Where to look for opportunities when ‘cash is king’

The Multi Asset team frequently risk test their portfolios against a scenario in which ‘cash is king’ with bonds and equities providing no diversification. Fund manager Dave Jubb underlines why the risks of this becoming reality are higher now than in the last 20 years.

‘Cash is king’ is a scenario in which there is no diversification between equities and bonds. While it doesn’t happen too often our calculations show that the risk is as high as it has been in the last 20 years – so it’s probably not a good time to ignore it and just hope for the best.

Bonds generally respond positively to economic weakness while equities prefer strength. The charts below display that relationship – they show that six-month changes in each market have a stable relationship with six-month changes in Purchasing Managers indices (PMIs). These indices provide a measure of the prevailing direction of economic trends in the manufacturing and service sectors. Here, we’ve used the median value of 43 countries to get a global perspective.

During the summer, we believe bond yields over-reacted to weakening economies and perceived trade issues – the US 30-year Treasury yield briefly reached 1.90% on 28th August, a big move from 3.45% in the final quarter of 2018, according to Bloomberg.

There are three ways the relationship in the left-hand chart above can come back into line - rising bond yields, weaker PMIs or nothing much happening for six months. Since the summer, bond yields have risen a small amount (the US 30-year treasury yield is currently 2.2%, as at 11th December 2019) and PMIs have been subdued (at just below 50).

A further rise in yields to 2.6% would bring the market back into alignment with the PMIs and, in the process, give us close to a 50% retracement of the rally over the last year – not unusual even in an ongoing bull market.

So, even if you have a bearish view of the global economy, you might not want to own too much outright bond duration – at least for a few more months.

At the same time, the implications of a continued sell-off in bonds should also hint at caution on equities. If the future earnings stream of equities improves with a strong economy, the value of those earnings can also increase if bond yields fall. This latter driver explains why 2019 equity performance is running ahead of the PMIs.

However, as the chart below shows, a move higher in yields can also shift the normal diversifying relationship between bonds and equities to one where they can both lose money at the same time.

A sharp change in yields (dark blue, lhs) such as we saw in 2013 or 2016 is typically more powerful than any change in growth expectations and will cause the correlation between bond yields and equities (light blue, rhs) to flip from positive to negative (the scale is inverted) – this scenario where there is no diversification is what we “cash is king”.

Even without a further bond sell-off, equities are probably running ahead of economic conditions – a global equity index fall of 12% would bring it into line with the PMIs – but a bond sell-off would make that outcome much more likely.

While there is a heightened threat of a ‘cash is king’ scenario becoming reality and we are seeing increasingly rich valuations (on both equities and bonds), we believe it is prudent to find investment ideas in other areas. For example, while we wait for more attractive levels in the major asset classes, we think there are many opportunities to generate positive returns in relative value equity, bonds and currencies in our two- to three-year investment horizon.