Royal Cash and Limited Convictions
Markets are less volatile than two weeks ago. There have not been any more bank failures. Bond yields are low, and stocks are up on the month and the year. Yet conviction is absent. For every bull, there is a bear. On the positive side, there is no recession and nominal GDP continues to grow strongly. On the negative side, the legacy of years of quantitative easing (QE) and the COVID-19 shock means the global economy has potential to surprise. On balance, recent events have highlighted the risks, but have also shown that authorities have tools to deal with these issues. This might all just tip the odds in favour of markets continuing to grind out positive returns, as they have done so already in 2023. And there is a lot of cash to buy dips.
Cash is king
Current macro uncertainties and concerns about financial stability continue to undermine investor sentiment. It seems like we are in a ‘cash is king’ environment. Parts of the financial markets where there is value – like in credit – have had the outlook tarnished by the potential for more bank-related volatility and a tighter credit environment. For non-US equity markets, where there are cheap stocks, the global earnings outlook and the correlation to an expensive US market are key considerations. For the US stock market itself, the renewed defensive characteristics of quality growth have pushed valuations higher again. There are some great long-term themes, but the near-term earnings outlook is problematic. More than anything, there is no consensus on where markets go next.
The cash is king phenomenon reflects the relative attractiveness of interest rates on low-risk assets. Yields on US three-month Treasury bills stand at around 4.4%. For euro-denominated Treasury bills the yield is 3.0%. The Livret A savings product in France offers an interest rate of 3.0%. Other than on exceptionally large deposits, banks are not paying rates anywhere near these on regular savings accounts. In the US market, banks’ certificates of deposit (CD) offer a range of rates, depending, I guess, on how needy banks are for deposits. Selected CD rates are above 5%. These securities constitute part of the asset base of money market funds. This is a sector that has attracted huge inflows in the last couple of years.
Banks to funds
It is always tempting to try and simplify what generates flows between bank accounts, cash-like instruments, and other investment assets. Yet we can observe a general decline in the level of bank deposits in the US and a rise in the assets of money market funds. Liquidity was boosted during COVID-19 with bank deposits and money market funds rising. As rates started to rise and the Federal Reserve (Fed) stopped adding bank reserves to the system, deposits peaked and started to steadily decline. These trends have accelerated recently with deposit flight out of small banks in the US. The amount of cash in money market funds has continued to rise.
Rates up, money market assets up
The Investment Company Institute (ICI) in the US provides historical and current data on money market funds. The data series is available on Bloomberg for those with access to a terminal (MMFA Index). Flows into money markets have accelerated with higher rates on Treasury bills and other short-term securities. That is understandable in the current environment and especially with confidence in banks undermined by recent events. Yet looking at the longer-term picture it is interesting to see how these assets fluctuate during the business cycle. Money market funds tend to correlate to the interest rate cycle but tend to peak in size once the Fed has already embarked on rate cutting. As an indicator of risk sentiment, they also tend to peak around the time the stock market bottoms. That was the case in 2002 and 2008 and, more locally, during the COVID-19 drop in stock prices.
Ready to buy?
The inference here is that all the cash sitting in money market funds will not finance purchases of risky assets until the Fed Funds Rate has passed its peak and the equity market falls to lower levels. Both fit a recession scenario with the Fed cutting into the recession but stocks bottoming out only when the Fed has made significant cuts in rates. Only then will lower interest rates and cheaper equity levels encourage holders of cash to dump their money market fund shares and buy equities again. This maybe cash constitutes support for a ‘buy on dips’ strategy as well.
Bonds and equities are trading towards the more bullish frontier of the trading ranges that have been in place since last October. I am sure that many people are surprised by the resiliency of returns when rates have continued to rise, the inflation and growth outlook is still far from ideal and there has just been a major shudder through the global financial system. The counter-argument would rest on data showing the global economy to be more resilient than we thought, on China moving back to stronger economic growth, and on the markets playing a game of chicken with the central banks. The Fed is losing that one now with the market pricing in at least 50 basis points of cuts this year. The second quarter of the year tends to be positive for US equities, with the S&P 500 index delivering positive returns in 12 out of the last 20 years. Whether returns will be positive this year is, as they say, data dependent.
Legacies of abnormality
A few weeks ago I wrote a piece and did a couple of client presentations around the idea that this cycle was not normal. The effects of years of QE and zero interest rates culminating with the huge disruptions from COVID-19 have led us to where we are – the other side of an inflation and interest rate shock. We hope that the adjustments in 2022 were enough and things can normalise but even today there are legacies from years of excessive liquidity growth. One of these is that nominal GDP growth has been strong. According to Bloomberg data, nominal GDP grew by 20% over 2021 and 2022. The total amount of money sitting in money market funds is not unusual when seen as a percentage of nominal GDP. The level of earnings per share is not unusual either when seen in the context of what has happened to nominal GDP. Earnings season starts soon and will be critical in suggesting how much further earnings are likely to correct. If nominal GDP keeps rising strongly, the earnings recession might be limited.
Back to the inflation data
It remains an environment in which it is hard to have strong views. Our fixed income team just completed its quarterly strategy review. The conclusion is an expectation that government bond yields range trade, credit spreads remain wide, and carry strategies are the most attractive. To be bullish, and to see the S&P break out to the upside and 10-year yields to break lower than 3.5% in the US, we need to put faith in a positive market reaction to headline inflation moving decisively lower in the second quarter and the Fed moving to a pause.
Let’s see how things play out. I am taking a break for a couple of weeks over Easter and will be back on 27 April