Over the past couple of years, negative yields and a high opportunity cost steered us away from cash. But, the world is changing because, says Wouter Sturkenboom, Senior Investment Strategist at Russell Investments
Disliking cash was easy…
In a world of dovish central bank policy, it was easy to dislike cash. After all, central banks clearly signaled yields were going to stay low for a prolonged period of time and simultaneously increased inflation expectations. As a result, investors in cash in developed markets were confronted with a long period of deeply negative real yields.
Attractive valuations in other asset classes made disliking cash all the more reasonable. Further, with the wall of liquidity coming from central banks, the expectation was that volatility in financial markets would fall and stay low, so the element of optionality imbedded in cash meant you had the option to buy something once you consider it attractive.
It is really an extension of Buffett’s famous adage that you know who is swimming naked when the tide goes out. Cash is like a swimsuit. However, if you expect volatility in financial markets to fall that option value decreases and the swimsuit is merely bothersome while the tide keeps coming in.
… but now, liking cash is also easy
Looking ahead, there are a number of reasons to be positive about cash. Although real yields are still negative, they have been rising over the course of 2014, mostly a result of falling inflation on the back of lower commodity prices. We expect this to continue in 2015 when we anticipate the Fed and BoE will begin to raise interest rates, likely in Q2.
Secondly, the opportunity cost of holding cash has decreased notably over the past few years as valuations in everything from equities to corporate bonds, real estate and government bonds have increased. All of these asset classes have low to negative expected returns, making cash almost painless to hold from an opportunity cost perspective.
Finally, with the wave of central bank liquidity dissipating now that the Fed has ended its programme of quantitative easing, we expect volatility in financial markets to rise. The ECB looks ready to partially pick up the mantle but it won’t fully compensate for the Fed’s exit; we expect heightened risk awareness around the first couple of rate hikes.
In such an environment, the option value of cash is very attractive as it allows the dynamic management of an investment portfolio. 2015 is a year in which we expect having a swimsuit will come in very handy.
The continued fall in commodity prices might delay Fed and BoE rate hikes, making cash particularly useful, though given the US and UK are slowly running out of non-inflationary growth potential, any delay is unlikely to last beyond a quarter or two.