For a professional equity investor, holding cash can be tough for a number of reasons – financial in nature, but also psychological. The deliberate decision to hold elevated levels of cash is regarded by many as an asset allocation outcome that is not even within the remit of the long-only equity fund manager. Since we are paid to manage equity portfolios, we should only invest in equities, or so the argument goes. On the other hand, cash is the default (indeed, the only) option for long-term investors that do not want to commit capital to prospective ideas where there is little or no value.
It is our belief that preservation of capital should take precedence in the decision of whether or not to hold elevated levels of cash in a portfolio, even if that means incurring a potential opportunity cost in the short-term. Not retaining the option to make this decision is surely one small step down the road to indexing, specifically the idea that one feels compelled to buy stocks for a reason other than the fundamental attractiveness of their investment case.
Allocation to cash is a tactical option for the value-conscious investor, and there are currently three principal drivers behind this.
The first reason for our cautious approach is US valuations. Not a reason per se to hold cash, but a reason to allocate away from the US market, and at the very least consider your market exposures. This is largely because the US market makes up over 50% of global equity benchmarks, such as the MSCI World index. While allocating to other, less inflated markets might mitigate any potential drawdown to some degree, cash would do a better job in this regard. US equities might be poised to deliver only very low single-digit returns over a 7 to 10-year period and other markets should be capable of more than that. Median valuations are in many cases even more elevated.
The credit cycle is critical in determining the direction of the overall economic cycle. Ebbs and flows in the availability as well as the price of credit are intuitively obvious causal factors in the gyrations of the business cycle. As an equity investor, it generally pays to believe that credit markets are more likely to ‘get it right’ than equity markets. This makes the latest move in US high yield spreads of particular note. Crucially, these moves were not just confined to speculative energy companies in the US. Overall rates are still very low by historic standards, but what is a notable break of the downtrend in the spread relative to the US 10-year benchmark is suggestive of a decline in risk tolerance across the market and should be closely monitored.
The economic cycle is the subject of countless debate, lately mostly in the context of ‘lift-off’ and ‘escape velocity’. It can be defined in a myriad of ways, but the inventory cycle is as good an indicator of where the economy is in terms of current output – and confidence about future output – as any other. What is evident is that while inventory is still being added at a healthy rate across the US economy as a whole, we are very probably nearing a cyclical peak. Mid-cycle drawdowns are evident in most cycles, and in this case that would correspond to the 2011/12 period. Inventory drawdowns are generally sudden and destabilising for participants, and needless to say not positive for markets as a whole.
The modest correction we have seen in US equity markets recently is therefore not entirely unexpected, but has not changed the big picture much, representing less than a 10% drawdown at the time of writing. What that means is that the balance of risk is still stacked considerably against investors in the US market right now, and hence we remain underweight the US equity market. In this environment, cash holds a vital role in not only being able to navigate potential turbulence with less impact on capital, but also in actually being able to take advantage of opportunities that present themselves along the way.