The cash conundrum

With inflows into money market funds on the rise and ECB deposit rates being reduced further, there is an ongoing debate whether rising cash holdings are benefitting or hurting investors in Germany.

In The General Theory of Employment, Interest and Money, economist John Maynard Keynes asked why investors would prefer to hold cash, given that interest rates could not turn negative.

Today, not only has economic history been rewritten, with interest rates turning negative, but investors are still increasingly turning towards cash. What are their motives and what does it suggest about the state of the asset management industry more generally?

Recent research by Bank of America Merrill Lynch suggests that average cash balances hit 5.4% at the beginning of 2016, the third highest reading since 2009. Some 38% of respondents were overweight on cash. Perhaps unsurprisingly, this coincides with a growing number of investors pulling out of equity funds, the number of investors overweight on equity halved from 42% to 21% between December 2015 and January 2016, according to BofAML.

This sentiment is also reflected in the German market, as suggested by recent fund flow data from the German funds industry published by trade association BVI. While equities mutual funds recorded outflows of €0.7bn in January, money market mutual funds attracted €0.27bn of net inflows.

For Peter Reichel, head of the Investement Office at Berenberg, holding cash is not necessarily a negative sign in the current environment. “Liquidity can generally be understood as room for manoeuvre, with lower equity indices, it allows for ad hoc hoc responses in order to pick up on successful opportunities on bond markets.

Particularly in the current low interest environment, liquidity represents a cheap opportunity to use market weaknesses opportunistically and to conduct anti cyclical investments.”

“Moreover, due to its neutral correlation to other asset classes, liquidity represents a good opportunity to stabilise the portfolio throughout difficult market phases. At Berenberg, we divide liquidity as an asset class into money market investments and transaction liquidity, which in turn will be differentiated according to the respective currencies,” he adds.

In contrast, for Carsten Mumm, head of Asset Management at Donner & Reuschel, increasing cash is predominantly a symptom of a more bearish outlook on equities.

“Having already significantly reduced out equity exposure since the summer of 2015, we cut our equity exposure within the first trading week of 2016 in two steps from 50% to 0%”

“The reason for the reduction were responses in our asset allocation model, which includes data on fundamentals as well as trend indicators in particular, the model has been applied successfully within our business since years.”

“At the moment, 60% of our equity allocation is parked in liquidity investments. In practice, this means that it is being held in night deposits of partner bank,” he adds.
He is now also considering shift at least some of his cash investments into money market funds, which showed a positive performance throughout 2015.

There is of course a paradox between deposit rates turning increasingly negative and investors parking cash, with a key explanation being that retail banks have so far avoided passing on negative rates to their clients. Reichel explains: “For one, parking liquidity through money market funds might be more affordable than the penalty interest an investor would have to pay to banks and indirectly to the ECB.

“Moreover, client restrictions limit direct liquidity management through issuers or custodians due to diversification concerns. Money market funds therefore remain a popular alternative. “The higher the penalty interest imposed by the ECB, the more challenging the environment for euro denominated cash investments.”

Consequently, the Bank for International Settlements (BIS) noted in its March 2016 Quarterly Review that a failure of negative rates to translate into a lending boost to real economy raised the question about what the rationale for negative rates was in the first place.

Liquidity comes at a price, as the BIS warns. Eurozone money market funds have so far managed to circumvent liquidity constraints by increasing the risk levels and lengthening the maturity of their assets, whether this is sustainable remains to be seen.

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