How to beat cash: Is cash still king?

In part 1 of the series, we wrote about the recent bond market volatility and our outlook for US Treasury yields.
We discussed how investors may want to take advantage of the recent spike in yields that has made US bank loans, EM soft currency government bonds and private credit a whole lot more interesting.
In part 2 of the series, we delve further into whether “cash is still king?” and examine how more traditional assets such as credit and equities fare in the face of high yields.
Our analysis shows that intermediate and long-term government bonds have outperformed following a yield curve inversion.
More so, we expect the yield curve to start normalizing over the next year, which would generally lead to municipal bonds, core bonds and corporate bonds outperforming short-term bonds.
Money market assets are at all-time highs
In today’s environment, the USD money market assets are at all-time highs as investors seek income and relative safety.
Investors have been moving money out of lower yielding bank deposits in search of attractive yields.
Money markets are the primary beneficiaries which isn’t surprising since they’re yielding roughly 5% or more.

Sources: US Federal Reserve and Investment Company Institute, 7/31/23. Deposit and money market rates are sourced from Bankrate.com.
In the near-term, we maintain an overweight on cash in our model asset allocation strategy since we believe the global economy continues to decelerate and being defensive makes sense.
Central bank policy rates have continued to rise and we believe cash now offers decent return potential, along with attractive diversification characteristics.
Riskier assets such as high growth equity sectors could continue to face a period of consolidation.
The current money market appeal is obvious – yields have been competitive with other high quality fixed income investments and have less historical volatility.
It seems like a “no-brainer” for investors to take advantage of money market current yields, but there’s more to the story.

Sources: Bloomberg L.P., 7/31/23. Certificate of deposit is represented by the FDIC National Rate 12-Month Certificate of Deposit. Money market is based on the Bloomberg 1-3 Month US Treasury rate. US Treasury bonds are represented by the Bloomberg US Treasury Index. Core bonds are represented by the Bloomberg US Aggregate Bond Index. Corporate bonds are represented by the Bloomberg US Corporate Bond Index. Municipal bonds are represented by the Bloomberg US Municipal Bond Index. *TEY=tax-equivalent yield based on a 25% tax bracket. High yield bonds are represented by the Bloomberg US Corporate High Yield Bond Index. Yield to worst is the lowest potential yield an investor can receive on a bond without the issuer defaulting. An investment cannot be made directly into an index. Past performance does not guarantee future results.
Risks to holding too much cash
Still, money markets may not be the best strategy for investors over the coming years.
History has shown that investors may be better off locking in yields with longer-term securities vs exposing themselves to the reinvestment risk that’s inherent in shorter-term securities.
1) Elevated inflation & taxes erode net gains
Firstly, investors from around the region must assess their net income from investments, after inflation and taxes (if any) are considered.
In an environment where inflation could remain persistently high, the income generated from money markets is less enticing.
2) Opportunity cost of holding cash
There is also certainly an opportunity cost for holding short-term assets since they have historically underperformed over long periods of time.
Cash-like instruments have historically generated significantly lower returns than longer-term government bonds, corporate bonds and equities.

Sources: Bloomberg L.P., 12/31/22. Large-cap stocks are represented by the S&P 500 Index, including dividends. High yield bonds are represented by Bloomberg US Corporate High Yield Bond Index. Corporate bonds are represented by Bloomberg US Corporate Bond Index. Government bonds are represented by the Bloomberg US Treasury Index. Cash-like instruments are represented by the S&P US Treasury Index 0-1 Year Index. Inflation is represented by the Consumer Price Index. The charts are hypothetical examples, which are shown for illustrative purposes only, and do not predict or depict the performance of any investment. An investment cannot be made directly into an index. Index definitions can be found in the appendix. Past performance does not guarantee future results.
While cash-like instruments may outperform Treasuries over short time periods, they rarely did during any rolling 10y period during the past 30 years.

Sources: Bloomberg L.P., 12/31/22.
3) Reinvestment risk
Reinvestment risk is the probability that an investor won’t be able to reinvest cash flows such as coupon payments, at a rate equal to their current return.
In May 2000 and June 2006, short-term interest rates were as attractive as long-term rates. In both examples, investing in a 5yr US Treasury and “locking in” the yield was a better approach than taking advantage of the elevated short-term yield and reinvesting at lower rates when short-term yields declines.

Source: Bloomberg L.P, 12/31/22. For illustrative purposes only. Past performance does not guarantee future results.
Thus, we believe that locking in longer-term rates could be a better strategy. Let me reinforce this argument – the current US yield curve is inverted and history has shown that long-term bonds have outperformed after peak yield curve inversions.
An inverted yield curve is when short-term interest rates are higher than long-term rates, which often prompts investors to invest in shorter-term securities.
Inverted yield curves are an anomaly and often point to recession risks. The take-away here is that we believe that peak yield curve inversion has already occurred and that investors may want to take advantage of the dislocation along the yield curve.
For example, intermediate and longer-term government bonds have outperformed shorter-term bonds following the last three peak inversions of the US Treasury yield curve.

Source: Bloomberg L.P., 7/31/23. A basis point is one-hundredth of a percentage point. An investment cannot be made into an index. Past performance does not guarantee future results.
Strategies to consider for excess cash
It’s not just intermediate- and long-term government bonds that have outperformed following an inversion (or, in the case of 1995, a near inversion) of the yield curve.
The yield curve has tended to normalize (short rates falling below long rates) in the immediate aftermath of interest rate hikes by the US Federal Reserve. Over the next year, short-term bonds generally underperformed municipal bonds, core bonds, and corporate bonds.

Sources: Bloomberg L.P., 7/31/23. Short government bonds are represented by the S&P 0-1 Year US Treasury Index. Municipal bonds are represented by the Bloomberg US Municipal Bond Index. Core bonds are represented by the Bloomberg US Aggregate Bond Index. Corporate bonds are represented by the Bloomberg US Corporate Bond Index. Indexes cannot be purchased directly by investors. Past performance does not guarantee future results.
In fact, downturns in corporate bonds, which have typically occurred during periods of monetary policy tightening, have historically represented buying opportunities during the next year.

Sources: Macrobond, Bloomberg L.P., 7/31/23. Historical analysis reviews Bloomberg US Corporate Index annualized rolling 12-month total return data dating back to index inception (1/31/1973). An investment cannot be made in an index. Past performance is not a guarantee of future results.
How should investors approach allocating their money out of cash?
Let’s look at three instances when cash balances were elevated — following the 1991 recession, the 2001 recession, and in the aftermath of the Global Financial Crisis/European debt crisis.
In each instance, investors were better off investing their money in equities versus holding cash, regardless of how they did it.
Investing on the first days of the year or dollar cost averaging ($1,000 per month) were sound strategies.
All investors wish they could have perfect timing, but even having the worst timing each year still outperformed cash.
With contribution from Brian Levitt

Sources: Bloomberg L.P., Invesco, 12/31/22. Assumes $12,000 invested yearly into a hypothetical S&P 500 Index portfolio. Cash return is based on return of $12,000 invested yearly in a hypothetical portfolio of 3-month Treasury bonds represented by the Bloomberg 1-3 Month US Treasury Index. Perfect timing (worst timing) assumes that you maximize (minimize) your return in the S&P 500 Index each year. Dollar cost averaging assumes a $1,000 per month investment in the S&P 500 Index yearly. For illustrative purposes only and not meant to depict or predict the performance of any strategies. Indexes cannot be purchased directly by investors. Past performance does not guarantee future results.