Cash is not usually part of the asset allocation mix for long-term investors willing to take on a fair amount of investment risk.
Volatility is usually baked in to long-term investment assumptions, and long-term investors should expect to encounter some periods when equities or bonds, and sometimes both, fall in value.
The long-term cost of missed equity returns is usually sufficient for cash to remain an unused option in the asset allocators toolkit.
There are, however, some circumstances when allocating to cash or defensive alternative assets is appropriate – even for investors willing to take on a lot of volatility in the pursuit of their long-term goals.
Ken Griffin, founder of hedge fund Citadel, recently said that with the benefit of hindsight, cash would have been the best option to manage the volatility seen after US president Donald Trump shocked markets by announcing a 10% base tariff on almost all US goods imports, and additional tariffs of up to 50% on countries with significant trade deficits with the US.
Returns from money market funds over the last two years have been very good
In a recent interview with Bloomberg, Griffin said the current environment has made it very difficult for fundamental stock analysis, as company valuations are being driven by rapidly changing US government policy.
“In retrospect, holding cash would have been the best way to navigate this,” was Griffin’s suggestion for the best way to navigate the market turmoil in April.
Looking at recent performance, an allocation to cash would have helped dampen the market gyrations considerably, as US treasuries were caught up in the general equity sell-off.
There is a similar picture for the UK, as gilts tracked the decline of US treasuries in the first half of April when confusion over US tariffs was at its most severe.
Returns from money market funds over the last two years have been very good as high interest rates combined with inflation falling back towards target.
Despite UK CPI rising to 3.6% and the Bank of England cutting interest rates twice this year, money market funds continue to yield more than inflation – although that may not hold for much longer if the Bank cuts rates further.
However, for long-term investors the threat of inflation is less of a concern than the potential for missing out on equity market returns when it comes to considering an allocation to cash.
It is easy to criticise Griffin’s slightly flippant solution to recent market turbulence by pointing out that that anyone can be right in hindsight.
However, there is a good case for an allocation to cash, even just a small exposure to dampen volatility in a portfolio in the short term.
Investors say inflation still poses biggest risk to portfolio performance
The US government under Trump is very different from a typical presidency. Decision making is much more centralised on the president and, because it is not driven by long-held political beliefs or set out in a manifesto, it can and does change frequently and unpredictably.
Trump’s approach to governing in his second term has seen him take a much more robust approach where he appears much less likely to seek consensus, even within the Republican party, before setting out on a course of action.
This approach makes it both more likely that Trump will embark on an unconventional policy and also that policies will be abandoned or reversed if they experience considerable push-back.
However, even if changes in policy are hard to predict, Trump is unlikely to change the nature of his government and this means rapid and unpredictable changes in policy are likely to continue to be a feature of his administration.
In the short-term, there are a number of identifiable risks that investors should consider
Markets have seen a number of dramatic short-term moves in the last few years, including this April’s tariff shock, and last September’s round-trip for Japanese equities. Further policy shocks are likely to trigger more big market movements.
In the short-term, there are a number of identifiable risks that investors should consider.
Tariffs remain an important issue for markets. With the US involved in many bilateral trade discussions and the most punitive tariff rates only suspended for 90 days, there is the potential for US tariffs to change dramatically in the coming weeks.
This remains a risk for equity markets, primarily the US, as if this policy continues to be poorly implemented there, risk of recession is not insignificant.
Even without the return of the higher tariff rates, a 10% base level tariff has the potential to hit corporate earnings. But the S&P 500 Index is back to pre-April levels, despite pre-existing concerns about the valuations placed on some companies.
Government debt is also a pressing issue for investors. The passage of the latest tax bill in Congress raises concerns about whether the US government deficit is sustainable.
This is currently running at around 6% of GDP but the tax bill will require significant additional government borrowing if new tax cuts are passed by Congress, without any reduction in government spending.
The combination of factors set out above means that a small allocation to the money market, or defensive absolute return strategies, is prudent for many investors – even those with the longest time horizon, at least until some of the short-term uncertainty is resolved.
Charles Younes is deputy chief investment officer at FE Investments
