For more than a decade during the ultra-low interest rate period after the 2008 financial crisis, it was incredibly challenging for investors with a low tolerance for risk to find compelling sources of returns.
However, this environment turned on its head about two years ago, as central banks were forced to continuously hike rates to combat the return of inflation. For example, from December 2021 to August 2023, the Bank of England raised interest rates from 0.1% to 5.25%, with other central banks following the same pattern.
As a result, low-risk investors have been served well by cash, especially considering the outperformance of cash relative to conservative fixed income assets. The last time cash witnessed sustained outperformance over bonds was during the aforementioned global financial crisis. Back then, the reversal of fortune for bonds came at about the peak in interest rates.
Cash is still king for many investors today, but we could be on the cusp of a similar turning point, as the market expects central banks to begin reducing rates in the coming months as inflation continues to moderate amid sluggish economic growth.
Should investors continue to lock up their deposits for an extended period, there is a risk they will miss out on attractive entry points to reallocate into fixed income solutions better suited to delivering positive real returns during the next phase of the market.
We expect cash-heavy investors to increasingly look to optimise their asset allocation in the weeks and months ahead, but careful consideration will be required during this reallocation process, as fixed income offers a wide range of risk and return options.
Below, we explore the three likely economic scenarios we are likely to witness over the remainder of 2024, as well as the allocations best placed to capitalise.
1. Positioning for continued economic growth
The first scenario – which, in our view, is the least likely of the three – is where economic growth remains positive, with inflation moderating and rates staying near current levels. If this eventuates, cash will likely remain the holding of choice for investors with a low tolerance for risk, as conservative bond securities would likely underperform.
In order to be tempted to reallocate from cash, investors would need to move towards the high yield credit market, which should remain relatively attractive as economies continue to expand. Crossover solutions, which straddle the high yield and investment grade credit segments, are another way of capturing higher returns without committing so heavily to lower-rated bonds.
2. Assets able to negotiate mild recession
The second scenario is a mild recession, where economic growth and inflation continue to fall, and central banks look to cut interest rates. Here, falling interest rates will negatively impact the returns offered by cash deposits. While bond yields will also decline, the capital gains achieved by these securities will compensate for the loss of income. In such a scenario, bonds will outperform cash, but bond selection will be important.
The high yield segment of the market could come under increased pressure during a mild recession, so investors may find a better risk-return balance in crossover solutions. For more conservative investors, investment grade bonds will likely be the destination of choice. Falling rates will drive performance at the longer end of the yield curve, so investors should focus on higher-duration strategies.
3. Seek quality amid a severe downturn
The third scenario is a more severe recession, with sharper falls in economic growth, inflation and interest rates. Similar to the mild recession scenario, while yields for both cash and fixed income will decline, bond prices will go up – especially longer-dated securities – and this will offset the falling yields. Again, bond returns will likely outperform cash.
As for the bonds to hold during a deeper recession, longer duration and higher quality assets are likely to witness accelerating investor demand. Safer haven securities are typically sovereign debt, covered bonds and top-rated corporate credit.
Fabio Angelini is senior investment specialist at Nordea Asset Management
