The last few months have seen a significant change in the macroeconomic environment and the market debate has shifted from “how many more rate hikes?”, to “when (and how aggressively) will central banks cut rates?”
In December 2023, the US Federal Reserve’s latest dot plot (the interest rate projections of individual Federal Open Market Committee [FOMC] members) showed 75 basis points (bps) of cuts in 2024 and a further 100bps of cuts in 2025. While week-to-week we see volatility around market expectations for inflation and interest rates, the Fed and many other central banks have clearly signalled an intent to bring rates down over the next few years.
Historically, these pivots in monetary policy have significantly impacted market returns and, as such, warrant a rethink of investors’ defensive allocations.
A striking asset allocation trend over the last few years has been a significant build-up of investors’ cash balances. US money market fund assets have doubled since pre-COVID days to reach almost US$6 trillion today; if term deposits and other cash alternatives are also included, the number would be even higher. And this is not just a US trend. Many other countries around the world have also seen large increases in the allocation to cash.
A mountain of cash sitting on the sidelines
Money market holdings have reached record levels
Data as at 31 December 2023. Sources: Capital Group, Bloomberg, Investment Company Institute (ICI). Time lengths for “Global Financial Crisis” and “Pandemic” are approximations.
In the right circumstances, outsized cash allocations can serve as an effective defensive ballast in portfolios and the heightened volatility of 2022 illustrated this well. Then, both equity and fixed income markets simultaneously delivered negative returns (for the first time in almost five decades) and cash stood out as the rare asset class that delivered positive returns.
But with the macro backdrop having changed significantly, investors should be asking themselves whether this large build-up of cash still makes sense. As inflation eases and central banks move toward rate cuts, the benefits of maintaining such high allocations to cash may be diminishing. On the other hand, high-quality bonds can provide that ballast, while also seeing stronger returns as bond prices rise with falling rates. In other words, this is an environment where it may make sense to shift back toward a more traditional defensive bond allocation.
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