Risk Beats Cash

Risk Beats Cash
From Chris Iggo, Chief Investment Officer, Core Investments, AXA Investment Managers.

It’s been difficult for investors to move away from cash. However, the days of high cash returns are numbered. Rate cuts are back on the agenda. Fixed income credit strategies are more attractive than cash with short duration being the least risky step out of bank deposits. But everything is doing well. Rate hike and war risks have diminished and the soft landing scenario for the US economy is on track. Be patient and stay invested.

If the US economy avoids a hard landing, equities should continue to outperform bonds. We are not in a recession. The soft landing scenario is very much priced in and for the US at least, the data suggests it might be the softest of soft landings. The recession – if there is to be one – is delayed. Interest rates might have peaked but a long plateau could be ahead of us.

​Cover those shorts

​Risk has been rewarded in May after April’s market stumble. Long duration fixed income has had a good month and some equity indices are at new highs. Concerns about geopolitical and monetary tightening risks have receded. Indeed, upbeat data and central bank rhetoric has seen confidence on the likelihood of seeing interest rate cuts this year rise once again. Even so-called meme stock trading is back. US day traders have been targeting heavily shorted stocks in order to provoke short-covering rallies and benefit from big price gains. Look at the share price of Faraday Future Intelligent Electric, a Nasdaq-traded electric vehicle manufacturer (up 1,300% in two trading days this week). It has been one of the most shorted stocks in the market. Meme trading, long duration, risk-on equities.​

Flaming June

​Central banker messaging has also been helpful. US Federal Reserve (Fed) officials have dismissed the need for higher rates. Meanwhile European Central Bank (ECB) policymakers have steered markets to expect a rate cut in June. The Bank of England (BoE) has been less explicit but recent comments from Governor Andrew Bailey are consistent with the Bank also starting to cut rates next month. Markets are now pricing in two Fed cuts, and slightly more than two cuts from both the ECB and BoE before the end of the year.

​Also read: Inflation Still On The Bumpy Path

This Goldilocks outlook is positive for markets. I doubt the backdrop will always seem as benign as it has in recent weeks but for now the risk rally looks set to continue to the benefit from credit and equity investors. Rates to ease, growth modest but positive and inflation generally moving lower.

Yield can equal return

​For fixed income investors, the current outlook is beneficial to a broad exposure to credit, including high yield. Credit spreads may be towards the tightest levels of recent years but the total yield for credit strategies is attractive.

​Curves to move, but slowly

​The duration call from here is interesting. Rates are at their peak and the risk of additional rate hikes has disappeared for now. That should mean long-term rates (10-year government bond yields) are not likely to move materially higher than the range in which they have been trading this year. Thus, a long-duration stance is less risky today than it has been. This is reflected in short-term performance with long dated US Treasuries being the strongest performing fixed income asset this month.

​However, long-term yields are unlikely to move materially lower either. Inflation remains above target and monetary easing will come slowly.

Credit just looks good

Looking at those same maturity buckets in credit markets provides a slightly different story. Over the last decade in the US, longer duration credit has outperformed short duration credit. Unlike the Treasury market, the credit curve has tended to be positively sloped most of the time, so longer duration returns benefit from higher yield (carry). In euro and sterling markets, shorter duration credit strategies outperformed over three-and-five-year horizons but not over the full 10 years, nor over the last 12 months.

Bonds vs. cash

The case for short duration credit strategies is strongest when compared to cash. Interest rates on cash have peaked and will decline over the next year. When rates are cut, remuneration on cash declines but bond prices rise. So, a short duration credit strategy benefits from having, today, the same yield as overnight cash rates but also the potential for capital gains when rates are cut and, perhaps, from the further modest tightening of credit spreads.

Volatility is low, liquidity is strong…no-one is selling

​I can understand investors that remain with large cash balances being frustrated by having missed a strong equity market rally and having seen credit spreads tighten. At the same time, there are convincing cyclical and secular reasons for investing today or staying invested. Another rate shock has a low probability. The macro backdrop in developed economies is benign. Commodity markets are calm. Equity markets, while making new highs in terms of price, are close to their average valuation levels over the last three years (measured by forward price-to-earnings ratios). It may all be too good to be true, but volatility is low, so it’s cheap to hedge risk exposure – the VIX is at a five-month low, and the crossover credit default swap is at its lowest level since the beginning of 2022. It’s turning out to be a reasonable year.

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 16 May 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.