Why cash isn’t king

“While temporarily worthwhile, holding cash tends to be less rewarding than a diversified portfolio.”

Cash and cash equivalents have been performing well over the past two years. Better than a diversified portfolio allocated to both equities and bonds (sections in grey correspond to cash faring better than a diversified portfolio) in an environment where there were few places to hide as the worst bear market in fixed income markets continued to unfold¹. This phenomenon has possibly contributed to the success of the recent tapping of domestic savings by European governments². While in hindsight holding cash has been temporarily more rewarding that holding bonds and equities, looking in the rear view mirror has seldom been the best guide for future returns.

A cash portfolio does provide a most welcome safe haven, notably at times of stagflationnary³ concerns. Yet timing is a difficult exercise. History suggests that investors are better off being invested in a diversified portfolio allocating to both equities and bonds, even when cash and cash equivalents are displaying yields as high or higher than equity risk premiums, corporate bonds yields or longer dated bonds.

Locking in 4% in EUR terms (or 5% in USD) by holding cash like instruments can be tempting. Yet rational investors should seek to look beyond the conspicuous and indisputable carry⁴ offered by such short-term instruments. After all, if it is yield one is seeking, some more compelling opportunities can be found in different market segments and asset classes.

In fixed income assets one can seek to capture both the yield component and the price component. Especially as reinvestment risk⁵ is a reality in an environment where both the European Central Bank (ECB) and the Federal Reserve (FED) are likely done with their hiking cycle. As such, one can secure the benefits of both an attractive yield today and lower bond yields down the line (which all else being equal, has a positive impact on the prices of such instruments).

In equity markets, bracing for tougher times ahead means debating whether this will take the form of a slower growth environment or a stagflationnary environment, where inflation surprises more on the upside than growth surprises on the down side. Beyond the delicate art of timing, the best suited approach to such a conundrum is the so-called “barbell”, investing in both stocks and sectors⁶ which would benefit from more persistent inflation and/or more stimulus from China, as well as in defensive sectors or stocks⁷.

In any case cash does not appear to be the whole answer. Rather cash can play the helpful role in reducing short-term risk and allows for speedy reallocation of investments towards the most promising side of the barbell, when the environment becomes more readable.