we’ve observed in markets lead us to believe most investors are overallocated to cash relative to their long-term goals.

Why should investors think differently about cash?

There is still a cost to owning too much cash

While earning 4 to 5% with limited risks sounds like the holy grail of investing, it’s worth remembering that cash has underperformed virtually everything this year, especially when factoring the impact of inflation. We also think current yields only tell a part of the story when comparing income markets vs. cash. The total return potential for many different income markets today goes beyond current yields.

Cash will only outperform in worst-case scenarios

Investors that own a lot in cash today are essentially making a bet that the worst-case economic scenarios play out. We think it’s unlikely we get a repeat of 2022 when many parts of a portfolio were negative.

While we agree the outlook is murky, we think there is a higher probability of a soft-landing or no-landing than a hard landing (more on next page). In such instances, it’s unlikely cash outperforms much of anything. Furthermore, history shows that stock and bond markets tend to perform strongly after the end of hiking cycles (Chart 1), a scenario we are approaching.

Chart 1: Average 12-month return following the last Fed hike
Since February 1995†

Reinvestment risk

Interest rate cuts seem unlikely this year, but markets expect them to start in 2024. In fact, markets are currently pricing in approximately 1.0% in rate cuts in 2024 in the US.² Though it’s unlikely to play out exactly like this, investors in short-term cash vehicles will be forced to reinvest at lower yields at some point, possibly not too far in the distant future. We think investors are better off locking in income opportunities that can support them for the next several years, not the next several quarters.

Aren’t we heading into a recession?

It’s true that the global economy is slowing. However, growth data has been much more resilient than expected. This is especially true in the US where the bulk of our global portfolios remain invested. Thus far, the Federal Reserve has managed to pull off a steep rate hike cycle without triggering a rapid deterioration in the economic or employment data. Furthermore, leading economic indicator levels stabilized earlier this year and have been improving modestly since March. More specifically, cyclical sectors like manufacturing and housing have largely stabilized in recent months.

What’s been notable is that resilient economic activity and labor markets have not prevented softening in inflation. Inflation has turned meaningfully lower in recent months, which represents a tailwind for the soft-landing scenario and takes pressure off the Fed from tightening much more from current levels.

On the other hand, our relative optimism in the US is somewhat offset by a more challenged outlook in Europe and China. Europe is still dealing with record inflation and a worsening growth outlook when compared with the US, driven by a sharper slowdown in manufacturing and services. The optimism around China reopening from earlier this year has also quickly receded amid evidence of softening growth. Thus, we are keeping a close eye on activity in both markets. Ultimately, renewed optimism on the US and the relative strength across the Emerging Markets ex. China lead us to stay reasonably upbeat in our views.

If not cash, then what should investors buy?

Markets have rebounded strongly in 2023 leaving investors wondering if they have missed the boat. However, looking underneath the surface reveals a lot of compelling opportunities still exist. These opportunities also come at a time when we think traditional diversification can make a comeback. This excites us as multi-asset income managers as it means we can seek compelling income and return with improved diversification.

Here are a few areas we favor in our multi-asset income portfolios:

1. Undervalued dividend stocks complemented with covered calls

Much ink has been spilled on the concentration of this year’s equity rally, which has been led by a handful of mega-cap tech stocks. What’s gotten much less attention is the potential appeal of other types of equities. Valuations still look very reasonable for dividend stocks. One way to look at this is breaking the equity universe into dividend quintiles, which shows higher yielding stocks are cheap relative to historical valuations and relative to growth stocks (Chart 2). This means the bar to exceed expectations is much lower in these pockets of equity markets, and they should benefit more in the case of a soft landing.

Chart 2: Forward P/E by Dividend Quintiles – MSCI USA Index

That said, we also want to make sure we have growth exposures in our income portfolios, especially given the importance of tech today. One way we get access is through covered calls. This means we sell away some upside potential on individual stocks, which we think makes sense considering today’s valuations, and in exchange we get a very attractive income stream. As an example, we can sell a 1-month 6% OTM call option on Microsoft and receive annualized yield of 11.0%.³

2. Select opportunities in higher yielding credit

The current yield profile of the US high yield market continues to offer attractive carry at ~8.3% with a strong fundamental profile for the core of the market.⁴ However, index levels don’t tell the full story as dispersion continues to sit at elevated levels for this market. In our strategies, we are avoiding the tails. In other words, we have less exposure to the very tight names (spreads inside 200 bps) and very distressed names (spreads over 800 bps). We still think there is a lot of value in between, but investors will need to stay selective.

We also think investors should consider owning a portion in European high yield. Relative to the US, it is a higher quality market on average and USD investors get the added benefit of earning approximately 2% more income when hedging back to US dollars.⁵ We also don’t anticipate a meaningful spike in defaults.

3. Higher quality, lower duration bonds

Lastly, a rise in short-term rates has led to much more attractive valuations in higher quality fixed income. A couple of areas that stand out to us, especially in our more conservative portfolios, include short-term investment grade bonds and collateralized loan obligations (CLOs). Even though we don’t expect a meaningful rise in rates from here, these markets offer compelling yields with minimal duration risk. We also like having an allocation to agency mortgage-backed securities (MBS), where valuations have become much more compelling. As the below chart shows (Chart 3), these areas have much higher yields today and may provide investors with strong downside protection versus stocks should volatility rise.

Chart 3: High quality fixed income offer attractive risk-adjusted yields

How can multi-asset income help?

The outlook is cloudier than normal and choosing the next turn in markets is never easy. Our strategies are designed to help investors navigate different environments by tapping into an incredibly broad opportunity set, taking a dynamic approach to asset allocation, and keeping a close eye on risk. This approach has served us well for the last decade and we think it will continue to in the years ahead. However, it’s clear we are in a different backdrop today that requires a fresh look at portfolios. We launched our first multi-asset income strategy in 2011 when the 10-year treasury yield was below 2%; today it’s over 4%.⁶ This is a good thing in our view. Investors may achieve attractive income and total return using a multi-asset approach with the added benefit of diversification again. That’s the sweet spot for multi-asset income.